Rev. Rul. 69-188

Advice has been requested whether for Federal income tax purposes, a payment made under the circumstances set forth below is considered to be interest.

A taxpayer on the cash receipts and disbursements method of accounting who wished to purchase a building, arranged with a lender to finance the transaction. A conventional mortgage loan of 1,000x dollars was negotiated, secured by a deed of trust on the building, and repayable in monthly installments over a ten-year period at a stated annual interest rate of 7.2 percent. In addition to the annual interest rate the parties agreed that the borrower would pay a "loan processing fee" of 70x dollars (sometimes referred to as "points") prior to receipt of the loan proceeds. The borrower established that this fee was not paid for any specific services that the lender had performed or had agreed to perform in connection with the borrower's account under the loan contract. The loan agreement provided for separate charges for these services. For example, separate charges were made for a preliminary title report, a title report, an escrow fee, the drawing of the deed and other papers, and insurance.

In determining the amount of this "loan processing fee" the lender considered the economic factors that usually dictate an acceptable rate of interest. That is, he considered the general availability of money, the character of the property offered as security, the degree of success that the borrower had enjoyed in his prior business activities, and the outcome of previous transactions between the borrower and his creditors.

The taxpayer tendered a check for 70x dollars drawn on a bank account owned by him, which contained a sufficient balance, in payment of the fee. The monies in this account were not originally obtained from the lender.

Section 163(a) of the Internal Revenue Code of 1954 provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

Section 446(a) of the Code provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. Section 446(b) of the Code provides, in part, that if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary of the Treasury or his delegate, does clearly reflect income.

For tax purposes, interest has been defined by the Supreme Court of the United States as the amount one has contracted to pay for the use of borrowed money, and as the compensation paid for the use or forbearance of money. See Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), Ct. D. 456, C.B. XI-1, 274 (1932); Deputy v. Dupont, 308 U.S. 488 (1940), Ct. D. 1435, C.B. 1940-1, 118. The Board of Tax Appeals has stated that interest is the compensation allowed by law or fixed by the parties for the use, forbearance, or detention of money. Fall River Electric Light Co. v. Commissioner, 23 B.T.A. 168 (1931). A negotiated bonus or premium paid by a borrower to a lender in order to obtain a loan has been held to be interest for Federal income tax purposes. L-R Heat Treating Co. v. Commissioner, 28 T.C. 894 (1957).

The payment or accrual of interest for tax purposes must be incidental to an unconditional and legally enforceable obligation of the taxpayer claiming the deduction. Paul Autenreith v. Commissioner, 115 F. 2d 856 (1940). There need not, however, be a legally enforceable indebtedness already in existence when the payment of interest is made. It is sufficient that the payment be a "prerequisite to obtaining borrowed capital." L-R Heat Treating Co. The fee of 70x dollars in the instant case was paid prior to the receipt of the borrowed funds; however, this does not preclude the payment from being classified as interest.

It is not necessary that the parties to a transaction label a payment made for the use of money as interest for it to be so treated. See L-R Heat Treating Co. The mere fact that the parties in the instant case agreed to call the 70x dollars a "loan processing fee" does not in itself preclude this payment from being interest under section 163(a) of the Code. Further, this conclusion would not be affected by the fact that this payment is sometimes referred to as "points." Compare Revenue Ruling 67-297, C.B. 1967-2, 87, relating to the deductibility as interest of a loan origination fee paid by the purchaser of a residence to a lending institution in connection with the acquisition of a home mortgage. Also, compare Revenue Ruling 68-650, C.B. 1968-2, 78, relating to the deductibility as interest of the payment of a loan charge paid by the seller of a residence to assist the purchaser in obtaining a mortgage loan.

The method of computation also does not control its deductibility, so long as the amount in question is an ascertainable sum contracted for the use of borrowed money. See Kena, Inc. v. Commissioner, 44 B.T.A. 217 (1941). The fact that the amount paid in the instant case is a flat sum paid in addition to a stated annual interest rate does not preclude a deduction under section 163 of the Code.

To qualify as interest for tax purposes, the payment, by whatever name called, must be compensation for the use or forbearance of money per se and not a payment for specific services which the lender performs in connection with the borrower's account. For example, interest would not include separate charges made for investigating the prospective borrower and his security, closing costs of the loan and papers drawn in connection therewith, or fees paid to a third party for servicing and collecting that particular loan. See Workingmen's Loan Ass'n v. United States, 142 F. 2d 359 (1944); Rev. Rul. 57-541, C.B. 1957-2, 319. Compare Revenue Ruling 57-540, C.B. 1957-2, 318, relating to the classification as interest of the fees imposed on borrowers by a mortgage finance company. Also, even where service charges are not stated separately on the borrower's account, interest would not include amounts attributable to such services. See Rev. Rul. 67-297; compare Norman L. Noteman, et al., Trustees v. Welch, 108 F. 2d 206 (1939) relating to the classification as interest of the charges paid by borrowers to a personal finance company.

Accordingly, in the instant case, because the taxpayer was able to establish that the fee of 70x dollars was paid as compensation to the lender solely for the use or forbearance of money, and because he did not initially obtain the funds to pay this fee from the lender, the 70x dollars is considered to be interest.