•

Part I

Section 163.\--Interest

26 CFR 1.163-1: Interest deduction in general.

(Also § 7805(b)(8); 301.7805-1.)

Rev. Rul. 2003-97

ISSUE

Under the facts presented below, if a corporation issues units, each
consisting of instruments in the form of a 5--year note and a 3--year
forward contract to purchase a quantity of the corporation's common
stock, is the "interest" accruing on the note deductible under § 163(a)
of the Internal Revenue Code and not disallowed under § 163(*l*)?

FACTS

On August 18, 2003 ("Issue Date"), [X]{.underline}, a corporation,
issues units, each consisting of instruments in the form of a 3--year
forward contract to purchase a quantity of [X]{.underline}'s common
stock ("Purchase Contract") and a 5--year note issued by [X]{.underline}
("Note") (together, a "Purchase-Contract/Note unit"). The Purchase
Contract requires the holder to purchase, and [X]{.underline} to sell,
on August 18, 2006 ("Settlement Date"), a quantity of [X]{.underline}'s
common stock that is determined by reference to the market price of the
stock on the Settlement Date. The Note has a stated maturity date of
August 18, 2008 ("Maturity Date\").

Under the Purchase Contract, on the Settlement Date the holder must pay
an amount ("Settlement Price") that is equal to the stated principal
amount of the Note. If the market price of [X]{.underline}'s common
stock on the Settlement Date falls within a specific range of market
prices (bounded by a "lower limit" based on the market price on the
Issue Date and an "upper limit" equal to approximately 120 percent of
the lower limit), the quantity of stock deliverable under the Purchase
Contract will have a market value equal to the Settlement Price. If the
market price on the Settlement Date is less than the lower limit or
greater than the upper limit, the quantity of stock that is deliverable
under the Purchase Contract is the quantity that would be deliverable if
the market price on that date were equal to the lower limit or the upper
limit, respectively.

[X]{.underline} allocates the purchase price of a Purchase-Contract/Note
unit between the Purchase Contract and the Note according to their
respective fair market values, as if the Purchase Contract and the Note
were separate instruments. The amount allocated to the Note is equal to
the Note's stated principal amount.

The Note contained in a Purchase-Contract/Note unit is pledged to secure
the holder's obligation to pay the Settlement Price under the Purchase
Contract. As described below, the holder, however, has the legal right
to separate the Note from the Purchase-Contract/Note unit in either of
two ways (producing a "Separated Note"). The holder is not economically
compelled to keep a unit unseparated.

The holder may separate the Note from the Purchase-Contract/Note unit
before the Settlement Date without paying the Settlement Price. To do
so, the holder must transfer the unit to [X]{.underline}'s agent
("Purchase Contract Agent") together with a specific zero-coupon
Treasury security ("Strip"), and then the holder will receive a
"Purchase-Contract/Strip unit" together with the Separated Note (a
"conversion"). The Strip contained in the Purchase-Contract/Strip unit
replaces the Note as collateral. Once a holder has effected a
conversion, the holder may transfer the Note and retain the
Purchase-Contract/Strip unit or transfer the Purchase-Contract/Strip
unit and retain the Note. The Strips mature shortly before the
Settlement Date and pay an amount equal to the Settlement Price. On the
Settlement Date, [X]{.underline} will apply the proceeds from the Strip
contained in any Purchase-Contract/Strip unit to satisfy the holder's
obligation to pay the Settlement Price under the associated Purchase
Contract.

In addition, before the completion of a successful remarketing
(described below), the holder of a Purchase-Contract/Note unit or a
Purchase-Contract/Strip unit may transfer the unit to the Purchase
Contract Agent together with cash in an amount equal to the Settlement
Price and receive a quantity of shares of [X]{.underline}'s common stock
together with the Separated Note or the Strip (a "settlement with
separate cash").

The Note provides for quarterly payments of amounts denominated as
interest, including a payment on the Settlement Date. This interest is
payable at a single fixed rate ("Initial Rate"). The Notes are required
to be remarketed on specific dates before the Settlement Date, including
May 15, 2006, and August 15, 2006 ("Final Remarketing Date"). A
successful remarketing of the Notes generally will result in the sale of
the Notes to new holders effective on the next quarterly interest
payment date (for example, May 18, 2006, and August 18, 2006) and will
establish a new interest rate ("Reset Rate"), which will be effective
after the remarketing for the remaining term of the Notes.

The Note is not subject to optional redemption by [X]{.underline} at any
time. Neither the written terms of the Note nor any other understanding
or agreement requires the Note to be paid in, or converted into,
[X]{.underline}'s stock. Similarly, neither the written terms of the
Note nor any other understanding or agreement grants [X]{.underline} an
option to pay the Note in, or convert the Note into, [X]{.underline}'s
stock.

[X]{.underline} enters into a contract with an investment bank,
[Y]{.underline}, to serve as remarketing agent. [Y]{.underline} will
attempt to remarket the Notes with a Reset Rate that will permit the
Notes to be sold for an amount equal to at least 100 percent of, and up
to a target of 100½ percent of, a specific price ("Minimum Required
Price\"). There is no upper limit on the Reset Rate. For a remarketing
on the Final Remarketing Date, the Minimum Required Price is the
aggregate stated principal amount of the remarketed Notes. For
remarketings before the Final Remarketing Date, the Minimum Required
Price is the amount that could be invested in then-available zero-coupon
Treasury securities ("Treasury Zeros") that mature shortly before the
Settlement Date and pay an amount equal to the sum of the aggregate
stated principal amount of the remarketed Notes, plus the aggregate
interest at the Initial Rate that would have been payable on the Notes
on the Settlement Date if the Notes had not been remarketed.

The remarketings will include all of the Notes contained in
Purchase-Contract/Note units on the remarketing dates. In addition,
holders of Separated Notes may elect to include those Notes in the
remarketings. If a remarketing succeeds, the interest rate on all the
Notes will be changed from the Initial Rate to the Reset Rate for the
remaining term of the Notes, whether or not they were included in the
remarketing.

A remarketing will not occur if a condition precedent to the remarketing
(for example, the existence of an effective registration statement for
the Notes) is not fulfilled. Moreover, even if all conditions are
satisfied and a remarketing does occur, the remarketing will not succeed
if [Y]{.underline} is unable to obtain the Minimum Required Price. (In
either case, the remarketing is said to "fail.") On the Issue Date, it
is substantially certain that a remarketing of the Notes will succeed.

In the case of a Separated Note, if all of the remarketings fail, then,
on the Settlement Date, the holder of the Note will have the right to
put the Note to [X]{.underline} in exchange for cash equal to the Note's
stated principal amount plus any accrued but unpaid interest. If such a
Note is not put to [X]{.underline}, the Initial Rate will remain in
effect for that Note until the Maturity Date.

In the case of a Note contained in a Purchase-Contract/Note unit, if all
of the remarketings fail, [X]{.underline} will exercise its rights as a
secured party to dispose of the Notes in accordance with applicable law
and satisfy in full the holder's obligation to purchase
[X]{.underline}'s common stock under the Purchase Contract. As a result,
the holder will receive the interest payment due on the Settlement Date
and the amount of [X]{.underline}'s common stock deliverable under the
Purchase Contract.

If a remarketing succeeds, the remarketing proceeds (or the proceeds of
the Treasury Zeros in the case of a successful remarketing before the
Final Remarketing Date) must be used by [X]{.underline} in the following
manner. If a Note was part of a Purchase-Contract/Note unit on the date
of the successful remarketing, [X]{.underline} must apply an amount
equal to the stated principal amount of the Note to satisfy the former
holder's obligation to pay the Settlement Price under the associated
Purchase Contract.

In addition, [X]{.underline} must pay the former holder cash in an
amount equal to the interest (at the Initial Rate) that would have been
payable to the holder on the Settlement Date had the Notes not been
remarketed. If the successful remarketing occurs before the Final
Remarketing Date, this amount will be paid out of the proceeds of the
Treasury Zeros. If the successful remarketing occurs on the Final
Remarketing Date, the amount will be paid out of [X]{.underline}'s own
funds. [X]{.underline} will make similar payments to the former holders
of any participating Separated Notes.

[Y]{.underline} will receive a remarketing fee of one quarter of
one percent of the Minimum Required Price. This remarketing fee will be
paid first from the excess, if any, of the remarketing proceeds over the
Minimum Required Price and then, if necessary, by [X]{.underline} from
its own funds. If any proceeds in excess of the Minimum Required Price
are not applied to the remarketing fee (that is, if the proceeds are
between 100¼ percent and 100½ percent of the Minimum Required Price),
these excess proceeds will be distributed to the former holders of the
remarketed Notes (including any participating Separated Notes).

Purchase-Contract/Note units are listed on a national securities
exchange. Purchase-Contract/Strip units and Separated Notes are not so
listed but are freely assignable without restrictions on their
transferability.

The Purchase Contract provides that, in the event of [X]{.underline}'s
bankruptcy, the Purchase Contract will terminate and the associated Note
or Strip will be released to the holder. On the Issue Date,
[X]{.underline} reasonably believes, based on advice from counsel, that
this provision will be enforceable in bankruptcy and will result in the
holder of a Purchase-Contract/Note unit being treated as a creditor in
any bankruptcy proceeding.

Based on the terms of the Note and other facts and circumstances, if the
Note were issued independently of the Purchase Contract in a transaction
that did not link the rights and obligations under the Note with the
rights and obligations under the Purchase Contract, then the Note would
qualify as debt for federal income tax purposes, interest accruing on
the Note would be deductible unless § 163(*l*) applies, and, under
§ 1.1001--3 of the Income Tax Regulations, the Note in existence before
a successful remarketing would continue to exist after the remarketing.
That is, the Note would not be treated as having been retired in
conjunction with the issuance of a new debt instrument that bears an
interest rate equal to the Reset Rate.

LAW AND ANALYSIS

As stated above, the Note would qualify as debt for federal income tax
purposes if it were issued independently of the Purchase Contract in a
transaction that did not link the rights and obligations under the Note
with the rights and obligations under the Purchase Contract. Upon the
earlier of a conversion, a settlement with separate cash, or a
successful remarketing of the Note, the Note will no longer be linked
with the Purchase Contract. At that time, the Note will qualify as debt
for federal income tax purposes. Interest accruing on the Note after
that time will be deductible under § 163(a).

On the other hand, during the time that the Note is contained in a
Purchase-Contract/Note unit, there is an issue of whether the bundle of
rights and obligations resulting from the unit should be treated for
federal income tax purposes as consisting of a debt instrument and a
stock purchase contract. An important initial inquiry bearing on whether
the Note may be separately analyzed for federal income tax purposes is
whether the Note is separable from the Purchase-Contract/Note unit. Even
if the Note is separable, however, various features of the Note and
Purchase Contract raise the possibility that, for federal income tax
purposes, the Purchase-Contract/Note unit nevertheless is treated as
some other combination of instruments. For example, a
Purchase-Contract/Note unit could be treated as a prepaid forward
contract to purchase a variable quantity of [X]{.underline}'s stock
together with options (1) to acquire a Note by tendering a Strip to be
combined into a Purchase-Contract/Strip unit or (2) to purchase a Note
for cash by settling the forward contract early, together with a
commitment by [X]{.underline} to issue new Notes in the context of a
"remarketing."

The correct characterization for federal income tax purposes of a
transaction creating multiple rights and obligations depends on the
facts and circumstances of the particular transaction. In deciding among
multiple potential characterizations, the tax law seeks to find the best
match between the bundle of rights and obligations and one or more
categories of widely recognized instruments. In the instant case, the
form chosen for the components of the unit reflects one reasonable
division of the bundle of rights and obligations in the unit.
Consequently, it is appropriate to begin the analysis of the issuer's
tax consequences with respect to the unit by treating the unit as
comprising these two components---namely, the Note and the Purchase
Contract.

After the Note has been identified as one of the components of the
Purchase-Contract/Note unit, determining whether [X]{.underline} may
deduct the amounts identified as interest on the Note contained in the
Purchase-Contract/Note unit involves a multi-step analysis:

-   Is the Note separable from the associated Purchase Contract?

-   If the Note is separable from the Purchase Contract but is not in
    fact separated from the Purchase Contract, does the Note qualify as
    debt?

-   If the Note qualifies as debt, does § 163(*l*) prevent
    [X]{.underline} from deducting the interest that accrues on the
    Note?

**[Is the Note separable from the associated Purchase
Contract]{.underline}?**

Two factors are particularly important in analyzing whether the Note
should be treated as separable from the Purchase Contract: whether the
Purchase Contract and Note are separately transferable, and whether any
factors (economic or otherwise) prevent the holder from effecting such a
separate transfer.

*Separate Transferability*

Rev. Rul. 88--31, 1988--1 C.B. 302, holds that a share of common stock
and a contingent payment right issued together as an investment unit are
separate items of property for federal income tax purposes because they
are separately tradable on a national securities exchange shortly after
issuance. Similarly, in cases involving bond-warrant investment units in
which the bond and warrant were separately tradable, several courts have
stated in dicta that, because of the potential for separate trading, the
bond and warrant were properly treated as separate instruments.
[See]{.underline} [Chock Full O'Nuts Corp. v. United
States]{.underline}, 453 F.2d 300 (2d Cir. 1971); [Hunt Foods and
Industries, Inc. v. Commissioner]{.underline}, 57 T.C. 633 (1972). In
contrast, when financial instruments cannot be separately traded, the
courts have generally treated them as a single instrument.
[See]{.underline} [Universal Castings Corp. v.
Commissioner]{.underline}, 37 T.C. 107 (1961) (finding that a
corporation\'s notes were "locked" to its stock by a shareholders'
agreement so that neither the note nor the stock could be sold without
the other, and therefore holding that the notes and stock constituted a
"single investment" and the notes did not qualify as debt),
[aff'd]{.underline}, 303 F.2d 620 (7th Cir. 1962). [Cf]{.underline}. [De
Coppet v. Commissioner]{.underline}, 38 B.T.A. 1381 (1938) (finding that
an investment corporation's stock was "stapled" to a bank's stock
through a trust arrangement so that neither could be sold without the
other, and therefore holding that no part of the basis of the
taxpayer\'s stapled stock could be recognized as a loss when the stock
of the investment corporation became worthless), [aff'd]{.underline},
108 F.2d 787 (2d Cir.), [cert. denied]{.underline}, 310 U.S. 646 (1940).
These authorities indicate that, unless a holder has a legal right to
separate linked instruments, they generally cannot be considered
separable.

*Economic Compulsion*

The existence of a mere legal right to separate is insufficient for the
Note and Purchase Contract to be considered separable. If the
characterization of an instrument or a transaction for federal income
tax purposes either depends on, or could be affected by, the existence
of a person's legal right or option to elect a certain course of action,
the tax consequences often depend on whether the exercise (or
nonexercise) of the right or option is economically compelled based on
all the facts and circumstances. [See]{.underline} [American Realty
Trust v. United States]{.underline}, 498 F.2d 1194, 1199 (4th Cir. 1974)
(upholding a verdict that a transaction was a good-faith sale and
lease-back with a repurchase option, in part because the seller was not
under "economic compulsion" to exercise the option); [Roberts v.
Commissioner]{.underline}, 71 T.C. 311, 323 (1978) (holding that a trust
was not a mere conduit used by the taxpayer to obtain installment sale
treatment under § 453 for a stock sale, in part because the trustees
were under "no legal commitment or economic compulsion" to resell the
stock when they did), [aff'd]{.underline}, 643 F.2d 654 (9^th^ Cir.
1981); Rev. Rul. 2003--7, 2003--5 I.R.B. 363 (holding that a
collateralized forward contract to sell stock is not a current sale if
the shareholder is not economically compelled to deliver the pledged
shares); [see also]{.underline} [Comtel Corp. v.
Commissioner]{.underline}, 45 T.C. 294, 307 (1965) (arrangement for
stock purchase and subsequent sale of stock pursuant to an "option" was
characterized as in substance a financing arrangement, in part because
the Court concluded, after evaluation of the economic terms of the
transaction, that taxpayer was "practically compelled" to exercise the
option), [aff'd]{.underline}, 376 F.2d 791, 796 (2d Cir.) (rejecting
taxpayer's argument that it was not "economically compelled" to exercise
the option), [cert. denied]{.underline}, 389 U.S. 929 (1967);
[cf]{.underline}. Rev. Rul. 82--150, 1982--2 C.B. 110 (treating the
holder of an option to purchase stock as the current owner because the
holder paid 70 percent of the stock's value for the option and the
strike price of the option was 30 percent of the stock's value).

For a Note to become separated from the Purchase-Contract/Note unit and
transferable separately, one of three events must occur: (1) the holder
effects a conversion, (2) the holder effects a settlement with separate
cash, or (3) a successful remarketing occurs. If all of the remarketings
fail, a Note in a Purchase-Contract/Note unit in effect will be
exchanged on the Settlement Date for the [X]{.underline} stock that is
due to the holder under the Purchase Contract.

Notwithstanding these conditions and possibilities, however, under the
facts stated in this ruling, the holder has the unrestricted legal right
to separate the Note from the Purchase-Contract/Note unit and transfer
the Note separately, and is not economically compelled to keep the unit
unseparated. The need to take certain steps to effect a separation does
not contradict the separateness that can ultimately be achieved. On the
Issue Date, it is substantially certain that the remarketing will
succeed; thus, the consequences of a hypothetical remarketing failure
are not controlling. Accordingly, in light of all the facts and
circumstances, when the Notes and Purchase Contracts were issued they
were separable instruments.

**[If the Note is separable from the Purchase Contract but is not in
fact separated from the Purchase Contract, does the Note qualify as
debt]{.underline}?**

Whether an instrument is debt for federal income tax purposes depends on
the facts and circumstances of each case. No particular fact is
conclusive in making such a determination. [John Kelley Co. v.
Commissioner]{.underline}, 326 U.S. 521 (1946). Among the factors
considered by the courts are (1) whether there is an unconditional
promise to pay a sum certain in money on a specific date, (2) the intent
of the parties, and (3) the holder's right to enforce the payment of
principal and interest. [Bauer v. Commissioner]{.underline}, 748 F.2d
1365, 1368 (9^th^ Cir. 1984); [Estate of Mixon v. United
States]{.underline}, 464 F.2d 394, 402 (5^th^ Cir. 1972); [Gilbert v.
Commissioner]{.underline}, 248 F.2d 399, 402 (2d Cir. 1957); [Litton
Business Systems, Inc. v. Commissioner]{.underline}, 61 T.C. 367, 377
(1973) ("Was there a genuine intention to create a debt, with a
reasonable expectation of repayment, and did that intention comport with
the economic reality of creating a debtor-creditor relationship?"),
[acq]{.underline}., 1974--2 C.B. 3.

In form, the transaction provides for investors to make an initial
payment of money that will be repaid to the holder of a Note upon the
maturity of the Note. Although the Note is pledged as collateral for
satisfaction of the separate Purchase Contract, the payment obligation
under that contract is intended to be satisfied out of the proceeds of
the remarketing of the Note. However, an initial holder is obligated in
all events to acquire [X]{.underline}'s stock and will not itself
receive the principal payment on the Note unless the holder takes action
to separate the Note from the Purchase Contract.

A question is thus presented whether the amount paid by an initial
holder should be characterized as the purchase price for the Note or as
a prepayment on the Purchase Contract, with the actual Notes being
issued by [X]{.underline} only if and when there is a conversion, a
settlement for separate cash, or a successful remarketing. An important
consideration in answering this question is whether the issuance and
acquisition of the units create debt characteristics.

On the one hand, in addition to the conditions necessary to cause a
separation of the Note from the Purchase-Contract/Note unit as described
above, the following factors suggest that the amount paid by a holder to
acquire a unit could be treated simply as a prepayment of the Settlement
Price under the Purchase Contract:

1.  Ownership of a Purchase-Contract/Note unit exposes the holder to no
    risk of loss from a decline in the value of the Note because (i) if
    the Note is sold through a successful remarketing, the holder of a
    Purchase-Contract/Note unit is assured of having on the Settlement
    Date the amount necessary to satisfy the holder's obligation under
    the Purchase Contract; and (ii) if all remarketings fail, the holder
    of a Purchase-Contract/Note unit nevertheless receives the stock the
    acquisition of which is provided for under the Purchase Contract.

2.  Ownership of a Purchase-Contract/Note unit provides the holder
    virtually no opportunity for gain from an increase in the value of
    the Note because the Initial Rate will be reset and the gain to be
    received from a remarketing is limited to 25 basis points.

3.  Absent bankruptcy or the holder's decision to effect a conversion or
    a settlement with separate cash, the holder of a
    Purchase-Contract/Note unit will receive [X]{.underline}'s stock in
    all events under the Purchase Contract and will not receive any
    payments on the Note other than accrued interest and a distribution
    of excess proceeds in the event of a successful remarketing.

4.  Upon a successful remarketing of the Note prior to the Final
    Remarketing Date, the holder will receive on the Settlement Date an
    amount equal to interest at the Initial Rate rather than the amount
    earned on the Treasury Zeros purchased with the proceeds from the
    remarketing.

On the other hand, the form in which the transaction is cast is a debt
instrument, with a term that is substantially certain to last 5 years,
with current interest payments, and with a remarketing that is to occur
no later than 3 years after the Issue Date and that is not considered to
be a reissuance under § 1001.

In addition, the Note has a critical debt characteristic even before the
Note is separated from the Purchase Contract because the Purchase
Contract provides that, in the event of [X]{.underline}'s bankruptcy,
the Purchase Contract will terminate and the associated Note will be
released to the holder; and on the Issue Date, [X]{.underline}
reasonably believes, based on the advice of counsel, that the provision
will be enforceable in bankruptcy and will result in the holders being
treated as creditors in the bankruptcy proceeding. The existence of
these bankruptcy rights is an important debt characteristic.
[See]{.underline} [P.M. Finance Corp. v. Commissioner]{.underline}, 302
F.2d 786, 789--90 (3d Cir. 1962) (describing the right to share with
general creditors in a corporation's assets in the event of dissolution
or liquidation as "a most significant characteristic of the
creditor-debtor relationship"); [Nestlé Holdings, Inc. v.
Commissioner]{.underline}, 94 T.C. 803, 813--14 (1990) (distinguishing
mandatorily redeemable preferred stock from debt in part because
preferred stockholders are always subordinate to creditors in
liquidation).

In this context, the foregoing debt characteristics are sufficient to
cause a Note included in a Purchase Contract/Note unit to be treated as
debt for federal income tax purposes.

**[If the Note qualifies as debt, does § 163(*l*) prevent X from
deducting the interest that accrues on the Note]{.underline}?**

Section 163(*l*)(1) disallows a deduction for any interest paid or
accrued on a "disqualified debt instrument." Section 163(*l*)(2) defines
a "disqualified debt instrument" as indebtedness of a corporation that
is payable in equity of the issuer or a related party. Section
163(*l*)(3) provides that indebtedness shall be treated as "payable in
equity" of the issuer or a related party only if (A) a substantial
amount of the principal or interest is required to be paid in or
converted into, or at the option of the issuer or a related party is
payable in or convertible into, such equity; (B) a substantial amount of
the principal or interest is required to be determined, or at the option
of the issuer or a related party is determined, by reference to the
value of such equity; or (C) the indebtedness is part of an arrangement
that is reasonably expected to result in a transaction described in (A)
or (B). Section 163(*l*)(3) further provides that principal or interest
shall be treated as required to be so paid, converted, or determined if
it may be required at the option of the holder or a related party and
there is a substantial certainty the option will be exercised. The
legislative history of § 163(*l*) states that an instrument is treated
as payable in stock if it is part of an arrangement designed to result
in payment with or by reference to such stock, including certain
issuances of a forward contract in connection with the issuance of debt,
nonrecourse debt that is secured principally by such stock, or certain
debt instruments that are convertible at the holder's option when it is
substantially certain that the right will be exercised.
[See]{.underline} H.R. Conf. Rep. No. 220, 105^th^ Cong., 1^st^ Sess.
523--24 (1997), 1997--4 (Vol. 2) C.B. 1993--94.

All of the interest payments on all of the Notes will be made in cash.
The principal payments on Separated Notes as well as Notes that have
been sold in a remarketing will also be made in cash. Thus, if there is
a successful remarketing, the principal payments on all of the Notes
will be made in cash at the end of the 5--year term. If all of the
remarketings fail, however, [X]{.underline}'s obligation to pay the
stated principal amount of the Notes contained in the
Purchase-Contract/Note units will be offset against the obligation of
the holders to pay the Settlement Price on the Purchase Contracts. In
that case, although the Note contained in a Purchase-Contract/Note unit
technically will be applied in satisfaction of the holder's obligation
to pay the Settlement Price rather than paid in stock, the holder will
effectively receive [X]{.underline}'s stock in satisfaction of the
stated principal amount of the Note. Thus, the Note may be considered to
be "paid in" or "converted into" [X]{.underline}'s stock for purposes of
§ 163(*l*)(3).

Even without either a provision in the written terms of the Notes or any
other understanding or agreement, in certain situations the facts and
circumstances might support a conclusion that the issuance was part of
an arrangement reasonably expected, in effect, to give [X]{.underline}
an option either to repay the Note with [X]{.underline}'s stock or to
convert the Note into [X]{.underline}'s stock, or otherwise to result in
such a repayment or conversion. For example, if [X]{.underline} does not
use its best efforts to make the remarketing succeed and all of the
remarketings fail, the holder in effect will be compelled to receive
[X]{.underline}'s stock in satisfaction of the stated principal amount
of the Note.

In the instant transaction, however, several critical facts and
contractual provisions support a contrary conclusion:

> 1\. [X]{.underline} has contracted to have the Notes remarketed and
> such an undertaking is subject to the requirements and sanctions of
> the Securities Act of 1933, 15 U.S.C. 77a--77aa (2000);
>
> 2\. It is substantially certain that a remarketing of the Notes will
> succeed (in which case the Notes will remain outstanding until the
> Maturity Date and consequently will not be paid in, or converted into,
> [X]{.underline}'s stock);
>
> 3\. The remarketing dates and the Maturity Date are such that the
> Notes will remain outstanding after the remarketing for a period that
> is significant both absolutely and relative to the total term of the
> Notes; and
>
> 4\. On the Maturity Date, [X]{.underline} will have an obligation to
> pay the principal amount of the Notes.

Thus, absent specific evidence of bad faith with respect to
[X]{.underline}'s performance of its obligation to remarket the Notes,
these critical facts and contractual provisions support the conclusion
that the transaction is not reasonably expected to give [X]{.underline}
an option to pay the Notes in, or convert them into, [X]{.underline}'s
stock, or to otherwise result in such a repayment or conversion .

**[Conclusion]{.underline}**

The interest accruing on a Note contained in a Purchase-Contract/Note
unit is deductible under § 163(a), and the deduction is not disallowed
under § 163(*l*).

Four factors critical to this conclusion are:

> Critical Factor I. The holder has the unrestricted legal right to
> convert the Purchase-Contract/Note unit into a Purchase-Contract/Strip
> unit or to settle the Purchase Contract with separate cash and retain
> the Note, and the holder is not economically compelled to keep the
> unit unseparated.
>
> Critical Factor II. The Purchase Contract provides that, in the event
> of [X]{.underline}'s bankruptcy, the Purchase Contract will terminate
> and the associated Note or Strip will be released to the holder; and,
> on the Issue Date, [X]{.underline} reasonably believes, based on
> advice from counsel, that the provision would be enforceable in
> bankruptcy and would result in the holder of a Purchase-Contract/Note
> unit being treated as a creditor in the bankruptcy proceeding.
>
> Critical Factor III. The period the Notes will remain outstanding
> after a remarketing is significant, both absolutely and relative to
> the total term of the Notes. For purposes of this factor, Notes are
> considered to remain outstanding only during the period when they are
> not subject to redemption at the option of the issuer.
>
> Critical Factor IV. On the Issue Date, it is substantially certain
> that a remarketing of the Notes will succeed. For purposes of this
> factor, a remarketing of the Notes is not substantially certain to
> succeed if the Reset Rate is capped.

HOLDING

Under the facts presented, the interest accruing on a Note contained in
a Purchase-Contract/Note unit is deductible under § 163(a), and the
deduction is not disallowed under § 163(*l*).

PROSPECTIVE APPLICATION

Under the authority of § 7805(b)(8), the holding of this revenue ruling
will not be applied adversely with respect to a unit that was issued on
or before August 22, 2003, provided that interest accruing on the unit
would be deductible under this revenue ruling if---

\(1\) Critical Factor II required only that, under the transaction
documents, in the event of the issuer's bankruptcy, the Purchase
Contract will terminate and the associated Note or Treasury security
will be released to the holder; and

\(2\) Critical Factor IV required only that the issuer of the unit
undertook a legal obligation to attempt to cause a remarketing to
succeed and reasonably believed that a remarketing would succeed.

REQUEST FOR COMMENTS

The Internal Revenue Service and the Treasury Department are considering
whether to issue regulations under § 163(*l*) to address the policy
issues raised by the transaction described in this ruling. The Internal
Revenue Service and the Treasury Department request comments as to
whether regulations should be promulgated and, if so, what these
regulations should provide.

Comments should be submitted by October 22, 2003. Comments may be
submitted to CC:PA:RU (Rev. Rul. 2003--97), room 5203, Internal Revenue
Service, POB 7604 Ben Franklin Station, Washington, DC 20044. Comments
may be hand delivered between the hours of 8:00 a.m. and 4 p.m. Monday
to Friday to CC:PA:RU (Rev. Rul. 2003--97), Courier's Desk, Internal
Revenue Service, 1111 Constitution Avenue NW, Washington, DC.
Alternatively, comments may be submitted via the Internet at
[Notice.Comments@irscounsel.treas.gov]{.underline}. All comments will be
available for public inspection and copying.

DRAFTING INFORMATION

The principal author of this revenue ruling is Charles Culmer of the
Office of Associate Chief Counsel (Financial Institutions and Products).
For further information regarding this revenue ruling contact Mr. Culmer
at (202) 622--3960 (not a toll--free call).