Interest allocation: The disallowance rules for dealers in exempt obligations are found in Rev.
265(a)(2) when an affiliated group member borrows funds and transfers them to another member, who then invests them in exempt obligations, However, the Tax Court addressed this issue in H Enterprises Int'l, Inc.
although the borrowing member cannot take an interest deduction, the lending member receives exempt interest income on the intercompany loan and can deduct interest paid to the third party; thus, there is no net interest expense disallowance on a consolidated basis, even though a consolidated borrowing supports the exempt investment).
P then directly loans the $1,000 to S, which directly invests the proceeds in exempt obligations.
The disallowance is calculated by multiplying the dealer's nondirectly traceable interest expense by a fraction, the numerator of which is the dealer's average balance of exempt obligations, and the denominator of which is the dealer's average balance of total assets, less the balance of debt the interest on which is not subject to disallowance.
The first issue is the determination of disallowed interest expense under the general allocation formula applicable to dealers in exempt obligations.
In this scenario, the IRS holds that the interest expense disallowance is applied at the contributing member level (against its borrowing from the unrelated party), but is calculated at the dealer level based on the dealer's average assets and exempt obligations.
Example 3: P, the common parent of an affiliated group that includes subsidiary S (a dealer in exempt obligations), borrows $40 from unrelated lender X.
1502-13(c)(6)(i), when investments in exempt obligations and the borrowings to fund such investments are undertaken by different affiliates via an intercompany loan.
150213 (c)(6)(i), P's interest income on the loan is exempt.
150213(c)(6)(i) exemption, when an exempt investment is directly traceable to debt recurred by a related affiliate to an unrelated lender.
1502-13(c)(6)(i), by disallowing the exemption to the lending member, if: (1) the loan proceeds are directly traceable to investments in the borrowing member's exempt obligations; and (2) the source of the intercompany loan is directly traceable to the lending member's third-party borrowing.