Rev. Rul. 57-541

Advice has been requested whether certain financing fees and application fees imposed on borrowers with respect to operative building loans and owner occupancy loans constitute personal holding company income within the meaning of section 543 of the Internal Revenue Code of 1954 under the circumstances described below.

The taxpayer, a corporation properly organized under State law, is primarily engaged in a loan servicing business and in carrying out such business. It arranges for and sometimes makes, on a short-term basis, operative building loans and owner occupancy loans. It has acquired the status of an approved Federal Housing Administration mortgagee by proper application to the Federal Housing Administration to handle Federal Housing Administration mortgages. In dealing with borrowers, especially with regard to application fees for commitments from the Federal Housing Administration and interest rates and service charges on loans which are consummated, it is subject to the administrative rules and regulations issued by such administration under section 203 of the National Housing Act, as amended. 24 C.F.R. 222, 12 U.S.C. 1701(j). Taxpayer is likewise controlled as to such fees, service charges and interest rates by the Veterans' Administration regulations covering loans which are insured by such agency under the loan guaranty program.

After a firm commitment has been issued by the Federal Housing Administration or the Veterans' Administration, it is the practice of the taxpayer to find an investment institution which will agree to purchase the loan from the taxpayer upon the sale of the home to an ultimate purchaser. The commitment with the investor is consummated prior to the release or advance of funds to the builder for construction purposes.

Mortgage loans to home purchasers are not held by the taxpayer for investment but are sold to investors within a reasonably short time. In addition, the taxpayer does not service (collect loan payments) such assigned loans for investors. In those cases where the taxpayer itself advances money, it receives the legally authorized and negotiated rate of interest in addition to the service fees.

Services rendered by the taxpayer relative to the fees earned are substantial. In general, they consist of obtaining and providing information for and to Federal agencies, of making and accounting for partial disbursements, and of inspecting and supervising the progress of construction, services which are required of the lender by governmental authority as a condition to obtaining Federal loan insurance for a loan.

The income of the taxpayer is derived principally from `application fees' and `financing fees' in connection with its activities in obtaining Federal Housing Administration and Veterans' Administration mortgages. During the year involved, the aggregating of the financing fees and application fees, if considered as interest income, with the pure interest income received exceeded 80 percent of its gross income and since five or fewer individuals own, directly or indirectly, more than 50 percent of the corporation's outstanding stock, the taxpayer corporation would constitute a personal holding company within the meaning of section 542 of the Code. However, if the financing fees and application fees are not considered as interest and, therefore, not personal holding income as defined in section 543 of the Code, then the personal holding income of the corporation would not constitute at least 80 percent of its gross income and, therefore, the taxpayer corporation would not constitute a personal holding company. The issue then resolves itself as to whether the application fees and financing fees constitute interest and thus personal holding income for Federal income tax purposes.

Section 543 of the Internal Revenue Code of 1954 provides, in part, that the term `personal holding company income' means the portion of gross income which consists of interest but does not apply to interest constituting rent as defined in paragraph (7) or to interest on amounts set aside in a reserve fund under section 511 or 607 of the Merchant Marine Act, 1936.

Section 39.502-1(b) of Regulations 118, applicable to the 1954 Code by virtue of T.D. 6091, C.B. 1954-2, 47, defines interest as any amounts, includible in gross income, received for the use of money loaned.

Section 221.26 of the Administrative Rules and Regulations issued by the Federal Housing Administration (FHA Form No. 2010), relative to the fees in question provides:

(a) The mortgagee may charge the mortgagor the amount of the application fees provided for in this part and an initial service charge to reimburse itself for the cost of closing the transaction, which service charge shall not exceed-

(1) $20 or 1 percent of the original principal amount of the mortgage, whichever is the greater, with respect to a mortgage on existing property; or

(2) $50 or 2 1/2 percent of the original principal amount of the mortgage, whichever is the greater, with respect to mortgages on property under construction or to be constructed where the mortgagee makes partial disbursements and inspections of the property during the progress of construction.

(b) In addition to the charges hereinabove mentioned, the mortgagee may collect from the mortgagor customary costs of title search, recording fees, reasonable-out-of-pocket appraisal and other fees which are approved by the Commissioner, and mortgage insurance premiums together with other fees and charges which the mortgagee is required to pay to the Commissioner under this part * * *

Part I of Veterans Administration pamphlet 4-3, entitled `Lender's Handbook' provides in part, as follows:

B. A lender may charge and the veteran may pay a flat charge not exceeding 1 percent of the amount of the loan, provided that such flat charge shall be in lieu of all other charges relating to costs of origination not expressly specified and allowed in this schedule.

C. In cases where a lender makes advances to a veteran during the progress of construction, alteration, improvement, or repair, either under a commitment (VA Form 4-1866) of the Veterans Administration to issue a guaranty certificate or insurance credit upon completion, or where the lender would be entitled to guaranty or insurance on such advances when reported under automatic procedure, the lender may make a charge against the veteran of not exceeding 2 percent on advances so disbursed for its services in supervising the making of advances and the progress of construction. Such charge may be in addition to the 1 percent charge allowed in paragraph B above.

In several cases involving finance companies, the courts have ruled that certain fees imposed on borrowers, designated as other than interest, represent service charges which do not warrant a separable charge in addition to that for the use of borrowed money. In other words, such charges constitute interest. A leading case in this area is Norman L. Noteman et al. v. Welch , 108 Fed.(2d) 206. In that case, as far as is pertinent, the petitioner contended that a portion of the amount charged the borrower constituted compensation for services rendered, rather than interest. The court reasoned that these charges were actually for services furnished, not to the borrower, but to the lender, in deciding whether to make the loan and in safeguarding the loan after it was made. In ruling adversely to the taxpayer, the court also pointed out that some of the charges were blanket assessments against all borrowers, whether or not the enumerated services were rendered to the particular borrower and whether or not the enumerated expenses were incurred in connection with any particular loan. However, the same court cited numerous cases involving the usury laws, as well as other issues, in support of its statement that sometimes these extra charges were legitimately for a consideration other than for the use of borrowed money and recognized such principle subsequently in Workingmen's Loan Ass'n. v. United States , 142 Fed.(2d) 359.

The case under consideration is considered distinguishable from the Noteman case. The fees in question are received for services which are required by the Government agencies to be rendered in order to obtain a loan guarantee and the mortgagee has no alternative but to follow the rigid procedure outlined in Federal Housing Administration and Veterans Administration regulations in processing, handling, and servicing each case involving an insured and guaranteed loan. The cost of obtaining these loan guarantees, which assure low rate loans, is of direct benefit to the borrower.

The finance company, in the instant case, does not retain any of the insured or guaranteed loans, the transfer of such loans being arranged with investors prior to advance of any funds to the builder for construction purposes. It is mainly a service organization. Once the investor assumes the loan on a home sold, all responsibility of the taxpayer with respect thereto ceases and no further servicing is supplied by it. The fees in question are specifically authorized as separate and distinct charges for the services rendered and may be earned by an approved Federal Housing Administration mortgagee whether or not it lends money in connection with the insured mortgage and realizes pure interest income therefrom.

In view of the above, the application fees and financing fees under consideration do not represent interest within the meaning of section 543(a)(1) of the Code but represent legitimate charges for services rendered either for the investor or the ultimate owner of the mortgages or partially for both. Consequently, such fees do not qualify as personal holding company income.