Guidance on intercompany interest expense disallowance related to tax-exempt investments.
Sec. 265(a)(2) disallows an interest deduction for debt recurred or continued to purchase or carry exempt obligations. Sec. 265(a)(2)'s intent is to prevent taxpayers from realizing a double benefit by deducting interest incurred to produce exempt income. Although the theory behind this statute appears simple, its application is often complicated when the entity borrowing the funds is not the same entity investing them in exempt obligations. In an affiliated group, this typically occurs when one corporation borrows funds from a third party, then transfers the funds to a related affiliate that invests them in exempt obligations.
In Rev. Proc. 72-18, the IRS provided guidance on how to apply Sec. 265(a)(2). Generally, the interest disallowance provisions apply only when it can be demonstrated that a taxpayer's purpose in incurring or continuing debt is to purchase or carry exempt obligations. This can be established by (1) borrowings directly traceable to exempt investments (i.e., by pledging exempt obligations as security for debt) or (2) examining a particular transaction's facts and circumstances.
However, certain taxpayers are required to apply a general, ratable interest allocation rule to determine the interest expense disallowed when purchasing or carrying exempt obligations. These taxpayers include financial institutions subject to an interest disallowance formula under Sec. 265(b), and dealers in exempt obligations.
Interest allocation: The disallowance rules for dealers in exempt obligations are found in Rev. Proc. 72-18, Sections 5 and 7. Under these rules, dealers must allocate their nondirectly traceable interest expense to exempt obligations held in the general course of business in addition to allocating directly traceable interest expense under the rules described above.
H Enterprises: Neither the statute nor the applicable guidance has historically addressed the application of Sec. 265(a)(2) when an affiliated group member borrows funds and transfers them to another member, who then invests them in exempt obligations, However, the Tax Court addressed this issue in H Enterprises Int'l, Inc., TC Memo 1998-97, aff'd, 183 F3d 907 (8th Cir. 1999). In that case, a subsidiary borrowed funds from a third party to make a distribution to the parent, which, in turn, invested part of the proceeds in exempt obligations. In examining the borrower subsidiary's purpose, the court looked through the separate entities and held that a portion of the subsidiary's debt was directly traceable to exempt obligations purchased by the parent. The court reasoned that if the analysis of the borrowing's overall purpose focused only on the borrower and not the transferee, then the borrower's purpose would always be acceptable, thereby frustrating Sec. 265(a)(2)'s legislative intent.
When an affiliated group member borrows funds from a related affiliate and invests them directly in exempt obligations, Sec. 265(a)(2) disallows the interest expense. However, Regs. Sec. 1.1502-13(c)(6)(i) exempts a lending member's interest income on the borrowing. This rule is needed to prevent double taxation (i.e., as there is no outstanding debt on a consolidated basis, there is no need for interest expense disallowance; thus, such has to be offset by an exemption for the lending member's interest income).
However, this exemption is inappropriate when the funds loaned by the lending member are directly traceable to a borrowing from a third party. In this situation, the affiliated group would enjoy a double benefit from the exemption (i.e., although the borrowing member cannot take an interest deduction, the lending member receives exempt interest income on the intercompany loan and can deduct interest paid to the third party; thus, there is no net interest expense disallowance on a consolidated basis, even though a consolidated borrowing supports the exempt investment).
Example 1: P, the common parent of an affiliated group that includes subsidiary S, borrows $1,000 from unrelated lender X. P then directly loans the $1,000 to S, which directly invests the proceeds in exempt obligations.
S cannot deduct the interest expense incurred on the intercompany loan, under Sec. 265(a)(2). However, under Regs. Sec. 1.150213 (c)(6)(i), P's interest income on the loan is exempt. The net effect is to eliminate any disallowance of interest expense on a consolidated basis. However, the rationale of H Enterprises may prevent a deduction for the interest P incurred on its loan from X.
To provide guidance in this area and incorporate the effect of the Tax Court decision in H Enterprises into the regulations, the Service issued proposed regulations on the application of the Sec. 265(a)(2) disallowance and the Regs. Sec. 1.150213(c)(6)(i) exemption, when an exempt investment is directly traceable to debt recurred by a related affiliate to an unrelated lender.
Specifically, Prop. Regs. Sec. 1.265-2(c) (1)(i) overrides Regs. Sec. 1.1502-13(c)(6)(i), by disallowing the exemption to the lending member, if: (1) the loan proceeds are directly traceable to investments in the borrowing member's exempt obligations; and (2) the source of the intercompany loan is directly traceable to the lending member's third-party borrowing. According to Prop. Regs. Sec. 1.265-2 (c) (1) (ii), the disallowance of the interest income exemption is limited to the interest expense incurred on the portion of the lending member's third-party debt directly traceable to the borrowing member's exempt investment.
Example 2: The facts are the same as in Example 1, except in year 1, S's interest expense on its loan from P is $10 and P's interest expense on its loan from X is $8.
Sec. 265(a)(2) disallows a deduction for S's $10 interest expense, in year 1. Under Prop. Regs. Sec. 1.265-2(c)(1)(i), P is generally not entitled to exclude its interest income Oil the loan to S. However, under Prop. Regs. Sec. 1.265-2(c)(1)(ii), P's disallowed interest income exemption is limited to $8 (of the amount of directly traceable interest expense on its borrowing from X). Regs. Sec. 1.1502-13(c) (6)0) permits P to exclude the remaining $2 of interest charged by P to S.
Effective date: The proposed regulations will apply to tax years beginning on or after the date they are issued in final form in the Federal Register. However, prior to the effective date, taxpayers must continue to consider the Tax Court's decision in H Enterprises in applying the Sec. 265(a)(2) interest disallowance rules in a consolidated group.
Rev. Rul. 2004-47
Concurrent with the issuance of the Sec. 265(a)(2) proposed regulations, the IRS issued Rev. Rul. 2004-47 on determining the disallowed interest expense for intercompany borrowings, as they apply to dealers in exempt obligations. Although this pronouncement is directed at dealers in exempt investments, taxpayers subject to similar rules under Sec. 265 (e.g., financial institutions) will find the guidance useful.
As noted above, dealers in exempt investments are subject to two separate calculations in determining Sec. 265 disallowed interest expense. Like other taxpayers, dealers cannot deduct interest on debt directly traceable to exempt investments. In addition, Rev. Proc. 72-18 requires a ratable disallowance of interest expense incurred in the general operation of a dealer business, to the extent that the business involves the acquisition and holding of exempt obligations.
The disallowance is calculated by multiplying the dealer's nondirectly traceable interest expense by a fraction, the numerator of which is the dealer's average balance of exempt obligations, and the denominator of which is the dealer's average balance of total assets, less the balance of debt the interest on which is not subject to disallowance.
Rev. Rul. 2004-47 contains four scenarios demonstrating how to apply Sec. 265(a)(2) to intercompany borrowings. While the ruling's conclusions are consistent with the determinations reached under the Sec. 265(a)(2) proposed regulations, the ruling also addresses two specific concerns.
The first issue is the determination of disallowed interest expense under the general allocation formula applicable to dealers in exempt obligations. The ruling holds that, similar to the proposed regulations, if an affiliated group member borrows from an unrelated party and directly loans the funds to a related dealer affiliate for the purpose of carrying on the dealer's general business, the disallowed interest expense allocation is both calculated and applied at the dealer level.
The second issue is the determination of disallowed interest expense under Sec. 265(a)(2) when an affiliated group member borrows from an unrelated party and directly contributes the funds to the capital of a dealer subsidiary for use in its general operations, rather than loaning the dealer the funds. In this scenario, the IRS holds that the interest expense disallowance is applied at the contributing member level (against its borrowing from the unrelated party), but is calculated at the dealer level based on the dealer's average assets and exempt obligations.
Example 3: P, the common parent of an affiliated group that includes subsidiary S (a dealer in exempt obligations), borrows $40 from unrelated lender X. P contributes the $40 to the capital of S, which uses it in its general business operations. In year 1, the average balance of S's exempt obligations is $500 and the average balance of S's total assets is $1,000; P's interest expense on the loan from X is $2.
In year 1, Sec. 265(a)(2) disallows P $1 of the $2 deduction ($2 ($500/$1,000)). Although the proposed regulations do not discuss a borrowing affiliate contributing to the capital of the investing affiliate (rather than lending), H Enterprises would apply to link the borrowed funds with the dealer affiliate's use of the funds.
The Sec. 265(a)(2) proposed regulations, once they become effective, will directly address the application of the interest expense disallowance rules under that section, as well as the corresponding income exemption rules of Regs. Sec. 1.1502-13(c)(6)(i), when investments in exempt obligations and the borrowings to fund such investments are undertaken by different affiliates via an intercompany loan. Until the regulations become effective, taxpayers must continue to rely on the guidance provided by the Tax Court in H Enterprises. Dealers in exempt obligations should consult Rev. Rul. 2004-47 in applying Sec. 265(a)(2) when borrowed funds of an affiliate are directly traceable to the operations of the dealer's business.
FROM DAVID A. THORNTON, CPA, COLUMBUS, OH
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|Author:||Thornton, David A.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2004|
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