worthless in 1987, Intergraph is not entitled to the claimed bad debt deduction under section 166. Decision will be entered for respondent. CITY OF COLUMBUS, OHIO, PETITIONER v. COMMISSIONER Docket No. 3301-95B. Filed May 14, 1996. P, a home rule municipal corporation and political subdivision of the State of Ohio, seeks a declaratory judgment that interest on bonds it proposes to issue will be exempt from taxation under sec. 103(a), I.R.C. In 1967, in exchange for the assumption of P's accrued unfunded pension obligation by a fund established for that purpose by the State of Ohio, P incurred a long-term obligation to the State fund. In 1994, P made a lump-sum payment equal to 65 percent of the remaining principal in satisfaction of the long-term obligation. Taking into account the 35-percent discount, the yield to P in making the prepayment, as compared to the payments it otherwise would have made, is 7.57484 percent. P proposes to issue long-term obligations, with an interest rate of 6 percent, to fund the prepayment to the State fund. Pending our decision herein, P has issued short-term obligations to fund the prepayment. Held, P entered into the prepayment transaction with a principal purpose being to profit from the discount offered by the State fund. Held, further, to reflect the economic substance of the transaction, R may characterize the prepayment as the acquisition of property. Sec. 1.148-10(e), Income Tax Regs. Held, further: The prepayment constitutes investment type property, sec. 148(b)(2), I.R.C., with a materially higher yield than the proposed bonds. Thus, interest on the proposed bonds will not be excludable from gross income under sec. 103(a), I.R.C. David L. Miller, Jerry O. Allen, and David A. Rogers, for petitioner. Rebecca L. Caldwell-Harrigal, Joel E. Helke, and Richard L. Carlisle, for respondent. OPINION TANNENWALD, Judge: This is an action for a declaratory judgment pursuant to section 7478 and Rule 211.1 On June 3, 1994, petitioner submitted a ruling request to respondent seeking a determination that interest on certain proposed bonds will be excludable from gross income under section 103(a). After administrative review, on December 5, 1994, respondent ruled that interest on the proposed bonds will not be excludable under section 103(a) on the grounds that the bonds would be arbitrage and/or hedge bonds within the meaning of sections 148 and 149(g), respectively. All of the jurisdictional requirements for a declaratory judgment action have been satisfied. Rule 210(c). Petitioner bears the burden of proof. Rule 217(c)(2)(A). Our decision is based upon the stipulated administrative record, which is incorporated herein by this reference, and additional evidence received pursuant to an order of this Court. Rule 217(a).2 Petitioner is the City of Columbus, Ohio (city). On December 20, 1993, the City Council of Columbus adopted an ordinance authorizing the issuance of bonds in a principal amount not to exceed $28 million. In its ruling request, petitioner anticipated the actual amount of the proposed bonds would be $27,300,000. Having retired $600,000 in principal amount of its 1994 bond anticipation notes (see infra p. 329), petitioner now anticipates the actual amount of the proposed bonds will be $26,700,000. Petitioner is a home rule municipal corporation and political subdivision of the State of Ohio (State). Before 1967, the city maintained two pension funds for its police officers and firefighters (collectively referred to hereinafter as the city fund). In 1965, a State law was enacted creating the Police and Firemen's Disability and Pension Fund (the State fund), a statewide pension fund for police officers and firefighters. The State fund was created to replace unfunded plans of the city and other municipalities with a fully funded pension 1 All statutory references are to the Internal Revenue Code, and all Rule references are to the Tax Court Rules of Practice and Procedure. 2 Respondent objects to what she describes as petitioner's attempt to admit additional material into evidence, by way of appendices A and B to petitioner's opening brief. Appendix A contains an amortization of the city obligation based on an exhibit in the stipulated record and is thus not new evidence. Appendix B, however, is an amortization schedule of the proposed bonds and is new evidence as to which we sustain respondent's objection. plan. The State fund assumed and guaranteed the pre-1967 pension liabilities of Ohio municipalities, including the city (the State fund obligation). In addition, the State law provided that pension liabilities for police officers and firefighters accruing on and after January 1, 1967, would be supported by current employer and employee contributions. Pursuant to the State law, the value of the transferred liabilities and assets of each municipality was determined by the Wyatt Co. (Wyatt), an actuarial company employed by the State to make the calculations. Wyatt computed the present value of each municipality's accrued unfunded pension liability, using a discount factor of 4.25 percent, compounded annually (the mathematical equivalent of 4.21 percent compounded semiannually), and certain actuarial assumptions based on mortality tables. Wyatt determined the present value of the accrued unfunded liabilities of the city fund that were transferred to the State fund to be $44,638,971. Of that amount, $1,929,702 was satisfied by assets of the city fund, and the city was credited with $21,470 of accrued interest, resulting in a net accrued liability of $42,687,799. On January 1, 1967, as required by the law creating the State fund, the liabilities and assets of the city fund were transferred to the State fund. The State law required each municipality to pay to the State fund, either immediately or over time with interest, an amount equal to its accrued unfunded pension liability; i.e., the difference between the transferred liabilities and assets. If a municipality opted to pay that amount over time, the State law, as originally enacted, required it to pay interest at 4 percent per annum on the unpaid balance. Subsequent to an amendment to the State law in 1968, the interest rate charged by the State fund has been 4.25 percent per annum. Petitioner chose to pay the present value of its accrued unfunded pension liability over time (the city obligation). It has never been obligated to make up for any shortfalls or deviations from the actuarial calculation of its accrued unfunded pension liability. The deferred payment option in the original State law required any amount unpaid as of January 1, 1968, to be paid over 20 years in equal principal installments, i.e., at least 5 percent of the amount unpaid as of January 1, 1968, each year, together with interest at 4 percent. Principal and interest on the obligation were payable semiannually on dates to be determined by the trustees of the State fund. By State law, effective November 25, 1969, the unpaid city obligation, as of January 1, 1969, was to be paid 2 percent in 1969, 2 percent in 1970, 3 percent in 1971, 4 percent in 1972, and 5 percent per annum beginning in 1973 and each year thereafter for 62 years. This repayment schedule incorporated the payment of interest at a rate of 4.25 percent, compounded semiannually. The city made payments pursuant to the above schedule through 1993. Under the State fund pension system, both municipal corporations and their employees who are police officers and firefighters contribute a percentage of current wages to the State fund. The State fund pays pensions in defined amounts to retired police officers, firefighters, and surviving spouses and dependents. It treats all participating municipal corporations and their police officers and firefighters equally based on current contributions. No consideration is given as to whether a particular municipal corporation paid the principal amount of its accrued unfunded pension liability in full or agreed to pay such liability over time. Amounts in the State fund are invested for the equal benefit of all police officers and firefighters throughout the State. The actuary for the State fund has assumed a rate of return on investments of the State fund of 8.25 percent, compounded annually. Approximately 304 municipalities transferred their assets and accrued liabilities as of January 1, 1967, to the State fund. In 1993, section 742.30(C) was added to the Ohio Revised Code, which provided: (C) The board of trustees of the police and firemen's disability and pension fund may enter into an agreement with a municipal corporation for a single payment by the municipal corporation of the employer's accrued liability. The agreement may provide for a reduction in the amount of the accrued liability based on the value to the fund of receiving a single payment. A municipal corporation that has made payment in accordance with such an agreement shall have no further obligation to make payments under this section. [Ohio Rev. Code Ann. sec. 742.30(C) (Anderson Supp. 1995).] Pursuant to this provision, the State fund allowed single, lump-sum payments, beginning October 20, 1993. The State fund adopted 65 percent of the outstanding principal balance as the discounted amount it would accept for such a payment. From October 20, 1993, to December 14, 1995, 36 municipalities, including the city, made lump-sum payments, in exchange for release of the full amount of their outstanding liabilities to the State fund. On November 3, 1993, the city entered into a prepayment agreement with the State fund. On November 15, 1993, the outstanding principal balance of the city obligation was $41,435,720, which amount was still to be paid periodically until 2035. Under the agreement, the city agreed to pay a lump sum of $26,933,218, following which it would have no further obligation to the State fund. The city was obligated to make the lump-sum payment within 90 days of November 3, 1993, and was required to pay interest at a rate of 4.25 percent per annum from November 15, 1993, until the payment was made. The city made the payment of $27,304,720 to the State fund on January 31, 1994, including interest of $371,502. If the 35-percent discount is taken into account, the yield to petitioner for prepaying the city obligation, as compared to the payments it otherwise would have made, is 7.57484 percent. It was commercially reasonable for the city to finance the lump-sum payment by issuing obligations carrying a taxable interest rate. However, petitioner initially contemplated issuing tax-exempt bonds. After discussions with respondent, and before issuing long-term bonds, petitioner decided to obtain a private letter ruling from respondent on whether interest on the bonds would be excludable from gross income under section 103. On January 31, 1994, the city issued $27,300,000 in 1-year bond anticipation notes (BAN'S), due January 31, 1995. The BAN's sold for $27,334,125 and were general obligations of the city. On January 31, 1994, the city transferred $27,304,720 of the BAN proceeds to the State fund in satisfaction of the lump-sum payment agreement. Upon the maturity of the 1994 BAN's, petitioner, having repaid $600,000 of the 1994 BAN's, refinanced the remaining $26,700,000 with an issue of BAN's in that amount, maturing January 30, 1996 (the 1995 BAN'S). All 1995 BAN proceeds |