Excludable, Includable, Included

Issue

Statements in transaction documents oftentimes include covenants that are triggered when interest on bonds is no longer excludable from gross income for federal income tax purposes of the registered owners of the bonds.  The covenants may frequently be stated in the inverse – such that the covenant is triggered when interest is included or even includable in gross income.  Is it critical that such covenants be written in terms of interest not being excludable from rather than being included or includable in gross income?

Discussion

I.R.C. 103(a) states that gross income does not include interest on any State or local bond.  The inverse of this statement would be that interest is included in gross income.  This suggests that the proper phraseology of tax covenants ought to refer to inclusion in gross income.

The use of the term “included” means that interest is actually included in gross income.  This term is appropriate only if there are no other circumstances outside of I.R.C. 103 and 141 to 150 that would not prevent such inclusion.  If there are other circumstances, those circumstances may invalidate the effect of the meaning of the covenant.  For instance, even though an event may have happened that, under I.R.C. 103, causes the inclusion, the default condition technically goes away if, under another provision of the Code, interest is excluded.  Under what circumstances could interest be excluded from gross income for federal income tax purposes outside of the I.R.C. 103 realm?  I.R.C. 149(c) suggests that there are no other sources of exemption.  For bonds issued after 1983, this section of the Code provides that the exemption requirements under Part IV (Tax Exemption Requirements for State and Local Bonds) must be satisfied as a condition to exemption.

Use of the term “includable” suggests that there is some discretion in including the interest.  As discussed above, there are no other actual sources of exemption from federal income tax of interest on State or local bonds.  Therefore, if interest is not excluded under I.R.C. 103, interest is absolutely included (versus “includable”) in gross income.

There does not appear to be a meaningful difference in phrasing a covenant using the term “included” or “excludable.”

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