Interest income can be debt-financed.

• Author: Possin, Jim
• Position: Brief Article

A recent case may cause some consternation to exempt organizations that borrow more funds than they currently need.

In Southwest Texas Electric Cooperative, Inc., TC Memo 1994-363, an electric cooperative was subject to unrelated business income tax (UBIT) on interest earned on Treasury note investments. The co-op had been granted a loan from the Rural Electrification Administration at a relatively low interest rate. The amount of the loan exceeded the co-op's immediate construction needs. Because of the difficulty in obtaining loans, however, the co-op decided to draw down the entire amount approved, and use the excess temporarily to purchase Treasury notes.

Interest income is generally exempt from UBIT. If the interest is earned on property acquired with borrowed funds, it is taxable under the "debt-financed property" rules.

The co-op made several arguments as to why imposition of the tax was improper. Its primary argument was that the funds were borrowed to construct...