SERVICE ISSUES GUIDELINES ON DISALLOWANCE OF FINANCIAL INSTITUTION'S INTEREST EXPENSE ALLOCABLE TO TAX-EXEMPT OBLIGATIONS.

Rev. Rul. 90-44

PURPOSE

This revenue ruling sets forth guidelines with respect to the disallowance, pursuant to section 265(b) of the Internal Revenue Code, of interest expense allocable to tax-exempt obligations held by financial Institutions.

LAW

Section 265(b)(1) of the Code provides that, in the case of a financial institution, no deduction is allowed for that portion of the taxpayer's interest expense that is allocable to tax-exempt interest. Section 265(b) is effective for tax years ending after December 31, 1986.

Section 265(b)(2) of the Code provides that the portion of the taxpayer's interest expense that is allocable to tax-exempt interest is an amount that bears the same ratio to such interest expense as the taxpayer's average for the tax year of the adjusted bases of tax- exempt obligations acquired after August 7, 1986, bears to the average for the tax year of the adjusted bases of all assets of the taxpayer.

Under section 265(b)(3) of the Code, "qualified tax-exempt obligations" as defined in section 265(b)(3)(B) are provided an exception from the rule of section 265(b)(1). Any qualified tax- exempt obligation acquired after August 7, 1986, is treated for purposes of sections 265(b)(2) and 291(e)(1)(B) as if it were acquired on August 7, 1986.

Section 265(b)(4)(A) of the Code defines "interest expense" as the aggregate amount allowable to the taxpayer as a deduction for interest for the taxable year (determined without regard to sections 265(b) and 291). For this purpose, "interest" includes, but is not limited to, amounts (whether or not designated as interest) paid in respect of deposits, investment certificates, or withdrawable or repurchasable shares.

Section 265(b)(4)(B) of the Code provides that a "tax-exempt obligation" is any obligation the interest on which is wholly exempt from taxes imposed by subtitle A of the Code. Interest is wholly exempt from taxes imposed by subtitle A if it is --

(1) wholly excluded from gross income under any provision of subtitle A other than section 597(a), or

(2) wholly exempt from the taxes imposed by subtitle A under the provisions of any law as provided in section 149(c)(2).

COMPARE section 1.265-1(b)(1) of the Income Tax Regulations. Section 59(i) provides that interest does not fail to be treated as wholly exempt from tax imposed by subtitle A solely by reason of being included in alternative minimum taxable income. Section 265(b)(4)(B) also provides that the term "tax-exempt obligation" includes shares of stock of a regulated investment company that during the tax year of the holder of the stock thereof distributes exempt-interest dividends.

Section 265(b)(5) of the Code defines a "financial institution" as any person that 1) accepts deposits from the public in the ordinary course of such person's trade or business and is subject to federal or state supervision as a financial institution, or 2) is a corporation described in section 585(a)(2).

Section 291 of the Code, in part, disallows 20 percent of the amount allowable as a deduction with respect to any financial institution preference item. The term "financial institution preference item" includes a financial institution's interest expense that is allocable to tax-exempt obligations acquired after December 31, 1982, and before August 8, 1986. Tax-exempt obligations acquired after August 7, 1986, in a tax year ending in 1986 are subject to the 20 percent disallowance rule of section 291 for the tax year ending in 1986 and are subject to section 265(b) for subsequent tax years. 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 11-334 (1986), 1986-3 (Vol. 4) C.B. 334.

ANALYSIS AND HOLDINGS

OBLIGATIONS ACQUIRED AFTER AUGUST 7, 1986

For purposes of section 265(b)(2) of the Code, a tax-exempt obligation is treated as acquired after August 7, 1986, if the taxpayer's holding period with respect to the obligation as determined under section 1223 (which generally begins on the day after the acquisition date) begins after August 8, 1986. If, under section 1223, the taxpayer's holding period is determined by reference to the holding period of the transferor, the acquisition is not treated as a new acquisition for purposes of section 265(b)(2). Thus, the acquisition of bonds as part of a tax-free reorganization is not treated as a new acquisition for purposes of this provision. 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-333 (1986), 1986-3 (Vol. 4) C.B. 333. Tax-exempt obligations acquired after August 7, 1986, pursuant to a direct or indirect written commitment to purchase or repurchase such obligations entered into before September 25, 1985, are treated as if acquired before August 8, 1986. Section 902(f) of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 299.

For purposes of section 1001 of the Code, if there is a material change in the terms of an obligation, the old obligation is deemed to have been exchanged for a newly issued obligation. See Rev. Rul. 81- 169, 1981-1 C.B. 429, Rev. Rul. 87-19, 1987-1 C.B. 249, and Rev. Rul. 89-122, 1989-2 C.B. 200. Thus, if a material change in the terms of a tax-exempt obligation occurs after August 7, 1986, section 265(b)(2) applies to the obligation unless the obligation is designated by the issuer at the time of the deemed reissuance as a "qualified tax- exempt obligation" and the obligation satisfies the other requirements of section 265(b)(3).

If under section 338(a)(2) of the Code a tax-exempt obligation is treated as having been purchased by a target corporation, that obligation shall be treated as having been acquired, for purposes of section 265(b), on the day after the first day on which there is a qualified stock purchase with respect to the stock of the target corporation (i.e., the acquisition date as defined in section 338(h)(2)).

If one member of an affiliated group (as defined in section 1504 of the Code) transfers a tax-exempt obligation to another member of the same group, the obligation is treated as having been acquired by the transferee on the date that it would be so treated under section 1502 and the regulations thereunder. Thus, for example, if one member of an affiliated group purchases a tax-exempt obligation from a member of the same group in a deferred intercompany transaction, the obligation is treated as having been acquired by the purchasing member on the date of that purchase. See section 1.1502-13(g) of the regulations.

INTEREST EXPENSE

"Interest expense" as defined in section 265(b)(4)(A) of the Code includes any amount that is treated as interest for purposes of the Code. It therefore includes amounts of original issue discount allowable as a deduction under section 163(e). In addition, a tracing concept is not used for purposes of section 265(b) of the Code; therefore, even if debt is directly or indirectly incurred to acquire assets other than tax-exempt obligations, the interest expense attributable to that debt must be taken into account under section 265(b).

However, if a deduction for interest expense on any indebtedness is disallowed under section 265(a) of the Code on the grounds that the indebtedness was incurred or continued to purchase or carry a tax-exempt obligation, the disallowed interest expense is not taken into account for purposes of applying section 265(b). For purposes of applying section 265(b)(2), the adjusted basis of any such tax-exempt obligation is reduced (but not below zero) by the outstanding principal amount of indebtedness incurred or continued to purchase or carry the obligation. See section 265(b)(6).

The disallowance rule of section 265(b) of the Code is to be applied before any provision that requires capitalization of interest expense. Thus, an amount disallowed under section 265(b) may not be added to the basis of any asset.

FINANCIAL INSTITUTIONS

Section 265(b)(5) of the Code provides that a "financial institution" is any person that 1) accepts deposits from the public in the ordinary course of such person's trade or business and is subject to federal or state supervision as a financial institution, or 2) is a corporation described in section 585(a)(2). Therefore, a "financial institution" includes, but is not limited to, any taxpayer to which section 291(a)(3), 581, 585, 591, or 593 applies, such as a bank (including a foreign bank doing business within the United States), a mutual savings bank, a cooperative bank, a domestic building and loan association, a savings and loan association, or a similar savings institution. For purposes of determining whether or not an entity not described above is one to which section 265(b) applies, the term "deposits" has the meaning set forth in 12 U.S.C. section 1813(l)(1) (1982) and includes, but is not limited to, demand deposits, time deposits, certificates of deposit, repurchase agreements, short-term notes, investment certificates, and withdrawable or repurchasable shares. For the same purposes, a person is considered subject to federal or state supervision as a financial institution if it is subject to the supervision of the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, or a similar state agency.

DETERMINATION OF INTEREST EXPENSE ALLOCABLE TO TAX-EXEMPT OBLIGATIONS

A calculation of the average for the tax year of the adjusted bases of tax-exempt obligations, and total assets, held each day is the most accurate method for determining under section 265(b)(2) of the Code the portion of a financial institution's interest expense that is allocable to tax-exempt interest. However, the Service generally will allow the average adjusted bases of tax-exempt obligations for a tax year to be calculated using the average of the adjusted bases of tax-exempt obligations held by the taxpayer at the end of each month ending within the tax year. The Service generally will allow the average adjusted bases for all assets of the taxpayer for the tax year to be calculated using the average of the adjusted bases of all assets held by the taxpayer at the end of each quarter of the tax year. A taxpayer may compute for any tax year, without prior permission, the average adjusted bases of tax-exempt obligations or total assets on a more frequent basis than set forth above. However, a taxpayer may not compute such averages for any tax year on a less frequent basis than above without obtaining prior approval of the District Director. This permission will be granted only in extraordinary circumstances. In addition, a taxpayer may not compute such averages for any tax year on a less frequent basis than it used for the preceding tax year unless the taxpayer obtains prior approval of the District Director.

The purpose of the computations described in the preceding paragraph is to produce amounts that are fairly representative of the amounts that the taxpayer would compute if a daily average were used. If the District Director determines that a computation permitted above produces results that are not fairly representative of the average adjusted bases of tax-exempt obligations, or total assets, held by a financial institution during a tax year, then the taxpayer shall be required to use a method of computation prescribed by the District Director to fairly represent the average adjusted bases of tax-exempt obligations or total assets. For example, if a manipulation of assets distorts a computation permitted above, the District Director may require a different computation method.

The adjusted bases of a taxpayer's assets shall be determined under section 1011 of the Code, with appropriate adjustments under section 1016, and shall be determined by reference to the financial institution's books and records maintained for tax purposes ("tax bases"), rather than those maintained for financial reporting purposes ("book bases").

However, a taxpayer may elect to use an estimate of the adjusted tax bases of its total assets for each of the first three quarters of the taxable year. This estimate is determined as shown in Table 1. The estimate is based on the book bases of the taxpayer's total assets at the end of each quarter, and it reflects an assumption that any change in the ratio between the tax and book bases of those assets occurs ratably during the taxable year.

                                TABLE 1

For example, assume that the adjusted tax bases of a calendar year taxpayer's total assets are $450z on December 31, 1989, and $480z on December 31, 1990. Also assume that the book bases of those assets are $500z on December 31, 1989; $520z on March 31, 1990; $540z on June 30, 1990; $560z on September 30, 1990; and $600z on December 31, 1990. Applying the estimation method shown in Table 1, the taxpayer's "tax/book ratio" as of the close of 1989 ("R"), is 0.9 (450z/500z). The taxpayer's "tax/book ratio" as of the close of 1990 is 0.8 (480z/600z).

Thus, "Y" is -0.1. The estimated adjusted tax bases of the taxpayer's total assets are as follows:

 1st Qtr  =  B x (R  + 1/2Y)

RELATED TAXPAYERS

If one or more financial institutions are members of an affiliated group of corporations (as defined in section 1504 of the Code), then, even if the group files a consolidated return, each such institution must make a separate determination of interest expense allocable to tax-exempt interest, rather than a combined determination with the other members of the group.

However, in situations involving taxpayers which are under common control and one or more of which is a financial institution, in order to fulfill the congressional purpose underlying section 265(b) of the Code, the District Director may require another determination of interest expense allocable to tax-exempt interest to clearly reflect the income of the financial institution or to prevent the evasion or avoidance of taxes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Carol A. Schwartz of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Ms. Schwartz or Karl T. Walli on (202) 566-3297 (not a toll- free call).