Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 73-27

1973-1 C.B. 46

Sec. 61
Sec. 103
Sec. 212
Sec. 265

IRS Headnote

Treatment of interest from undivided shares of tax-exempt short-term municipal notes sold for cash by a bank to individuals who receive no-recourse participation certificates as evidence of their shares.

Full Text

Rev. Rul. 73-27

Advice has been requested concerning the treatment, under the circumstances described below, of interest received by the purchasers of participation certificates in tax-exempt municipal notes.

A commercial bank regularly makes loans to municipalities and political subdivisions on a short term basis. In return the bank receives notes maturing in one year or less with interest at the rate of 6 percent per annum. The purpose of these bank loans is to furnish interim funds to the political subdivisions pending the issuance and sale of bonds which have been previously authorized, or pending the collection of revenues which are assured. The notes are to be retired with the proceeds of such issues or collections.

The bank sells for cash to investors, who are individuals, participation certificates in these tax-exempt municipal notes. The individuals hold such participation certificates as investments. However, the bank never divests itself of 100 percent interest in a particular note, and continues to hold and service the notes just as any other notes in its portfolio.

Under the terms of the participation certificates, the holder or owner thereof is the owner of an undivided share, to the extent of the sum stated, in one particular note of the municipality or political subdivision. Upon payment of the principal and interest on the note of the municipality, the bank remits to the participant his proportionate share of the principal and interest less a stated percentage thereof of its services in holding and servicing the notes. The participation certificates recite that the holder or owner thereof shall have no recourse against the bank, either for the principal or interest on the underlying note, and that the bank's only liability is to remit to the holder of the certificate his share of the principal and interest when, as, and if collected by the bank. The bank may not, without prior written consent of all participants in a particular note, extend or renew the note, change the rate of interest thereon, or otherwise amend the terms thereof. The participation certificates are neither transferable nor negotiable, and the participant is liable for his proportionate cost of all expenses incurred by the bank in connection with the enforcement or collection of the note in case of default.

Section 61(a) of the Internal Revenue Code provides, in part, that except as otherwise provided gross income means all income from whatever source derived.

Section 1.61-1(a) of the regulations provides, in part, that gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services.

Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a State, a Territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia.

Section 212 of the Code provides, in part, that in the case of an individual there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income.

Section 265(1) of the Code provides, in pertinent part, that no deduction shall be allowed for any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by subtitle A of the Code. Accordingly, in the instant case, it is held that:

(1) since the holder of the participation certificate has no recourse against the bank, either for the principal or interest on the underlying note, and the bank's only liability is to remit to the participant his share of the principal and interest when, as, and if collected, the holder of the participation certificate is owner of an undivided share of the municipal security, and his proportionate share of the interest payable thereon is excludable from gross income under section 103(a)(1) of the Code;

(2) Although the participation certificate is held for investment by the owner, and although a portion of the participant's interest is retained by the bank as compensation for servicing the tax exempt securities, such expense for services rendered by the bank is not deductible under section 212 of the Code. Since such expense is allocable to interest income which is wholly exempt from Federal income taxes, no deduction to the owner of the participation certificate is allowed for such expense in accordance with the provisions of section 265(1) of the Code;

(3) since that portion of the participant's interest retained by the bank is a payment for services rendered, such amount is includible in the gross income of the bank and no part thereof is excludable by the bank from gross income under section 103(a)(1) of the Code.