SERVICE CLARIFIES THE SECTION 265 NONSALABLE MUNICIPAL BOND STANDARD IN REV. PROC. 72-18 WHERE BONDS RECEIVED FOR GOODS OR SERVICES.

Rev. Proc. 87-53

SECTION 1. PURPOSE

The purpose of this revenue procedure is to modify section 6.03 of Rev. Proc. 72-18, 1972-1 C.B. 740, in order to implement the nonsalable standard intended by that section. Under the nonsalable standard, section 265(a)(2) of the Internal Revenue Code generally does not apply to a taxpayer's holdings of tax-exempt obligations acquired in the ordinary course of the taxpayer's business as payment for goods or services from state or local governments, if such obligations are not salable.

SEC. 2. BACKGROUND

01 Rev. Proc. 72-18 provides guidelines for the application of section 265(a)(2) of the Internal Revenue Code to certain taxpayers holding state and local obligations the interest on which is wholly exempt from federal income taxation. (Before redesignation by section 902 of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 1, 297, section 265(a)(2) was section 265(2).)

02 Section 265(a)(2) of the Code provides, in part, that no deduction shall be allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from federal income taxation. The application of section 265(a)(2) requires a determination, based on all the facts and circumstances, of the taxpayer's purpose in incurring or continuing each item of indebtedness. This purpose may be established by either direct or circumstantial evidence.

03 Section 6 of Rev. Proc. 72-18 provides guidelines for corporations that are not dealers in tax-exempt obligations. Section 6.03 of Rev. Proc. 72-18 provides, "The required relationship will generally not be present where the taxpayer's holdings of tax-exempt obligations are nonnegotiable obligations acquired in the ordinary course of business in payment for services performed for, or goods supplied to, state or local governments. R.B. George Machinery Co., 26 B.T.A. 594 (1932) (Acquiesced C.B. XI-2, 4)."

04 R.B. George Machinery Co., stands for the proposition that section 265(a)(2) of the Code does not apply if the tax-exempt obligations held by the taxpayer are nonsalable. See Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420, 423 (7th Cir. 1968); Illinois Terminal Railroad Co. v. United States, 375 F.2d 1016, 1021 (Ct. Cl. 1967). The use of the term "nonnegotiable" in section 6.03 of Rev. Proc. 72-18 does not precisely convey the nonsalable standard established by R.B. George Machinery Co.

SEC. 3. APPLICATION

Section 6.03 of Rev. Proc. 72-18 is modified to read, in part, as follows:

The required relationship will generally not be present when the taxpayer is unable to sell holdings of tax-exempt obligations acquired in the ordinary course of business in payment for services performed for, or goods supplied to, state or local governments. R.B. George Machinery Co. v. Commissioner, 26 B.T.A. 594 (1932), acq., XI-2 C.B. 4 (1932); Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir. 1968); Illinois Terminal Railroad Co. v. United States, 375 F.2d 1016 (Ct. Cl. 1967).

SEC. 4. EFFECTIVE DATE

This revenue procedure is effective for all tax-exempt obligations acquired on or after January 11, 1988.

SEC. 5. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 72-18 is modified.

SEC. 6. DRAFTING INFORMATION

The principal author of this revenue procedure is Mr. Ned Blanchard of the Corporation Tax Division. For further information regarding this revenue procedure contact Mr. Ned Blanchard on (202) 377-9589 (not a toll-free call).