UNITED STATES TAX COURT



  REYNOLDS METALS COMPANY AND CONSOLIDATED SUBSIDIARIES,
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent



 Docket No. 24939-93.                     Filed October 16, 1995.



      In 1968, S, P's wholly owned subsidiary, issued
 debentures, convertible into shares of common stock of
 P. In 1987, S called the debentures for redemption,
 thereby prompting most debenture holders to convert
 their debentures into P's common stock. The converted
 debentures were subsequently redeemed by S for cash in
 an amount equal to the principal of the debentures with
 accrued interest. P and its consolidated subsidiaries
 claimed a capital loss deduction under sec. 165(f),
 I.R.C., in the amount by which the fair market value of
 P's stock issued in the exchange exceeded the principal
 of the exchanged debentures. Held, P is not entitled
 to a capital loss deduction. International Telephone &
 Telegraph v. Commissioner, 

(1981),
 supplemented by 

, affd. per curiam 

(2d Cir. 1983), distinguished.
                               - 2 -

     Robert A. Warwick and Frederick H. Robinson, for

petitioners.

     Lindsey D. Stellwagen and Kristine A. Roth, for respondent.



                              OPINION


     TANNENWALD, Judge:   Respondent determined deficiencies in

petitioners' 1987 and 1988 Federal income taxes in the amounts of

$430,030 and $357,028, respectively. The sole issue remaining in

dispute is whether petitioners are entitled to a capital loss

deduction for 1987, under section 165(f),1 with respect to

certain convertible debentures issued by a wholly owned

subsidiary and convertible into the stock of the common parent

corporation.

     All the facts have been stipulated.    The stipulation of

facts and attached exhibits are incorporated herein by this

reference.

     Petitioners are the Reynolds Metals Company and Consolidated

Subsidiaries (the Reynolds Group).     The common parent is Reynolds

Metals Company (hereinafter referred to as Metals).    Metals is a

Delaware corporation with its principal place of business in

Richmond, Virginia.   Metals and its consolidated subsidiaries


1
  Unless otherwise indicated, all statutory references are to the
Internal Revenue Code in effect for the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 3 -

filed their corporate income tax return for the taxable year

ended December 31, 1987, with the Internal Revenue Service at

Memphis, Tennessee.

     At all relevant times, Metals served global markets as a

supplier and recycler of aluminum and other products.    It is a

vertically integrated producer of a wide variety of value-added

aluminum products.    In 1987, Metals and its affiliates were among

the largest producers of aluminum and aluminum products in the

world.

     On May 16, 1968, the Board of Directors of Metals

unanimously approved the draft forms of an Offering Prospectus,

Indenture, and Underwriting Agreement proposed to be used in the

foreign offering of $50 million of subordinated guaranteed

convertible debentures due 1988, predicated upon the fact that

Metals' financial advisers recommended that the offering be

marketed as promptly as practicable.    The Board further approved

a plan to organize a wholly owned Delaware subsidiary to issue

the debentures.   The plan was outlined in a document, presented

to each member of the Board, entitled "Memorandum To The Holders

Of First Mortgage Bonds Of Reynolds Metals Company".    The plan

contemplated that Metals would contribute its 31-percent interest

in the Canadian British Aluminum Company Limited (CBA), a Quebec

corporation, to the newly formed subsidiary, and that the

subsidiary would purchase 47-percent and 5-percent interests in

CBA from The British Aluminum Company Limited (BA), and Tubes
                               - 4 -

Canadian Holdings Limited (TCH), respectively, using the proceeds

of the offering.   The remaining 17-percent interest in CBA was to

remain publicly held.   Metals owned directly and indirectly a 48-

percent interest in BA.

     It was intended that the funds were to be raised abroad in a

manner not adversely affecting the U.S. balance of payments in

compliance with a program initiated by the U.S. government on

January 1, 1968, and set forth in Direct Foreign Investment

Regulations.   See 33 Fed. Reg. 49 (Jan. 3, 1968).   The plan also

contemplated that the newly formed subsidiary would satisfy the

80-percent income from non-U.S. sources requirement of those

regulations in order to exempt the interest on the debentures

from the U.S. withholding tax on nonresident aliens or foreign

corporations and provide estate tax benefits to such aliens.    See

Committee on Taxation of International Finance and Investment of

New York State Bar Association, Tax Section, "Report on

International Finance Subsidiaries," 28 Tax L. Rev. 443, 444

(1973).

     The memorandum presented to the Board contemplated that

Metals would benefit from the outlined plan in the following

manner:

     1.   BA will increase its capacity for the production
          of primary aluminum and alumina in the United
          Kingdom.

     2.   Reynolds Metals will increase its equity ownership
          in CBA from 31% to 83%.
                                - 5 -

     3.    By making the Debentures convertible into its
           Common Stock, Reynolds Metals is potentially
           enlarging its equity base and is providing for a
           wider international distribution of its Common
           Stock.

     On May 27, 1968, Reynolds Metals European Capital

Corporation (RMECC) was organized as a wholly-owned subsidiary of

Metals.   RMECC's authorized capital stock was 100,000 shares,

having a par value of $1.    Metals acquired 1,000 shares of the

RMECC stock for $1,000, which constituted all of the issued and

outstanding stock.   The organization of RMECC was ratified and

approved by the Board of Directors of Metals at a special meeting

held June 4, 1968.   The board further directed that authorized,

but unissued, common stock of Metals be reserved for the

conversion feature of the debentures to be issued by RMECC.

     Since its organization, RMECC has joined in the filing of

the Reynolds Group's consolidated Federal income tax return.      As

of July 17, 1968, RMECC did not own or lease any physical

facilities or properties other than books and records.    Also,

each of RMECC's directors and officers was an officer or director

of Metals and received no remuneration from RMECC.

     At the time of RMECC's incorporation, CBA owned and operated

an aluminum reduction plant located at Baie Comeau, Quebec,

having the capacity to produce approximately 115,000 tons of

primary aluminum annually.    An aluminum reduction plant converts

raw materials, principally alumina, into primary aluminum using

an electrolytic process.    As of December 31, 1968, CBA had
                                - 6 -

authorized and issued 1,088,999 class A shares and 3,500,000

class B shares.

     In connection with the organization of RMECC, Metals made a

contribution to RMECC's capital of its 31-percent interest in

CBA, represented by 271,329 class A shares and 1,162,000 class B

Shares of CBA.    At the time of transfer, the shares, which Metals

had acquired in 1966, had a total value on the books of Metals of

$32,975,000.   Metals also intended that RMECC would acquire, and

then hold, the stock of CBA held by BA and TCH.

     Metals and RMECC together negotiated the CBA stock

acquisition from BA.   Initially, it had been contemplated that

RMECC would either acquire the shares directly, or that Metals

would acquire the shares and make a capital contribution of the

shares to RMECC.

     On August 15, 1968, RMECC purchased from BA its 47-percent

interest in CBA, including 56,400 class A shares and 2,100,000

class B shares, for the Canadian dollar equivalent of

US$39,194,618 (C$42,049,800 x 0.9321).   In consideration of the

sale of its CBA stock to RMECC, Metals agreed to several

considerations in favor of BA, including to procure the full and

prompt performance of RMECC, to aid BA in procuring CBA to enter

into termination contracts with BA, and to acquire the rights and

assume all the obligations of BA with respect to its long-term

contracts with CBA for exchanging alumina for aluminum and for

the purchase of aluminum.
                               - 7 -

     RMECC purchased a 5-percent interest in CBA, represented by

6,392 class A shares and 238,000 class B shares, on December 27,

1968, from TCH.

     As of December 31, 1968, RMECC owned 334,121 class A shares

and 3,500,000 class B shares of CBA.   These shares represented a

95.9-percent voting interest and an 83-percent interest by value.

     As of December 31, 1968, RMECC had a capital surplus of

$34,290,413.47 and retained earnings of $692,457.82.

     In 1968, RMECC issued $50 million of 5-percent Subordinated

Guaranteed Convertible Debentures Due 1988 (the debentures) in

the European market.   The debentures were bearer bonds in

denominations of $1,000, with interest coupons attached.     The

debentures bore interest from June 1, 1968, which was payable

semi-annually on June 1 and December 1 each year.   They were

dated June 1, 1968, and matured on June 1, 1988.

     RMECC sold the debentures to underwriters Dillon, Read &

Co., S. G. Warburg & Co., Ltd., and Reynolds & Co., who agreed

not to sell, directly or indirectly, any of the debentures to any

citizen, resident, partnership, corporation, or any other entity

located in the United States or its territories or possessions.

     The legend on the face of the debentures states:

          The issuer of this Debenture has been formed or
     availed of for the principal purpose of obtaining funds
     (directly or indirectly) for foreign issuers or foreign
     obligors. Consequently, the United States Internal
     Revenue Service has ruled that United States persons
     (as that term is defined in Section 4920(a)(4) of the
     United States Internal Revenue Code of 1954) will be
                                   - 8 -

     required to report and pay United States Interest
     Equalization Tax with respect to acquisition of this
     Debenture except where a specific statutory exemption
     is applicable. [Emphasis added.]

     The debentures were issued under an indenture (the

indenture) dated as of June 1, 1968, among RMECC as obligor,

Metals as guarantor and Chemical Bank New York Trust Company as

indenture trustee.   The indenture governs the rights and

obligations of RMECC, Metals, and Chemical Bank as between

themselves and with respect to the holders of debentures.    The

indenture was never modified or revoked.

     The indenture contains, in part, the following provisions:

                            Definitions.

          Section 1.01.    * * *

                 *     *     *      *      *   *   *

          The term "outstanding", when used with reference
     to Debentures, shall, subject to the provisions of
     Section 9.04, mean, as of any particular time, all
     Debentures, except

               (a) Debentures theretofore cancelled by the
          Trustee or delivered to the Trustee for
          cancellation;

               (b) Debentures for the payment or redemption
          of which moneys in the necessary amount shall have
          been deposited in trust with the Trustee, provided
          that if such Debentures are to be redeemed prior
          to the maturity thereof, notice of such redemption
          shall have been given as in Article Five provided,
          or provision satisfactory to the Trustee shall
          have been made for giving such notice; and

               (c) Debentures in lieu of or in substitution
          for which other Debentures shall have been
          authenticated and delivered pursuant to the terms
          of Section 2.07.
                          - 9 -

            *    *    *    *      *   *   *

     Section 2.08. * * * If the Company [RMECC] or the
Guarantor [Metals] shall acquire any of the Debentures
(including, without limitation, Debentures delivered to
the Company or the Guarantor to effect a conversion
pursuant to Article Four), such acquisition shall not
operate as a redemption or satisfaction of the
indebtedness represented by such Debentures unless and
until the same are delivered to the Trustee for
cancellation.

            *    *    *    *      *   *   *

     Section 4.12. All Debentures upon conversion
pursuant to this Article Four (hereinafter in this
Section 4.12 called "Converted Debentures") shall be
imprinted or stamped with a legend indicating such
conversion and whether it was effected by the Guarantor
or by the Company and such Converted Debentures shall,
except as they may be used to reduce, or for credit
against, sinking fund payments, as permitted by Section
5.03, be held by the Guarantor or the Company and may,
at any time, be delivered to the Trustee for
cancellation and thereupon shall be cancelled by it.
Converted Debentures shall not be transferred except
from the Guarantor to the Company or from the Company
to the Guarantor. Converted Debentures shall not be
further convertible into Common Stock of the Guarantor,
and shall not be redeemable, whether by operation of
the sinking fund provided for in Section 5.02 or
otherwise, unless all Debentures at the time
outstanding shall be redeemed at the same time.

            *    *    *    *      *   *   *

     Section 5.01. The Company may, at its option,
redeem Debentures at the times, in the amounts and at
the redemption prices then applicable thereto as
specified in the form of Debenture hereinabove set
forth. * * *

     Section 5.02. The Debentures shall also be
subject to redemption on June 1, 1979 and on each June
1 thereafter to and including June 1, 1987 (each such
date being herein referred to as a "sinking fund
redemption date"), through the operation of the sinking
fund, at a redemption price equal to 100% of the
principal amount of the Debentures to be redeemed,
                              - 10 -

     together with accrued interest to the date fixed for
     redemption.

          As a mandatory sinking fund for the retirement of
     the Debentures, the Company will, * * * pay to the
     Trustee, on or before the business day next preceding
     each sinking fund redemption date * * * an amount in
     cash equal to five percent * * * of the aggregate
     principal amount of Debentures outstanding at the close
     of business on March 1, 1979 (excluding any Debentures
     which shall have been converted on or prior to such
     date pursuant to Article Four). * * * [Emphasis
     added.]

     Section 5.05 of the indenture provides that, in the event of

a notice of redemption pursuant to sections 5.01 and 5.02,

interest would accrue to a date specified in the notice and cease

to accrue thereafter.   Section 5.05 further excludes converted

debentures from the determination of the amount of funds needed

after a redemption call.   Section 5.07 provides for the repayment

to REMCC of the amount in the sinking fund not required for the

redemption of converted debentures.

     Under Article Four of the indenture, a holder of debentures

had the right, at any time beginning March 31, 1969, and prior to

maturity or other redemption of the debentures, to exchange

debentures for common shares of Metals at a fixed price,

initially $46 per share (i.e., 21.74 shares per $1,000 principal

value of debentures), subject to adjustment under certain

circumstances.   Section 4.01 provides that Metals would

effectuate any such exchange absent an agreement between Metals

and RMECC that RMECC should do so.
                              - 11 -

     If an agreement was reached by which RMECC would effect the

conversion, Metals was obligated to sell to RMECC upon demand

shares of common stock sufficient to convert all outstanding

debentures (less any shares held by RMECC).    Unless otherwise

agreed, RMECC would pay Metals the conversion price for shares

purchased.

     Between June 1, 1971, and June 1, 1981, inclusive, the

debentures were redeemable with a premium.    After June 1, 1981,

RMECC had the right to call the debentures for redemption without

premium.   Debentures could be redeemed in two ways:   (1) RMECC at

its option could call some or all of the debentures for

redemption; or (2) debentures were subject to redemption through

the operation of the sinking fund.     If all of the debentures were

called for redemption (or specifically numbered debentures were

called), the holder could effect conversion up to the close of

business on the date of redemption.    Upon conversion, the rights

of the holder of such debenture ceased.    RMECC could call for a

redemption if the U.S. tax laws changed and caused RMECC to pay

"additional interest".   Under the indenture, RMECC agreed to pay

as "additional interest" any taxes, assessments, and governmental

charges that may be imposed on foreign debenture holders, with

specified conditions and exceptions.

     As guarantor of the debentures, Metals unconditionally

guaranteed to the debenture holders the punctual payment of the
                               - 12 -

debenture principal, premiums, interest, and the sinking fund, as

well as the conversion of the debentures.

      Debentures which had been either redeemed or converted could

be delivered by Metals or RMECC to the trustee with an Officers'

Certificate to receive additional credit against the sinking fund

payments.

      In the event that RMECC made a call of redemption under

section 5.01 of the indenture, RMECC was required to deposit with

the trustee enough money to redeem all the debentures called for

redemption (except for debentures converted prior to the payment

date) plus the accrued interest.   The indenture did not require

RMECC to deposit money with the trustee for the redemption of

converted debentures.   After a call for redemption, the indenture

provided that the trustee would repay to RMECC the money that was

deposited with the trustee for redemption of debentures but was

not used because debentures were converted.

      In 1970, CBA was amalgamated with CRM Capital Limited

(Capital), a Quebec corporation, to form Canadian Reynolds Metals

Company Limited (CRM), a Quebec corporation.    In the

amalgamation, RMECC received all of the issued and outstanding

common stock of CRM.    Under CRM, the production capacity of the

Baie Comeau plant increased from 175,000 tons per year in 1970 to

over 300,000 tons per year in 1985.2    In 1983, CRM expanded its

2
    As noted above, at p. 5, production capacity in 1968 was
                                                    (continued...)
                               - 13 -

operations to include the manufacture of finished and

semifinished aluminum products by amalgamating with other

Canadian affiliates of Metals.    In 1987, CRM produced 304,955

tons of primary aluminum.    In 1987, CRM's gross sales to

unaffiliated customers totaled about $110 million, and CRM's

gross sales to affiliates totaled about $400 million.

     In February 1987, RMECC issued additional stock for $31

million to Reynolds Energy Resources Corporation (RERC) in

contemplation of the redemption of the debentures.    At that time,

RERC was 100-percent owned by RMC Holdings, Inc., which was 100-

percent owned by Metals.

     From their issuance through February 24, 1987, the aggregate

principal amount of outstanding debentures was reduced to

$29,773,000.

     On February 24, 1987, RMECC called the debentures for

redemption (the call), effective at the close of business

March 26, 1987 (the redemption date).    On February 23, 1987,

Metals filed with the Securities and Exchange Commission a

registration statement registering 681,503 shares, the maximum

number of shares required if all of the debentures that were

outstanding on February 24, 1987, had been exchanged for shares

pursuant to the indenture.

2
 (...continued)
115,000 tons per year. There is nothing in the record explaining
the capacity increases, although Metals infers that it is
responsible in some manner.
                               - 14 -

     A holder who surrendered debentures for redemption in cash

pursuant to the call would have been entitled to receive

$1,015.97, consisting of $1,000.00 principal and $15.97 accrued

interest for each $1,000.00 face value of debentures surrendered.

     If a debenture holder instead exercised the right of

conversion, the holder would have been entitled to receive 22.89

shares for each $1,000 face value of debentures delivered to

Metals, pursuant to the terms of the indenture.    During the

period of redemption, the market price of shares at the close of

business on the day prior to the dates on which conversions

occurred ranged from a low of $52.75 on March 4, 1987, to a high

of $65.00 on March 26, 1987.    Thus, the value of the shares into

which a debenture having a face value of $1,000.00 could be

converted ranged from $1,207.45 to $1,487.85, respectively.

     On February 24, 1987, Metals entered into a standby

agreement with Goldman, Sachs & Co. and Salomon Brothers Inc.

(the standby purchasers).    Under the agreement, the standby

purchasers offered to purchase debentures from holders at a price

of $1,017 per $1,000 face amount until the close of business on

the redemption date.   The price offered exceeded the redemption

price of $1,015.97, reflecting Metals' desire to minimize the

amount of debentures surrendered for redemption.

     The standby purchasers were obligated to convert all

debentures they purchased.    They could also purchase debentures
                              - 15 -

in the open market and agreed to convert all debentures so

purchased.

     By letter dated March 4, 1987, Metals instructed Chemical

Bank in New York, Chemical Bank in London, S. G. Warburg & Co.,

Ltd., in London, and Banque Internationale a Luxembourg S.A. in

Luxembourg (the agents), that any debentures surrendered to them

for conversion "should be forwarded in the normal course to

Chemical Bank in New York as principal conversion agent (not as

Trustee, as indicated in the letter to you dated February 24,

1987 from the Guarantor)."   By a second letter dated March 4,

1987, Metals advised Chemical Bank in New York that it had

instructed all of the conversion agents "to forward all

Debentures surrendered to them for conversion to Chemical Bank in

New York as principal conversion agent."   Metals further

instructed Chemical Bank in New York that such converted

debentures were to be held for the account of Metals, as provided

by section 4.12 of the indenture dated as of June 1, 1968.     The

letter to Chemical Bank also provided:

          In your role as principal conversion agent,
     converted Debentures held for the account of the
     Guarantor should be surrendered for redemption to
     Chemical Bank as paying agent as provided by Section
     4.12 of the Indenture. Chemical Bank as paying agent
     is further instructed to pay the redemption price
     ($1,000 principal amount plus $15.97 accrued interest
     per $1,000 Debenture) to the Guarantor on the
     Redemption Date, or, in the event that knowledge of
     conversions is not known in time to make payment on the
     Redemption Date, as soon as possible thereafter. * * *
                              - 16 -

          When payment of the redemption price has been made
     to the Guarantor, the paying agent should surrender
     converted Debentures for cancellation to the Trustee.

     From March 4, 1987, to March 26, 1987, debentures having an

aggregate face value of $29,150,000 were delivered to the agents

and were exchanged upon delivery for 667,314 shares pursuant to

the indenture.   Of this total, debentures with a face value of

$23,000 were delivered by the standby purchasers.     The value of

the shares delivered in exchange for debentures was $41,879,710.

In connection with these exchanges, Metals paid $6,242 in lieu of

fractional shares and incurred expenses in the amount of

$288,769.

     After February 24, 1987, and before April 21, 1987,

debentures with a face value of $25,000 were delivered to the

agents and were redeemed for cash.     As of April 21, 1987,

debentures having an aggregate face value of $598,000 were

unaccounted for.   These debentures ceased to accrue interest as

of March 26, 1987, and, if and when surrendered for redemption,

have been or will be redeemed in cash for their face value plus

interest accrued to March 26, 1987.     Chemical Bank, as indenture

trustee, opened Chemical Bank account number 506-032647 as the

bond account to redeem the debentures.     As of October 25, 1994,

the account was still open as not all debentures have been

presented for redemption.

     On March 25, 1987, RMECC delivered $30,248,474.81 to account

number 506-032647 by wire transfer.     This amount represented the
                              - 17 -

full amount required to pay all principal and interest due on the

debentures outstanding on the date of the call.

     Between March 26, 1987, and April 1, 1987, Chemical Bank,

the indenture trustee, transferred to Metals' account by wire

transfer a total of $29,680,547.52.    The amount of the transfers

represents an amount equal to the amount of principal and

interest payable by RMECC on the redemption date ($1,015.97 for

each $1,000.00 of face value) that would apply to $29,214,000

total face value of debentures.   Because Metals had only received

$29,150,000 of debentures in exchange for shares, Metals received

cash payments for $64,000 face value of debentures to which it

was not entitled.   Thus, on April 13, 1987, Metals transferred to

the indenture trustee by debit memorandum from Metals' bank

account at Chemical Bank $65,022.08.

     On October 27, 1987, the Indenture Trustee destroyed the

certificates representing the 29,150 debentures acquired by

Metals in exchange for shares.

     In a notice of deficiency, respondent disallowed

petitioners' claimed capital loss deduction in the amount of

$13,024,721, representing the difference between the cost of

exchanging Metals' stock (the fair market value of the stock plus

expenses incurred plus cash paid in lieu of fractional shares)

for the debentures ($42,174,721), and the face value of the

exchanged debentures ($29,150,000).
                                - 18 -

     Petitioners recognize that the issuance of Metals' shares in

satisfaction of its conversion obligation under the debentures

does not give rise to a loss.    Sec. 1032(a);3 National Can Corp.

v. United States, 

, 1116 (7th Cir. 1982).

Petitioners argue, however, that:    (1) When Metals exchanged the

debentures acquired as a result of the conversions, they became

capital assets in its hands and acquired a basis equal to the

fair market value of its shares issued to the debenture holders;

and (2) when RMECC redeemed the debentures, Metals had a capital

loss under section 165(f) equal to the excess of such value over

the redemption price paid to it by RMECC.    Respondent counters

that:   (1) The debentures did not survive the conversions with

the result that Metals suffered no loss on their redemption; and

(2) if the debentures did survive the conversions, the excess of

the fair market value of Metals' shares over the amount it

received on redemption, i.e., the principal, of the debentures

constituted a capital contribution to RMECC rather than a capital

loss under section 165(f).   The burden is on petitioners to show

that they are entitled to the deduction.    INDOPCO, Inc. v.

Commissioner, 

, 84 (1992).




3
   Sec. 1032(a) provides in pertinent part: "No gain or loss
shall be recognized * * * on the receipt of money or other
property in exchange for stock (including Treasury stock) of such
corporation."
                              - 19 -

Did the debentures survive the conversions?

     Petitioners and respondent agree that the rights and

obligations of Metals, RMECC, and the debenture holders are

governed by the terms of the indenture.

     Under the terms of the indenture, cancellation of debentures

occurs in a circumscribed manner.   Section 1.01 (supra p. 8)

provides that debentures are outstanding until they have been

canceled or delivered for that purpose to the indenture trustee.

Under the terms of the indenture, Metals was obligated to

exchange its stock for the debentures, upon their submission by

the debenture holders.   Section 2.08 (supra p. 9) states that

such acquisition by Metals "shall not operate as a redemption or

satisfaction of the indebtedness represented by such Debentures

unless and until the same are delivered to the Trustee for

cancellation."

     There are further indications that the parties clearly

contemplated that converted debentures would exist after

conversion.   Thus, section 4.12 (supra p. 9) provides: "Converted

Debentures shall not be further convertible into Common Stock of

* * * [Metals], and shall not be redeemable, * * * unless all

Debentures at the time outstanding shall be redeemed at the same

time."

     The several provisions of Article Five, cited by respondent,

admittedly treat converted debentures differently from other
                                - 20 -

debentures.    For example, under section 5.02 (supra pp. 9-10),

minimum payments to a sinking fund are to be computed by

reference to outstanding debentures less converted debentures.

Sections 5.05 and 5.07 (supra p. 10) contain provisions for

adjustment of the sinking fund and calculation of payment for

redemption to take converted debentures into account.     These

provisions do no more than modify the need for a sinking fund

with respect to converted debentures that would be in the hands

of RMECC, the entity obligated on the debenture, or Metals, its

parent, neither of whom would need to have funds set aside to pay

themselves.     Elimination of converted debentures from the sinking

fund does no more than reflect the realities of the relationship

between RMECC and Metals and fails to counteract the other

indications that the converted debentures were to survive the

exchange.     Nor are we persuaded that Metals was attempting to

change the terms of the debentures by the correspondence with

Chemical Bank in New York relating to its status as conversion

agent instead of as trustee, see supra p. 15.     In our judgment,

this correspondence reflects a careful effort to comply with, not

modify, the terms of the indenture.

     The terms of the indenture herein are substantially similar

to those of the indenture involved in Husky Oil Co. v.

Commissioner, 

(1984), affd. sub nom. Marathon Oil Co.

v. Commissioner, 

(10th Cir. 1987), where we
                                - 21 -

concluded that liability for the principal of debentures issued

by the subsidiary remained outstanding after their acquisition by

the parent in exchange for the latter's stock.    Respondent seeks

to distinguish Husky Oil Co. because of language in the indenture

relating to the subordination of the converted debentures, see

which is not present in the debenture involved

herein.   We are satisfied, however, that the presence of this

language was not the exclusive basis for our conclusion that the

debentures survived in the hands of the parent.   Moreover, we are

satisfied that any gap in the indenture involved herein by reason

of the omitted language is filled by at least one other

provision, i.e., the parenthetical clause in section 2.08 of the

within debenture, see supra p. 9, which is omitted from the

comparable provision in the debenture in Husky Oil Co. v.

Commissioner, 

.

     Further support for our conclusion can be found in

International Telephone & Telegraph v. Commissioner, 

(1981), supplemented by 

, affd. per curiam 

(2d Cir. 1983), as interpreted by the Court of Appeals for

the Second Circuit in ITT Corp. v. United States, 

(2d Cir. 1992), revg. 90-1 USTC par. 50,214 (S.D.N.Y. 1990),

which is further discussed later in this opinion (infra pp. 22-23

and 25-26).   In that case, the parent exchanged its stock for

debentures of its subsidiaries in accordance with the terms of
                               - 22 -

the debentures.    We dealt with the question of entitlement of the

parent or subsidiary to a loss in light of a provision in a

consolidated return regulation that is no longer in effect.4    Our

holding that the subsidiaries had deductible losses was within

that narrow framework.   Although not expressly articulated, that

the debentures survived their acquisition by ITT was an essential

element of our ultimate conclusion.     See 

at 565-

566.

       The cases relied upon by respondent, Chock Full O'Nuts Corp.

v. United States, 

, 304-305 (2d Cir. 1971); AMF

Incorporated v. United States, 

, 

,

1353-1354 (1973); Hunt Foods & Industries, Inc. v. Commissioner,

, 642 (1972), affd. per curiam 

(9th Cir.

1974), for the proposition that convertible debentures can be

only converted or redeemed, but not both, are clearly

distinguishable.   First, each case addressed the distinct issue

whether the taxpayer could deduct as original issue discount the

part of the issue price attributable to the conversion feature.



4
   The regulation, sec. 1.1502-41A, Income Tax Regs., is not
applicable for tax years beginning after Dec. 31, 1965. See T.D.
6894, 1966-2 C.B. 362. Under former sec. 1.1502-41A, Income Tax
Regs., the subsidiaries in International Telephone & Telegraph v.
Commissioner, 

(1981), supplemented by 

,
affd. per curiam 

(2d Cir. 1983), were considered to
have purchased their debentures from the parent, ITT, for an
amount equal to ITT's basis in the debentures and the
subsidiaries bore losses. International Telephone & Telegraph v.
Commissioner, 

.
                              - 23 -

Second, in each case, the taxpayer was both the issuer of the

debentures and the party responsible for their conversion into

its stock, so that it was not possible for the debentures to be

converted without being returned to the issuer and obligor.     Such

is not the case herein.

     Respondent seeks to find support for her position from the

District Court opinion in ITT Corp. v. United 

.     In

that case, the District Court first held that this Court's

decision in International Telephone & Telegraph v. 

, had collateral estoppel effect with respect to the issue

of ITT's basis in debentures acquired in an exchange for stock,

but not as to whether the debentures survived the exchange.     The

court then proceeded to find that the debentures did not survive

the exchange.   This decision was reversed, on the basis that

collateral estoppel applied to both issues.    The Court of Appeals

reasoned that, although we had applied a particular consolidated

return regulation in International Telephone & Telegraph v.

, we had necessarily decided that the

debentures had survived the exchange, following which, ITT had

sold the converted debentures to the issuing subsidiaries.      ITT

Corp. v. United 

.

     Finally, respondent argues that the converted debentures

were not redeemable because section 4.12 of the indenture

requires that all debentures be presented for redemption at the
                               - 24 -

same time, which did not happen as evidenced by the few

debentures still unaccounted for.   We disagree.   All that was

required in order for the converted debentures to be redeemable

was that all the outstanding debentures be called for redemption

at the same time, a requirement that was satisfied.    In this

connection, we note the debentures ceased to accrue interest as

of the redemption date.   The fact that some holders, for reasons

of their own and over whom neither Metals nor RMECC had any

control, did not seek to be paid or to exchange their debentures

is and should be irrelevant.   A contrary conclusion would produce

a totally unworkable situation.

     In sum, we hold that the converted debentures survived as

obligations of RMECC.   This being the case, we must now determine

the extent of the loss, if any, to Metals upon their subsequent

redemption by RMECC.



Did Metals have a capital loss upon the redemption of the

debentures?

     Resolution of this question involves a determination of

Metals' basis in the debentures and whether there was an excess

of that basis over the principal amount of the debentures

received by Metals upon the redemption of RMECC which constitutes

a deductible capital loss.   We turn first to the question of

basis.
                              - 25 -

      Generally, a corporation issuing its own stock in exchange

for property has a basis in the property equal to the fair market

value of the stock issued in exchange for the property.     Sec.

1012; Simmonds Precision Prods. v. Commissioner, 

, 115

(1980).   Expenses incurred in the transaction are also properly

included in basis.   Sec. 1016(a).5

      We applied this general rule in the similar situation

presented in International Telephone & Telegraph v. 

, wherein we held the debentures had a basis to ITT equal to

the value of the ITT stock for which they were exchanged, for

purposes of applying a then-existing consolidated return

regulation.   ITT Corp. v. United 

;

Bittker & Eustice, Federal Income Taxation of Corporations and

Shareholders, sec. 3.12[2], at 3-61 n.270 (6th ed. 1994).     Our

application of the regulation produced the conclusion that the

subsidiaries, not ITT, were entitled to the losses.   See

International Telephone & Telegraph v. Commissioner, 

.   The issue of ITT's basis was presented to the court in terms

of the Government's contention that the exchange of ITT's stock

extinguished the obligation of the subsidiaries to redeem the

debentures so that the entire fair market value of the ITT stock

constituted a contribution by ITT to the capital of the


5
   The parties do not dispute that $6,242 payments for fractional
shares and $288,769 expenses, see supra p. 16, should be included
in basis.
                              - 26 -

subsidiaries.   Neither party suggested that such fair market

value should be allocated between the elements involved in the

exchange.   Under these circumstances, we did not address the

question whether, had ITT been entitled to deduct such losses,

the full amount of the fair market value of the ITT stock should

have been taken into account or whether a portion of that value

should have been treated as a capital contribution to the

subsidiaries.   Furthermore, we noted that we were expressing no

opinion as to what our position would be outside the consolidated

return arena, i.e., in a situation where the consolidated return

regulations did not apply.   See International Telephone &

Telegraph v. Commissioner, 

n.26.    In light of the

foregoing, we do not think we are precluded by International

Telephone & Telegraph, from examining the question whether the

fair market value of Metals' stock should be attributed in part

to the conversion of the debentures by Metals and thus not

constitute an element of loss upon redemption.6   Cf. National Can

Corp. v. United States, 

, 1116 (7th Cir. 1982).

     In our view, there were two elements involved in the

issuance of Metals' stock:   (1) The acquisition of the debentures

and the right to obtain reimbursement for the principal amount



6
   We note that neither party has suggested that any provision of
the existing consolidated return regulations applies to the
instant case. See National Can Corp. v. United States, 

, 1117 (7th Cir. 1982).
                              - 27 -

thereof from RMECC; and (2) the discharge of the conversion

obligation under the indenture, an obligation which Metals had

both directly and as guarantor of the conversion obligation of

RMECC.   On this basis, the excess of the fair market value of

Metals' shares into which the debentures were converted over such

principal amount would be attributable to the conversion feature

and the balance to the debentures.     Such an approach has been

suggested, albeit implicitly, by National Can Corp. v. United

, and Honeywell Inc. v. Commissioner, 

(1986) (in the context of disallowing the parent a deduction for

bond premium under sec. 171);7 see also Clark Equipment Co. v.

United States, 

(6th Cir. 1990); Strasen, "The

Taxation of Convertible and Other Equity-Flavored Debt

Instruments," 65 Taxes 937 (1987); Committee on Taxation of

International Finance and Investment of New York State Bar

Association, Tax Section, "Report on International Finance

Subsidiaries," 28 Tax L. Rev. 443 (1973).     Under this approach,

Metals' basis in the debentures would be limited to their



7
   We recognize that we looked askance at a breakdown of a
convertible debenture into components in Hunt Foods & Industries,
Inc. v. Commissioner, 

, 641 (1972), affd. per curiam

(9th Cir. 1974). But that case dealt with the
rights of an issuer to deduct original issue discount in respect
of the conversion feature of a debenture which involved the
issuance of its own shares and not the shares of another
corporation as is involved herein. Thus, Hunt Foods is
distinguishable as are other cases relied upon by respondent to
sustain her position herein.
                              - 28 -

principal amount, with the result that Metals would have neither

gain nor loss on their redemption.     The excess of the fair market

value of Metals' shares over that amount would be considered a

capital contribution by Metals to RMECC and an addition to

Metals' basis in its RMECC shares.     Cf. Honeywell Inc. v.

at 641-642; see also Marathon Oil Co. v.

Commissioner, 

(10th Cir. 1987), affg. Husky Oil Co.

v. Commissioner, 

(1984).     That such value may not be

an item that can be reflected in the capital account of RMECC

does not negate the existence of a capital contribution.

Commissioner v. Fink, 

, 97 (1987).

     Petitioners insist that the conversions encompassed only a

single element, i.e., the acquisition of the debentures by

Metals, that the fair market value of Metals' shares represents

the cost of such acquisition and therefore the basis of the

debentures and that it is error to bifurcate that cost into

separate elements.   The premise of petitioners' position, namely,

the presence of a single element, is erroneous.    What is involved

herein is not a bifurcation of the cost of a single property; it

is the apportionment of a value among the elements acquired for

that value.   Our approach is no different than what occurs, for

example, in the apportionment of a purchase price of a business

among the different assets, e.g., depreciable and nondepreciable,

or different benefits, e.g., business assets and a covenant not
                              - 29 -

to compete.   Petitioners' reliance on Republic Petroleum Corp. v.

United States, 

, 919-920 (E.D. La. 1975), affd.

in part and revd in part 

(5th Cir. 1980), is

misplaced as that case involved only the acquisition of a single

asset, stock.

     Nor are we impressed with petitioners' attempt to salvage

their position by asserting that the excess value involved herein

represented an expenditure by Metals to discharge an obligation

incurred in furtherance of a business purpose of its own.

     Petitioners argue that Metals incurred the exchange

obligation, and subsequently made the stock outlay on its own

behalf, because it sought to increase its supply of Canadian

aluminum.   It is, however, more accurate to state that Metals

guaranteed the exchange of its stock so as to make RMECC's

debentures marketable in the Eurobond market,8 the sale of which

enabled RMECC to acquire a majority of CBA's stock while BA, 48

percent owned by Metals, was able to raise cash to build new

aluminum plants by selling its CBA stock to RMECC.   The link that

petitioners fail to explain is why holding an 83-percent interest

in CBA, through RMECC, its 100-percent owned subsidiary, improved

its supply of Canadian aluminum as compared to when Metals owned



8
   For discussion of the Eurobond market see New York State Bar
Association, Tax Section, Committee on U.S. Activities of Foreign
Taxpayers, "The Withholding of Tax on Interest Paid by U.S.
Borrowers to Foreign Lenders," 6 Intl. Tax J. 126, 127 (1979).
                              - 30 -

31 percent of CBA directly and indirectly held 47 percent through

BA, of which it owned 48 percent.    The record does show that, in

1987, about 80 percent of CBA's sales were to affiliates, but

there are no earlier figures with which to compare.    The record

also shows that the production capacity of CBA's Baie Comeau

plant increased concurrently with the involvement of RMECC, but

the reasons go unexplained.   In short, we are not persuaded that

Metals' stock outlay was made in exchange for a direct and

quantifiable benefit to Metals so as to preclude a finding that

the outlay was a contribution to capital.    See Nalco Chemical Co.

& Subsidiaries v. United States, 

, 1289-1290

(N.D.Ill. 1983); cf. United States v. Chicago, B. & Q. R. Co.,

, 413 (1973).

     Nor are we persuaded by the fact that Metals had a

conversion obligation under the indenture, for it is the origin

and nature of the obligation that determines deductibility.    See

Interstate Transit Lines v. Commissioner, 

, 594

(1943); Eskimo Pie Corp. v. Commissioner, 

, 677 (1945),

affd. 

(3d Cir. 1946).     The fact that this standard

has generally been articulated in the context of the issue

whether an expenditure is a deductible business expense under

section 162(a) or is a capital contribution under section 118(a)

does not impair its applicability in the instant case when the

capital nature of the transaction is considered.
                              - 31 -

     Even if we were to accept petitioners' assertion as to

Metals' objective in entering into the arrangements for and

effecting the conversion of the RMECC debentures, the excess

value of the Metals' shares would, at best, constitute a capital

expenditure without a determinable useful life and would

therefore not represent a deductible capital loss.   INDOPCO, Inc.

v. Commissioner, 

, 84 (1992).

     The long and the short of the matter is that Metals'

obligation to convert and its implementation of that obligation

stemmed from its status as the sole shareholder of RMECC and has

a strong "shareholder/investor aura".   Centel Communications v.

Commissioner, 

, 637 (1989), affd. 

(7th

Cir. 1990) (taxpayer-corporation executed indemnification and

subordination agreements in favor of corporation of which it was

a shareholder).   The fact of the matter is that the only thing of

value that Metals acquired by the conversion was the right to

obtain payment from RMECC of the principal amount of the

debentures.   Given the further fact that the holder of a

convertible debenture will usually exercise his conversion right

only where the value of the stock to be received on the

conversion exceeds the amount of the debentures, see Honeywell

Inc. v. Commissioner, 

, it is apparent that Metals

had a guaranteed loss from the conversions.
                              - 32 -

     To accede to petitioners' blandishments and hold that Metals

is entitled to a capital loss would, in effect, be the equivalent

of allowing a loss to which Metals was not entitled on the

conversion, under section 1032, albeit as a capital loss rather

than an ordinary loss, or the equivalent of a bond premium

amortization deduction disallowed by section 249.

     We are not prepared to accept such an eccentric result.     See

Darby v. Commissioner, 

, 68 (1991).     Petitioners assert

that respondent has not pointed to any specific provision of the

Internal Revenue Code that disallows the claimed capital loss.

The simple answer to that assertion is that deductions are a

matter of legislative grace, and it was petitioners' burden to

demonstrate that the claimed capital loss was allowable under the

Internal Revenue Code.   INDOPCO, Inc. v. 

.

They simply have not carried that burden.

     We hold that petitioners are not entitled to deduct a

capital loss for the amount of the excess of the fair market

value of Metals' shares utilized in the conversion over the

principal of the RMECC debentures.     Such excess presumably will

become part of Metals' basis in its RMECC shares.9


9
   The portion of the expenses of the conversion (and amounts
paid for fractional shares), see supra note 5, represented by the
fraction whose numerator is the principal amount of the debenture
and whose denominator is the total value of Metals' stock issued
on the conversions, would appear to be an additional capital loss
which can be allocated to the value of the stock representing
such principal.
                            - 33 -

    To take into account the disposition of other issues by the

parties,

                             Decision will be entered

                        under Rule 155.