Rev. Rul. 89-70

1989-1 C.B. 88, 1989-21 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

                 QUALIFIED TAX-EXEMPT OBLIGATIONS; DRAW-DOWN NOTE

                            Published: May 22, 1989

Section 265. - Expenses and Interest Relating to Tax-Exempt Income

  Qualified tax-exempt obligations; draw-down note. A draw-down note is considered issued, for purposes of section 265(b) of the Code, on the date that more than a de minimis amount is first advanced under the note. The amount of the draw-down note is its stated principal amount.

ISSUES

  (1) For purposes of section 265(b) of the Internal Revenue Code, what is the date of issue of a draw-down note?

  (2) For purposes of section 265(b), what is the amount of a draw-down note?

FACTS

  X is a financial institution described in section 265(b)(5) of the Code. In November 1987, X entered into a construction loan agreement with city CI pursuant to which X agreed to provide the financing for construction of a new facility. At the closing of the loan agreement, CI executed and delivered to X its note, the interest on which is exempt from federal income tax under section 103 of the Code. CI intends to designate the note as a 'qualified tax-exempt obligation' within the meaning of section 265(b)(3) of the Code.

  Under the terms of the note, X agrees to honor requests by CI for draw-down advances on an as-needed basis. The note provides for a rate of interest that applies to all advances under the note. Interest accrues from the time amounts are advanced.

  The total amount of the advances to CI cannot exceed the stated principal amount of the note. All advances under the note are secured by the same collateral and are repayable from substantially the same source of funds.

  In January 1988, CI received the first significant advance under the note.

LAW AND ANALYSIS

  Section 265(b)(1) of the Code provides the general rule that, in the case of a financial institution, no deduction shall be allowed for that portion of a taxpayer's interest expense that is allocable to tax-exempt interest income.

  Section 265(b)(2) provides that the portion of interest expense that is allocable to tax-exempt interest income is that amount that bears the same ratio to such interest expense as the taxpayer's average adjusted bases of tax- exempt obligations acquired after August 7, 1986, bears to the average adjusted bases of all assets of the taxpayer.

  Section 265(b)(3) of the Code provides that qualified tax-exempt obligations will be treated as if they were acquired on August 7, 1986. A qualified tax- exempt obligation is a tax-exempt obligation that (1) is issued after August 7, 1986, by a qualified small issuer, (2) is not a private activity bond (as defined in section 141), and (3) is designated by the issuer for purposes of section 265(b)(3).

  Sections 265(b)(3)(C) and (D) of the Code imposes volume limitations on the issuers of qualified tax-exempt obligations. Under section 265(b)(3)(C), a 'qualified small issuer' means any issuer that reasonably anticipates that the amount of tax-exempt obligations (other than certain obligations described in section 265(b)(3)(C)(ii)) that it will issue during the calendar year will not exceed $10,000,000. In addition, section 265(b)(3)(D) provides that not more than $10,000,000 of the obligations issued by an issuer during any calendar year may be designated by the issuer for purposes of section 265(b)(3).

  Section 265(b)(4)(B) of the Code provides that the term 'tax-exempt obligations' means any obligation the interest on which is wholly exempt from federal income tax.

  Section 103(a) of the Code provides that, except as provided in section 103(b), gross income does not include interest on any state or local bond.

  The exception in section 265(b)(3) of the Code for qualified tax-exempt obligations is intended to reduce the extent to which section 265(b) increases the borrowing costs of smaller localities that depend on local financial institutions for financing bona fide governmental projects. H.R. Rep. No. 426, 99th Cong., 1st Sess. 589 (1985), 1986-3 (Vol. 2) C.B. 589. The volume limitations of sections 265(b)(3)(C) and (D) are intended to limit the benefit of the exception to small governmental units.

  Although the regulations under section 265 of the Code do not address the volume limitations of section 265(b)(3)(C) and (D), these limitations may be construed in light of regulations under related sections of the Code that affect the issuance of tax-exempt obligations. Generally, for purposes of determining whether a debt is a tax-exempt obligation, these other regulations provide that a loan agreement providing for periodic advances is treated as a single issue the date of issue of which is the first date on which more than a de minimis amount of loan proceeds is advanced. Sections 1.103-13(b)(6) and 1.103-13(b)(10) of the Income Tax Regulations; section 1.103-7(a) of the regulations; section 1.103-15AT(b)(8) of the temporary Income Tax Regulations.

  In the present situation, CI obtained a commitment from X for funding in an amount equal to the stated principal amount of the note. Each advance received by CI pursuant to the note is part of a single, integrated financing arrangement under which all advances are subject to the same interest rate. The total amount borrowed is secured by the same collateral and repayable from substantially the same source of funds.

  Accordingly, for purposes of section 265(b) of the Code, the advances under the draw-down note are advances made under a single obligation that is issued on the date on which more than a de minimis amount of funds is first advanced. The amount of the obligation is the maximum amount that can be advanced under the note.

  Therefore, for purposes of section 265(b)(3)(C) of the Code, CI includes the stated principal amount of the note in determining the amount of obligations it reasonably anticipates issuing during 1988. Furthermore, in designating tax- exempt obligations as qualified tax-exempt obligations under section 265(b)(3). CI treats the note as issued in 1988 in an amount equal to its stated principal amount.

  The determination of the amount of a draw-down note in the manner described above applies only with respect to the issuers of the tax-exempt obligations. Thus, it does not affect the computation of a financial institution's adjusted basis in such a note for purposes of section 265(b)(2) of the Code.

HOLDINGS

  (1) For purposes of section 265(b) of the Code, the date of issue of the draw-down note is the date on which more than a de minimis amount of funds is first advanced under the note.

  (2) For purposes of section 265(b)(3), the amount of the draw-down note is the stated principal of the note.

DRAFTING INFORMATION

  The principal authors of this revenue ruling are Robert N. Deitz of the Office of Assistant Chief Counsel (Income Tax and Accounting), and Carol A. Schwartz of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Ms. Schwartz or Karl T. Walli on (202) 566-3297 (not a toll-free call.)

Rev. Rul. 89-70, 1989-1 C.B. 88, 1989-21 I.R.B. 5.