Guidance on intercompany interest expense disallowance related to tax-exempt investments.

• Author: Thornton, David A.

In May 2004, the IRS issued two pronouncements on applying the Sec. 265(a)(2) interest expense disallowance rules to loans between related affiliates: proposed regulations (REG-128590-03, 5/7/04) and Rev. Rul. 2004-47. The proposed regulations address an inappropriate income exclusion under the current regulations, occurring when a corporation borrows funds from a third party, then lends them to a related affiliate to invest in tax-exempt obligations. The revenue ruling relates to affiliate borrowings used to fund business operations of a dealer in exempt obligations. The Service is soliciting public comments on the proposed regulations and, more broadly, on the need for additional guidance on borrowings among related entities to fund exempt investments.

Background

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...