Rev. Proc. 72-18

Section 1. Purpose.

The purpose of this Revenue Procedure is to set forth guidelines for taxpayers and field offices of the Internal Revenue Service for the application of section 265(2) of the Internal Revenue Code of 1954 to certain taxpayers holding state and local obligations the interest on which is wholly exempt from Federal income tax. Guidelines for the application of section 265(2) of the Code to banks holding such tax-exempt obligations were set forth in Revenue Procedure 70-20, C.B. 1970-2, 499. This Revenue Procedure provides guidelines for the application of section 265(2) of the Code to individuals, to dealers in tax-exempt obligations, and to business enterprises that are not dealers in tax-exempt obligations, and to banks in situations not dealt with in Revenue Procedure 70-20.

Sec. 2. Background.

.01 Section 265(2) of the Code provides, with two exceptions not here relevant, 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 265(2) of the Code is derived from section 1201(1) of the Revenue Act of 1917 and section 234(a)(2) of the Revenue Act of 1918. It is clear from the legislative history of those sections and of subsequent unsuccessful efforts to amend such sections (or their successors) that Congress intended to disallow interest under section 265(2) of the Code only upon a showing of a purpose by the taxpayer to use borrowed funds to purchase or carry tax-exempt securities. See, e.g., H. Rept. 767, 65th Cong., 10; S. Rept. 617, 65th Cong., 6, 7 (1918); 65 Cong. Rec. 7541-7542 (1924); and 67 Cong. Rec. 2964 (1925).

.03 Where the required purposive relationship is established, section 265(2) of the Code will be applicable even though the taxpayer does not receive tax-exempt interest, as for example, where the taxpayer holds defaulted obligations (see Clyde C. Pierce Corp. v. Commissioner, 120 F. 2d 206 (1941)), or where the taxpayer holds the obligation for a period before interest begins to accrue (see Illinois Terminal Railroad Co. v. United States, 375 F. 2d 1016, 1022 (1967)). Similarly, section 265(2) of the Code may be applicable even though the taxpayer's purpose in purchasing or carrying the tax-exempt obligations is to produce a taxable profit rather than tax-exempt interest. See Denman v. Slayton, 282 U.S. 514 (1931).

Sec. 3. General Rules.

.01 Section 265(2) of the Code 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) of the Code requires a determination, based on all the facts and circumstances, as to the taxpayer's purpose in incurring or continuing each item of indebtedness. Such purpose may, however, be established either by direct evidence or by circumstantial evidence.

.02 Direct evidence of a purpose to purchase tax-exempt obligations exists where the proceeds of indebtedness are used for, and are directly traceable to, the purchase of tax-exempt obligations. Wynn v. United States, 411 F. 2d 614 (1969), certiorari denied 396 U.S. 1008 (1970). Section 265(2) does not apply, however, where proceeds of a bona fide business indebtedness are temporarily invested in tax-exempt obligations under circumstances similar to those set forth in Revenue Ruling 55-389, C.B. 1955-1, 276.

.03 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 (1968).

.04 In the absence of direct evidence linking indebtedness with the purchase or carrying of tax-exempt obligations as illustrated in paragraphs .02 and .03 above, section 265(2) of the Code will apply only if the totality of facts and circumstances supports a reasonable inference that the purpose to purchase or carry tax-exempt obligations exists. Stated alternatively, section 265(2) will apply only where the totality of facts and circumstances establishes a "sufficiently direct relationship" between the borrowing and the investment in tax-exempt obligations. See Wisconsin Cheeseman, 388 F. 2d 420, at 422. The guidelines set forth in sections 4, 5, and 6 shall be applied to determine whether such a relationship exists.

.05 Generally, where a taxpayer's investment in tax-exempt obligations is insubstantial, the purpose to purchase or carry tax-exempt obligations will not ordinarily be inferred in the absence of direct evidence as set forth in sections 3.02 and 3.03. In the case of an individual, investment in tax-exempt obligations shall be presumed insubstantial only where during the taxable year the average amount of the tax-exempt obligations (valued at their adjusted basis) does not exceed 2 percent of the average adjusted basis of his portfolio investments (as defined in section 4.04) and any assets held in the active conduct of a trade or business. In the case of a corporation, an investment in tax-exempt obligations shall be presumed insubstantial only where during the taxable year the average amount of the tax-exempt obligations (valued at their adjusted basis) does not exceed 2 percent of the average total assets (valued at their adjusted basis) held in the active conduct of the trade or business. This paragraph shall not apply to a dealer in tax-exempt obligations.

Sec. 4. Guidelines for Individuals.

.01 In the absence of direct evidence of the purpose to purchase or carry tax-exempt obligations (as set forth in sections 3.02 and 3.03), the rules set forth in this section shall apply.

.02 An individual taxpayer may incur a variety of indebtedness of a personal nature, ranging from short-term credit for purchases of goods and services for personal consumption to a mortgage incurred to purchase or improve a residence or other real property which is held for personal use. Generally, section 265(2) of the Code will not apply to indebtedness of this type, because the purpose to purchase or carry tax-exempt obligations cannot reasonably be inferred where a personal purpose unrelated to the tax-exempt obligations ordinarily dominates the transaction. For example, section 265(2) of the Code generally will not apply to an individual who holds salable municipal bonds and takes out a mortgage to buy a residence instead of selling his municipal bonds to finance the purchase price. Under such circumstances the purpose of incurring the indebtedness is so directly related to the personal purpose of acquiring a residence that no sufficiently direct relationship between the borrowing and the investment in tax-exempt obligations may reasonably be inferred.

.03 The purpose to purchase or carry tax-exempt obligations generally does not exist with respect to indebtedness incurred or continued by an individual in connection with the active conduct of trade or business (other than a dealer in tax-exempt obligations) unless it is determined that the borrowing was in excess of business needs. However, there is a rebuttable presumption that the purpose to carry tax-exempt obligations exists where the taxpayer reasonably could have foreseen at the time of purchasing the tax-exempt obligations that indebtedness probably would have to be incurred to meet future economic needs of the business of an ordinary, recurrent variety. See Wisconsin Cheeseman v. United States, 388 F. 2d 420, at 422. The presumption may be rebutted, however, if the taxpayer demonstrates that business reasons, unrelated to the purchase or carrying of tax-exempt obligations, dominated the transaction.

.04 Generally, a purpose to carry tax-exempt obligations will be inferred, unless rebutted by other evidence, wherever the taxpayer has outstanding indebtedness which is not directly connected with personal expenditures (see section 4.02) and is not incurred or continued in connection with the active conduct of a trade or business (see section 4.03) and the taxpayer owns tax-exempt obligations. This inference will be made even though the indebtedness is ostensibly incurred or continued to purchase or carry other portfolio investments.

Portfolio investment for the purposes of this Revenue Procedure includes transactions entered into for profit (including investment in real estate) which are not connected with the active conduct of a trade or business. Purchase and sale of securities shall not constitute the active conduct of a trade or business unless the taxpayer is a dealer in securities within the meaning of section 1.471-5 of the Income Tax Regulations. A substantial ownership interest in a corporation will not be considered a portfolio investment. For example, where a taxpayer owns at least 80 percent of the voting stock of a corporation that is engaged in the active conduct of a trade or business, the investment in such controlling interest shall not be considered to be a portfolio investment.

A sufficiently direct relationship between the incurring or continuing of indebtedness and the purchasing or carrying of tax-exempt obligations will generally exist where indebtedness is incurred to finance portfolio investment because the choice of whether to finance a new portfolio investment through borrowing or through the liquidation of an existing investment in tax-exempt obligations typically involves a purpose either to maximize profit or to maintain a diversified portfolio. This purpose necessarily involves a decision, whether articulated by the taxpayer or not, to incur (or continue) the indebtedness, at least in part, to purchase or carry the existing investment in tax-exempt obligations.

A taxpayer may rebut the presumption that section 265(2) of the Code applies in the above circumstances by establishing that he could not have liquidated his holdings of tax-exempt obligations in order to avoid incurring indebtedness. The presumption may be overcome where, for example, liquidation is not possible because the tax-exempt obligations cannot be sold. The presumption would not be rebutted, however, by a showing that the tax-exempt obligations could only have been liquidated with difficulty or at a loss; or that the taxpayer owned other investment assets such as common stock that could have been liquidated; or that an investment advisor recommended that a prudent man should maintain a particular percentage of assets in tax-exempt obligations. Similarly, the presumption would not be rebutted by a showing that liquidating the holdings of tax-exempt obligations would not have produced sufficient cash to equal the amount borrowed.

The provisions of this paragraph may be illustrated by the following example:

Taxpayer A, an individual, owns common stock listed on a national securities exchange, having an adjusted basis of $200,000; he owns rental property having an adjusted basis of $200,000; he has cash of $10,000; and he owns readily marketable municipal bonds having an adjusted basis of $41,000. A borrows $100,000 to invest in a limited partnership interest in a real estate syndicate and pays $8,000 interest on the loan which he claims as an interest deduction for the taxable year. Under these facts and circumstances, there is a presumption that the $100,000 indebtedness which is incurred to finance A's portfolio investment is also incurred to carry A's existing investment in tax-exempt bonds since there are no additional facts or circumstances to rebut the presumption. Accordingly, a portion of the $8,000 interest payment will be disallowed under section 265(2) of the Code.

See section 7 concerning the amount to be disallowed.

.05 In the case of a partnership which incurs indebtedness or which holds tax-exempt obligations, the partners shall be treated as incurring or holding their partnership share of such indebtedness or tax-exempt obligations. For purposes of this Revenue Procedure, the interest of a partner in the partnership's assets and indebtedness shall be determined in accordance with his capital interest in the partnership. The purposes for which the partnership incurs any indebtedness shall be attributed to the general partners in applying section 265(2). A general partner's interest in corporate stock owned by a partnership will ordinarily be considered a portfolio investment unless the partnership meets the substantial ownership requirement of section 4.04; and (1) the partner has at least an 80 percent interest in the partnership or (2) the business of the corporation and of the partner are closely related and the partner has an interest of more than 50 percent in the partnership. A limited partnership interest will be considered as representing portfolio investment.

Sec. 5. Guidelines for Dealers in Tax-Exempt Obligations.

.01 A dealer in tax-exempt obligations (whether a corporation, partnership, or sole proprietorship) is subject to section 265(2) of the Code where it is established that indebtedness is incurred or continued for the purpose of holding tax-exempt obligations, even though the tax-exempt obligations are held for the purpose of resale at a gain rather than for the purpose of receiving tax-exempt interest income. See Denman v. Slayton, supra.

.02 Where the proceeds of indebtedness are directly traceable to the purchase of tax-exempt obligations by a dealer in such obligations, section 265(2) of the Code applies as specified in section 3.02. Direct tracing may occur for example, where a brokerage business maintains a municipal bond account with a bank through which it purchases and sells all of its municipal bonds, with the brokerage business incurring an indebtedness to the bank during any period in which purchases exceed receipts from sales in the account. See Wynn v. United States, supra. As provided in section 7, where there is such direct tracing the entire interest on the indebtedness is nondeductible under section 265(2) of the Code.

.03 Where indebtedness is incurred or continued for the general purpose of carrying on a brokerage business which includes the purchase of both taxable and tax-exempt obligations, and the use of the borrowed funds cannot be directly traced, it is reasonable to infer that the borrowed funds were used for all the activities of the business which include the purchase of tax-exempt obligations. Accordingly, section 265(2) of the Code is applicable in such circumstances. See Commissioner v. Leslie, 413 F. 2d 636 (1969), certiorari denied, 396 U.S. 1007 (1970). However, in such a case only an allocable portion of the interest deduction is disallowed, as provided in section 7.

.04 The purpose to purchase or carry tax-exempt obligations generally cannot be inferred where indebtedness is incurred to acquire or improve physical facilities. In such circumstances a dominant business purpose apart from the purchasing or carrying of tax-exempt obligations is sufficiently established, with the result that any inference that the indebtedness was incurred or continued for the proscribed purpose is adequately rebutted. Compare Wisconsin Cheeseman, supra.

Sec. 6. Guidelines for Corporations That Are Not Dealers in Tax-Exempt Obligations.

.01 Where there is no direct evidence of the purpose to purchase or carry tax-exempt obligations (as set forth in sections 3.02 and 3.03), the rules set forth in this section shall apply to a corporation which is not a dealer in tax-exempt obligations.

The purpose to purchase or carry tax-exempt obligations will generally not be inferred with respect to indebtedness incurred or continued to provide funds for carrying on an active trade or business, not involving the holding of tax-exempt obligations, unless it is determined that the borrowing was in excess of business needs. Thus the purpose may be present where the borrowings exceed the reasonable needs of business or provide funds for portfolio investments. For example, where indebtedness is incurred and the proceeds are used, directly or indirectly, to purchase tax-exempt obligations which are retained for a substantial period of time as an investment, the purpose to purchase or carry tax-exempt obligations may be inferred. Similarly, where the taxpayer invests a disproportionately large portion of its liquid assets in tax-exempt obligations and there are no facts indicating that such investment is related to the reasonable needs of the taxpayer's business operations or is required on the basis of the financial conditions prevailing with respect thereto, the required purpose may also be inferred with respect to indebtedness of the taxpayer. On the other hand, temporary, short-term, investment of working capital in tax-exempt obligations, particularly where such obligations are of a nature suited for such investment (such as 90 day tax anticipation notes), and where such investments are liquidated frequently to provide funds for use in the taxpayer's business, normally provides no basis for inferring that the purpose to purchase or carry tax-exempt obligations exists with respect to indebtedness of the taxpayer. An inference may arise, however, with respect to indebtedness which is itself short-term and is incurred other than in the normal course of the taxpayer's trade or business.

.02 Generally, the purpose to carry tax-exempt obligations will be inferred unless rebutted by other evidence where the taxpayer could reasonably have foreseen at the time of purchasing the tax-exempt obligations that indebtedness probably would have to be incurred to meet future economic needs of the corporation of an ordinary, recurrent variety. For example, a purpose to carry tax-exempt obligations can be inferred in a case (such as Wisconsin Cheeseman, supra) where the regular business pattern of a corporation shows that it would be required to borrow funds to meet its recurring needs for working capital if it bought or retained tax-exempt obligations as a long-term investment. The presumption will not apply, however, if the taxpayer demonstrates that business reasons unrelated to the purchase or carrying of tax-exempt obligations dominated the transaction. For example, the purpose to carry tax-exempt obligations generally cannot be inferred where a mortgage debt is incurred to finance a new plant which is a nonrecurrent major expenditure. In such cases, a dominant business purpose, other than the purchase or carrying of tax-exempt obligations will normally exist and, accordingly, any inference will be rebutted. On the other hand, the purpose to carry tax-exempt obligations can be inferred where a corporation continues indebtedness which it could discharge, in whole or in part, by liquidating its holdings of tax-exempt obligations without withdrawing any capital which is committed to, or held in reserve for, the corporation's regular business activities. See Illinois Terminal Railroad Co. v. United States, supra.

.03 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). Similarly, it generally will not be present where such holdings are required as a condition to performing a contract to provide services or property other than money to a state or local government in the ordinary course of the taxpayer's trade or business. See Commissioner v. Bagley & Sewall Co., 221 F. 2d 944 (1955).

Sec. 7. Procedures.

.01 When there is direct evidence under sections 3.02 and 3.03 establishing a purpose to purchase or carry tax-exempt obligations (either because tax-exempt obligations were used as collateral for indebtedness or the proceeds of indebtedness were directly traceable to the holding of particular tax-exempt obligations) no part of the interest paid or incurred on such indebtedness may be deducted. However, if only a fractional part of the indebtedness is directly traceable to the holding of particular tax-exempt obligations, the same fractional part of the interest paid or incurred on such indebtedness will be disallowed. For example, if A borrows $100,000 from a bank and invests $75,000 of the proceeds in tax-exempt obligations, 75 percent of the interest paid on the bank borrowing would be disallowed as a deduction.

.02 In any other case where interest is to be disallowed in accordance with this Revenue Procedure, an allocable portion of the interest on such indebtedness will be disallowed. The amount of interest on such indebtedness to be disallowed shall be determined by multiplying the total interest on such indebtedness by a fraction, the numerator of which is the average amount during the taxable year of the taxpayer's tax-exempt obligations (valued at their adjusted basis) and the denominator of which is the average amount during the taxable year of the taxpayer's total assets (valued at their adjusted basis) minus the amount of any indebtedness the interest on which is not subject to disallowance to any extent under this Revenue Procedure.

Sec. 8. Inquiries.

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