The deduction for interest has been under some pressure lately. In particular, the Tax Cuts and Jobs Act (P.L. 115-97) recently amended Section 163(j) of the Internal Revenue Code of 1986, as amended (the "Code"), to place substantial limitations on the ability of all taxpayers to deduct "business interest."1 Thus, costs and expenses of obtaining credit that are deductible, but are not treated as interest expense, are particularly attractive to borrowers. On June 22, 2018, the US Internal Revenue Service ("IRS") released a "legal advice issued by field attorneys" (a "LAFA"), LAFA 20182502F2 (the "Advice"), holding that a borrower in a lending transaction is entitled to deduct unused commitment fees as ordinary business expenses. The Advice provides a short roadmap for borrowers to take advantage of this treatment in other lending transactions.
In the Advice, the taxpayer entered into a revolving credit agreement with a third party lender for a term of five years. The purpose of the loan was to fund general corporate activities. The agreement required the taxpayer to pay a quarterly commitment fee (in addition to other fees not disclosed in the Advice). The amount of the quarterly commitment fee was calculated based on the average daily unused amount of the total commitment during the previous quarter multiplied by a percent, which varied based on the taxpayer's credit rating at time each fee was calculated. Such fees are commonly referred to as "unused commitment fees."
In addition to unused commitment fees, many lending facilities carry other fees. The main types of fees consist of (1) upfront fees (fees paid from a borrower to a lender at or before issuance), (2) facility fees (fees paid based on the total amount of the commitment of a facility, regardless of amounts drawn) and (3) utilization fees (fees paid based on the amount of debt outstanding to the borrow under a facility), among others. The tax treatment of these fees has an impact on both the deductibility of such fees to the party paying the fee and on the determination of whether withholding will be required if a particular fee is paid to a non-US person not in connection with the conduct of a US trade or business.
The treatments of the various fees commonly present in lending facility transactions vary for federal income tax purposes. The Advice supports a dichotomy between the federal income tax treatment for commitment fees for credit (fees based on the current amount of unissued commitment) and that for unused commitment fees (lending fees based on the unused amount of a commitment to loan money). This article discusses IRS guidance on the various types of fees. It also considers planning opportunities for borrowers to structure fees incident to lending transactions to be treated as ordinary and necessary business expenses under Code § 162. This treatment will avoid fees being treated as interest expense, potentially being disallowed under Code § 163(j) or causing other interest expense to be disallowed.
Treatment of Certain Borrower Fees
COMMITMENT FEES TO ACQUIRE CREDIT
Prior to the issuance of the Advice, the IRS had consistently treated commitment fees as premiums paid for the option to borrow money, that is, granting the borrower the right to sell debt securities containing pre-specified terms to the lender for a fixed price. In Revenue Ruling 81-160, 1981-1 C.B. 312, 3 the IRS ruled on the treatment of commitment fees paid by a wouldbe borrower. In the facts of the ruling, the commitment fee was determined based upon the amount of unissued debt. The IRS held that the loan commitment fees were in the nature of a standby charge that resulted in the acquisition of a valuable property right, that is, the right to borrow money.
Revenue Ruling 81-160 reasons that a commitment fee is similar to the cost of an option, which becomes part of the cost of the property acquired upon exercise of the option. Therefore, if the right is exercised, the IRS treats the commitment fee as a cost of acquiring the loan that is to be deducted ratably over the term of the loan. While Revenue Ruling 81-160 is not explicit on the point, the IRS has held in other contexts that the commitment fees should not be treated as interest expense.4 Commitment fees, as a cost of acquiring the loan, are amortized over the term of the loan. 5 If the right is not exercised, the borrower may be entitled to a current loss deduction.
In TAM 8537002 (May 22, 1985), the IRS considered the treatment of fees substantially similar to commitment fees from the perspective of the recipient of such fees. Specifically, the IRS considered whether fees for issuing credit card should be treated as fees for services or for the acquisition of a property right, specifically, the right to borrow money. The IRS noted that a credit card fee is "similar to a loan commitment fee, i.e., a fee charged for making money available for a loan." Accordingly, the IRS held that the principle of Revenue Ruling 81-160 applied because "the character of the loan commitment fee should be the same on both the income and expenditure side." Thus, the credit card fees were held to be a payment for a property right and not a fee for services.7
Facility fees are fees paid in consideration for a credit facility to remain open. In contrast to commitment fees, the amount of a facility fee is typically based on the total amount of the commitment of a facility, regardless of what portion of such commitment is actually outstanding debt. In TAM 200514020, the IRS distinguished facility fees from commitment fees. The loan agreements in TAM 200514020 allowed the obligors to draw letters of credit or loans based on a maximum outstanding balance computed with respect to both obligations, and repayments of either created additional capacity to draw new loans or letters of credit. In exchange for the right to borrow and draw letters of credit, the borrower paid a facility fees to the lenders. The facility fee was computed with respect to the total available balance that could be drawn under the letters of credit and as loans. The facility fee was not affected by the amount outstanding as loans or letters of credit.
The IRS held that the rule promulgated by Revenue Ruling 81-160 was inapplicable to the facility fee. The holding of Revenue Ruling 81- 160 was based on the fact that the commitment fee created an opportunity for the borrower to sell loans. In contrast, the facility fee was payable regardless of the amount borrowed. The IRS held that facility fees were "akin to maintenance charges which are currently deductible." The IRS, in reaching its conclusion, noted that "facility fees did not produce significant future benefits for the Taxpayer." Although the TAM does not directly state the exact nature of facility fees, the TAM implicitly treats the facility fees as fees payable to the lenders for the provision of credit. Such fees are not in the nature of interest because they are not in respect of the cost of borrowed money. The fees are payable to ensure that the line of credit is available.
1 For an overview of the Tax Cuts and Jobs Act's main provisions, please see " The Good, the Bad and the Ugly Fundamental Tax Reform Is Enacted Into Law."
2 LAFA 20182502F (June 22, 2018).
3 See also C.C.A. 201136022 (Sep. 9, 2011).
4 See Revenue Ruling 70-540, 1970-2 C.B. 101 (Situation 3); FSA 200037034 (Sep. 15, 2000).
5 See Rev. Rul. 81-161, 1981-1 CB 313 (loan commitment fee capitalized and amortized over loan term).
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