Expenses and Interest Relating to Tax-Exempt Income (I.R.C. 265)

September 8, 2009

General Overview:

A. General Rule: Under Section 265(b) of the Code, amended by the 1986 Code, banks generally may not deduct any of the carrying cost (the interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds.  For banks, this has the effect of eliminating the tax-exempt benefit of investing in bonds.

B. Bank Qualification Exception: An exception to the general rule, under Section 265(b)(3), allows banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.”  This 80% rule comes from Section 291(e)(10)(B) which applies to obligations issued on or before August 7, 1986.  The exception in Section 265(b)(3) thus treats certain bonds as being issued on August 7, 1986, which means Section 291(e)(10)(B) applies.

In order for bonds to be qualified tax-exempt obligations, the bonds must (a) not be private activity bonds (other than qualified 501(c)(3) bonds), (b) be issued by a “qualified small issuer,” (c) issued for a public purpose, and (d) designated as qualified tax-exempt obligations.  A qualified small issuer” is an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year.

C. 2% De Minimis Rule: Under Section 265(b)(2), no deduction is allowed for that portion of the taxpayer’s interest expense which is allocable to tax-exempt interest. Thus, there is no 2% rule absent the Recovery Act modifications described below.

Recovery Act Modifications:

Under the Recovery Act, two important changes were introduced:

1. Deduct 100% (or 80%) if 2% or Less: The Recovery Act creates a temporary safe harbor (the “2% de minis rule”) in Section 265(b)(7) that permits financial institutions to deduct 100% of the cost of buying and carrying tax-exempt bonds (even if not classified as bank qualified bonds) to the extent their tax-exempt holdings do not exceed 2% of their assets.  Nevertheless, interest on the bonds is still a “financial institution preference item” under Section 291 of the Code which means that 20% of the interest expense allocable to such bonds is nondeductible.

2. $30 Million Qualified Small Issuer: The Recovery Act also changes the $10 million to $30 million.  This expanded limit is applied to borrowers in conduit transactions so that a single issuer can issue bonds for several borrowers and the bonds will all be bank qualified so long as each borrower does not receive proceeds from more than $30 million in bonds. Each borrower must comply with this limit.  If one borrower does not comply, none of the bonds are bank qualified.

Calculation Examples:

Bank has total taxable and tax-exempt assets of $100 mm, of which $50 mm are tax-exempt assets. How much of the carrying cost of the tax-exempt assets may the bank deduct?  Tax-exempt assets are 50% of all assets. No deduction is permitted under Section 265(b).

Bank has $100 mm total assets, with only $1 mm in tax-exempt assets (1% of total assets). Under Recovery Act 2% de minimis rule, the Bank may deduct 80% of the cost of carrying the tax-exempt asset.

Bank’s total interest expense for the tax year is $1 mm. The Bank’s average adjusted basis of tax-exempt assets acquired after August 7, 1986 that are not “qualified tax-exempt obligations” is $20 mm. The Bank’s average adjusted basis for all assets is $200 mm. Therefore, 10% of all assets are tax-exempt assets. How much can the Bank deduct for these tax-exempt assets? The interest expense allocated to the tax-exempt assets is 10% of total interest expense, $100,000. No deduction is allowed for this $100,000 under Section 265(b).

“Basis” is the purchase price after commissions or other expenses. Also known as cost basis or tax basis.

Treatment of Composite Issues:

There is a special rule for composite issues in I.R.C. 265(b)(3)(F).  This rule was added in 1988 pursuant to Pub. L. 100-647 (see House Report No. 100-795).  The Code and Regulations do not define “composite issue.”  However, the House Report explains that a composite issue is a “combined issue of bonds for different entities. […] An issue is a composite issue if the separate lots are sold under a common marketing arrangement that effectively provides the issuers of the separate lots access to the capital markets in a manner similar to the issuance of one issue.  In order for separate lots to be treated as a composite issue, all lots need not have the same collateral or security for the lots or have cross-collaterization among lots.”

The House Report goes on to explain that a composite issue may qualify for the BQ exception only if:

  1. the total composite issue does not exceed $10 million; and
  2. each issuer benefiting from the composite issue reasonably anticipates to issue not more than $10 million of tax-exempt obligations during the calendar year.

What this may mean is that, if the composite issue is note more than $10 million and if an issuer in the composite issue satisfies the second test regarding reasonable expectations, the lot related to such issue can qualify for bank qualification.

BQ Questions and Answers:

Bank Qualification

“Question” 1.  Aggregation of Issuers: For policy reasons, several bond counsel firms require that there be a jurisdictional or other nexus between the issuer and the conduit borrower for purposes of avoiding an “aggregation of issuers” problem under Section 265(b)(3)(E)(iii) of the Code.  Clause (E)(iii) states that for purposes of defining the qualified small issuer and assigning the $10,000,000 limitation, an entity formed (or, to the extent provided by the Secretary, availed of) to avoid the purposes of subparagraphs (C) (qualified small issuer) or (D) ($10 million limitation), and all entities benefiting thereby, are to be treated as one issuer.  A nexus could, arguably, be proven by showing that a certain percentage of a financed facility come from the issuer’s jurisdiction, even though the facility and borrower are not located within the issuer’s jurisdiction.

Question 2. Refunding Bonds Inheriting BQ Status:  Does a refunding bond issued in Year 2 inherit the QTEO status of the refunded bond (issued in Year 1), or does the refunding bond need to meet the QTEO test anew in Year 2?  To answer this question, the following paragraphs address the small issuer and designation prongs of the QTEO test.

Small Issuer Prong:  A “small issuer,” as defined in Section 265(b)(3)(C), is any issuer if the reasonably anticipated amount of tax-exempt obligations which will be issued by such issuer (together with subordinate entities of the issuer) during the relevant calendar year does not exceed $10 million.  The following do not count against the $10 million issuance limit:  (a) Private activity bonds (other than qualified 501(c)(3) bonds); and (b) current (but not advance) refunding obligations, to the extent the “amount” (likely the issue price) of such refunding obligations does not exceed the outstanding amount of the refunded obligation.  Therefore, if the “amount” of the refunding bond does not exceed the outstanding amount of the refunded bond, the refunding bond is not counted against the issuer’s Year 2 $10 million issuance limit for determining the “small issuer” status.  In other words, the issuer does not reduce its new Year 2 QTEO capacity as a result of issuing the Refunding Bond.

Designation Prong:  The small issuer may not designate more than $10 million of obligations as QTEOs during any calendar year under Section 265(b)(3)(D)(i).  A refunding obligation is treated as a QTEO and is not included in the $10 million designation limit described in the prior sentence if the following “Designation Test” is met: (1) the issue was not counted against the small issuer issuance limit; (2) the average maturity date of the refunding obligation is not later than the average maturity date of the obligation to be refunded (but this requirement is not applicable if the average maturity of the original QTEO and of the refunding obligation is three years or less); and (3) the refunding obligation has a maturity date that is not later than 30 years after the date the original QTEO was issued.

Question 3. Refunding Bonds Inheriting ARRA BQ Status:  Does a refunding bond issued after 2010 inherit the QTEO status of the refunded bond (issued between 2009 and 2010), and what limitations are there?

The basic refunding limitations apply to these post-2010 refunding bonds as described in Question 2. However, it should be noted that the refunding bond issue must not have an aggregate face amount of greater than $10 million in order to satisfy the special subclause (II) limitation under Treas. Reg. 265(b)(3)(D)(ii).  In other words, if an issuer is intent on refunding $30,000,000 of bank qualified refunding bonds (originally issued in 2009 or 2010 under the special ARRA rules) in 2011 or thereafter, the refunding bond issue must be split into $10,000,000 separate issues.  Assuming the other requirements of the refunding limitations are satisfied, these separate $10,000,000 are eligible for inheriting the BQ status.

Question 4.  Reasonable expectation:  Assume at the beginning of Year 1, the issuer did not reasonably expect to issue more than $10 million in tax-exempt obligations, and based on that expectation designates the full $10 million QTEO to a $10 million tax-exempt bond issue.  As it turns out, however, unexpectedly the issuer determines to issue additional tax-exempt bonds in Year 1.  Does the issuance of these additional tax-exempt bonds jeopardize the QTEO status of the original tax-exempt bond issue?  Some bond counsel have determined that, so long as the original designation was done with true reasonable expectation of satisfying the Small Issuer Prong, the new tax-exempt bond issue will not jeopardize the original bond issue’s QTEO status.

Question 5. Refunding Bonds Inheriting 2% Safe Harbor Status:  Does a refunding bond issued after 2010 inherit the 2% safe harbor status of the refunded bond (issued between 2009 and 2010 as a new money bond or refunding a new money bond originally issued during such time)?

For new money bonds issued after 2010, banks are no longer permitted to take advantage of the 2% rule.  However, they may take advantage of the rule by acquiring bonds that were issued in 2009 or 2010, and it also appears reasonable to conclude that refunding bonds that refund new money bonds originally issued between 2009 or 2010 (or refunding bonds refunding new money bonds issued between 2009 or 2010) also retain the 2% characteristic.  More congressional and IRS guidance may be forthcoming concerning this topic, however.  See Section 265(b)(7) regarding the 2% rule and the special provision relating to refunding bonds. Notiz 20120206.

Question 6. Does the $10 million limit apply to issue price or face amount:  Does the $10 million limit in section 265(b)(3) mean that the issue price cannot exceed $10 million or is the limit similar to the small issuer exception to section 148 of the code.  For purposes of the small issuer exception, the issue price can be over $10 million and still satisfy the small issuer exception so long as the par amount is not greater than $10 million and there is no more than a de minimis (2%) premium.  This question still needs to be answered.  Many bond counsel prefer to use the greater of issue price or par amount to test against the $10 million limit.  However, there is significant support in other relevant sections of the code that the test may incorporate the 2% de minimis + underwriter’s spread, such that par amount may be used if issue price does not exceed the de minimis + underwriter’s spread.  (Notiz 201301142.)

Question 7.  What types of Bonds are excluded from the Small Issuer Determination:  QECBs, which are taxable bonds, are excluded in determining the status of the issuer as a small issuer for purposes of I.R.C. 265(b)(3)(C).


Rev. Rul. 89-70 (Jan. 1, 1989):  Bank qualification and draw down bonds.
Rev. Rul. 90-44 (Jan. 1, 1990):  Bank qualification and related financial institutions.

Miscellaneous District Financing Rules

September 3, 2009

Filing Form DLG-32

Section 32-1-1604, C.R.S., requires a special district to file a notice of any authorization or incurrence of general obligation debt and a description of such debt in a form prescribed by the director of the division of local government in the department of local affairs with the county clerk and recorder in each county in whcih the district is located.  The recording must be done within 30 days after authorizing or incurring the debt.  This requirement does not apply to debt or lease purchase agreements that are not general obligation debt. In other words, revenue bonds or lease purchase agreements are not subject to this requirement.

Special Districts (Colorado)

Special Districts are created pursuant to Title 32 of the Colorado Revised Statutes, as amended (“C.R.S.”).

Community Development Districts (Florida)

Community development districts are created pursuant to the Uniform Community Development District Act of 1980, Chapter 190, Florida Statutes, as amended (“F.S.”).

Established for the purpose of providing basic community development services.

The initial board of five persons is designated when the district is created.  Each member holds office for a term of 2 or 4 years.  Within 90 days following the rule or ordinance establishing the district, there is to be held a meeting of the landowners at which the landowners elect five supervisors of the district.  Each landowner is entitled to case one vote per acre of land owned by him or her located within the district, for each person to be elected.

If the district intends to exercise ad valorem taxing power, the board must call an election at which members of the board of supervisors will be elected by “qualified electors.”

Regardless of whether the taxing power is to be exercised, generally by 6 years after the initial appointment of members and only if there are at least 250 qualified electors in the district, the position of each member whose term has expired must be filled by a qualified elector of the district.  If fewer than 250 qualified electors are in the district, members of the board will continue to be elected by landowners.

The power of eminent domain permits the district to exercise the power over any property within the state, except certain governmental and federal property, for the uses and purposes of the district.

Assessments may be imposed for the types of public improvements listed in F.S. 170.01.

TEFRA Approval (I.R.C. 147(f))

September 1, 2009


Section 147(f)(2)(B)(i) requires an issue to be approved by any governmental unit if such issue is approved by the applicable elected representative of such governmental unit after a public hearing following reasonable public notice.


The statute is silent on what constitutes reasonable public notice. Section 5f.103-2(g)(3) of the Regulations provides guidance on this subject. Note that the IRS has proposed changes to this section of the Regulations to be implemented as Section 1.147(f)-1 “Public Approval of Private Activity Bonds” – these proposed changes have not been implemented yet.

According to Section 5f.103-2(g)(3) of the Regulations, Reasonable Public Notice means the following:

  1. Published notice which is reasonably designed to inform residents of the affected governmental units, including residents of the issuing unit and the governmental unit where a facility is to be located, of the proposed issue; and
  2. Notice must state the time and place for the hearing; and
  3. Notice must include the following: (a) general functional description of the type and use of the facility to be financed, (b) the maximum aggregate face amount of obligations to be issued with respect to the facility, (c) the initial owner, operator or manager of the facility, (d) the prospective location of the facility by its street address or, if none, by a general description designed to inform readers of its specific location; and
  4. Notice must be published no fewer than 14 days before the hearing; and
  5. Publication of notice presumed reasonable to inform residents of the approving governmental unit if given in the same manner and same locations as required of the approving governmental unit for any other purposes for which applicable state or local law specifies a notice of public hearing requirement.
  6. Publication of notice presumed reasonable to inform affected residents in the locality of the facility only if published in one or more newspapers of general circulation available to residents of that locality or if announced by radio or television broadcast to those residents.

Note that the current requirement is that the “maximum” aggregate face amount be included. Some bond counsel believe that the expected face amount may be increased by a healthy “buffer” amount (perhaps up to 20% of the expected amount) in order to cover unanticipated adjustments in the face amount prior to pricing but after publication of the TEFRA notice.  The Proposed Regulations would change this requirement, however, to provide that there may not be any “substantial” deviations in the “public approval information.”  Therefore, if, e.g., the difference between the maximum aggregate face amount and the actual aggregate face amount is greater than 5% of the net proceeds, there exists a “substantial” deviation.  The public approval requirement in this case is not met until certain special “curing” requirements are met.  In other words, while current regulations do not have a “substatial” deviation threshold, care must be taken under the Proposed Regulations to ensure that the difference between the stated maximum aggregate face amount is not greater than the 5% limit.

Insubstantial Deviations:

PLR 201430001:  State nonprofit corporation’s proposed use of bond proceeds to construct described athletic facility for exclusive use of university and its athletics department is insubstantial deviation from uses of bond proceeds described in stated notice and won’t cause bonds to fail to meet public notice and approval requirements.

PLR 200821031:  State agency’s proposed use of bond proceeds to further its maritime operations at city port by making improvements to described parcel is insubstantial deviation from uses of bond proceeds described in stated notice, and won’t cause bonds to fail to meet public notice and approval requirements.

PLR 200703017:  Exempt organization’s planned use of bond proceeds to substantially rehabilitate building on new property that will be functionally integrated into existing facility is insubstantial deviation from statutory public note and approval requirements.

PLR 200050026:  Org.’s planned transferred use of bond proceeds to improve and purchase new property is insubstantial deviation from statutory public notice and approval requirements.

PLR 200049022:  Transferred use of bond proceeds from one hospital to another is insubstantial deviation from statutory public notice and approval requirements.

PLR 9851005:  The Service has ruled that the proposed use of unexpended bond proceeds for developing a tract of land will be an insubstantial deviation from information contained in a public notice issued to comply with public notice requirements.

PLR 9609032:  A medical center’s proposed use of bond proceeds for a project at a different site than originally anticipated was an insubstantial deviation from the public notice and approval requirements.

PLR 9508029:  Two hospital facilities located approximately one mile apart, with equipment moved from one to the other.

PLR 9452021:  Use of bond proceeds to finance a hospital’s working capital expenditures was an insubstantial devision from the public notice requirements where there were exigent circumstances for such use of proceeds.

PLR 931109:  Cost savings leave a medical center with remaining bond proceeds.  The medical center plans to use those proceeds to construct an additional medical clinic at another location.  Ruled that the corporation has not given adequate public notice of the additional project despite the claim that the new facility would be part of an integrated health care system.

PLR 9220032:  Similar to the 1993 ruling above, except that cost savings were to be used for facility across the street from the original facility.  This was ruled to be an “insubstantial deviation.”

PLR 8948007:  The Company is a manufacturer and wholesale distributor. It operates two facilities, the Road Facility and the Street Facility, located three-fourths of one mile apart within the City. The City is located within the County. Related products are manufactured at both facilities and sold to the same customers.

PLR 8831046:  There was an error in the street address number of the facility to be financed.  Ruled that the error was an “insubstantial deviation” under Temp. Reg. 5f 103-2(f)(2) and that the notice and approval met the requirements of I.R.C. 147(f)(2).

PLR 8411077:  Argument that it is too burdensome to list all properties not accepted.  The notice must include specific locations.


Section 147(f)(2)(D) of the Code states that:

No approval under section 147(f)(2)(A) [which requires the approval] is necessary with respect to any bond which is issued to refund (other than to advance refund) a bond approved under subparagraph (A) (or treated as approved under subparagraph (C)) unless the average maturity date of the issue of which the refunding bond is a part is later than the average maturity date of the bonds to be refunded by such issue.  For purposes of the preceding sentence, average maturity is determined in accordance with subsection (b)(2)(A).

Note that section 147(f)(2)(D) – the exception to TEFRA – applies only to current refundings.  It does not provide for deemed approval for advance refunding issues.

Under prior law, described in Treas. Reg. 5f.103-2(b)(1), the requirement merely stated that the refunding obligation have a maturity date which is “not later than the maturity date of the obligation to be refunded.”  There is no revised regulation that more fully describes the current rule in Section 147(f)(2)(D).

If under the rules of section 147(f)(2)(D) no approval is necessary because the average maturity date of the refunding bonds is not later than the average maturity date of the refunded bonds, write “No approval needed under section 147(f)(2)(D) of the Code” in line 37 of the April 2011 IRS Form 8038.

Section 147(f)(2)(D) refers to an “issue” of which the refunding bond is a part (see also Treas. Reg. 5f.103-2(b)(1)).  What analysis is needed if the issue of bonds consists of a new money portion and a current refunding portion?  Can the issue, for section 147(f)(2)(D) purposes, be treated as two issues?  The language in section 147(f)(2)(A) states that the entire issue must satisfy the approval requirement – not merely a portion of the issue.  The exception in section 147(f)(2)(D) further provides that the average maturity date of the entire issue – not merely a portion of such issue – must not be later than the average maturity date of the refunded bonds.  Thus, the express language does not appear to allow a multipurpose-style differentiation between a new money and a refunding portion of the bonds in order to satisfy the exception.  Nevertheless, a valid argument for separating the issue into two separate issues for purposes of section 147(f)(2)(D) may be available in the definition of “Issue” in Treas. Reg. 1.150-2(c).  Indeed, Treas. Reg. 1.150-1(c)(3) can be used to elect a separate issue, at least for purposes of section 147(f)(2)(D).  Remember, a separate IRS Form 8038 would need to be filed.


Public approval may be given once for a three-year plan of financing, which may contemplate several bond issues occurring within three years after the initial issue date of the first bonds issued pursuant to the approved plan.  This rule includes refunding bonds that refund private activity bonds issued pursuant to the approved plan which are issued within the three-year period.


Q: May a TEFRA notice identify alternative sites or alternative facilities to be financed? A: PLR 9851005. Alternate sites in TEFRA notice were okay. Bond proceeds used on site across the street from TEFRA identified site was okay.

Q: What is the limitation on use of bond proceeds on TEFRA identified site where the use may go beyond what was specifically identified? A: PLR 200821031. Use for maritime operations.

Q: How long is a TEFRA approval valid for? A: Under Section 147(f)(2)(C), if there has been public approval of the plan for financing a facility, such approval constitutes the approval for any additional bond issue (a) which is issued pursuant to that plan within 3 years after the date of the 1st bond issue that was issued pursuant to that approval, and (b) all or substantially all of the proceeds of such additional bond issue will be used to finance the facility or to refund previous financing under such plan.  So, if the project described in the TEFRA is still valid for the new issue, that TEFRA remains valid for three years after the first bond issue that is done under the TEFRA.

Q: What to do if bond-financed property is mobile and is moved throughout the country?  Consider Rev. Rul. 80-12 and similar rulings relating to trailers and rolling stock.  PLR 8213107, PLR 8235049, PLR 8307012, PLR 8311047, PLR 8324053, REV. RUL. 77-281, REV. RUL. 80-12


PLR 200126006:  State’s acting governor fulfills I.R.C. 147(f)(2)(B) requirement that private activity bonds be approved by an elected representative for purposes of treating bonds as qualified bonds.

PLR 9622032:  The state agency’s proposed public notice and hearing regarding its issuance of bonds will not satisfy the public approval requirements where the notice will not include the name of the initial owner, operator or manager of the facility and will not include the prospective location of the facility, either by street address or by general description designed to inform the public of the specific location.

PLR 9123058:  Authority with two counties on the board.  One county’s designated agent who was an elected representative qualified as an “applicable elected representative” for purposes of giving public approval.