Funding infrastructure programs has become a centerpiece for many policy makers. Various federal government direct loan programs, state revolving loan programs funded largely by federal grants, and state loan programs, provide long-term loans to public-private partnership infrastructure developers, and to private infrastructure developers, at an interest rate that is often below the IRS Applicable Federal Rate (AFR).
For example, the federal Environmental Protection Agency, pursuant to the Clean Water State Revolving Fund program, has capitalized revolving funds in each state. Under 33 U.S.C. Section 1383(d)(1)(A), these state funds are authorized to make project loans at as low as a zero interest rate. As another example, the federal Department of Transportation’s Build America Bureau, pursuant to 23 U.S.C. Section 603(b)(4)(B)(i), prices its direct project loans that are made pursuant to the Transportation Infrastructure Finance and Innovation Program Rural Project Initiative at half of the prevailing U.S. Treasury rate.
Tax code Section 7872(b)(1) generally applies to term loans whose interest rate is below the AFR. Section 7872(b)(1) treats the excess of the amount loaned, over the present value of the required loan repayments discounted at the AFR, as being immediately transferred from the lender to the borrower.
The IRS generally treats government subsidies to businesses as immediate income, unless a specific statutory exclusion applies. See Notice 2003-18. Since 2018, Section 118(b)(2) denies an exclusion for governmental contributions to corporate capital, an exclusion claimed by some government grantees before 2018. Therefore, the IRS is likely to treat the Section 7872(b)(1) amount as immediate income to the borrower.
Section 7872(b)(2) allows the borrower to treat the Section 7872(b)(1) inclusion as original issue discount on the loan, thereby, over the life of the loan, mathematically offsetting the initial inclusion triggered by the loan disbursement. However, the borrower’s offset for original issue discount expense is deferred over the term of the loan. The borrower’s tax benefit is further diluted by the requirement to capitalize construction period original issue discount expense under Section 263A, the inability to carry back excess original issue discount expense under Section 163(j), and the inability to carry back net operating losses under Section 172(b). Thus, the borrower may well need to finance any initial tax triggered by Section 7872(b)(1).
In Private Letter Ruling 9024022, a borrower was able to finance its tax liability on receipt of an item of income by a tax-related no-interest loan from the payor of that item. PLR 9024022 concluded that such loan itself triggered tax under Section 7872(b)(1). If a below-AFR loan triggered a Section 7872(b)(1) tax liability, the program terms would have to be examined to see if that tax, as possibly grossed-up, could itself be financed by the borrower through an additional government agency below-AFR loan.
Section 7872, however, does not apply to every below-AFR term loan. The question of which, if any, government agency below-AFR loans can be within the scope of Section 7872 has been the subject of differing government views. The statutory framework, regulations, rulings and Committee Reports are not entirely coherent. Thus, while the IRS has favorably consistently sought to permit private borrowers to avoid the application of Section 7872(b)(1) to government agency below-AFR loans, there seems to be no assurance that a specific borrower will necessarily achieve the same result in the future.
Some authorities have focused on the question of when below-AFR loans made by a government agency can be brought within the scope of Section 7872 by reason of Section 7872(c)(1)(D) or Section 7872(c)(1)(E). Section 7872(c)(1)(D) includes a below-AFR loan one “of the principal purposes of the interest arrangements of which is the avoidance of any Federal tax.” Section 7872(c)(1)(E) includes a below-AFR loan “to the extent provided in regulations . . . if the interest arrangements on such loan have a significant effect on any Federal tax liability of the lender or the borrower.”
Other authorities have focused on the question of, without regard to whether or not a below-AFR loan by a government agency can be described in Sections 7872(c)(1)(D) and Section 7872(c)(1)(E), such loan could be excepted from Section 7872 by Section 7872(i)(1)(C). Section 7872(i)(1)(C) allows for “regulations exempting from the application of this section any class of transactions the interest arrangements of which have no significant effect on any Federal tax liability of the lender or the borrower.”
Proposed and Temporary Section 7872 Regulations
Shortly after the 1984 enactment of Section 7872, in 1985 Treasury issued Proposed Treasury Regulation Section 1.7872-1 and Temporary Treasury Regulation Section 1.7872-5T. As of 2021, Prop. Treas. Reg. Section 1.7872-1 has not been finalized. Temp. Treas. Reg. Section 1.7872-5T remains in effect. Temp. Treas. Reg. Section 1.7872-5T was promulgated before the 1998 effective date of Section 7805(e)(2), which sunsets temporary regulations after three years.
Prop. Treas. Reg. Section 1.7872-4(e) describes Section 7872(c)(1)(D) tax avoidance loans as covering those loans where “a principal factor in the decision to structure the transaction as a below-market loan (rather than, for example, as a market interest rate loan and a payment by the lender to the borrower) is to reduce the Federal tax liability of the borrower, or the lender, or both. The purpose for entering into the transaction (for example, to a make a gift or to pay compensation) is irrelevant in determining whether a principal purpose of the interest arrangements of the loan is the avoidance of Federal tax.”
Prop. Treas. Reg. Section 1.7872-4(f) reserved regulations concerning Section 7872(c)(1)(E) significant effect loans. The 1985 preamble stated that “no transaction will be treated as a significant effect loan earlier than the date that future regulations under section 7872(c)(1)(E) are published in proposed form.”
Temp. Treas. Reg. Section 1.7872-5T describes loans exempted from Section 7872 by reason of regulations authorized by Section 7872(i)(1)(C), concerning the absence of a significant tax effect. Temp. Treas. Reg. Section 1.7872-5T(a)(1) provides that except as provided in Temp. Treas. Reg. Section 1.7872-5T(a)(2), Section 7872 does not apply to the 15 classes of loans listed in Temp. Treas. Reg. Section 1.7872-5T(b). However, Temp. Treas. Reg. Section 1.7872-5T(a)(2) provides that if a taxpayer structures a transaction to be a loan described as exempted under Temp. Treas. Reg. Section 1.7872-5T(b), and one of the principal purposes of so structuring the transaction is the avoidance of federal tax, then the transaction will be recharacterized as a tax avoidance loan described in Section 7872(c)(1)(D), and thus apparently will be subject to Section 7872. Temp. Reg. Section 1.7872-5T(a)(1), tracking the language of Section 7872(i)(1)(C), states that the rationale of each of the 15 exemptions in Temp. Reg. Section 1.7872-1(b)(1) through (15) is that “the interest arrangements do not have a significant effect on the Federal tax liability of the borrower or the lender.”
Among the exemptions listed in Temp. Treas. Reg. Section 1.7872-5T(b) are those listed in paragraphs (5), (14), and (15). Temp. Treas. Reg. Section 1.7872-5T(b)(5) exempts: “Loans subsidized by the Federal, State (including the District of Columbia), or Municipal government (or any agency or instrumentality thereof), and which are made available under a program of general application to the public.”
Temp. Treas. Reg. Section 1.7872-5T(b)(14) exempts “loans the interest arrangements of which the taxpayer is able to show have no significant effect on any Federal tax liability of the lender or the borrower.” The existence or non-existence of such a significant effect is described in Temp. Treas. Reg. Section 1.7872-5T(c)(3) as being “determined according to all of the facts and circumstances. Among the factors to be considered are— (i) Whether items of income and deduction generated by the loan offset each other; (ii) The amount of such items; (iii) The cost to the taxpayer of complying with the provisions of section 7872 if such section were applied; and (iv) Any non-tax reasons for deciding to structure the transaction as a below-market loan rather than a loan with interest at a rate equal to or greater than the applicable Federal rate and a payment by the lender to the borrower.”
Commentators note that since regulations establishing significant effect as triggering adverse coverage of a below-AFR loan under Section 7872(c)(1)(E) have not been promulgated, and that Sections 7872(i)(1)(C) and Temp. Treas. Reg. Section 1.7872-5T(b)(14) treats the absence of significant effect as an affirmative defense to potential Section 7872 coverage as a Section 7872(c)(1)(D) tax avoidance loan, the concept of significant effect is in essence a one-way street that operates only to benefit some taxpayers from avoiding Section 7872 coverage. For example, taxpayers borrowing under a tax avoidance loan who demonstrate the absence of significant effect can avoid Section 7872 coverage under Temp. Treas. Reg. Section 1.7872-5T(b)(14).
In KTA-Tator Inc., v. Commissioner, the U.S. Tax Court stated that the IRS need only show a significant effect on the borrower or the lender, rather than on both, to establish an adverse significant effect and thereby block relief under Temp. Treas. Regs. Sections 1.7872-5T(b)(14) and 1.7872-5T(c)(3). In McGinnis v. Commissioner, the Tax Court, ruling for the IRS, indicated that a permanent Section 7872 income inclusion of approximately $6,000 for each of two years was an adverse significant effect for purposes of preventing relief under Temp. Treas. Regs. Sections 1.7872-5T(b)(14) and 1.7872-5T(c)(3). Thus, a private borrower under a large infrastructure below-AFR loan is unlikely to be entitled to rely on the tax-exempt status of the government lender, or the current low AFR rates, to prevent an adverse finding of significant effect.
Overall, the application of the significant effect factors in Temp. Treas. Reg. Section 1.7872-5T(c)(3) to major infrastructure below-AFR government loans is uncertain. Factor (i), lack of an offsetting interest deduction to the borrower, would adversely indicate significant effect if timing were taken into account. Factors (ii) and (iii), large loan size, and modest borrower compliance costs, would also adversely indicate significant effect. Factor (iv), non-tax reasons for structuring the subsidy as a non-interest loan, would indicate lack of significant effect if the reasons considered were only those of the government lender and there was no reason to impute borrower tax motives to that government lender. Temp. Treas. Reg. Section 1.7872-5T(c)(3) gives no guidelines on how the enumerated facts and circumstances are to be weighted.
Temp. Treas. Reg. Section 1.7872-5T(b)(15) exempts: “Loans, described in revenue rulings or revenue procedures issued under section 7872[i](1)(C), if the Commissioner finds that the factors justifying an exemption for such loans are sufficiently similar to the factors justifying the exemptions contained in this section.”
Part 2 of this article will look at IRS guidance in the form of Revenue Ruling 98-34 and other IRS rulings intended to except government loans from the tax consequences of the provision.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, FL
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