Rev. Rul. 76-325

Advice has been requested whether, under the circumstances described below, the taxpayer has made an election under section 266 of the Internal Revenue Code of 1954 to capitalize interest.

P corporation is the common parent of an affiliated group of corporations that have, since 1970, filed a consolidated Federal income tax return on the basis of a fiscal year ending September 30. In January 1975, S, one of P's subsidiaries, purchased a machine to be used in its business. The purchase of the machine was financed by an intercompany loan from P to S, which is an intercompany transaction under section 1.1502-13(a)(1) of the Income Tax Regulations.

In the consolidated Federal income tax return of the affiliated group for their taxable year ending September 30, 1975, the interest on the loan from P to S was capitalized and treated as a deferred intercompany transaction pursuant to section 1.1502-13(a)(2)(iii) of the regulations. On a schedule of S, which was attached to the return, the intercompany interest was separately listed under the heading deferred intercompany interest. In addition, a footnote at the bottom of the schedule stated that the interest was intercompany interest deferred in accordance with section 1.1502-13(c)(1)(ii). However, no statement of the type described in section 1.266-1(c)(3) electing to capitalize such interest was attached or filed.

Section 266 of the Code provides that no deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under the regulations prescribed by the Secretary of the Treasury or the Secretary's delegate, are chargeable to the capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or charges as so chargeable.

Section 1.266-1(b)(1)(iii) of the regulations provides, in general, that the taxpayer may elect to capitalize certain items, including interest on a loan to purchase personal property.

Section 1.266-1(c)(3) of the regulations provides, in part, that if the taxpayer elects to capitalize an item or items under section 266 of the Code, such election shall be exercised by filing with the original return for the year for which the election is made a statement indicating the item or items that the taxpayer elects to treat as chargeable to the capital account.

Section 1.1502-13(a)(2)(iii) of the regulations provides, in part, that the term deferred intercompany transaction means any other expenditure in a case where the amount of the expenditure is capitalized (for example, prepaid rent, or interest that is included in the basis of property).

Rev. Rul. 70-539, 1970-2 C.B. 70, concerns the question of whether a taxpayer made a valid and binding election to capitalize interest, taxes, and carrying charges under section 266 of the Code by including such amounts in the cost of its property when filing its Federal income tax returns for the years involved therein. That Revenue Ruling holds that inasmuch as the taxpayer did not file a statement with its original returns identifying the item or items it elected to capitalize, the taxpayer did not make a valid and binding election under section 266. Thus, it was not clearly ascertainable from the information submitted with the taxpayer's return whether the taxpayer had made an election.

In Kentucky Utilities Co. v. Glenn, 394 F. 2d 631 (6th Cir. 1968), one of the issues involved was whether the taxpayers had elected to capitalize social security taxes paid on construction work under section 24(a)(7) of the Internal Revenue Code of 1939 (the predecessor of section 266 of the 1954 Code). The taxpayers had treated the social security taxes in the Federal income tax returns for the years involved therein as if they had elected to capitalize such taxes. The taxpayers attached a schedule to their returns that clearly indicated those items that the taxpayers were deducting and those items that the taxpayers were capitalizing. However, no formal statement of election to capitalize was ever made by the taxpayers. The taxpayers amended their returns and filed statements claiming deductions for such taxes. The court held that the taxpayers had made a binding election with their original returns that could not be retroactively changed.

In the instant case, P and its subsidiaries did not attach to their consolidated Federal income tax return for the year ended September 30, 1975, a statement specifically electing to capitalize the intercompany interest under section 266 of the Code. However, in a schedule of S attached to the return, it was clearly indicated that the intercompany interest was being capitalized and treated as a deferred intercompany transaction in accordance with section 1.1502-13(c)(1)(ii) of the regulations. Pursuant to section 1.1502-13(a)(2)(iii), a deferred intercompany transaction is an expenditure, such as interest, which has been capitalized. Therefore, inasmuch as intercompany interest must be capitalized to be treated as a deferred intercompany transaction, P and its subsidiaries have clearly indicated that they intended to treat the intercompany interest as a capital expenditure. Thus, the attached schedule in the instant case is similar to the schedule filed by the taxpayers in Kentucky Utilities Co. v. Glenn and is distinguishable from the facts in Rev. Rul. 70-539, in which the taxpayer did not file such a schedule.

Accordingly, P and its subsidiaries have made a proper election to capitalize the intercompany interest on the loan from P to S under section 266 of the Code.

Rev. Rul. 70-539 is distinguished.