Rev. Proc. 80-55

Section 1. Purpose

The purpose of this revenue procedure is to amplify Rev. Proc. 70-20, 1970-2 C.B. 499 and Rev. Proc. 72-18, 1972-1 C.B. 740, to provide that section 265(2) of the Internal Revenue Code will be applied to disallow deductions for interest paid by commercial banks on certain time deposits made by a state when such deposits are made for a specific period of time and 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 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 tax.

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

.03 A bank deposit secured by tax-exempt obligations is one of the types of borrowings not specifically dealt with in Rev. Proc. 70- 20.

.04 Rev. Proc. 72-18 provides guidelines for the application of section 265(2) of the Code to banks in situations not dealt with in Rev. Proc. 70-20. Section 3.01 of Rev. Proc. 72-18 sets forth the general rule that section 265(2) is only applicable where the indebtedness is incurred or continued for the purpose of purchasing or carrying tax-exempt securities. Accordingly, the application of section 265(2) requires a determination, based on all the facts and circumstances, of the taxpayer's purpose in incurring each item of indebtedness. The taxpayer's purpose may be established either by direct evidence or by circumstantial evidence.

.05 Section 3.03 of Rev. Proc. 72-18 provides that direct evidence of a purpose to carry tax-exempt obligations exists where tax-exempt obligations are used as collateral for indebtedness. "[O]ne who borrows to buy tax-exempts and one who borrows against tax-exempts already owned are in virtually the same economic position. Section 265(2) makes no distinction between them." Wisconsin Cheeseman v. United States, 338 F. 2d 420 at 422 (7th Cir. 1968).

.06 In Rev. Proc. 78-34, 1978-2 C.B. 535, the Service amplified Rev. Proc. 70-20 to provide that section 265(2) of the Code 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. This treatment afforded to borrowings of Treasury tax and loan funds is permitted because the borrowing of such funds, notwithstanding the pledge of tax-exempt obligations, is in the nature of a demand deposit. Also, the availability of these funds is subject to the exclusive discretion of the Treasury. In addition, access to these funds by depository banks is not subject to negotiated rates of interest or any other market factors that normally influence arm's length money market transactions.

Sec. 3. Application

.01 State law will often permit state funds to be placed on deposit with local banks. The state law generally requires that a contract be entered into designating the rate of interest to be paid on such deposit and the duration of the deposit. The contract may provide, with respect to the duration of the deposit, that funds will remain on deposit for a specified period of time (30 days to 1 year), or it may provide that the availability of the state funds is subject to the exclusive discretion of the state. In addition, the bank may also be required to deposit with the proper state authority certain securities at least equal in market value to the money deposited by the state in that bank. The state law generally lists those securities that are acceptable for this purpose. A bank receiving such deposits often pledges tax-exempt securities as collateral.

.02 A depository bank that holds demand deposits that it has collateralized with tax-exempt obligations is not in virtually the same economic position as one who borrows to buy tax-exempt obligations. That depository bank does not have the unrestricted use of the amount of the borrowed funds because such amount is subject to immediate withdrawal at any moment in time. See Rev. Proc. 78-34.

.03 A depository bank that holds state funds as time-deposits that it has collateralized with tax-exempt obligations is in virtually the same economic position as one who has borrowed to buy tax-exempt obligations. The depository bank knows with certainty that it will have the amount of deposited funds available to it, without restriction, for a fixed period of time. Accordingly, direct evidence of a purpose to purchase or carry tax-exempt obligations exists under section 3.03 of Rev. Proc. 72-18.

.04 Commercial banks that participate in a state program that requires them to bid for state funds, negotiate the rate of interest, and requires the state to leave such deposits for a specified period of time will create an indebtedness of the type described in section 265(2) of the Code. Thus, the interest paid by commercial banks on such deposit will be disallowed under section 265(2).

.05 Commercial banks that participate in a state program in which funds are awarded in the manner described in Rev. Proc. 78-34 and where the placement of such funds is at the discretion of the state do not create indebtedness of the type described in section 265(2) of the Code. Thus, section 265(2) will not be applied to disallow a deduction for interest paid by the commercial banks on such funds.

Sec. 4. Prospective Application

Under the authority of section 7805(b) of the Code, sections 3.03 and 3.04 of Rev. Proc. 80-55 will be applied prospectively to interest paid on deposits made after May 31, 1981.

Sec. 5. Effect on Other Documents

Rev. Proc. 70-20 and Rev. Proc. 72-18 are amplified.

Sec. 6. Inquiries

Inquiries in regard to this revenue procedure should refer to its number and be addressed to Assistant Commissioner (Technical), Attention TC:C:C, Washington, DC 20224.