Internal Revenue Service
Revenue Ruling
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smRev. Rul. 55-73
1955-1 C.B. 236
Sec. 61
Sec. 103
IRS Headnote
Secondary or `Class B' interest coupons which are detached and retained by brokers of certain municipal bonds are considered to be the brokers' commission and do not represent `interest' as that term is generally used. The fair market value of such coupons is includible in gross income of the broker when received. Any gain realized by the broker from the sale of the coupons prior to maturity constitutes ordinary income. Any payments received by the broker from the municipality upon maturity of the coupons in excess of such fair market value previously reported constitute ordinary income.
Full Text
Rev. Rul. 55-73
Advice has been requested whether the proceeds, received by brokers of municipal bonds, of a secondary or `Class B' interest coupon, which is attached to certain municipal bonds handled by such brokers, are excludable from gross income under section 22(b)(4) of the Internal Revenue Code of 1939.
Certain municipal bonds are now issued with two series of coupons attached. `Class A' coupons are sold with the bonds. `Class B' coupons, having an early maturity date, are detached and retained by the brokers. The `B' coupons may be sold at a discount to banks, individuals or other brokers.
As in the orthodox one-coupon series bonds, brokers place bids with the issuing authority on the basis of total interest cost over the life of the issue. One-coupon series bonds are usually sold at a premium which represents the brokers commission. The two coupon series bonds are sold at par, but at a reduced interest rate. The over-all interest cost to the municipality would be the same for both types of bonds. Similarly, the net yield to the investor would be the same.
Example . For purposes of illustration assume that a municipality has for issue one-coupon bonds of $1,000 par value bearing interest at 3 percent maturing 10 years from the date of issue.
One Coupon Two Coupon
Bond Bond
Par value................................ $1000 $1000
Premium representing broker's commission. 20 ----
------ -----
Investor's cost.......................... $1020 $1000
Broker's commission
Cash................................. $20 ---
"B" coupons.......................... --- $20
Interest cost to municipality for life of
bonds
"A" coupons.......................... $300 $280
"B" coupons.......................... --- 20
------- -------
Total interest cost...................... $300 $300
Net yield to investor for life of bonds
Interest on bond...................... $300 $280
Less: Bond premium amortization....... 20 ---
---- ----
Net Yield.......................... $280 $280
The interest rate on a comparable two-coupon bond would be 2.8 percent on the `A' coupons and .2 percent on the `B' coupons maturing 1 year from date of issue.
Section 22(b)(4) of the Code provides generally that interest on obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia is exempt from income tax.
The usual import of the term `interest' is the amount which one has contracted to pay for the use of borrowed money. Old Colony Railroad Co. v. Commissioner , 284 U.S. 552, Ct. D. 456, C.B. XI-1, 274 (1932).
A situation similar to that under consideration here is present in the case of H. Gates Lloyd v. Commissioner , 154 Fed.(2d) 642, certiorari denied, 329 U.S. 717. There, a syndicate would purchase old out-standing bonds, exchange them for new refunding bonds with `A' and `B' coupons attached, detach the `B' coupons, sell the bonds with `A' coupons attached to investors and sell the `B' coupons to a bank at a discount. In holding the proceeds from the `B' coupons to be taxable, the court said in part:
Finally, the Syndicate's money was invested in the City bonds for but an indefinite, short period of time in `an almost simultaneous' operation through which the Syndicate bought and held the new refunding bonds, detached the B coupons and then sold both the bonds and coupons to different purchasers. Obviously, the Syndicate could not have, simultaneously, a return of its capital investment and compensation for the use of such money. Consequently, we cannot conclude logically that the Syndicate received the $647,630.38 as `interest' on the new City bonds.
With respect to the question whether the payment to the taxpayer for services rendered in tax-free bonds, instead of cash money, rendered the income thus received, exempt from taxation, the court, in the case of Joseph G. Hitner v. Lederer , 63 Fed.(2d) 877, said in part:
* * * if the tax was assessed, not upon the medium of payment, but upon income from wages or salary, it follows as a matter of law that the tax was legal. The income of the appellant was taxable and this could not be rendered nontaxable by being paid with tax-free bonds. * * *
Section 39.22(a)-4 of Regulations 118 provides in part as follows:
Notes or other evidences of indebtedness received in payment for services constitute income to the amount of their fair market value. * * *
Under the long established position of the Internal Revenue Service notes and other evidences of indebtedness received in payment for services are includible in gross income to the extent of their fair market (discounted) value.
In view of the above, it is held that the fair market value of the so-called `B' coupons should be included in the gross income of the broker for the taxable year in which such coupons are received. Any gain realized by the broker from the sale of the coupons prior to maturity constitutes ordinary income and is includible in gross income when received. Any payments received by the broker from the municipality upon maturity of the coupons in excess of such fair market value previously reported constitute ordinary income