[Federal Register Volume 69, Number 89 (Friday, May 7, 2004)]
[Proposed Rules]
[Pages 25535-25537]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-10477]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-128590-03]
RIN 1545-BC23


Special Consolidated Return Rules for the Disallowance of 
Interest Expense Deductions Under Section 265(a)(2)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 
265(a)(2) that affect corporations filing consolidated returns. These 
regulations provide special rules for the treatment of certain 
intercompany transactions involving interest on intercompany 
obligations.

DATES: Written or electronic comments and requests for a public hearing 
must be received by August 5, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-128590-03), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
128590-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the IRS Internet site at www.irs.gov/regs 
or via the Federal eRulemaking Portal at www.regulations.gov (indicate 
IRS and REG-128590-03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Frances L. Kelly, (202) 622-7770; concerning submissions of comments 
and/or requests for a public hearing, Guy Traynor, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

Section 265(a)(2)

    Section 163(a) generally allows a deduction for all interest paid 
or accrued within the taxable year on indebtedness. Under section 
265(a)(2), however, no deduction is allowed for interest on 
indebtedness incurred or continued to purchase or carry obligations the 
interest on which is wholly exempt from Federal income taxes.
    Rev. Proc. 72-18 (1972-1 C.B. 740) provides guidelines for the 
application of section 265(a)(2) to taxpayers holding tax-exempt 
obligations. Section 3.01 of the revenue procedure states that the 
application of section 265(a)(2) requires a determination, based upon 
all the facts and circumstances, of the taxpayer's purpose in incurring 
or continuing each item of indebtedness. Such purpose may be 
established by either direct or circumstantial evidence. Direct 
evidence includes direct tracing of borrowed funds to investments in 
tax-exempt obligations and the pledging of tax-exempt obligations as 
security for the indebtedness. To the extent that there is direct 
evidence establishing a purpose to purchase or carry tax-exempt 
obligations, the interest paid or incurred on such indebtedness may not 
be deducted. In certain other cases when an interest deduction is 
disallowed (for example, when amounts borrowed by a dealer in tax-
exempt obligations are not directly traceable to tax-exempt 
obligations), section 7 of Rev. Proc. 72-18 sets forth a formula to 
calculate the disallowed interest deduction. That formula provides that 
the amount of the disallowed interest deduction is determined by 
multiplying the total interest on the indebtedness by a fraction, the 
numerator of which is the average amount during the taxable year of the 
taxpayer's tax-exempt obligations (valued at their adjusted bases), and 
the denominator of which is the average amount during the taxable year 
of the taxpayer's total assets (valued at their adjusted bases) minus 
the amount of any indebtedness the interest deduction on which is not 
subject to disallowance to any extent under Rev. Proc. 72-18.
    In H Enterprises International, Inc. v. Commissioner, 75 T.C.M. 
(CCH) 1948 (1998), aff'd, 183 F.3d 907 (8th Cir. 1999), a parent and a 
subsidiary were members of the same consolidated group of corporations. 
The subsidiary declared a dividend and, a few days later, borrowed 
funds and immediately used part of those funds to make the dividend 
distribution to the parent. A portion of the distributed funds was 
disbursed to two investment divisions of the parent, which used the 
funds to acquire investments including tax-exempt obligations.
    The court held that a portion of the subsidiary's indebtedness was 
incurred for the purpose of purchasing or carrying tax-exempt 
obligations (held in the parent's investment divisions) and, therefore, 
no deduction was allowed for the interest on this portion of the 
indebtedness under section 265(a)(2). To establish the required 
purposive connection under section 265(a)(2), the court reasoned that 
the activities of the parent corporation were relevant in determining 
the subsidiary's purpose for borrowing the funds. The court stated that 
if the analysis only focused on the borrower and not the transferee, 
then the purpose of the borrower corporation would always be 
acceptable, frustrating the legislative intent of section 265(a)(2).
    Rev. Rul. 2004-47 (2004-21 I.R.B.) provides guidance on the 
application of section 265(a)(2) in a number of situations in which a 
member of an affiliated group borrows money from an unrelated party and 
transfers funds to another member of the group that is a dealer in tax-
exempt obligations. In Situation 4, P and S are members of the same 
affiliated group but file separate tax returns. P borrows funds from L, 
an unrelated bank, and lends the borrowed funds to S, a dealer in tax-
exempt obligations. S uses the borrowed funds in its business. The 
ruling examines the obligation from L to P and the obligation from P to 
S for the application of section 265(a)(2). With regard to the loan 
from L to P, P uses the borrowed funds to make a loan to S, and P 
separately

[[Page 25536]]

accounts for the taxable interest income from the obligation. The 
ruling concludes that P does not have a purpose of using the borrowed 
funds to purchase or carry tax-exempt obligations within the meaning of 
section 265(a)(2). With regard to the loan from P to S, although the 
borrowed funds are not directly traceable to S's purchase or carry of 
tax-exempt obligations, the ruling concludes that section 265(a)(2) 
applies to disallow a deduction for a portion of S's interest expense. 
The portion of S's interest deduction that is disallowed is determined 
pursuant to the formula of section 7 of Rev. Proc. 72-18.

The Intercompany Transaction Regulations

    Section 1.1502-13 prescribes rules relating to the treatment of 
transactions between members of a consolidated group. With respect to 
intercompany obligations, the intercompany transaction rules generally 
operate to match the debtor member's items with the lending member's 
items from the intercompany obligation.
    Under Sec.  1.1502-13(c)(6)(i), if section 265(a)(2) permanently 
and explicitly disallows a debtor member's interest deduction with 
respect to a debt to another member, the lending member's interest 
income is treated as excluded from gross income. See Sec.  1.1502-
13(g)(5), Example 1(d). In cases when a member of the group borrows 
from another member to purchase or carry tax-exempt obligations, and 
the lending member has not borrowed from sources outside of the group 
to fund the intercompany obligation, the result reached under the Sec.  
1.1502-13(c)(6)(i) exclusion rule is appropriate in that it reflects 
that intercompany lending transactions do not alter the net worth of 
the group and, thus, should not affect consolidated taxable income.
    However, when the lending member borrows from a nonmember, the 
lending member lends those funds to the debtor member, and the debtor 
member uses those funds to purchase or carry tax-exempt obligations, 
the application of the Sec.  1.1502-13(c)(6)(i) exclusion rule may 
produce inappropriate results. For example, assume P borrows $100 from 
L, a nonmember, for the purpose of lending the $100 to S under the same 
terms, and S's purpose for borrowing $60 of the intercompany loan from 
P is to purchase $60 of tax-exempt obligations. Under section 
265(a)(2), a deduction would be disallowed for a portion of S's 
interest expense on the intercompany obligation and a portion of P's 
interest income would be excluded from P's gross income under Sec.  
1.1502-13(c)(6)(i). Accordingly, section 265(a)(2) may have no effect 
on the group's taxable income, even though the group has borrowed to 
purchase tax-exempt obligations.

Explanation of Provisions

    The IRS and Treasury Department believe that, when a member's 
indebtedness to a nonmember is directly traceable to an intercompany 
obligation and another member of the group uses the funds borrowed from 
the nonmember to purchase or carry tax-exempt obligations, the net tax 
effect of these transactions for the group should be a disallowance of 
a deduction for interest under section 265(a)(2).
    These proposed regulations reflect that when a member (P) borrows 
funds from a nonmember and lends all of those funds to another member 
(S) that uses those funds to purchase tax-exempt obligations, section 
265(a)(2) will apply to disallow a deduction for the interest on S's 
obligation to P, not P's obligation to the nonmember. These proposed 
regulations provide that, if a member of a consolidated group incurs or 
continues indebtedness to a nonmember, that indebtedness to the 
nonmember is directly traceable to all or a portion of an intercompany 
obligation extended to a member of the group (the borrowing member) by 
another member of the group (the lending member), and section 265(a)(2) 
applies to disallow a deduction for all or a portion of the borrowing 
member's interest expense incurred with respect to the intercompany 
obligation, then Sec.  1.1502-13(c)(6)(i) will not apply to exclude an 
amount of the lending member's interest income with respect to the 
intercompany obligation that equals the amount of the borrowing 
member's disallowed interest deduction. This override of the exclusion 
rule is subject, however, to a limitation. In particular, the amount of 
interest income not excluded cannot exceed the interest expense on the 
portion of the nonmember indebtedness that is directly traceable to the 
intercompany obligation. This limitation ensures that applying section 
265(a)(2) to disallow an interest deduction with respect to an 
intercompany obligation that can be directly traced to nonmember 
indebtedness does not result in a worse overall tax position for the 
group than applying section 265(a)(2) to disallow a deduction for the 
interest paid to the nonmember.
    Therefore, subject to the limitation discussed above, if the 
proceeds of P's borrowing from a nonmember can be directly traced to a 
P-S intercompany obligation and all or a portion of S's interest 
expense on the P-S intercompany obligation is disallowed as a deduction 
under section 265(a)(2), these proposed regulations require that all or 
a portion of P's interest income on the intercompany obligation not be 
excluded under Sec.  1.1502-13(c)(6)(i).
    In an Advance Notice of Proposed Rulemaking (REG-128572-03) in this 
issue of the Federal Register, the IRS and Treasury Department are 
soliciting comments regarding whether regulations under section 7701(f) 
should address the application of sections 265(a)(2) and 246A in 
transactions involving related parties, pass-thru entities, or other 
intermediaries, and suggestions as to the approach that should be taken 
by those regulations. It is possible that those comments and any 
regulations proposed under section 7701(f) will result in amendments to 
the rules set forth in these proposed regulations.

Proposed Effective Date

    These regulations are proposed to apply to taxable years beginning 
on or after the date these regulations are published as final 
regulations in the Federal Register.

Special Analysis

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based upon the fact that these regulations will primarily affect 
affiliated groups of corporations that have elected to file 
consolidated returns, which tend to be larger businesses. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the 
Internal Revenue Code, these regulations will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be

[[Page 25537]]

available for public inspection and copying. A public hearing will be 
scheduled if requested in writing by any person that timely submits 
written comments. If a public hearing is scheduled, notice of the date, 
time, and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal author of these proposed regulations is Frances L. 
Kelly, Office of the Associate Chief Counsel (Corporate). However, 
other personnel from the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 is amended by adding an entry 
in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.265-2 also issued under 26 U.S.C. 1502 and 7701(f). * 
* *

    2. In Sec.  1.265-2, paragraph (c) is added to read as follows:


Sec.  1.265-2  Interest relating to tax-exempt income.

* * * * *
    (c) Special rule for consolidated groups--(1) Treatment of 
intercompany obligations--(i) Direct tracing to nonmember indebtedness. 
If a member of a consolidated group incurs or continues indebtedness to 
a nonmember, that indebtedness is directly traceable to all or a 
portion of an intercompany obligation (as defined in Sec.  1.1502-
13(g)(2)(ii)) extended to a member of the group (B) by another member 
of the group (S), and section 265(a)(2) applies to disallow a deduction 
for all or a portion of B's interest expense incurred with respect to 
the intercompany obligation, then Sec.  1.1502-13(c)(6)(i) will not 
apply to exclude an amount of S's interest income with respect to the 
intercompany obligation that equals the amount of B's disallowed 
interest deduction.
    (ii) Limitation. The amount of interest income to which Sec.  
1.1502-13(c)(6)(i) will not apply as a result of the application of 
paragraph (c)(1)(i) of this section cannot exceed the interest expense 
on the portion of the indebtedness to the nonmember that is directly 
traceable to the intercompany obligation.
    (2) Examples. The rules of this paragraph (c) are illustrated by 
the following examples. For purposes of these examples, unless 
otherwise stated, P and S are members of a consolidated group of which 
P is the common parent. P owns all of the outstanding stock of S. The 
taxable year of the P group is the calendar year and all members of the 
P group use the accrual method of accounting. L is a bank unrelated to 
any member of the consolidated group. All obligations are on the same 
terms and conditions, remain outstanding at the end of the applicable 
year, and provide for payments of interest on December 31 of each year 
that are greater than the appropriate applicable Federal rate (AFR). 
The examples are as follows:

    Example 1. (i) Facts. On January 1, 2005, P borrows $100x from L 
and lends the entire $100x of borrowed proceeds to S. S uses the 
$100x of borrowed proceeds to purchase tax-exempt securities. P's 
indebtedness to L is directly traceable to the intercompany 
obligation between P and S. In addition, there is direct evidence 
that the proceeds of S's intercompany obligation to P were used to 
fund S's purchase or carrying of tax-exempt obligations. During the 
2005 taxable year, P incurs $10x of interest expense on its loan 
from L, and S incurs $10x of interest expense on its loan from P. 
Under section 265(a)(2), the entire $10x of S's interest expense on 
the intercompany obligation to P is disallowed as a deduction.
    (ii) Analysis. Because section 265(a)(2) permanently and 
explicitly disallows $10x of S's interest expense, ordinarily $10x 
of P's interest income on the intercompany obligation would be 
redetermined to be excluded from P's gross income under Sec.  
1.1502-13(c)(6)(i). However, under this paragraph (c), Sec.  1.1502-
13(c)(6)(i) will not apply to exclude P's interest income with 
respect to the intercompany obligation in an amount that equals S's 
disallowed interest deduction with respect to the intercompany 
obligation. Accordingly, Sec.  1.1502-13(c)(6)(i) will not apply to 
exclude P's $10x of interest income on the intercompany obligation 
and P must include in income $10x of interest income from the 
intercompany obligation.

    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that P incurs only $8x of interest expense on its loan from 
L.
    (ii) Analysis. Section 1.1502-13(c)(6)(i) will apply to exclude 
only a portion of P's $10x of interest income on the intercompany 
obligation. Under paragraph (c)(1)(ii) of this section, the amount 
of P's interest income that Sec.  1.1502-13(c)(6)(i) will not apply 
to exclude is $8x, the total interest expense incurred by P on its 
indebtedness to L. Consequently, P must include in income $8x of 
interest income from the intercompany obligation and Sec.  1.1502-
13(c)(6)(i) will apply to exclude $2x of interest income from the 
intercompany obligation.
    (3) Effective date. The provisions of this section shall apply to 
taxable years beginning on or after the date these regulations are 
published as final regulations in the Federal Register.
    3. Section 1.1502-13 is amended by:
    1. Adding a sentence after the second sentence of paragraph 
(c)(6)(ii)(A).
    2. Adding paragraph (c)(6)(iii).
    3. Revising the first sentence of Example 1(d) of paragraph (g)(5).
    The revisions and additions read as follows:


Sec.  1.1502-13  Intercompany transactions.

* * * * *
    (c) * * *
    (6) * * *
    (ii) * * *
    (A) * * * However, see Sec.  1.265-2(c) for special rules related 
to the application of paragraph (c)(6)(i) of this section to interest 
income with respect to certain intercompany obligations the interest 
deduction on which is disallowed under section 265(a)(2). * * *
* * * * *
    (iii) Effective date. The third sentence of paragraph (c)(6)(ii)(A) 
of this section shall apply to taxable years beginning on or after the 
date these regulations are published as final regulations in the 
Federal Register.
* * * * *
    (g) * * *
    (5) * * *
    Example 1 * * *
* * * * *
    (d) Tax-exempt income. The facts are the same as in paragraph (a) 
of this Example 1, except that B's borrowing from S is allocable under 
section 265 to B's purchase of state and local bonds to which section 
103 applies and Sec.  1.265-2(c) does not apply. * * *
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-10477 Filed 5-6-04; 8:45 am]
BILLING CODE 4830-01-P