purpose for offering repurchase agreements was independent of the holding of tax-exempt obligations.18

20-percent reduction in preference items

Under a provision originally added by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), and later modified by the Deficit Reduction Act of 1984, the amount allowable as a deduction with respect to certain financial institution preference items was reduced by 20 percent. (The original TEFRA rule provided for a 15percent reduction.) Under prior law, financial institution preference items included interest on indebtedness incurred or continued by financial institutions 19 to purchase or carry tax-exempt obligations acquired after December 31, 1982, to the extent that a deduction would otherwise be allowable for such interest. Unless the taxpayer (under regulations to be prescribed by the Treasury) established otherwise, the 20 percent reduction applied to an allocable portion of the taxpayer's aggregate interest deduction, to be determined by multiplying the otherwise allowable deduction by the ratio of the taxpayer's average adjusted basis of tax-exempt obligations during the year in question to the average adjusted basis of the taxpayer's total assets. For example, a bank which invested 25 percent of its assets in tax-exempt obligations was denied a deduction for $5,000 of each $100,000 of interest paid to its depositors during the taxable year (20 percent x $25,000 interest allocable to debt used to acquire or hold tax-exempt obligations). For purposes of this provision, interest specifically included amounts paid in respect of deposits, investment certificates, or withdrawable or repurchasable shares, whether or not formally designated as interest.

Reasons for Change

The Congress believed that the prior law treatment of financial institutions for purposes of the interest disallowance rule should be changed for two reasons. First, the prior law rules, by allowing financial institutions to deduct interest payments regardless of taxexempt holdings, discriminated in favor of financial institutions at the expense of other taxpayers. Second, the Congress was concerned that financial institutions could drastically reduce their tax liability as a result of the prior-law rules. For example, under prior law, a bank often could totally eliminate its tax liabilities by investing as little as one-third or less of its assets in tax-exempt obligations.

To correct these problems, the Act denies financial institutions an interest deduction in direct proportion to their tax-exempt hold

18 Rev. Proc. 80-55, 1980-2 C.B. 849, would have disallowed a deduction for interest paid by commercial banks on certain time deposits made by a State and secured by pledges of taxexempt obligations. The revenue procedure concerned banks that participated in a State program that required the banks to bid for State funds and negotiate the rate of interest, and required the State to leave such deposits for a specified period of time. The IRS took the position that direct evidence of a purpose to purchase or carry tax-exempt obligations existed in such transactions under Rev. Proc. 72-18.

Rev. Proc. 80-55 was revoked by Rev. Proc. 81-16, 1981-1 C.B. 688. However, Rev. Proc. 81-16 stated that the disallowance provision would continue to apply to interest paid on deposits that are incurred outside of the ordinary course of the banking business, or in circumstances demonstrating a direct connection between the borrowing and the tax-exempt obligations.

19 The provision applied to commercial banks (including U.S. branches of foreign banks), mutual savings banks, domestic building and loan associations, and cooperative banks.

ings. The Congress believed that this proportional disallowance rule is appropriate because of the difficulty of tracing funds within a financial institution, and the near impossibility of assessing a financial institution's "purpose" in accepting particular deposits. Congress believed that the proportional disallowance rule would place financial institutions on approximately an equal footing with other taxpayers.

While desiring to change the prior-law rules, the Congress was concerned about the effect of the new rules on smaller localities which depend on financial institutions to buy tax-exempt bonds for bona fide governmental projects. To limit any potential increased borrowing costs to such localities, the Act provides a permanent "small issuer" exception, allowing up to $10 million in bonds per local issuer (including subordinate entities) to be exempt from the 100-percent disallowance rule. This exception is limited to bonds for governmental or charitable (i.e., section 501(c)(3) organization) purposes. The Act also exempts from the new disallowance rule tax-exempt obligations acquired pursuant to binding commitments entered into by financial institutions on or before September 25, 1985, to purchase or repurchase such obligations.

Explanation of Provision

100-percent disallowance of financial institution interest expense allocable to tax-exempt obligations

The Act denies banks, thrift institutions, and other financial institutions a deduction for that portion of the taxpayer's otherwise allowable interest expense that is allocable to tax-exempt obligations acquired by the taxpayer after August 7, 1986. The amount of interest allocable to tax-exempt obligations generally is determined as it was for purposes of the 20-percent reduction in preference items under prior law, after taking into account any interest disallowed under the general rules applicable to all taxpayers (sec. 265(2) of prior law and sec. 265(a)(2) under the Act). Thus, a deduction is denied for that portion of a financial institution's otherwise allowable interest deduction that is equivalent to the ratio of (1) the average adjusted basis (within the meaning of sec. 1016)20 during the taxable year of tax-exempt obligations held by the financial institution and acquired after August 7, 1986, to (2) the average adjusted basis of all assets held by the financial institution. For example, if an average of one-third of a financial institution's assets during the taxable year consists of tax-exempt obligations acquired after August 7, 1986, the financial institution is denied onethird of its otherwise allowable interest deduction. This allocation rule is mandatory and cannot be rebutted by the taxpayer.

Under the Act, the 20-percent disallowance rule of prior law continues to apply with respect to tax-exempt obligations acquired between January 1, 1983, and August 7, 1986. Thus, a financial institution reduces its otherwise allowable interest deduction in any year by the sum of (1) 100 percent of interest allocable to taxexempt obligations acquired after August 7, 1986, and (2) 20 per

20 This adjusted basis is reduced by the basis of any debt which is used to purchase or carry tax-exempt obligations under section 265(a)(2).

cent of interest allocable to tax-exempt obligations acquired between January 1, 1983, and August 7, 1986, each determined under the formula above. For example, if 25 percent of a bank's assets consists of tax-exempt obligations acquired after August 7, 1986, and an additional 25 percent consists of tax-exempt obligations acquired in 1983, 1984, 1985, or the first portion of 1986 (i.e., before August 8 of that year), the bank would be denied 30 percent of its otherwise allowable interest deduction (i.e., 25 percent attributable to obligations acquired after August 7, 1986, and 5 percent (.20 x 25 percent) attributable to obligations acquired between January 1, 1983, and August 7, 1986).

Financial institutions subject to the rule include any entity which (1) accepts deposits from the public in the ordinary course of its trade or business, and (2) is subject to Federal or State supervision as a financial institution. It is intended that this will include (but not necessarily be limited to) banks, mutual savings banks, domestic building and loan associations, cooperative banks, and any other entities to which the prior law 20-percent disallowance provision (sec. 291) applied. In addition, the 100-percent disallowance rule specifically applies to foreign banks doing business within the United States (sec. 585(a)(2)(B)).

Interest, the deduction of which is subject to the rule, includes amounts paid in respect of deposits, investment certificates, or withdrawable or repurchasable shares, whether or not such amounts are officially designated as interest. Tax-exempt obligations include shares in regulated investment companies (i.e., mutual funds) which distribute exempt-interest dividends during the recipient's taxable year.

For purposes of the disallowance rule, the acquisition date of an obligation is the date on which the holding period begins with respect to the obligation in the hands of the acquiring financial institution. Thus, the acquisition of bonds as part of a tax-free reorganization is not treated as a new acquisition for purposes of this provision.

The Act specifies that, where new section 263A (relating to required capitalization of preproductive expenses including interest and taxes) applies to a portion of the interest expense of a financial institution, 21 the disallowance of interest allocable to tax-exempt obligations is to be applied before the rules of section 263A. For example, assume that a bank has $100 million of interest expense, $25 million of which consists of construction period interest subject to section 263A, and that one-half the bank's assets consist of taxexempt obligations acquired after 1985. The bank's $100 million interest expense would first be reduced by one-half under the disallowance rule with respect to tax-exempt obligations. Of the remaining $50 million of interest expense, $25 million would be capitalized under section 263A.

The preference for interest income on tax-exempt private activity bonds, for purposes of the individual and corporate minimum taxes, is reduced by the amount of interest expense disallowed under section 265 (see Title VII, above). This includes amounts disallowed

21 A description of this provision is found in Title VIII., Part D., above.

under the general rules applicable to all taxpayers (sec. 265(a)) or the 100 percent disallowance rule for financial institutions.

Exception for certain small issuers

The Act provides an exception to the 100-percent disallowance rule for qualified tax-exempt obligations acquired by a financial institution. This exception applies whether the obligation is acquired at the original issuance of the obligation or by a subsequent pur

chaser.

Under the Act, qualified tax-exempt obligations include any obligation which (1) is not a private activity bond as defined by the Act (see, Title XIII, below), 22 and (2) is issued by an issuer which reasonably anticipates to issue not more than $10 million of taxexempt obligations (other than private activity bonds, as defined above) during the calendar year. For purposes of this computation, all tax-exempt obligations (other than private activity bonds, as defined above) which the issuer reasonably anticipates to issue during the calendar year are taken into account.23 Qualified tax-exempt obligations must be designated as such by the issuer; not more than $10 million of obligations may be so designated by any issuer (including subordinate entities, as described below) for any calendar year. Refundings of outstanding bonds qualify for the small issuer exception under the same terms as new issues.

For purposes of the exception for qualified tax-exempt obligations, an issuer and all subordinate entities are treated as one issuer. Subordinate governmental entities include entities deriving their issuing authority from another entity or subject to substantial control by another entity. For example, a sewer or solid waste authority created by a city or county in order to issue bonds for that city or county is considered a subordinate entity. Similarly, an "on behalf of" issuer is treated as a subordinate entity. Under this rule, if a city and all on behalf of issuers reasonably anticipate to issue an aggregate of more than $10 million in tax-exempt obligations (other than private activity bonds, as defined above) during the calendar year, neither the city not any of its on behalf of issuers qualify for the exception. An entity is not to be considered subordinate solely because of geographic inclusion in a larger entity (e.g., a city located within a larger county), if the smaller entity derives its powers independently of the larger entity and is not subject to significant control by the larger entity.

Qualified tax-exempt obligations are treated as acquired by the financial institution before August 8, 1986. Interest allocable to such obligations remains subject to the 20-percent disallowance contained in prior law.

22 For purposes of the small issuer exception only, qualified 501(c)(3) bonds (as defined in Title XIII of the Act) are not treated as private activity bonds. In the case of bonds issued on or before August 15, 1986, for purposes of this provision only, bonds are not to be treated as private activity bonds if they are not IDBs, mortgage revenue bonds, student loan bonds, or other private ("consumer") loan bonds for which tax exemption was permitted under prior law.

23 A technical correction may be needed so that the statute reflects this intent. Such a correction was included in H. Con. Res. 395 as passed by the House and Senate in the 99th Congress.

Repeal of special treatment of face-amount certificate companies

In connection with the changes above, the special rule of prior law relating to face-amount certificate companies is repealed. These companies are therefore subject to the disallowance rules above in the same manner as other financial institutions.

Effective Date

This provision generally is effective in taxable years of financial institutions ending after December 31, 1986. Obligations acquired after August 7, 1986, in taxable years ending during 1986, result in a 20-percent disallowance (under prior law) for the taxable year ending in 1986, but in a 100-percent disallowance in subsequent taxable years.

A transitional exception is provided for tax-exempt obligations acquired after August 7, 1986, pursuant to a direct or indirect written commitment to purchase or repurchase such obligation, which commitment was entered into on or before September 25, 1985. Obligations qualifying for this exception are treated as if acquired before August 8, 1986; interest allocable to such obligations thus remains subject to the 20-percent disallowance contained in prior law.

The Act also provides transitional rules for obligations to finance certain specifically identified projects. Interest allocable to such obligations also remains subject to the 20-percent disallowance rule contained in prior law.

Revenue Effect

This provision is estimated to increase fiscal year budget receipts by $51 million in 1986, $50 million in 1987, and $5 million in 1988, and to decrease fiscal year budget receipts by $17 million in 1989 and $34 million in 1990.