Rev. Rul. 89-76

1989-1 C.B. 24, 1989-25 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

         INTEREST ON CERTAIN LOANS USED TO ACQUIRE EMPLOYER SECURITIES

                            Published: June 2, 1989

Section 133 -- Interest on Certain Loans Used to Acquire Employer Securities, 26 CFR 1.133-1T: Questions and answers relating to interest on certain loans used to acquire employer securities.

  Interest on certain loans used to acquire employer securities. A corporation's actions as an underwriter in the sale of notes evidencing a securities acquisition loan will not adversely affect the status, under section 133 of the Code, of interest received or accrued on such notes. A qualified lender will be entitled to the partial interest exclusion of section 133 without regard to whether each previous holder of the note was a qualified lender.

ISSUES

  1) Whether X corporation's actions as an underwriter in the sale of ESOP notes will adversely affect the status, under section 133 of the Internal Revenue Code, of interest on an ESOP note that is received or accrued by a 'qualified lender' (as described in section 133(a)).

  2) Whether a qualified lender will be entitled to the partial interest exclusion of section 133 with respect to interest received or accrued on a note evidencing a securities acquisition loan for the period that it holds the note without regard to whether each previous holder of the note was a qualified lender.

FACTS

  X is a corporation whose activities consist of underwriting debt and equity securities and providing research and financial services to clients. X is not a qualified lender as described in section 133(a).

  Corporation Y maintains an employee stock ownership plan (ESOP) that is a qualified plan under section 401(a) and satisfies the requirements of section 4975(e)(7). The ESOP will borrow money through the issuance of notes guaranteed by Corporation Y and will purchase employer securities (as defined in section 409(1)) with the borrowed funds.

  X will act as the ESOP's underwriter in the sale of the notes guaranteed by Corporation Y. X will underwrite the notes on either a 'best efforts' or 'firm commitment' basis. In a 'best efforts' underwriting, X arranges for the borrower (the ESOP trust) to sell the notes directly to investors. This is contrasted with a 'firm commitment' underwriting in which the ESOP trust initially sells all the notes to X which then resells the notes to investors. If X cannot resell the ESOP notes, the ESOP trust has no obligation to repurchase the notes. (See Rev. Rul. 78-294, 1978-2 CB 141, for a further discussion of these underwriting techniques.) X will receive a percentage of the principal amount of the notes as commission.

  X sells or arranges to sell the note evidencing the ESOP loan to Z, a qualified lender. Z subsequently sells the note to R, an underwriter who is not a qualified lender. R, in turn, sells the note to its client W, who is a qualified lender.

LAW AND ANALYSIS

  Section 133(a) of the Code provides that fifty percent of the interest received or accrued with respect to a 'securities acquisition loan' by (1) a bank (as defined in section 581); (2) an insurance company to which subchapter L applies; (3) a corporation actively engaged in the business of lending money; or (4) a regulated investment company (as defined in section 851) is excludable from gross income.

  The actions of X as an underwriter (on either a best efforts or firm commitment basis) will not adversely affect the status, under section 133 of the Code, of interest on an ESOP note that is received or accrued by a qualified lender. However, if X receives or accrues any interest with respect to an ESOP note, the interest will not be excludable under section 133 because X is not a qualified lender.

  Interest received or accrued by Z with respect to the notes purchased from X in either a best efforts or firm commitment underwriting would be eligible for the partial interest exclusion of section 133 because Z is a qualified lender.

  If X, or another investor that purchased the ESOP note, sells the note evidencing the ESOP loan to a party that is not a qualified lender, the partial interest exclusion of section 135 will apply to interest received or accrued by a qualified lender who subsequently purchases the note regardless of whether all prior holders of the note were qualified lenders.

  Therefore, if Z subsequently sells the note to R, and R then sells the note to W, the interest received or accrued by W is eligible for the partial interest exclusion of section 133 because W is a qualified lender.

HOLDINGS

  (1) X corporation's actions as an underwriter (on either a best efforts or firm commitment basis) in the sale of notes evidencing a securities acquisition loan, will not adversely affect the status, under section 133 of the Code, of interest received or accrued by a qualified lender with respect to the ESOP notes. Question and Answer 3 of section 1.133-1T of the Temporary Income Tax Regulations will be modified in a manner consistent with the holding of this revenue ruling.

  (2) A qualified lender will be entitled to the partial interest exclusion of section 133 with respect to interest received or accrued on a note evidencing a securities acquisition loan for the period that it holds the note without regard to whether each previous holder of the note was a qualified lender.

DRAFTING INFORMATION

  The principal author of this revenue ruling is John T. Ricotta of the Office of Assistant Chief Counsel (Employee Benefits and Exempt Organizations). For further information regarding this revenue ruling contact Mr. Ricotta on (202) 566-4747 (not a toll-free call).

Rev. Rul. 89-76, 1989-1 C.B. 24, 1989-25 I.R.B. 5.