A borrower may incur expenses to its lender in connection with a borrowing. The tax treatment of those expenses may vary. For example, a payment from the borrower to the lender may reduce the issue price of a debt instrument under Regs. Sec. 1.1273-2(g)(2). However, payments for services provided by the lender, such as commitment fees, may be treated differently.
The IRS recently released Field Attorney Advice (FAA) 20182502F, which concluded that an accrual-based taxpayer was entitled to deduct quarterly commitment fees paid related to its revolving credit agreement.
In the FAA, the taxpayer entered into a revolving credit agreement with a consortium of lenders for a term of five years. Under the agreement, the taxpayer was required to pay a quarterly commitment fee on the last day of each calendar quarter and on the termination date of the agreement. Each commitment fee was computed based upon the average daily unused amount of the commitment during the most recent previous quarter multiplied by a percentage. The agreement allowed the taxpayer to reduce the amount of the unused portions of the commitment without penalty, but the taxpayer did not exercise the option. The taxpayer's failure to pay a commitment fee when due would constitute an "event of default," and failure to remedy would provide grounds for the lenders to accelerate the obligations under the agreement. The taxpayer currently deducted the commitment fee.
Sec. 263(a)(1) generally provides that no deduction is allowed for any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Regs. Sec. 1.263(a)-4 provides rules for applying Sec. 263(a)(1) to amounts paid or incurred to acquire or create (or to facilitate the acquisition or creation of) intangible assets. An amount paid to acquire or create an intangible not otherwise required to be capitalized by the regulations is not required to be capitalized on the ground that it produces significant future benefits for the taxpayer, unless the IRS publishes guidance requiring capitalization of the expenditure. Regs. Sec. 1.263(a)-4(d) provides that payments made to create an option, which is the right, but not the obligation, to purchase or sell a security or property at a fixed price and by a specified time, are required to be capitalized under Regs. Sec. 1.263(a)-4(d)(2)(i)(C)(7).
In Rev. Rul. 81-160, the taxpayer paid a commitment fee in connection with a bond sale agreement where the total amount of bonds to be issued to the purchaser was delivered in agreed amounts over a specified period. Under the bond sale agreement, the delivery of the bonds was related to the taxpayer's cash requirements, and the commitment fee was paid based on the amount of the unissued bonds. The commitment fees were paid by the taxpayer for the purpose of having money made available when needed and preserving a firm price and interest rate for bonds to be issued without incurring the increased interest expense if the bonds were sold in advance of the need for the funds.
The IRS determined that "a loan commitment fee in the nature of a standby charge is an expenditure that results in the acquisition of a property right, that is, the right to use the money. Such a loan 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, the IRS concluded that if the right is exercised, the commitment fee becomes a cost of acquiring the loan and must be deducted ratably over the term of the loan, and if the right is not exercised, the taxpayer may be entitled to a loss deduction under Sec. 165 when the right expires.
In Technical Advice Memorandum (TAM) 200514020, the IRS addressed a fee paid in connection with a revolving credit agreement, and, unlike Rev. Rul. 81-160, concluded the taxpayer could currently deduct the expenses and did not have to capitalize the fee under Sec. 263. In TAM 200514020, the taxpayer entered into a revolving credit agreement under which the taxpayer was required to pay a quarterly facility fee in arrears based on the average daily amount of the total commitment of the preceding quarter, and the taxpayer could reduce the amount of the total commitment without penalty.
In distinguishing certain relevant authority under Sec. 263, the IRS stated, "[t]he reasoning underlying these cases is that the costs incurred in an earlier year resulted in the acquisition of a future right, benefit, or interest that extended beyond the year in which the costs were paid or incurred. ... [T]he payment of [the fees at issue in the TAM] did not create or enhance a separate and distinct asset with a useful life extending substantially beyond the taxable year, nor did they generate significant future benefits for the [t]axpayer." The IRS also determined in TAM 200514020 that the payments were not in the nature of the standby charges discussed in Rev. Rul. 81-160; therefore, Rev. Rul. 81-160 did not apply. The IRS went on to conclude that the taxpayer was entitled to deduct the fees paid in the tax year incurred.
In addressing the commitment fee at issue in FAA 20182502F, the IRS first explained that it was deductible as an ordinary and necessary expense under Sec. 162(a), subject to the capitalization rules of Sec. 263(a), because it was an expense that was commonly and frequently incurred in the type of business conducted by the taxpayer and that the fees were appropriate and helpful for the development of the taxpayer's business.
In determining whether the commitment fee was subject to the capitalization rules of Sec. 263, the IRS concluded, without significant discussion, that payment of the commitment fee: (1) was not an amount paid to acquire an intangible under Regs. Sec. 1.263(a)-4(c); (2) was not an amount paid to create or enhance a separate and distinct intangible asset within the meaning of Regs. Sec. 1.263(a)-4(b)(3); and (3) was not an amount paid to facilitate (within the meaning of Regs. Sec. 1.263(a)-4(e)(1)) an acquisition or creation of an intangible.
In addition, the IRS considered, with more discussion, whether the payment of the commitment fee was an amount paid to create an intangible asset under Regs. Sec. 1.263(a)-4(d). Specifically, the IRS considered whether the payment of the commitment fee created an option, which would be required to be capitalized under Regs. Sec. 1.263(a)-4(d)(2)(i)(C)(7). The IRS advised that the payment of the commitment fee did not create an option; instead, each commitment fee was related to the rights and benefits maintained by the taxpayer during the three-month period prior to the date the payment was due under the agreement. Further, the IRS advised that even if the payment of the commitment fee was an amount paid to create an option, the option would only relate to the three-month period preceding the payment date (and would not extend beyond the close of the tax year). Therefore, the IRS advised that the taxpayer was permitted to deduct the payment of the commitment fee when the amount was paid or incurred.
FAA 20182502F provides support, in addition to TAM 200514020, to deduct commitment fees paid in connection with revolving credit agreements under certain circumstances. However, the FAA did not directly address Rev. Rul. 81-160 and gave two rationales for why the commitment fee was currently deductible.
The first rationale was that the commitment fee did not create an option, but, in connection with the FAA's failure to explicitly distinguish Rev. Rul. 81-160, this rationale may be contrary to Rev. Rul. 81-160, which stated a loan commitment fee is similar to the cost of an option.
The second rationale of the FAA is that, even if the commitment fee created an option, that option only related to the three-month period prior to the payment of the commitment fee, and therefore the commitment fee would be deductible at the end of the period when paid. However, in explaining this second rationale, the FAA fails to address why the quarterly payment only relates to the quarter for which it was made, when the failure of the taxpayer to pay the commitment fee would have resulted in a default under the agreement that could have caused a termination of the agreement.
Even though the FAA did not explicitly distinguish Rev. Rul. 81-160 and left some uncertainty as to the legal standing by which these amounts are deductible, the FAA provides support that commitment fees paid in revolving credit agreements based off the unused amount of the total commitment, particularly if paid quarterly and in arrears, are currently deductible, and that Rev. Rul. 81-160 does not apply to fees of this type. Since the conclusion in the FAA did not definitively determine that these payments did not create an option, it is unclear whether, under different circumstances, these fees will have to be capitalized.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
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