Rev. Rul. 81-23

1981-1 C.B. 50, 1981-4 I.R.B. 9.

                       Internal Revenue Service
                                 Revenue Ruling

    INDUSTRIAL DEVELOPMENT BONDS; EXEMPT SMALL ISSUE; CAPITAL EXPENDITURES;
                                    INTEREST

                          Published: January 26, 1981

26 CFR 1.103-10: Exemption for certain small issues of industrial development bonds

(Also Sections 61, 266; 1.61-7, 1.266-1.)

  Industrial development bonds; exempt small issue; capital expenditures; interest.  A state proposes to issue industrial development bonds and to place a portion of the bond proceeds in escrow to pay interest incurred during the period between the issuance of the bonds and the commencement of construction of a factory and the purchase of equipment.  The factory construction and purchase of equipment will begin within a reasonable time and will not be delayed for reasons unrelated to providing the facility.  The escrowed funds that are allocable to the factory and equipment are qualifying costs for purposes of the 'substantially all' test in section 103(b)(6)(A) of the Code.

ISSUE

  Whether, during the periods described below, interest paid from the proceeds of a governmental obligation to holders of the obligation is a qualifying cost incurred for the acquisition, construction, reconstruction or improvement of land or depreciable property under section 103(b)(6)(A) of the Internal Revenue Code.

FACTS

  Corporation X, which is not an exempt person within the meaning of section 103(b)(3) of the Code, plans to construct and equip an addition to X's factory.  State M proposes to issue $1,000,000 of industrial development bonds with an interest rate of 6 percent on February 3, 1981, to provide financing to X for this project.  M's resolution evidencing its intent to issue the bonds contains a reasonably specific description of the facility based upon plans developed by X.  X will pay the issuance cost of the bonds from its own funds. Of the $1,000,000 of obligation proceeds, $650,000 will be used to construct the addition to the factory, $180,000 will be used to purchase the equipment, and $80,000 will be used by X as working capital.  Construction will begin on April 2, 1981.  The equipment will be purchased on February 3, 1982, and installed during construction of the addition to the factory.  It is anticipated that the construction of the addition will be completed and the equipment placed into use on February 3, 1983.  The time that elapses between the issuance of the bonds, the commencement of construction and the purchase of the equipment will be reasonable under the facts and circumstances and will not be due to reasons that are unrelated to providing the facility.  The bond proceeds allocated to the construction of the factory and the purchase of equipment will be held in escrow pending their expenditure for those purposes.

  The remaining $90,000 of bond proceeds will be placed in escrow for the payment of interest to the holders of M's bonds through August 1, 1982. X will pay the interest on the bonds from August 1, 1982, through February 3, 1983, using its own funds.  Of the $90,000, $64,286 will represent interest attributable to the addition to the factory during the period beginning when the bonds are issued, February 3, 1981, and continuing through August 1, 1982, $17,802 will represent interest attributable to items of equipment accruing during the period beginning when the bonds are issued and continuing through August 1, 1982, and $7,912 will represent interest from February 3, 1981 through August 1, 1982, attributable to bond proceeds to be used by X as working capital.  The interest attributable to the factory, equipment, and working capital will include $8,100 representing interest due on the $90,000 of bond proceeds placed in escrow.  This $8,100 is to be allocated on a proportional basis to the factory, equipment, and working capital ($5,786 to the factory, $1,602 to equipment, and $712 to working capital).

  The bonds will not be arbitrage bonds within the meaning of section 103(c) of the Code.

LAW AND ANALYSIS

  Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state.  Under section 103(b)(1), the section 103(a)(1) exclusion from gross income is not available with respect to industrial development bonds unless they are described in one of the exceptions provided in section 103(b). Section 103(b)(6)(A) provides that section 103(b)(1) shall not apply to any obligation issued as part of an issue the aggregate authorized face amount of which is $1,000,000 or less and substantially all of the proceeds of which are to be used for the acquisition, construction, reconstruction, or improvement of land or property of a character subject to the allowance for depreciation. Section 1.103-10(b)(1) of the Income Tax Regulations provides

that the determination as to whether substantially all of the proceeds of an issue of governmental obligations are used in a manner described in the preceding sentence is to be consistent with the rules in section 1.103-8(a)(1)(i).

  Section 1.103-8(a)(1)(i) of the regulations provides that substantially all of the proceeds of an issue of governmental obligations are used to provide an exempt facility if 90 percent or more of such proceeds are so used.  Amounts used to provide an exempt facility include amounts paid or incurred that are chargeable to the facility's capital account or would be so chargeable either with a proper election by a taxpayer (for example, under section 266) or but for a proper election by a taxpayer to deduct such amounts.

  Section 1.266-1(b) of the regulations provides that a taxpayer may elect to treat certain items, otherwise deductible, as chargeable to capital account. In the case of real property, whether improved or unimproved and whether productive or unproductive, the items chargeable to capital account include interest on a loan (but not theoretical interest of a taxpayer using the taxpayer's own funds), paid or incurred for the development of real property or for the construction of improvements to such property, up to the time the development or construction work has been completed.  Sections 1.266- 1(b)(1)(ii)(a) and (d).  In the case of personal property, the items chargeable to capital account include interest on a loan to purchase such property paid or incurred up to the date of the installation or the date when such property is first put into use by the taxpayer, whichever date is later.  Sections 1.266- 1(b)(1)(iii)(b) and (c).

  Rev. Rul. 77-262, 1977-2 C.B. 41, holds that the gross amount of interest accruing to bondholders on that portion of bond proceeds allocable to the construction of a facility may be capitalized under section 266 up to the time the construction of the facility has been completed.  Rev. Rul. 77-262 also holds that the interest accruing to bondholders on that portion of the bond proceeds allocable to the purchase of equipment for the facility and other personal property relative to the facility may be capitalized under section 266 of the Code up to the date of installation of such property or up to the date such property is first placed into use, whichever is later.

  Although Rev. Rul. 77-262 defines the ends of the periods during which interest on bond proceeds allocable to the construction of a facility and the purchase of equipment for the facility may be capitalized, it does not define the beginning of the periods. Since, in the instant case, the bond proceeds allocable to the construction of the factory and the purchase of equipment are committed to that purpose from the date the bonds are issued and since the commencement of construction and the purchase of equipment will not be delayed for reasons that are unrelated to providing the facility, interest on bond proceeds allocable to both the construction of the factory and the purchase of equipment will be capitalizable beginning on the date the bonds are issued.

  Section 1.266-1 of the regulations contains support for capitalizing interest beginning on the date the bonds are issued. In addition to the items specifically listed in section 1.266-1 that may be capitalized, section 1.266- 1(b)(1)(ii)(d) provides that other necessary expenditures paid or incurred for the development of the real property or for the construction of an improvement or additional improvement to such real property may be charged to capital account.  Because in this case it is necessary and reasonable to issue the bonds before construction begins, the interest accruing before construction begins is a necessary and bona fide cost of financing the construction of the facility with industrial development bonds.  Similarly, the interest accruing on bond proceeds held in escrow for the purpose of acquiring the equipment that will be used in the factory is sufficiently related to the acquisition of the equipment, in this case, to be considered part of its cost of acquisition.

HOLDING

  Of the $90,000 of bond proceeds placed in escrow for the payment of part of the interest to M's bondholders prior to and during construction, $82,088 ($64,286 attributable to the addition and $17,802 attributable to the equipment) will be a qualifying cost for purposes of the 'substantially all' test.  The total amount of bond proceeds applied to qualified costs will be $912,088 ($650,000 + $180,000 + $82,088).  Because approximately 91 percent ($912,088 / $1,000,000) of the bond proceeds will be applied to qualifying costs, M's bonds will qualify under the exception provisions of section 103(b)(6)(A) of the Code as an exempt small issue. Therefore, the interest on the bonds will be excludable from the gross incomes of the bondholders under section 103(a)(1).

Rev. Rul. 81-23, 1981-1 C.B. 50, 1981-4 I.R.B. 9.