Economic benefit from below-market financing can be amortizable asset.
Under the Deficit Reduction Act of 1984 (DRA), Congress revoked the Federal Home Loan Mortgage Corp.'s (Freddie Mac's) tax-exempt status, effective Jan. 1, 1985. Freddie Mac held a number of financing arrangements (favorable financing) on Jan. 1, 1985, with interest rates payable lower than that date's prevailing market rate. The financing arrangements consisted essentially of issuances of (1) notes and bonds payable; (2) subordinated debt (capital debentures and zero-coupon bonds); (3) collateralized mortgage obligations; and (4) guaranteed mortgage certificates. The favorable financing asset, according to Freddie Mac, is the difference between the net present value of future cashflows computed at market rates as of Jan. 1, 1985, and the net present value of future cashflows for each respective instrument at its contract rate.
The DRA contained a specific adjusted basis for determining gain on the sale or other disposition of property Freddie Mac held on Jan. 1, 1985. Under DRA Section 177(d)(2)(A)(ii), the adjusted basis of any asset shall "for purposes of determining any gain, be equal to the higher of the adjusted basis of such asset or the fair market value of such asset as of such date." In a previous opinion, Federal Home Loan Mortgage Corp., 121 TC No. 8 (2003), the Tax Court held that under DRA Section 177(d)(2)(A)(ii), Freddie Mac's adjusted basis for purposes of determining Sec. 167 amortization of intangible assets held on Jan 1, 1985, was their respective FMVs on that date.
In the opinion discussed below, the Tax Court considered Freddie Mac's position that the FMV of the below-market financing in place on Jan. 1, 1985, was an intangible asset amortizable under Sec. 167. The asset's FMV is the difference between the market cost of using the borrowed money and its below-market cost. The IRS argued that the favorable financing arose from fortuitous interest rate fluctuations, is not an asset and is not amortizable as a matter of law.
Law and Analysis
Sec. 167(a) allows a depreciation deduction for property used in a trade or business or held for the production of income. For an intangible asset to be amortizable under Sec. 167(a), the taxpayer must prove with reasonable accuracy that the asset is used in a trade or business or held for the production of income and has a value that wastes over an ascertainable period of time; see Newark Morning Ledger Co., 507 US 546, 566 (1993); FMR Corp., 110 TC 402, 430 (1998). The taxpayer must prove that the intangible asset has a limited useful life, the duration of which can be ascertained with reasonable accuracy, and the asset has an ascertainable value separate and distinct from goodwill and going-concern value; see Southern Bancorporation, Inc., 847 F2d 131, 136-137 (4th Cir. 1988), aff'g TC Memo 1986-601.
An obligor's right to use borrowed money under an existing debt obligation may be more or less valuable, depending on current market interest rates; see, e.g., Dickman, 465 US 330, 337 (1984). The right to use borrowed money at below-market interest rates represents a valuable economic benefit in terms of the cost savings that can be achieved in financing income-producing activities. It is a benefit for which a third party would pay a premium if the favorable financing were included as part of a purchase transaction. As such, the court concluded that Freddie Mac's favorable financing arrangements represented something of value as of Jan. 1, 1985.
The court rejected the IRS's assertion that the differential between market interest rates and the contract interest rates stated in the debt obligations was not an asset. That differential serves as a measure of the economic value of the right to use borrowed money as of Jan. 1, 1985. The right to use borrowed money is interrelated with the corresponding interest cost of that right, in much the same way that the right to use property is interrelated with its corresponding rental cost.
The court analogized Freddie Mac's interest in its favorable financing to a bank's interest in its "deposit base" or "core deposits," which have been found to be intangible amortizable assets; see Citizens & S. Corp., 91 TC 463, 465 (1988), aff'd, 919 F2d 1492 (11th Cir. 1990). Like the core deposits in those cases, favorable financing involves the use of borrowed money at below-market rates. Also, like core deposits, below-market financing arrangements provide a cheaper way to generate income and contribute to a business's profitability.
The court also found "no principled difference" between the tax treatment of a favorable leasehold under Sec. 167(a) and favorable financing, stating that "[w]e have no problem equating a right to use money at a below-market interest rate with a right to use property at a below-market rental rate." Similar to Freddie Mac's favorable financing, an interest in a favorable leasehold involves a lease obligation with a rental rate less than the current fair rental value of that particular interest. Presumably, a hypothetical buyer would pay a premium to obtain the lessee's favorable position in the leasehold. This correlative value and premium give rise to amortization deductions; see Washington Package Store, Inc., TC Memo 1964-294.
The court also rejected the IRS's argument that Freddie Mac's treatment of its favorable financing implicates Sec. 163 or the original issue discount (OID) rules. Favorable financing is an economic benefit that arises from the below-market interest rates on Jan. 1, 1985, and the expectation of cost savings from its existing financing arrangements. The court found that this economic benefit is an asset, not a liability; permitting amortization deductions on the basis of this intangible asset does not run afoul of the Sec. 163 interest deduction or the OID rules.
In computing the FMV of its favorable financing intangible, Freddie Mac did not take into account any offset for "unfavorable debt" (i.e., debt obligations with above-market interest rates). Although the IRS noted this fact in its submissions to the Tax Court, it did not indicate its bearing on the legal issue. Accordingly, this fact had no effect on the Tax Court's decision.
Although Freddie Mac obtained its amortizable basis in the favorable financing intangible under a specific DRA provision that subjected the institution to Federal income tax, the Tax Court's holding in this case will apply broadly to any purchaser of assets that assumes the seller's existing debt with a below-market interest rate. A favorable financing intangible may arise in a direct trade or business acquisition described in Sec. 1060 or a deemed asset acquisition under a Sec. 338 election. In either case, the basis that the buyer properly allocates to the favorable financing intangible, under the residual method, may be amortized under Sec. 167 over the debt's remaining term.
As the Tax Court noted in its opinion, favorable financing is specifically excluded from the definition of "Section 197 intangible" by Sec. 197(e)(5)(B). Thus, favorable financing is a Class V asset, and will be allocated tax basis up to its FMV before tax basis is allocated under the residual method to any Sec. 197 intangibles in Class VI or VII. This means that in the case of below-market debt with a remaining term of less than 15 years, basis allocated to favorable financing will be recovered over a shorter period than the basis allocated to Sec. 197 intangibles.
The accelerated tax-basis recovery that may result from allocations of tax basis to favorable financing (as well as to favorable leases, whose basis similarly is excluded from Sec. 197 and amortized over the remaining lease term) may produce significant cashflow benefits.
FROM MARC LEVY, WASHINGTON, DC
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|Publication:||The Tax Adviser|
|Date:||Jan 1, 2004|
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