Rev. Proc. 70-20

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 banks holding tax-exempt state and local obligations. 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.

Sec. 2. Background.

.01 Section 265(2) 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 such section 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).

.02 As early as 1924 the Service stated with regard to the application of section 234(a)(2) of the Revenue Act of 1918 to banks, "It is clear that indebtedness incurred by reason of deposits in a bank is not incurred to purchase or carry tax-exempt securities * * *." I.T. 2028, C.B. III-1, 296 (1924). See also Rev. Rul. 61-222, C.B. 1961-2, 58, which enunciates the same principles.

.03 The Congress has repeatedly recognized that indebtedness incurred by a bank to its depositors is not to be treated as indebtedness incurred or continued to purchase or carry tax-exempt securities within the meaning of section 265(2). To do so would "seriously interfere with the marketing of government securities, which are bought for the most part by banks * * *." S. Rept. 558, 73rd Cong., 24 (1934), cf. H. Rept. 704, 73rd Cong. 21-22 (1934) and Hearings Before the Senate Committee on Finance on the Revenue Act of 1934, 73rd Cong., 206-209 (1934). Also, see 110 Cong. Rec. 2211-2215 (1964); Hearing Before the House Committee on Banking and Currency on H.R. 14026, 89th Cong., 152-153 (May 19, 1966).

.04 Developments and changes subsequent to the early revenue acts and rulings in the day-to-day methods of doing business within the banking community have raised a number of questions, the answers to which are of concern to the Service and the banking industry. These guidelines are intended to clear up any uncertainties as to the application of section 265(2) of the Code to the banks.

Sec. 3. Application.

.01 The primary purpose of a commercial bank is to make available to one segment of society money which is excess to the current needs of other segments of society. Because a large part of its indebtedness is subject to payment on immediate and short-term demand as contrasted to the money it lends, it must have considerable flexibility as to the source of its funds. In the ordinary course of the banking business, it has now become necessary in securing funds for day-to-day operations to resort to short-term indebtedness from a number of sources. The most common of these sources are demand deposits, time deposits, certificates of deposit, Federal funds, repurchase agreements, interbank borrowings, Federal Reserve borrowings, short-term notes, and Eurodollar deposits and borrowings. In addition to these sources of day-to-day funds, banks also raise capital funds from the sale of capital notes, which are generally long term in nature, the issuance of preferred and common stock and retained earnings.

.02 Certificates of deposit, except for minor technical differences which have little significance in this context, are essentially identical to time deposits and, except as provided in paragraph .09 of this section, are thus treated for the purposes of section 265(2) of the Code as identical with other deposits.

.03 A Federal funds transaction usually is an unsecured overnight loan or sale by one bank to another. The loan or sale is effected by an immediate debit to the reserve account of the lending or selling bank and a credit to the reserve account of the borrowing or buying bank on the books of the Federal Reserve bank. The following day the entry is reversed. The economic effect of a Federal funds transaction is very similar to what would have occurred if the borrowing bank had received a one-day deposit with the transfer accomplished by a check drawn upon the Federal Reserve by the lending bank. The most common use for the readily available Federal funds is to insure that the borrowing bank maintains a sufficient reserve. Federal funds transactions constitute ordinary day-to-day operations of a bank and in essence do not appear to differ sufficiently from "bank deposits" to warrant different treatment. Therefore, Federal funds borrowing, whether occasional or continuous, like deposits, does not, except as provided in paragraph .09 of this section, create indebtedness of the type described in section 265(2) of the Code. See Rev. Rul. 67-287, C.B. 1967-2, 133.

.04 Very similar to Federal funds transactions are certain repurchase agreements having the essential characteristics of a loan. These may arise when a bank sells securities with an agreement to buy these securities back at a specific price and on a specific date, often overnight. The amount required by the repurchase agreement to be paid on repurchase in excess of the amount for which the securities are sold is treated as interest by the selling bank. Such repurchase agreements constitute ordinary operations of a bank and in essence do not appear to differ sufficiently from Federal funds transactions to warrant different treatment. Therefore, repurchase agreements whether occasional or continuous, like deposits, do not, except as provided in paragraph .09 of this section, create indebtedness of the type described in section 265(2) of the Code.

.05 Federal Reserve borrowings occur when a member bank of the Federal Reserve system is permitted to borrow directly from a Federal Reserve bank. These borrowings, like borrowings of Federal funds, are short-term borrowings incurred in the course of the day-to-day business of the banks. Rev. Rul. 67-287, cited above, states in part, "Federal Reserve credit is intended primarily to permit banks to meet fixed reserve requirements when this proves to be temporarily impossible due to withdrawals of deposits of unusual loan demands made by bank customers." Thus, short-term borrowings from Federal Reserve banks, like deposits, do not, except as provided in paragraph .09 of this section, create indebtedness of the type described in section 265(2) of the Code.

.06 Very similar in function to Federal funds borrowing and to borrowing of member banks from Federal Reserve banks are the arrangements which banks that are not members of the Federal Reserve system may make with their correspondent banks in order to obtain reserve funds. These arrangements may involve overnight loans and differ very little from Federal funds transactions except that the transfer of funds is made directly between the two banks rather than through the intermediary of the Federal Reserve. Because of this similarity in function and the fact that such borrowings are usually made in the course of the day-to-day business of banks, short-term indebtedness so incurred will not, except as provided in paragraph .09 of this section, be indebtedness of the type described in section 265(2) of the Code.

.07 Short-term notes are treated by the banking authorities as deposits and ordinarily serve an identical function. Accordingly, indebtedness represented by short-term notes will not, except as provided in paragraph .09 of this section, be treated as indebtedness of the type described in section 265(2) of the Code.

.08 Eurodollars are dollar balances in foreign banks. A Eurodollar borrowing occurs when a United States bank borrows United States dollars on a short-term basis from a foreign bank. This is usually accomplished by virtue of the fact that the lending foreign bank has a deposit in another United States bank which it transfers to the borrowing bank. As a result of the transaction the borrowing bank has, in effect, obtained the transfer of a deposit from another United States bank to itself. A similar result occurs when the United States bank borrows Eurodollars on a short-term basis from foreign individuals or businesses. The availability of a Eurodollar market has made it possible for United States banks to secure funds when "tight money" conditions have pushed market interest rates above what the banks are permitted to pay on their time deposits. Interest payable on Eurodollars is ordinarily much higher than on domestic time deposits, and therefore, banks resort to such borrowings only when funds are unavailable from other sources. Nevertheless, transactions in Eurodollars constitute one of the ordinary day-to-day practices of the banking community. In view of the short-term nature of these loans, the fact that they are utilized in the day-to-day operations of banks, and because of their close similarity to deposits, indebtedness incurred in the ordinary course of business for short-term Eurodollar borrowings, like deposits, does not, except as provided in paragraph .09 of this section, create indebtedness of the type described in section 265(2) of the Code.

.09 In summary, section 265(2) should not be deemed applicable to interest paid or accrued by banks on indebtedness which they incur in the ordinary course of their day-to-day business unless there are circumstances demonstrating a direct connection between the borrowing and the tax-exempt investment. It will ordinarily be inferred that a direct connection does not exist in cases involving the following classes of short-term bank indebtedness: bank deposits (including interbank deposits and certificates of deposit); short-term notes; short-term Eurodollar deposits and borrowings; Federal funds transactions (and similar interbank borrowing to meet state reserve requirements and other day-to-day and short-term interbank borrowings), repurchase agreements (not involving tax-exempt securities), and borrowings directly from the Federal Reserve to meet reserve requirements. However, even though indebtedness falls within one of these categories unusual facts and circumstances outside of the normal course of business may demonstrate a direct connection between the borrowing and the investment in tax-exempt securities. A direct connection will be deemed to exist in circumstances such as those set forth in Rev. Rul. 67-260, C.B. 1967-2, 132, which held that interest expense incurred by a bank on certificates of deposit was not deductible where the certificates of deposit were issued to a state in exchange for tax-exempt obligations having maturity dates approximately the same as the certificates of deposits. On the other hand, a direct connection will not be inferred merely because tax-exempt obligations were held by the bank at the time of its incurring indebtedness in the course of its day-to-day business. See, for example, Rev. Ruls. 61-222 and 67-287, supra.

.10 Capital notes, unlike the preceding types of borrowing, are usually long-term borrowings issued by banks for the purpose of increasing their capital and thereby expanding their capacity to receive deposits and to make loans and investments. In view of the long-term nature of the indebtedness created by the issuance of such capital notes, the application of section 265(2) of the Code to the indebtedness is to be resolved in the light of all the facts and circumstances surrounding the issuance of the notes. Indebtedness created by the issuance of capital notes for the purpose of increasing capital to a level consistent with generally accepted banking practice in accordance with the policies, requirements, or recommendations of Federal or State regulatory officials is not indebtedness of the type described in section 265(2) of the Code. Long-term indebtedness incurred, for example, through issuance of capital notes or mortgages to finance bank building construction or for similar improvements or additions to physical facilities is not indebtedness of the type described in section 265(2) of the Code. However, capital notes that are issued without such motivations may constitute indebtedness of the type described in such section.

.11 Types of borrowings 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.

Sec. 4. Definitions.

For purposes of this Revenue Procedure, "short-term bank indebtedness" means indebtedness for a term not to exceed three years. Extensions of the original term will be disregarded unless provided for specifically in the loan agreement. Similarly, a bank deposit for a term in excess of three years will be treated as short-term where there is no restriction on withdrawal other than reduction, forfeiture or recapture in whole or in part of interest otherwise payable over the term.

Sec. 5. 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.

¹ Also released as Technical Information Release 1039, dated July 21, 1970.