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.