Medina, Mansfield and Mulligan, Circuit Judges.
MANSFIELD, Circuit Judge:
This appeal raises the question, apparently one of first impression, whether a corporation which has issued callable convertible bonds at par is entitled under the Internal Revenue Code of 1954 and the Treasury Regulations promulgated thereunder by the Commissioner of Internal Revenue to deduct as "original issue discount" that part of the issue price allocable to the conversion feature.
The factual background is undisputed. Appellant Chock Full O' Nuts Corporation ("the taxpayer"), a New York corporation engaged in the importing and sale of coffee and other food products and in the restaurant business, issued on or about August 1, 1961, its $100 par value convertible subordinated debentures, at 4 1/2% interest, due in 20 years, in the total principal amount of $6,938.900. The holder of each $100 debenture had the option of converting it into shares of the taxpayer's common stock at a stated conversion price per share ($28.50) unless the debenture should be called for redemption by the taxpayer before the holder exercised his option.*fn1 The parties have stipulated that as of the date of the sale of the debentures, the same debentures without the conversion feature would have sold at $89.625 for each $100 par value. In its corporate income tax return for the fiscal year ending July 31, 1962, the taxpayer claimed a deduction of $35,995.58 as that year's amortization of the bond discount, a figure arrived at by multiplying the number of debentures sold, 69,389, by $10.375, the claimed discount, and by dividing the result ($719,911) by the 20-year life of the bonds.
The Commissioner denied the deduction and assessed the sum of $18,717.70 plus $2,023.96 in interest. Taxpayer paid this amount under protest and began suit in the district court for a refund. In an opinion reprinted at 322 F. Supp. 772 (S.D.N.Y. 1971), Judge Levet, to whom the case was submitted by the parties for decision upon stipulated facts without taking of testimony, awarded judgment to the United States. We affirm.*fn2
No provision of the Internal Revenue Code explicitly allows issuers of bonds to deduct original issue discount. However, every federal income tax act since 1864 has included a provision for the deduction of interest paid.*fn3 Section 163 of the Internal Revenue Code of 1954, for instance, which was in effect at all relevant times, permits deduction of "interest paid or accrued within the taxable years on indebtedness." It has long been accepted that "original issue discount serves the same function as stated interest." United States v. Midland-Ross Corp., 381 U.S. 54, 57, 85 S. Ct. 1308, 1310, 14 L. Ed. 2d 214 (1965). Like interest, discount represents a cost of borrowing money. Both are also alternative means of determining the price which a bond will command in the market.*fn4 Ever since Article 150 of Treas. Reg. 33 was promulgated under the Internal Revenue Code of 1916 the Commissioner has recognized that this economic congruence required equal tax treatment. The current regulation is § 1.163-3(a)(1), which provides in pertinent part:
"Deduction for bond discount. -- (a) Discount upon issuance. (1) If bonds are issued by a corporation at a discount, the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds."
At the time of the taxpayer's issuance of its convertible bonds in 1961, the applicable regulation was § 1.61-12(c)(3), whose language is identical to that of § 1.163-3(a)(1).*fn5
To determine whether that part of the issue price paid by the holder for the conversion privilege of a convertible bond constitutes original issue discount, as appellant here contends, we look to the Code and regulations defining that term. At the time of the issuance of the taxpayer's bonds in 1961, § 1232(b)(1) defined "original issue discount" to be "the difference between the issue price and the stated redemption price at maturity." "Issue price" was defined by § 1232(b)(2) to be "the initial offering price to the public at which price a substantial amount of such bonds or other evidences of indebtedness were sold."
The Government has argued that our problem is greatly simplified by the Commissioner's promulgation in 1968 of Treas. Reg. § 1.1232-3(b)(2)(i), which was made retroactive to obligations issued after December 31, 1954. It defines "issue price" in the case of an obligation convertible into stock or into another obligation to include "any amount paid in respect of the conversion privilege." Since original issue discount is defined as the difference between the issue price and the stated redemption price at maturity, taxpayer's debentures would not have been issued at a discount if Treas. Reg. § 1.1232-3(b)(2)(i) were to be applied. In reply, the taxpayer contends that that Regulation should not be given retroactive effect, arguing that it represented an effort to change the policy of existing regulations in order to support the Government's position in its pending litigation with the taxpayer.
We recognize that subject to certain limitations the Commissioner is empowered to prescribe the extent, if any, to which his regulations shall be given retroactive effect. Int. Rev. Code § 7805(b). See Helvering v. Griffiths, 318 U.S. 371, 397-399 n. 49, 63 S. Ct. 636, 87 L. Ed. 843 (1943). Indeed, it is the Commissioner's position that every Revenue Ruling is to be accorded retroactive treatment unless some specific statement of nonretroactivity is included. Rev. Proc. 68-37, 1968-2 Cum. Bull. p. 926. The Commissioner's authority in this area, however, is subject to review for abuse of discretion. "The Internal Revenue Service does not have carte blanche. Its choice must be a rational one, supported by relevant considerations." International Business Machines Corp. v. United States, 343 F.2d 914, 920, 170 Ct. Cl. 357, 367 (1965), cert. denied, 382 U.S. 1028, 86 S. Ct. 647, 15 L. Ed. 2d 540 (1966).*fn6 While retroactivity in tax regulations is therefore presumptively permissible, it is in each case for the court to determine whether under all the circumstances retroactive application would be warranted.*fn7 See May Seed & Nursery Co. v. Commissioner, 242 F.2d 151, 155 (8th Cir.), cert. denied, 355 U.S. 839, 78 S. Ct. 62, 2 L. Ed. 2d 51 (1957); Kay v. Commissioner, 178 F.2d 772, 773 (3d Cir. 1950).
To the extent that a regulation interprets or elucidates the meaning of a statute, it is merely explanatory or confirmatory rather than retroactive.*fn8 A taxpayer, when acting in an area of unsettled law, has no "vested interest in a hypothetical decision in his favor prior to the advent of the regulations." Helvering v. Reynolds, 313 U.S. 428, 433, 61 S. Ct. 971, 974, 85 L. Ed. 1438 (1941).*fn9 On the other hand, the Commissioner may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations. Here, for instance, while the taxpayer issued its bonds in August, 1961, took its discount deduction in 1962, filed its claim for a refund in January, 1966, and began suit in January, 1968, Treas. Reg. § 1.1232-3(b)(2)(i) was not promulgated until December, 1968. 33 Fed. Reg. 19176.
Thus it is questionable whether Treas. Reg. § 1.1232-3(b)(2) represents a valid exercise of the Commissioner's power to promulgate retroactive regulations. We find it unnecessary to resolve that issue, however, for the reason that, even under the regulations that had been promulgated at the time of issuance of the debentures, the portion of the original issue price allocable to the conversion feature did not constitute "original issue discount," which turns on the definition of "issue price" in Internal Revenue Code § 1232(b)(2) as "the initial offering price to the public." To accept the taxpayer's contention would be to depart from that definition. Here the initial offering price of the bonds to the public was $100 per bond. The taxpayer asks that a component of that offering price -- the part attributable to the conversion feature -- be excluded and that the balance be treated as the offering price for the purpose of finding whether there was an "original issue discount" within the meaning of § 1232(b)(1). However, we find no evidence that the term "offering price" was intended to apply solely to the investment element of a convertible bond as distinguished from its conversion element. Moreover, if we were to exclude the value of the conversion feature in determining the issue price, we could by the same logic deduct that figure when arriving at the redemption price, in recognition of the fact that the bond contains two distinct and separate components. We do not believe that the statutory language contemplates such a division.*fn10
Furthermore, if we look to the substance of the transaction and overlook the failure of taxpayer's debentures to satisfy the express requirements of Treas. Reg. § 1.1232-3(b)(1) for computation of an original issue discount, the taxpayer has failed to satisfy its burden of showing that the amount of the issue price allocable to the conversion feature represents a cost of borrowing money that must without qualification be paid. Its inability to meet this condition arises from the fact that the debentures provide for two mutually exclusive modes of satisfaction. Under one the holder may exercise his right to convert the debenture into common stock, in which event he will surrender his debenture and it will not be redeemed or paid at maturity. To permit deduction of the amount attributable to the conversion feature in the face of such a possibility would be to disregard established conditions precedent to the allowance of discount as a cost of borrowing money which must be repaid. "Amortized bond discount," wrote Mr. Justice (later Chief Justice) Stone for the Supreme Court in 1934, "is deductible from the taxpayer's gross income only by way of anticipation of payment of the bonds at maturity." Old Mission Portland Cement Co. v. Helvering, 293 U.S. 289, 292, 55 S. Ct. 158, 160, 79 ...