ment Act of 1958 and business development companies to use the reserve method of computing losses on bad debts is repealed.

Effective Date

The provisions are effective for taxable years beginning after December 31, 1986.

Revenue Effect of Reserves for Bad Debts

The provisions effecting the bad debts reserves of commercial banks, thrift institutions, and small business investment and development companies are estimated to increase fiscal year budget receipts by $647 million in 1987, $1,092 million in 1988, $1,218 million in 1989, $1,406 million in 1990, and $631 million in 1991.

B. Interest on Debt Used to Purchase or Carry Tax-Exempt Obligations (Sec. 902 of the Act and secs. 265 and 291 of the Code) 8

In general

Prior Law

Prior and present law (sec. 265(2))9 disallow a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from Federal income tax (tax-exempt obligations). This rule applies both to individual and corporate taxpayers. The rule also applies to certain cases in which a taxpayer incurs or continues interest expense and a related person acquires or holds tax-exempt obligations (sec. 7701(f)).10 Application to taxpayers generally

The Internal Revenue Service (IRS) and the courts have consistently interpreted section 265(2) to disallow an interest deduction only when a taxpayer incurs or continues indebtedness for the purpose of acquiring or holding tax-exempt obligations.11 They have employed various tests to determine whether a taxpayer has the prohibited purpose. In general, when a taxpayer has independent business or personal reasons for incurring or continuing debt, the taxpayer has been allowed an interest deduction regardless of his tax-exempt holdings. When no such independent purpose exists, and when there is a sufficiently direct connection between the indebtedness and the acquisition or holding of tax-exempt obligations, a deduction has been disallowed.

In Wisconsin Cheeseman, Inc., v. United States, 388 F. 2d 420 (7th Cir. 1968), an interest deduction was disallowed for a corporation which made short-term bank loans to meet recurrent seasonal needs for funds, pledging tax-exempt securities as collateral. The court held that the taxpayer could not automatically be denied a deduction because it had incurred indebtedness while holding taxexempt obligations. However, use of the securities as collateral established a sufficiently direct relationship between the loans and the purpose of carrying tax-exempt securities. The court stated further that a deduction should not be allowed if a taxpayer could rea

For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 802; H. Rep. 99-426, pp. 584-91; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 332-34 (Conference Report).

• The Act redesignates this provision as section 265(a)(2).

10 In addition to interest deductions, prior and present law (sec. 265(a)(1) as redesignated by the Act) deny a deduction for nonbusiness expenses for the production of tax-exempt interest income, which expenses would otherwise be deductible under section 212. This may include, for example, brokerage and other fees associated with a tax-exempt portfolio. Prior and present law also disallow deductions for certain expenses of mutual funds which pay tax-exempt dividends, and for interest used to purchase or carry shares in such a fund.

11 Legislative history indicates that Congress intended the purposes test to apply. See, e.g., S. Rep. No. 617, 65th Cong., 3d Sess. pp. 6-7 (1918); S. Rep. No. 398, 68th Cong., 1st Sess. p. 24 (1924); S. Rep. No. 558, 73d Cong., 2d Sess. p. 24 (1934).

sonably have foreseen, at the time of purchasing tax-exempt securities, that a loan would probably be required to meet ordinary, recurrent economic needs.

In Rev. Proc. 72-18, 1972-1 C.B. 740, the IRS provided guidelines for application of the disallowance provision to individuals, dealers in tax-exempt obligations, other business enterprises, and banks in certain situations. 12

Under Rev. Proc. 72-18, a deduction is disallowed only when indebtedness is incurred or continued for the purpose of purchasing or carrying tax-exempt obligations. This purpose may be established either by direct or circumstantial evidence. Direct evidence of a purpose to purchase tax-exempt obligations exists when the proceeds of indebtedness are directly traceable to the purchase of tax-exempt obligations or when such obligations are used as collateral for indebtedness, as in Wisconsin Cheeseman, above. In the absence of direct evidence, a deduction is disallowed only if the totality of facts and circumstances establishes a sufficiently direct relationship between the borrowing and the investment in tax-exempt obligations. A deduction generally is not disallowed for interest on an indebtedness of a personal nature (e.g., residential mortgages) or indebtedness incurred or continued in connection with the conduct of an active trade or business. Generally, a purpose to carry taxexempt obligations will be inferred, unless rebutted by other evidence, if an individual holds tax-exempt indebtedness which is not directly connected with personal expenditures or the conduct of an active trade or business.

Under Rev. Proc. 72-18, when there is direct evidence of a purpose to purchase or carry tax-exempt obligations, no part of the interest paid or incurred on the indebtedness (or on that portion of the indebtedness directly traceable to the holding of particular taxexempt obligations) may be deducted. In other cases, an allocable portion of interest is disallowed, to be determined by multiplying the total interest on the indebtedness by the ratio of the average adjusted basis during the taxable year of the taxpayer's tax-exempt obligations to the average adjusted basis of the taxpayer's total

assets.

Rev. Proc. 72-18 provides specifically that dealers in tax-exempt obligations are denied an interest deduction when they incur or continue indebtedness for the purpose of holding tax-exempt obligations, even if such obligations are held for resale. 13 When dealers incur or continue indebtedness for the general purpose of carrying on a brokerage business, which includes the purchase of both taxable and tax-exempt obligations, an allocable portion of interest is disallowed. However, the disallowance rule generally does not apply when indebtedness is incurred to acquire or improve physical facilities. The revenue procedure does not specify under what circumstances, if any, a bank is to be treated as a dealer in taxexempt obligations.

12 That is, those situations not covered by Rev. Proc. 70-20, 1970-2 C.B. 499, discussed below. 13 See, Leslie v. Commissioner, 413 F.2d 636 (2d Cir. 1969), cert. den. 396 U.S. 1007 (1970). The court in Leslie held specifically that the effective exemption of banks from the disallowance provision (discussed below) did not apply to a brokerage business.

72-236 - 87 - 19

Application to financial institutions

The legislative history of section 265(2) suggests that Congress did not originally intend the disallowance provision to apply to the indebtedness incurred by a bank or similar financial institution to its depositors. 14 The IRS took the position as early as 1924 that indebtedness to depositors was not incurred to purchase or carry taxexempt obligations, within the meaning of the law. In Rev. Rul. 6122, 1961-2 C.B. 58, the IRS restated its position that the provisions of the law "have no application to interest paid on indebtedness represented by deposits in banks engaged in the general banking business since such indebtedness is not considered to be 'indebtedness incurred or continued to purchase or carry obligations *** within the meaning of section 265."

Despite this general rule, the IRS attempted under prior law to disallow interest deductions of financial institutions in certain cases. Rev. Rul. 67-260, 1967-2 C.B. 132, provided that a deduction would be disallowed when a bank issues certificates of deposit for the specific purpose of acquiring tax-exempt obligations. The ruling concerned a bank which issued certificates of deposit in consideration of, and in exchange for, a State's tax-exempt obligations, the certificates having approximately the same face amount and maturity dates as the State obligations.

In Rev. Proc. 70-20, 1970-2 C.B. 499, the IRS issued guidelines for application of the disallowance provision to banks holding taxexempt State and local obligations. Rev. Proc. 70-20 provided that a deduction would not be disallowed for interest paid or accrued by banks on indebtedness which they incurred in the ordinary course of their day-to-day business, unless there were circumstances demonstrating a direct connection between the borrowing and the taxexempt investment. The IRS would ordinarily infer that a direct connection did not exist (i.e., a deduction would ordinarily be allowed) in cases involving various forms of short-term indebtedness, including deposits and certificates of deposit; short-term Eurodollar deposits and borrowings; Federal funds transactions and similar interbank borrowing; repurchase agreements; and borrowing directly from the Federal Reserve to meet reserve requirements. Within these categories, unusual facts and circumstances outside of the normal course of business could demonstrate a direct connection between the borrowing and the investment in taxexempt securities; in these cases, a deduction would be disallowed. The IRS would not infer a direct connection merely because taxexempt obligations were held by the bank at the time of its incurring indebtedness in the course of its day-to-day business.

Under Rev. Proc. 70-20, application of the disallowance provision to long-term capital notes was to be resolved in the light of all the facts and circumstances surrounding the issuance of the notes. A deduction was not to be disallowed for interest on indebtedness created by the issuance of capital notes for the purpose of increasing

14 See, S. Rep. No. 558, 73d Cong., 2d Sess. p. 24 (1934); S. Rep. No. 830, 88th Cong., 2d Sess. p. 80 (1964).

15 For purposes of the revenue procedure, "short-term bank indebtedness" meant indebtedness for a term not to exceed three years. A deposit for a term exceeding three years was treated as short-term when there was no restriction on withdrawal, other than loss of interest.

capital to a level consistent with generally accepted banking practices.

Types of borrowings not specifically dealt with by Rev. Proc. 7020 were to be decided on a facts and circumstances basis. Additionally, Rev. Proc. 72-18, discussed above, was applicable to financial institutions in situations not dealt with in Rev. Proc. 70-20.16

After the issuance of Rev. Proc. 70-20, several cases and rulings addressed the treatment under prior law of bank deposits or similar arrangements which were secured or collateralized by taxexempt obligations. These decisions generally refrained from applying the disallowance provision to the facts of those cases.

Rev. Proc. 78-34, 1978-2 C.B. 535, allowed a deduction for interest paid by commercial banks on borrowings of Treasury tax and loan funds when those borrowings were secured by pledges of taxexempt obligations. The IRS took the position that this type of borrowing was in the nature of a demand deposit.

In Investors Diversified Services, Inc., v. United States, 573 F. 2d 843 (Ct. Cl. 1978), the court found that the use of tax-exempt securities as collateral for face-amount certificates 17 was not sufficient evidence of a purpose to purchase or carry tax-exempt obligations and, therefore, allowed an interest deduction. Noting various similarities between banks and face-amount certificate companies, the court held that the rationale for the "bank exception" to the disallowance provision was equally applicable to these companies. The court cited three further grounds for holding the disallowance provision inapplicable: (1) that the sale of certificates (i.e., borrowing) was wholly separate from and independent of the company's investment process, including the acquisition and maintenance of taxexempt securities; (2) that the essential nature of the company's business was the borrowing of money which had to be invested in order to pay off the certificate holders; and (3) that the company could not reduce its borrowings by disposing of its tax-exempt securities, since only the certificate holders had the power to terminate each certificate.

Further, in New Mexico Bancorporation v. Commissioner, 74 T.C. 1342 (1980), the Tax Court permitted a bank a deduction for interest paid on repurchase agreements which were secured by taxexempt State and municipal obligations. The court concluded that the repurchase agreements were similar to other types of bank deposits, and were not the type of loans or indebtedness intended to be covered by the disallowance provision. Furthermore, the bank's

16 Rev. Proc. 70-20 was modified by Rev. Proc. 83-91, 1983-2 C.B. 618, to provide that a deduction would generally not be disallowed in the case of repurchase agreements collateralized by tax-exempt securities (as well as agreements collateralized by taxable obligations). This modification was in response to the decision in New Mexico Bancorporation v. Commissioner, 74 T.C. 1342 (1980) (discussed below).

17 Face-amount certificates are certificates under which the issuer agrees to pay to the holder, on a stated maturity date, at least the face amount of the certificate, including some increment over the holder's payments. Prior law (sec. 265(2)) provided that interest paid on face-amount certificates by a registered face-amount certificate company was not to be considered as interest incurred or continued to purchase or carry tax-exempt obligations, to the extent that the average amount of tax-exempt obligations held by such institution during the taxable year did not exceed 15 percent of its average total assets. The Investors Diversified Services case involved a face-amount certificate company whose tax-exempt holdings exceeded 15 percent of its total

assets.