Revenue Ruling 2003-98
Rev. Rul. 2003-98
Rev. Rul. 2003-98, 2003-34 I.R.B. 378, 2003-2 C.B. 378
                      Internal Revenue Service (I.R.S.)
                                Revenue Ruling
                  DEDUCTION RULES; COMPENSATORY STOCK OPTIONS
                            Released: July 25, 2003
                          Published: August 25, 2003
 Section 83.–Property Transferred in Connection With Performance of Services, 26 CFR 1.83-6: Deduction by employer.
 Deduction rules; compensatory stock options. This ruling addresses the application of the deduction rules under section 83(h) of the Code with regard to the exercise or disposition of compensatory stock options following certain corporate transactions.
 Deduction rules; compensatory stock options. This ruling addresses the application of the deduction rules under section 83(h) of the Code with regard to the exercise or disposition of compensatory stock options following certain corporate transactions.
ISSUE
 Under s 83 of the Internal Revenue Code, in the situations described below, which corporation is entitled to deduct the compensation income includible in Employee’s gross income as a result of Employee’s exercise or disposition of a nonstatutory option?
FACTS
 Situation 1. On January 1, 2003, Employee begins employment with Company M and is granted a nonstatutory option to purchase a number of shares of M common stock (”the M Option”). The M Option has no readily ascertainable fair market value when it is granted and is not exercisable until January 1, 2006.
 On November 15, 2006, Company N acquires all of the outstanding shares of M for cash. N does not make an election under s 338(g) to treat its acquisition of M as a deemed acquisition of the assets of M, thus treating it instead as an acquisition of the stock of M. Thereafter, M conducts its business as a wholly owned subsidiary of N. M and N are accrual basis taxpayers, and each has a taxable year ending on September 30.
 On the acquisition date, either pursuant to the terms of the M Option or in response to an offer from N, Employee surrenders the M Option to N, and, in exchange, N grants an exercisable nonstatutory option to acquire a number of shares of N common stock (”the N Option”) to Employee. The N Option has no readily ascertainable fair market value. On January 15, 2007, while still employed by M, Employee exercises the N Option and receives substantially vested N shares from N.
 Situation 2. The facts are the same as in Situation 1, except that, under the terms of the N Option, N has the ability to cancel the option at any time in exchange for a payment in cash or in value-equivalent substantially vested N shares. On January 15, 2007, N cancels the N Option in exchange for a payment (in cash or shares) to Employee.
 Situation 3. The facts are the same as in Situation 1, except that the M Option is not exchanged for the N Option on the acquisition date. Instead, the M Option remains outstanding after the acquisition date until January 15, 2007, when either pursuant to the terms of the M Option or with Employee’s agreement, N cancels the M Option and pays the excess of the fair market value of the stock purchasable under the option over the option’s exercise price in cash or in value-equivalent substantially vested N shares to Employee.
 Situation 4. The facts are the same as in Situation 1, except that on November 15, 2006, M and N merge under state law, with N as the surviving corporation. The merger qualifies as a complete liquidation within the meaning of s 332.
LAW AND ANALYSIS
 Under s 83(a), when property is transferred to any person in connection with the performance of services, the service provider must include in gross income (as compensation income) the excess of the fair market value of the property, determined at the first time that the transferee’s rights in the property are either transferrable or not subject to a substantial risk of forfeiture (”substantially vested”), over the amount (if any) paid for the property.
 Section 83(e)(3) provides that s 83 does not apply to the transfer of an option without a readily ascertainable fair market value on the date of grant. Under s 1.83-7 of the Income Tax Regulations, s 83 applies at the time such an option is exercised, or otherwise disposed of. If the option is exercised, s 83(a) applies to the transfer of property pursuant to the exercise. Under s 1.83-7(a), if the option is sold or otherwise disposed of in an arm’s length transaction, ss 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as ss 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option. Under s 1.83-7T, the preceding sentence does not apply to a sale or other disposition of the option to a person related to the service provider that occurs on or after July 2, 2003. For this purpose, a person is not related to the service provider if the person is the service recipient with respect to the option or the grantor of the option.
 Thus, in each of the above Situations, because the M Option has no readily ascertainable fair market value when granted, s 83 does not apply to the option at that time. Rather, s 83(a) applies to the consideration received by Employee upon the disposition of the M Option in the case of Situation 3 and the exercise or disposition of the N Option in the case of Situations 1, 2, and 4.
 Under s 83(h) and s 1.83-6(a)(1), the service recipient is allowed a compensation expense deduction, under s 162, for the amount included in the service provider’s gross income under s 83(a). Under the general timing rule of s 83(h), the deduction is allowed for the service recipient’s taxable year in which or with which ends the service provider’s taxable year in which the amount is included in gross income. Section 1.83-6(a)(3) provides an exception to that rule: in cases where the property transferred is substantially vested upon transfer, the deduction is allowed to the service recipient under its method of accounting.
 Section 1.83-6(d)(1) generally provides that, if a shareholder of a corporation transfers property to an employee (or independent contractor) of the corporation in consideration for services performed by the employee for the corporation, the transaction is considered a contribution of the property by the shareholder to the corporation and, immediately thereafter, a transfer of the property by the corporation to the employee. The transfer of property to the employee is considered to be in consideration for services performed by the employee for the corporation if either the property is substantially nonvested at the time of transfer or if an amount is includible in the gross income of the employee at the time of transfer under the rules of s 83. See s 1.1032-3 for special rules that may apply to a corporation’s transfer of its own stock to any person in consideration of services performed for another corporation or partnership.
 Section 332(a) provides that no gain or loss is recognized on the receipt by a corporation (the acquiring corporation) of property distributed in complete liquidation of another corporation (the liquidating corporation).
 Section 381(a)(1) provides, in part, that, where the assets of a liquidating corporation are distributed to the acquiring corporation in a transaction to which s 332 applies, the acquiring corporation succeeds to and takes into account, as of the close of the day of distribution, the items described in s 381(c) of the liquidating corporation, subject to the conditions and limitations described in ss 381(b) and (c).
 In a transaction to which s 381(a) applies, s 381(c)(16) permits the acquiring corporation to deduct an assumed obligation of the liquidating corporation, as if it were the liquidating corporation, when that obligation is paid or accrued (1) if such obligation gives rise to a liability after the date of distribution and (2) if the liquidating corporation would have been entitled to deduct that liability in computing taxable income were that liability paid or accrued by the liquidating corporation. See s 1.381(c)(16)-1(a)(1).
 Section 1.381(c)(16)-1(a)(4) provides that an obligation of a liquidating corporation gives rise to a liability when the liability would be accruable by a taxpayer using the accrual method of accounting, notwithstanding the fact that the liquidating corporation is not using the accrual method of accounting. See s 1.461-1(a)(2).
 Section 1.461-1(a)(2)(i) provides that, under an accrual method of accounting, a liability is incurred, and generally is taken into account for federal income tax purposes, in the taxable year in which: (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect the liability. A liability with respect to an option generally is incurred and taken into account in the year in which the employee exercises the option because that is when the liability becomes fixed and determinable with reasonable accuracy. Therefore, for purposes of s 381(c)(16), an option generally gives rise to a liability when it is exercised.
 In Situations 1, 2, and 4, the substitution of the M Option for the N Option does not cause Employee to recognize compensation income under s 83(a). In Situations 1 and 4, Employee recognizes compensation income under s 83(a) in 2007, which is Employee’s taxable year in which the N Option is exercised. In Situations 2 and 3, Employee also recognizes compensation income under s 83(a) in 2007, which is Employee’s taxable year in which N cancels the substituted N Option or cancels the M Option.
 Applying s 83(h) and s 1.83-6 to Situations 1, 2, and 3, because M is the service recipient with respect to either the M Option or the N Option, M, and only M, is permitted to deduct the compensation includible in Employee’s gross income as a result of the disposition of the M Option or the exercise or disposition of the N Option. Although N actually pays the cash or transfers its stock directly to Employee, such payment (or transfer) is treated as a cash capital contribution by N to M (and M is treated as purchasing the stock from N in the case of a stock transfer to the Employee) and as a payment of cash (or transfer of stock) by M to the Employee. See ss 1.83-6(d)(1), 1.1032- 3(b)(1), and 1.1032-3(e), Example 8. Because the consideration received by Employee upon the disposition of the M Option or the exercise or disposition of the N Option is either cash or substantially vested N shares, the s 1.83- 6(a)(3) exception to the general timing rule for deductions in s 83(h) applies. Accordingly, to the extent that the compensation is otherwise deductible, M, and only M, is entitled to deduct the compensation, using its method of accounting, for its taxable year ending September 30, 2007.
 In Situation 4, because the merger of M into N qualifies as a liquidation within the meaning of s 332, under s 381, N succeeds to and takes into account those tax items of M described in s 381(c). Because (1) N assumed the obligation of M pursuant to the N Option, (2) after the date of the merger, the N Option gives rise to a liability under s 1.461-1(a)(2) by reason of its exercise, and (3) the liability, if paid or accrued by M would have been deductible in computing M’s taxable income, N is entitled to deduct that item when paid or accrued as if it were M. See s 381(c)(16).
 Under s 83(h) and s 1.83-6(a), N is entitled to a deduction for the amount of compensation income (if any) included in the gross income of Employee under s 83(a). The amount of compensation income (if any) included in the gross income of Employee is determined on January 15, 2007, when the option is exercised and the stock transferred to Employee. Because the stock is substantially vested when transferred to Employee, to the extent that the compensation recognized by Employee in Situation 4 is otherwise deductible, the deduction is allowed in accordance with N’s method of accounting. Thus, the deduction is allowed for N’s taxable year ending September 30, 2007.
HOLDINGS
 In Situations 1, 2, and 3, the compensation attributable to Employee’s disposition of the M Option or exercise or disposition of the N Option, if it is otherwise deductible, is deductible by M. In Situation 4, the compensation, if it is otherwise deductible, is deductible by N, as if it were M.
DRAFTING INFORMATION
 The principal author of this revenue ruling is Norm Paul of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this revenue ruling, contact Norm Paul or Robert Misner at (202) 622-6030 (not a toll-free number).
 Rev. Rul. 2003-98, 2003-34 I.R.B. 378, 2003-2 C.B. 378
Revenue Ruling 2003-92
Rev. Rul. 2003-92
Rev. Rul. 2003-92, 2003-33 I.R.B. 350, 2003-2 C.B. 350
                      Internal Revenue Service (I.R.S.)
                                Revenue Ruling
                           VARIABLE CONTRACT HOLDER
                            Released: July 23, 2003
                          Published: August 18, 2003
 Section 817.–Treatment of Variable Contracts
 A revenue ruling describes the tax treatment of the assets in a variable contract’s segregated asset account.
26 CFR 1.61-1: Gross income.
(Also s 801.)
  Variable contract holder. This ruling holds that a variable contract holder is the owner of interests in a nonregistered partnership where interests in the nonregistered partnership are not available exclusively through the purchase of a life insurance or annuity contract. Rev. Rul. 81-225 clarified and amplified.
 Variable contract holder. This ruling holds that a variable contract holder is the owner of interests in a nonregistered partnership where interests in the nonregistered partnership are not available exclusively through the purchase of a life insurance or annuity contract. Rev. Rul. 81-225 clarified and amplified.
ISSUES
 Under the facts set forth below, will the holder of a variable annuity or life insurance contract be considered to be the owner, for federal income tax purposes, of the partnership interests that fund the variable contract if interests in the partnerships are available for purchase by the general public? What are the income tax consequences to the holder of the contract if that holder is considered to be the owner of the partnership interests that fund the variable contract?
FACTS
 Situation 1. IC is a life insurance company subject to tax under s 801 of the Internal Revenue Code. In states where it is authorized to do so, IC offers deferred variable annuity contracts. IC has developed a variable annuity contract (”Annuity”) for sale only to “qualified purchasers” [FN1] that are “accredited investors” [FN2] or to no more than one hundred accredited investors. IC is not required to register Annuity under the federal security laws.
 Contract Holder, an individual qualifying as both a qualified purchaser and an accredited investor, purchases Annuity from IC. Annuity contains a number of provisions common to deferred annuity contracts, including the right of Contract Holder to surrender Annuity in part or entirely for cash (subject to a surrender charge) and the right to convert (at future dates chosen by Contract Holder) the accumulated values under Annuity into a stream of periodic payments under one of several settlement options.
 The assets supporting Annuity are held in a segregated asset account that is maintained separately from IC’s other accounts. The segregated asset account is divided into 10 sub-accounts (”Sub-accounts”). Each Sub-account’s assets and liabilities are maintained separately from the assets and liabilities of other Sub-accounts. At the time of purchase, Contract Holder specifies the premium allocation among the available Sub-accounts. Contract Holder may change the allocation of subsequent premiums at any time.
 Each Sub-account available under Annuity invests in interests in a partnership (”Partnership”). None of the Partnerships are publicly traded partnerships under s 7704. All of the Partnerships are exempt from registration under federal security laws. Interests in each Partnership are sold in private placement offerings and are sold only to qualified purchasers that are accredited investors or to no more than one hundred accredited investors.
 Each Partnership has an investment manager that selects the Partnership’s specific investments. Contract Holder may not act as an investment manager or independently own any interest in any Partnership offered under Annuity. In addition, Contract Holder will have no voting rights with respect to any Partnership interest held by any Sub-account.
 Each Sub-account will at all times meet the asset diversification test set forth in s 1.817-5(b)(1) of the Income Tax Regulations.
 Situation 2. The facts are the same as those in Situation 1, except IC offers, and Contract Holder purchases, a variable life insurance contract (”LIC”) that qualifies as a life insurance contract under s 7702.
 Situation 3. The facts are the same as those in Situation 1, except that (i) Contract Holder purchases both an Annuity and an LIC and (ii) interests in each Partnership are available for purchase only through the purchase of an Annuity, an LIC, or other variable contracts from insurance companies.
LAW
 Section 61(a) provides that the term “gross income” means all income from whatever source derived, including gains derived from dealings in property, interest, and dividends.
 Section 817, which was enacted by Congress as part of the Deficit Reduction Act of 1984 (Pub. L. No. 98-369) (the “1984 Act”), provides rules regarding the tax treatment of variable life insurance and annuity contracts. Section 817(d) defines a “variable contract” as a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to State law or regulation, is segregated from the general asset accounts of the company and that provides for the payment of annuities, or is a life insurance contract. In the legislative history of the 1984 Act Congress expressed its intent to deny life insurance treatment to any variable contract if the assets supporting the contract include funds publicly available to investors:
   The conference agreement allows any diversified fund to be used as the basis of variable contracts so long as all shares of the funds are owned by one or more segregated asset accounts of insurance companies, but only if access to the fund is available exclusively through the purchase of a variable contract from an insurance company…. In authorizing Treasury to prescribe diversification standards, the conferees intend that the standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors …
H. R. Conf. Rep. No. 98-861, at 1055 (1984).
 Section 817(h)(1) provides that a variable contract based on a segregated asset account shall not be treated as an annuity, endowment, or life insurance contract unless the segregated asset account is adequately diversified in accordance with regulations prescribed by the Secretary. If a segregated asset account is not adequately diversified, income earned by that segregated asset account is treated as ordinary income received or accrued by the policyholders.
 Approximately two years after enactment of s 817(h), the Treasury Department issued proposed and temporary regulations prescribing the minimum level of diversification that must be met for an annuity or life insurance contract to be treated as a variable contract within the meaning of s 817(d). The preamble to the regulations stated as follows:
   The temporary regulations … do not provide guidance concerning the circumstances in which investor control of the investments of a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the assets in the account. For example, the temporary regulations provide that in appropriate cases a segregated asset account may include multiple sub-accounts, but do not specify the extent to which policyholders may direct their investments to particular sub-accounts without being treated as owners of the underlying assets. Guidance on this and other issues will be provided in regulations or revenue rulings under section 817(d), relating to the definition of variable contracts.
51 FR 32633 (Sept. 15, 1986). The text of the temporary regulations served as the text of proposed regulations in the notice of proposed rulemaking. See 51 FR 32664 (Sept. 15, 1986). The final regulations adopted, with certain revisions not relevant here, the text of the proposed regulations.
 Prior to enactment of s 817, the Service issued a number of revenue rulings regarding when the owner of an annuity contract will be treated as the owner of the assets that fund the annuity. In the revenue rulings, the Service relied on long standing tax principles. See generally, Commissioner v. Sunnen, 333 U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940); Corliss v. Bowers, 281 U.S. 376 (1930). The revenue rulings consider whether the contract owners described in each ruling have retained sufficient incidents of ownership, as described in cases cited above, over the assets or retain sufficient control over the assets to be treated as the owners of those assets.
 Rev. Rul. 77-85, 1977-1 C.B. 12, concludes that if a purchaser of an “investment annuity” contract selects and controls the investment assets in the separate account of the issuing life insurance company, then the purchaser will be treated as the owner of those assets for federal income tax purposes. Thus, any interest, dividends, or other income derived from the investment assets are includible in the gross income of the purchaser. Similarly, Rev. Rul. 80- 274, 1980-2 C.B. 27, holds that if a purchaser of an annuity contract may select and control the certificates of deposit supporting the contract, then the purchaser is treated as the owner of the certificates of deposit for federal income tax purposes. In Rev. Rul. 80-274, the insurance company could not dispose of the deposit or convert it into a different asset. The insurance company did, however, have the power to withdraw the deposit from a failing savings and loan association.
 Rev. Rul. 81-225, 1981-2 C.B. 12, describes four situations in which investments in mutual fund shares to fund annuity contracts are treated as owned by the policyholder rather than by the issuing insurance company, and one situation in which the issuing insurance company is treated as the owner of the mutual fund shares. In Situation 1, the investment assets in the segregated account supporting the annuity contracts consisted solely of shares in a single, publicly available mutual fund managed by an independent investment advisor. Situation 2 is similar to Situation 1, except that the publicly available mutual fund was managed by the issuing insurance company or one of its affiliates. Situation 3 also is similar to Situation 1, except that the segregated asset account supporting the annuity contracts consisted of five sub-accounts. Each sub-account was invested in the shares of a different mutual fund. Shares of the mutual funds were offered for sale to the general public. The policyholder retained the right to allocate or reallocate funds among the five sub-accounts during the life of the annuity contract. Situation 4 is similar to Situation 2, except that the mutual fund did not sell shares directly to the public. The shares of the mutual fund were available only through the purchase of an annuity contract or by participation in an investment plan account of the type described in Rev. Rul. 70-525, 1970-2 C.B. 144. Situation 5 also was similar to Situation 2, except that the shares in the mutual fund were available only through the purchase of an annuity contract.
 Rev. Rul. 81-225 concludes that the policyholders in Situations 1 through 4 had sufficient control and other incidents of ownership to be treated as the owners of the mutual fund shares for federal income tax purposes. The ruling reaches the opposite conclusion in Situation 5, because the sole function of the mutual fund in Situation 5 was to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the insurance company possessed sufficient incidents of ownership to be treated as the owner of the underlying portfolio of assets of the mutual fund for federal income tax purposes.
 In Rev. Rul. 82-54, 1982-1 C.B. 11, the purchasers of certain annuity contracts could direct the issuing insurance company to invest in the shares of any one or any combination of three mutual funds that were not available to the public. One mutual fund invested primarily in common stocks, another in bonds, and the third in money market investments. Policyholders could allocate their premium payments among the three funds and had an unlimited right to reallocate contract values among the funds prior to the maturity date of the annuity contract. The ruling concludes that the policyholders’ ability to choose among general investment strategies (for example, between stock, bonds, or money market funds) either at the time of the initial purchase or subsequent thereto, did not constitute control sufficient to cause the policyholders to be treated as the owners of the mutual fund shares.
 In Christoffersen v. United States, 749 F.2d 513 (8th Cir.), rev’g 578 F. Supp. 398 (N.D. Iowa 1984), the Eighth Circuit considered the federal income tax ownership of the assets supporting a segregated asset account. The taxpayers in Christoffersen purchased a variable annuity contract that reflected the investment return and market value of assets held in an account that was segregated from the general asset account of the issuing insurance company. The taxpayers had the right to direct that their premium payments be invested in any one or a combination of six publicly traded mutual funds. The taxpayers could reallocate their investment among the funds at any time. The taxpayers also had the right upon seven days notice to withdraw funds, surrender the contract, or apply the accumulated value under the contract to provide annuity payments.
 The Eighth Circuit held that, for federal income tax purposes, the taxpayers, not the issuing insurance company, owned the mutual fund shares that funded the variable annuity. The court concluded that the taxpayers “surrender few of the rights of ownership or control over the assets of the sub-account” that supported the annuity contract. Christoffersen, 749 F.2d at 515. According to the court, “the payment of annuity premiums, management fees and the limitation of withdrawals to cash [did] not reflect the lack of ownership or control as the same requirements could be placed on traditional brokerage or management accounts.” Id. at 515-16. Thus, the taxpayers were required to include in gross income any gains, dividends, or other income derived from the mutual fund shares.
ANALYSIS
 In Situation 1, Sub-accounts hold interests in Partnerships available for purchase other than by purchasers of Annuity or other variable contracts from insurance companies. Therefore, for federal income tax purposes, Contract Holder is the owner of the interests in Partnerships held by Sub-accounts. As a result, pursuant to s 61(a), Contract Holder must include in its gross income any interest, dividends, or other income derived from the interests in the Partnerships in the year in which the interest, dividends, or other income is earned.
 In Situation 2, Sub-accounts hold interests in Partnerships available for purchase other than by purchasers of LIC or other variable contracts from insurance companies. Therefore, for federal income tax purposes, Contract Holder is the owner of the interests in Partnerships held by Subaccounts. As a result, pursuant to s 61(a), Contract Holder must include any interest, dividends, or other income derived from the Partnerships in gross income in the year in which the interest, dividends, or other income is earned.
 In Situation 3, Sub-accounts hold interests in Partnerships available for purchase only by a purchaser of an Annuity, a LIC, or other variable contracts from insurance companies. Therefore, for federal income tax purposes, IC owns the interests in Partnerships that fund the Sub-accounts. As a result, pursuant to s 61(a), any interest, dividends, or other income derived from the Partnerships is not included in Contract Holder’s gross income in the year in which the interest, dividends, or other income is earned.
HOLDINGS
 Under the facts set forth above, the holder of a variable annuity or life insurance contract will be considered to be the owner, for federal income tax purposes, of the partnership interests that fund the variable contract if interests in the partnerships are available for purchase by the general public. If the holder of a variable annuity or life insurance contract is considered to be the owner of the partnership interests that fund the variable contract, pursuant to s 61(a), the contract holder must include any interest, dividends, or other income derived from the partnership interests in gross income in the year in which the interest, dividends, or other income is earned.
EFFECT ON OTHER REVENUE RULING
 Rev. Rul. 81-225, 1981-2 C.B. 12 is hereby clarified and amplified.
DRAFTING INFORMATION
 The principal author of this revenue ruling is James Polfer of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Mr. Polfer at (202) 622- 3970 (not a toll-free call).
FN1. Under 15 U.S.C. s 80a-2(a)(51) a “qualified purchaser” is an individual, or other specified entity, that satisfies certain threshold financial requirements.
FN2. The term “accredited investor,” as defined by 15 U.S.C. s 77b(a)(15), and amplified by 17 CFR s 230.501(a), is also an investor that satisfies certain financial criteria. An accredited investor may be either an individual or certain enumerated entities. Because the criteria to be an accredited investor are similar to, but not identical to, the criteria that must be met to be a qualified purchaser it is possible for an accredited investor to also be a qualified purchaser. It is also possible for an investor to qualify only as either an accredited or qualified investor.
 Rev. Rul. 2003-92, 2003-33 I.R.B. 350, 2003-2 C.B. 350
Revenue Ruling 2003-97
Rev. Rul. 2003-97
Rev. Rul. 2003-97, 2003-34 I.R.B. 380, 2003-2 C.B. 380
                      Internal Revenue Service (I.R.S.)
                                Revenue Ruling
                           DEDUCTIBILITY OF INTEREST
                            Released: July 23, 2003
                          Published: August 25, 2003
 Section 7805.–Rules and Regulations, 26 CFR 301.7805-1: Rules and regulations.
 Rev. Rul. 2003-97 provides guidance on whether interest accruing on a note is deductible under section 163(a), and whether the deduction is disallowed under section 163(l), when a corporation issues units, each consisting of instruments in the form of a note and a forward contract to purchase a quantity of the corporation’s common stock. The holding of the revenue ruling is modified for units issued on or before August 22, 2003. See Rev. Rul. 2003- 97, page 380.
Section 163.–Interest, 26 CFR 1.163-1: Interest deduction in general.
 Deductibility of interest. This ruling provides guidance on whether interest accruing on a note is deductible under section 163(a) of the Code, and whether the deduction is disallowed under section 163(l), when a corporation issues units, each consisting of instruments in the form of a note and a forward contract to purchase a quantity of the corporation’s common stock. The holding of this ruling is modified for units issued on or before August 22, 2003. This ruling also requests comments concerning possible regulations under section 163(l).
 Deductibility of interest. This ruling provides guidance on whether interest accruing on a note is deductible under section 163(a) of the Code, and whether the deduction is disallowed under section 163(l), when a corporation issues units, each consisting of instruments in the form of a note and a forward contract to purchase a quantity of the corporation’s common stock. The holding of this ruling is modified for units issued on or before August 22, 2003. This ruling also requests comments concerning possible regulations under section 163(l).
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 s 163(a) of the Internal Revenue Code and not disallowed under s 163(l)?
FACTS
 On August 18, 2003 (”Issue Date”), X, a corporation, issues units, each consisting of instruments in the form of a 3-year forward contract to purchase a quantity of X’s common stock (”Purchase Contract”) and a 5-year note issued by X (”Note”) (together, a “Purchase-Contract/Note unit”). The Purchase Contract requires the holder to purchase, and X to sell, on August 18, 2006 (”Settlement Date”), a quantity of X’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’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 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’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 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’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 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’s stock. Similarly, neither the written terms of the Note nor any other understanding or agreement grants X an option to pay the Note in, or convert the Note into, X’s stock.
 X enters into a contract with an investment bank, Y, to serve as remarketing agent. Y 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 100 1/2 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 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 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, 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 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’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’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 in the following manner. If a Note was part of a Purchase-Contract/Note unit on the date of the successful remarketing, X 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 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’s own funds. X will make similar payments to the former holders of any participating Separated Notes.
 Y 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 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 100 1/4 percent and 100 1/2 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’s bankruptcy, the Purchase Contract will terminate and the associated Note or Strip will be released to the holder. On the Issue Date, X 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 s 163(l) applies, and, under s 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 s 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’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 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 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 s 163(l) prevent X from deducting the interest that accrues on the Note?
Is the Note separable from the associated Purchase Contract?
 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 Chock Full O’Nuts Corp. v. United States, 453 F.2d 300 (2d Cir. 1971); Hunt Foods and Industries, Inc. v. Commissioner, 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 Universal Castings Corp. v. Commissioner, 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, 303 F.2d 620 (7th Cir. 1962). Cf. De Coppet v. Commissioner, 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, 108 F.2d 787 (2d Cir.), cert. denied, 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 American Realty Trust v. United States, 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, 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 s 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, 643 F.2d 654 (9th 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 Comtel Corp. v. Commissioner, 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, 376 F.2d 791, 796 (2d Cir.) (rejecting taxpayer’s argument that it was not “economically compelled” to exercise the option), cert. denied, 389 U.S. 929 (1967); cf. 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 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?
 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, 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, 748 F.2d 1365, 1368 (9th Cir. 1984); Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Gilbert v. Commissioner, 248 F.2d 399, 402 (2d Cir. 1957); Litton Business Systems, Inc. v. Commissioner, 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., 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’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 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’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 s 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’s bankruptcy, the Purchase Contract will terminate and the associated Note will be released to the holder; and on the Issue Date, X 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 P.M. Finance Corp. v. Commissioner, 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”); Nestle Holdings, Inc. v. Commissioner, 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 s 163(l) prevent X from deducting the interest that accrues on the Note?
 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 s 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 H.R. Conf. Rep. No. 220, 105th Cong., 1st 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’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’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’s stock for purposes of s 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 an option either to repay the Note with X’s stock or to convert the Note into X’s stock, or otherwise to result in such a repayment or conversion. For example, if X 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’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 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’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 will have an obligation to pay the principal amount of the Notes.
 Thus, absent specific evidence of bad faith with respect to X’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 an option to pay the Notes in, or convert them into, X’s stock, or to otherwise result in such a repayment or conversion.
Conclusion
 The interest accruing on a Note contained in a Purchase-Contract/Note unit is deductible under s 163(a), and the deduction is not disallowed under s 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’ 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 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 s 163(a), and the deduction is not disallowed under s 163(l).
PROSPECTIVE APPLICATION
 Under the authority of s 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 s 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. 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).
 Rev. Rul. 2003-97, 2003-34 I.R.B. 380, 2003-2 C.B. 380