Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 68-6

1968-1 C.B. 325

Sec. 851

IRS Headnote

A small business investment company operating under the provisions of the Small Business Investment Act of 1958 and registered as a management company under the Investment Company Act of 1940, may not treat additional fees and other charges either received or constructively received from small business concerns in connection with the negotiation, preparation, and consummation of a loan agreement as interest for the purpose of determining whether the small business investment company satisfies the gross income requirements of a regulated investment company under section 851(b)(2) of the Internal Revenue Code of 1954.

Full Text

Rev. Rul. 68-6

Advice has been requested whether a small business investment company operating under the provisions of the Small Business Investment Act of 1958, as amended, 15 U.S.C. 661 to 696, and registered at all times during the taxable year under the Investment Company Act of 1940, as amended, 15 U.S.C. 80a-1 to 80b-2, as a closed-end, nondiversified management investment company, may treat additional fees and other charges either received or constructively received from small business concerns in connection with the negotiation, preparation, and consummation of a loan agreement as interest for the purpose of determining whether the small business investment company satisfies the gross income requirements of a regulated investment company under section 851(b)(2) of the Internal Revenue Code of 1954.

The purpose of the Small Business Investment Act of 1958 is to establish a program and to stimulate and supplement the flow of private equity capital and long term loans to small business concerns. The Act provides for the operation of small business investment companies organized to provide such capital to the small business concerns. Sometimes investments in small business concerns take the form of long term loans, payable in periods ranging from five to twenty years. These loans are usually represented by either promissory notes of convertible debentures. On some occasions, the small business investment company also acquires stock of the small business concern to which it is making a loan or warrants to purchase its capital stock. Thus, much of the income of a small business investment company consists of interest and dividends.

In connection with the negotiation, preparation, and consummation of some loan agreements, the small business concern obligates itself to pay either directly or indirectly to the small business investment company costs incurred for investigation services, review of financial structure, and assistance in connection with a public offering of its stock. Usually the small business investment company performs these services; however, the small business investment company may engage an independent management consultant to advise it with respect to the small business concern. Where the services are performed for the small business investment company by a management consultant, the small business concern may make payment direct to the consultant on behalf of the small business investment company.

Where the services are performed by the small business investment company, the fees are computed on a fixed percentage of the aggregate principal amount to be loaned. Where the services are performed by an independent business consultant engaged by the small business investment company, the small business concern agrees to pay the business consultant's fees and disbursements incident to the loan agreement and reimburse the small business investment company for its out of pocket expenses with a maximum amount to be paid which has no reference to the aggregate principal amount to be loaned. Whatever the arrangement, the fees are payable regardless of whether the loan agreement is consummated. If the loan is consummated, the fees are paid simultaneously with the receipt of the loan proceeds by the small business concern.

Section 851(b)(2) of the Code states that a corporation shall not be considered a regulated investment company for any taxable year unless at least 90 percent of its gross income is derived from dividends, interest, and gains from the sale or other disposition of stock or securities.

As defined in Old Colony Railroad Co. v. Commissioner , 284 U.S. 552 (1932), Ct. D. 456, C.B. XI-1, 274 (1932), interest is `* * * the amount which one has contracted to pay for the use of borrowed money * * *', or, as was stated in Fall River Electric Light Company v. Commissioner , 23 B.T.A. 168 (1931), interest is `the compensation allowed by law or fixed by the parties for use, or forbearance, or detention of money.'

In Workingmen's Loan Association v. United States , 142 F.2d 359 (1944), the court held that charges similar to those involved here were not interest. In that case the taxpayer finance company separated what it regarded as interest charges from charges for services to borrowers in investigating, identifying, inspecting and appraising the credit and security of the borrower. The initial charges for these separate services were made known to the borrowers before the loans were consummated and were collected in advance as a flat sum which did not vary with the duration of the loan.

Accordingly, the fees and other charges received or constructively received by the small business investment company in this case do not represent interest wihin the meaning of section 851(b)(2) of the Code but are compensation for services rendered for the small business concern.