Funding infrastructure programs has become a centerpiece for many policymakers. 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).
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 IRS Applicable Federal Rates (AFR) as being immediately transferred from the lender to the borrower.
Revenue Ruling 98-34
The possible applicability of tax code Section 7872(b)(1) to a below-AFR government loan arose in connection with the Multifamily Assisted Housing Reform and Affordability Act of 1997 (MAHRA). MAHRA authorized financial restructuring of certain apartment projects whose owners were receiving HUD rental assistance, with a goal of reducing that annual rental assistance, without triggering a default on the projects’ government-insured above-AFR first mortgage loans. Simplifying the program to compensate the project owner for the reduction in rental assistance payments and to avoid a project owner’s default on the first mortgage loan, HUD would make a second mortgage loan. The interest rate on the second mortgage loan could be less than the AFR. The HUD below-AFR second mortgage loan would in effect be used to reduce a significant portion of the existing balance of a government-insured above-AFR first mortgage loan, such that the project would be financially viable despite the reduction in annual government rental assistance.
In September 1997, a month before MAHRA was enacted, the staff of the Joint Committee on Taxation (JCT) presented to Congress testimony on some income tax issues that project owners would face that could inhibit them from participating in the program. See “Joint Committee on Taxation, Written Testimony of the Staff of the Joint Committee on Taxation Regarding Federal Income Tax Aspects of Proposals to Restructure Certain FHA-Insured Multifamily Mortgage Portfolios (JCX-46-97), September 17, 1997.”
The JCT staff concluded that, among other tax issues, there was an issue as to Section 7872(b)(1) immediate income to potential borrowers. The JCT staff felt that the IRS could view the below-AFR loans by HUD to be described as a tax avoidance loan under Section 7872(c)(1)(D). The JCT staff concluded that the governmental loan exception in Temp. Treas. Reg. Section 1.7872-5T(b)(5) might not be available, either because the HUD loan program might not be viewed as of “general application,” or because of the disqualification for tax avoidance-structured loans described in Temp. Treas. Reg. Section 1.7872-5T(a)(2). The JCT staff also concluded there could be a risk of coverage of the HUD loan program under the significant effect test of Section 7872(c)(1)(E), without mentioning the absence of implementing regulations.
Shortly after this 1997 testimony, the chairman of the Congressional Subcommittee on Housing and Community Opportunity wrote to the IRS requesting clarification as to whether or not the HUD program would be viewed as of “general application” within the meaning of Temp. Reg. Section 1.7872-5T(b)(5). If it did not, the chairman asked as to what technical modifications to the legislation were needed.
In 1998, after enactment of MAHRA, a practitioner wrote to Treasury criticizing the JCT staff testimony. See Blanchard, Kimberly - Letter 14, TaxCore (BNA) (04/29/1998). She argued that a below-AFR loan specifically contemplated by a congressional statute to achieve a desired policy goal should not be treated as a Section 7872(c)(1)(D) tax avoidance loan. She also pointed out that no regulations were issued implementing coverage of Section 7872(c)(1)(E) significant effect loans. She also stated that to her knowledge, the IRS had not applied Section 7872 to government-subsidized loans to housing projects before.
Later in 1998, the IRS released Rev. Rul. 98-34. Rev. Rul. 98-34 concluded that below-AFR second mortgage loans made by HUD under MAHRA were not subject to Section 7872. Rev. Rul. 98-34 relied on Temp. Treas. Reg. Section 1.7872-5T(b)(15). Rev. Rul. 98-34 found the requisite analogy in Temp. Treas. Reg. section 1.7872-5T(b)(5), relating to government-subsidized loans of general application to the public. Rev. Rul. 98-34 also concluded that because the loan program was part of a federal government public policy initiative, it should not be treated as a tax avoidance-structured loan under Temp. Treas. Section 1.7872-5T(a)(2).
Rev. Rul. 98-34 stated “the legislative history of Section 7872 indicates that most government-subsidized loans, such as government-insured residential mortgage loans, were intended to be exempt from § 7872,” citing a 1984 Senate Finance Committee explanation on an un-enacted version of 1984 legislation concerning below-AFR loans.
However, the un-enacted predecessor version to Section 7872, which the Senate Finance Committee explanation cited in Rev. Rul. 98-34, differed somewhat from Section 7872 as enacted. The Senate Finance Committee version of the statute would have covered only certain below-AFR loans affirmatively described in Treasury Regulations. The Senate Finance Committee explanation contemplated that such coverage regulations “will describe loans which have as a principal purpose the avoidance of income tax by either the lender or the borrower. The committee intends that such regulations will not apply to . . . most government-subsidized loans such as government insured or guaranteed . . . residential mortgages.” See Senate Finance Committee, “Explanation of Provisions Approved by the Committee on March 21, 1984,” at page 482.
The Senate Finance Committee version of the statute did not contain Section 7872(c)(1)(D) as enacted. Section 7872(c)(1)(D) requires that below-AFR loans 1 of the principal purposes of the interest arrangements of which is a tax avoidance purpose to be governed by Section 7872, unless affirmatively exempted from Section 7872 by Section 7872(i)(1)(C) no-significant-tax-effect regulations. The exemption for government loans “under a program of general application to the public” contained in Temp. Treas. Reg. Section 1.7874-5T(b)(5) is not, as the Senate Finance Committee explanation seems to have contemplated, couched as an exception to the tax avoidance purpose characterization described in Section 7872(c)(1)(D) and Prop. Treas. Reg. section 1.7872-4(e), but rather as an exemption from Section 7872 based upon a finding of the absence of a significant tax effect pursuant to Section 7872(i)(1)(C).
Moreover, it is not entirely clear which loans were contemplated as generally exempt under the quoted excerpt from the Senate Finance Committee explanation, which seemed to refer to residential mortgages that were both government-subsidized and government-insured. Perhaps the Senate Finance Committee was referring to the HUD Section 236 rental housing program. However, this is uncertain, because no more new Section 236 program loans were being initiated in 1984. Under the Section 236 program, generally private building owners borrowed from private mortgagees, under government-insured first mortgage loans, at market rates. HUD paid to the mortgagees, as an interest subsidy to the building owners, the excess of the market interest rate charged by that mortgagee over a 1% interest rate payable by the building owner. See 24 C.F.R. Section 236.520(a). By contrast, Rev. Rul. 98-34 involved a second mortgage loan owned directly by HUD. Moreover, the Senate Finance Committee explanation excerpt referred to in Rev. Rul. 98-34 would exempt “most” government-subsidized loans, leaving open the question as to what minority of government-subsidized loans could be covered by Section 7872.
Rev. Rul. 98-34 seemed to concede that the class of mortgagors eligible for below-AFR loans under MAHRA was too narrow to cause MAHRA to be “a program of general application to the public,” and thus such below-AFR loans did not qualify under Temp. Treas. Reg. Section 1.7872-5T(b)(5). Nevertheless, Rev. Rul. 98-34 stated that the MAHRA program presented factors similar to those justifying the exemption in Temp. Treas. Reg. Section 1.7872-5T(b)(5), so as to justify the issuance of a favorable revenue ruling pursuant to Temp. Treas. Reg. Section 1.7872-5T(b)(15).
Rev. Rul. 98-34 did not discuss any possible relevance to Rev. Rul. 98-34’s conclusion of the absence of a principal tax avoidance-structuring purpose under Temp. Treas. Reg. Section 1.7872-5T(a)(2), of the fact that Congress, shortly before passing MAHRA, was made aware by the Joint Committee Staff testimony that the structure of a below-AFR loan, if it avoided coverage under Section 7872, would create a significant tax benefit to the borrower compared to a direct subsidy and AFR loan. Indeed, the only evident purpose of Rev. Rul. 98-34 was to permit HUD to market to project owners the below-AFR loan program by assuring these project owners that they would receive tax deferral, rather than Section 7872(b)(1) tax acceleration, of their below-AFR loan economic benefit. The Secretary of HUD praised the issuance of Rev. Rul. 98-34 as facilitating implementation of MAHRA. See “HUD Secretary Cuomo Praises IRS Ruling on Below-Market Second Mortgage Loans,” Daily Tax Report (4/23/98). The HUD commentary on the 2000 HUD Regulations implementing MAHRA referred to Rev. Rul. 98-34. The HUD commentary stated that one reason those regulations provided for a minimum 1% interest rate, rather than a zero interest rate, on the HUD-owned second mortgage loan, was that Rev. Rul. 98-34 stated that the HUD second mortgage loan “provides for interest” below the AFR.
IRS Technical Advice Memorandum 8952001, revoking TAM 8831004, involved a below-AFR loan program, between private parties, that had been marketed by the taxpayer for years before the U.S. income tax was enacted, and thus was admittedly not designed for a principal tax avoidance purpose. However, where such program was, after Section 7872 was enacted, marketed as a means to avoid Section 7872, the IRS ruled that the loans under the program were converted into a principal tax avoidance purpose loan program covered by Section 7872 by reason of Section 7872(c)(1)(D).
While the result in Rev. Rul. 98-34 was favorable to the private owners of housing projects benefiting from below-AFR loans under MAHRA, borrowers for project loans under other programs would not necessarily benefit from the exception in Temp. Treas. Reg. Section 1.7872-5T granted by Rev. Rul. 98-34. Rev. Rul. 98-34 seems to imply that the exemption from Section 7872 in Temp. Treas. Reg. Section 1.7872-5T(b)(5), for loans of general application to the public, would likely not apply to loans available to a narrow class of borrowers, such as many infrastructure project loans. Rather, Rev. Rul. 98-34 could raise a concern that, absent a Revenue Ruling or Revenue Procedure, no exemption under Temp. Treas. Reg. Section 1.7872-5T for a narrowly targeted program of below-AFR loans made to project owners would be available. The Temp. Treas. Reg. Section 1.7872-5T(b)(15) exemption for below-AFR loans exempted by a Revenue Ruling or a Revenue Procedure has, to date, apparently only been applied in Rev. Rul. 98-34.
On the other hand, although Rev. Rul. 98-34 did not mention Section 7872(c)(1)(D), Rev. Rul. 98-34’s conclusion that the tax-avoidance disqualification in Temp. Treas. Reg. Section 1.7872-5T(a)(2) did not apply was based on language similar to that found in Section 7872(c)(1)(D). Therefore, Rev. Rul. 98-34 does not seem to rule out a finding that such below-AFR HUD second mortgage loan also avoided Section 7872 by reason of not being described in Section 7872(c)(1)(D).
Chief Counsel Advice Memorandum 200034025
CCA 200034025 contained the IRS response to a request by the state of North Carolina for advice as to the federal income tax consequences of North Carolina’s three year balloon term, interest-free, loan program, enacted in 1999. Borrowers were viable small and medium-size businesses that had suffered flood damage from a 1999 hurricane, but who were ineligible for federal Small Business Administration loans.
CCA 200034025 favorably concluded that the North Carolina loan program was not covered by Section 7872. CCA 200034025, like Rev. Rul. 98-34, cited the 1984 Senate Finance Committee explanation, for the proposition that “most government-subsidized loans such as government insured or guaranteed student loans or residential mortgages were intended to be exempt from section 7872,” even though the North Carolina loans were neither insured nor guaranteed, but rather were direct loans, and were neither student loans nor residential mortgage loans.
CCA 200034025 then noted that the loan program was “established by North Carolina to provide state-subsidized financial assistance to businesses that were damaged by the 1999 floods. The interest arrangements of loans under the programs are not structured with a principal purpose of avoiding federal tax and the loans are not tax avoidance loans for purposes of section 7872(c)(1)(D).” Apparently the IRS, having found the North Carolina legislature had a public policy reason for transferring the economic benefit of three years’ AFR from North Carolina to the damaged businesses, ignored any possibility that a principal reason for making the transfer through a zero interest loan, rather than a subsidy plus an AFR-loan, was to avoid tax acceleration under Section 7872(b)(1). CCA 200034025 also favorably concluded that in the current absence of implementing regulations on Section 7872(c)(1)(E) tax avoidance loans, the North Carolina program was exempt from coverage under such classification. CCA 200034025 did not mention either Temp. Treas. Reg. Section 1.7872-5T or Rev. Rul. 98-34.
An earlier Chief Counsel Advice, CCA 199943037, provided an even more abbreviated analysis. Having observed that a North Dakota zero-interest three-year balloon loan program was to aid businesses damaged by a flood, CCA 199943037 simply stated that “therefore” the loans were not described in Section 7872(c)(1)(D).
The approach of CCA 200034025 and CCA 199943037, of exempting government agency below-AFR loans from coverage under Section 7872(c)(1)(D), eliminates the need for the IRS to deal with puzzling questions about the scope of the exemption from Section 7872 contained in Temp. Treas. Reg. Section 1.7872-5T as interpreted in Rev. Rul. 98-34. Such questions include: When is a below-AFR government loan program available to businesses or public-private-partnerships a “program of general application to the public” within the meaning of Temp. Treas. Reg. Section 1.7872-5T(b)(5)? When viewed as too narrowly available to satisfy Temp. Treas. Reg. Section 1.7872-5T(b)(5), how and when will such program qualify for, and be the beneficiary of, a Revenue Ruling or Revenue Procedure concluding that the program is sufficiently analogous to such a generally available program to qualify under Temp. Treas. Reg. Section 1.7872-5T(b)(15)? Can a below-AFR government loan program that has a principal tax avoidance purpose for structuring the below-AFR interest arrangements, as described in Section 7872(c)(1)(D), not also have a principal purpose of structuring to qualify under Temp. Treas. Reg. Section 1.7872-5T(b) for purposes of tax avoidance, and thereby be disqualified under Temp. Treas. Reg. Section 1.7872-5T(a)(2)?
CCA 200943028 involved the payment of interest by the federal Small Business Administration (SBA) to private lenders on SBA-guaranteed loans made to small businesses facing financial hardship. The SBA loans were available on a temporary basis, had a maturity of approximately five years, and did not exceed $35,000. CCA 200943028, without citing Rev. Rul. 98-34, favorably concluded that the loans were both exempted under Temp. Treas. Reg. Section 1.7872-5T(b)(5) and not covered by Section 7872(c)(1)(D).
The IRS, understandably, probably does not wish to be viewed as an impediment to public policy relief initiatives promulgated by federal and state legislators. Such an impediment could arise if borrowers under below-AFR government loan programs were required to immediately come out of pocket for tax immediately triggered under Section 7872(b)(1), and that tax was not taken into account by the legislators.
CCA 200034025 achieved this result by apparently accepting that any principal public policy purpose of a below-AFR government direct loan program necessarily eliminates the existence of a second principal purpose of tax avoidance described in Section 7872(c)(1)(D). Rev. Rul. 98-34, by contrast, seemed to find an exception to Section 7872 in Temp. Treas. Reg. Section 1.7872-5T. Rev. Rul. 98-34 found the tax-avoidance structuring disqualification in Temp. Treas. Reg. Section 1.7872-5T(a)(2) inapplicable even though there were indications that the legislators were aware that private borrowers avoiding significant tax effects under Section 7872(b)(1) was crucial to the success of the below-AFR loan program.
The underlying premise of Rev. Rul. 98-34 and CCA 200034025 might be that government designers of below-AFR loan programs are incapable of seeing the very large dollar income tax benefits to the private borrowers in such programs, as compared to immediately taxable grants coupled with AFR or higher interest-rate loans. It might be more realistic for the Treasury to acknowledge that it is willing to delegate disbursement, of what would otherwise be income tax revenue from applying Section 7872(b)(1), to the various federal and state agencies making such loans. The Treasury could consider clarifying the scope of the exemption from Section 7872 with respect to below-AFR government loans made for a broad range of infrastructure projects involving private ownership in the borrowing entity.
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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