No deductions for repurchase premiums.

When a subsidiary issues debentures that can be exchanged for the parent company's stock, and the stock has appreciated above the conversion price, the parent company will issue shares with a value exceeding the principal amount of the debentures. When the parent surrenders this debt back to the subsidiary in exchange for the principal amount, it used to be able to claim a capital loss for the value of the stock that exceeds the principal amount.

In Reynolds Metals v. the Commissioner, the Tax Court concluded that a capital loss was not sustained in this type of exchange. Instead, the parent company's basis in the converted debentures is limited to the debentures' principal amount, and the excess of the value of the stock issued over this principal amount can be attributed to the conversion feature of the debentures. Accordingly, the excess of the fair value of the stock issued over the debentures' principal amount is a nondeductible capital contribution and not a capital loss.

Observation: Reynolds had a compelling argument. Nevertheless, the court's decision was not in its favor principally because a finding for Reynolds would have allowed taxpayers to circumvent the prohibition in Internal Revenue Code section 249 against deducting repurchase premiums attributable to the conversion feature of convertible instruments. Such premiums are deductible only if they are clearly attributable to the cost of borrowing.

--Robert Willens, CPA, managing director at Lehman Brothers, New York City.