Rev. Proc. 78-34

Section 1. Purpose

The purpose of this Revenue Procedure is to amplify Rev. Proc. 70-20, 1970-2 C.B. 499, to provide that section 265(2) of the Internal Revenue Code of 1954 will not be applied to disallow deductions for interest paid by commercial banks on borrowings of Treasury tax and loan funds when those borrowings are secured by pledges of tax-exempt obligations.

Sec. 2. Background

.01 Rev. Proc. 70-20 sets forth guidelines for taxpayers and field offices of the Internal Revenue Service for the application of section 265(2) of the Code to banks holding tax-exempt state and local obligations. Section 265(2) provides that no deductions 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 tax.

.02 Section 3.11 of Rev. Proc. 70-20 provides that types of borrowing not specifically dealt with in this Revenue Procedure are to be decided on the basis of all the facts and circumstances surrounding the borrowings and in the light of the general principles set forth herein.

.03 Pub. L. 95-147, 1978-1 C.B. 455, of October 28, 1977, was enacted to permit the Treasury to earn interest by the investment of its operating cash balances. Tax deposits accepted by institutions designated as depositaries for federal taxes will be remitted to the Treasury only by credit to a Treasury tax and loan account.

.04 Each Treasury tax and loan depositary selects (a) whether it wishes to remit immediately all deposits in its tax and loan account to the Treasury's operating account at the Federal Reserve Bank, or (b) whether it wishes to hold Treasury cash. Depositaries electing to remit only will be known as Remittance Option depositaries. Those electing to hold funds will be referred to as Note Option depositaries.

.05 Note Option depositaries will issue to the Treasury interest bearing notes representing funds withdrawn from their tax and loan account and, in effect, purchased by the financial institution. The notes will be payable upon demand.

.06 Prior to crediting deposits to its Treasury tax and loan account, a Note Option depositary must pledge acceptable collateral security, which may include certain tax-exempt obligations.

Sec. 3. Application

The borrowing by depositary banks of Treasury tax and loan funds, notwithstanding the pledging of tax-exempt obligations, is in the nature of a demand deposit. The availability of these funds is subject to the exclusive discretion of the Treasury. Access to these funds by depositary banks is not subject to negotiated rates or any other market factors that normally influence arm's-length money market transactions. Moreover, all depositary banks in a given class are affected pro-rata. Therefore, borrowings of Treasury tax and loan funds secured by pledges of tax-exempt obligations do not create indebtedness of the type described in section 265(2) of the Code.

Sec. 4. Effect on Other Documents

Rev. Proc. 70-20 is amplified.

Sec. 5. Inquiries

Inquiries in regard to this Revenue Procedure should refer to its number and be addressed to Assistant Commissioner (Technical), Attention: T:C:C, Washington, D.C. 20224.