In Field Attorney Advice 20182502F (the FAA), released June 26, 2018, the IRS concluded that, unless otherwise limited, a taxpayer could deduct quarterly payments of commitment fees as Section 162 expenses for the tax year in which the fees were incurred.

Background

Issuers of debt instruments are commonly required to incur various fees related to their debt that are not necessarily payments made under the terms of the instrument (i.e., income other than payments of principal or interest). Thus, the fees must be identified and analyzed to determine their proper treatment for US federal income tax purposes. Published IRS guidance for taxpayers incurring those fees generally addresses the tax aspects of the specific type of debt-related fee at issue, which is paid by taxpayers with a tax profile similar to that of the taxpayer in the FAA.

The FAA addresses debt-related fees, described as "commitment fees,"¹ that an accrual-basis taxpayer paid on a revolving credit facility. In Revenue Ruling 81-160, 1981-1 C.B. 312, the IRS previously addressed whether commitment fees were properly characterized as an interest charge or a charge for services and concluded that the fee was paid for the acquisition of a property right (i.e., the right to the use of money). The Revenue Ruling analogized the property right for which the fee was paid to an option. The Revenue Ruling then concluded that: (1) if the right were exercised, then the commitment fee should be taken into account ratably over the term of the loan; or (2) if it were not exercised, the taxpayer may be entitled to a Section 165 loss when the right expires. The FAA revisits the characterization of commitment fees to address the proper tax accounting of this specific type of debt-related fee.²

The FAA

The FAA involved an accrual-basis taxpayer (Taxpayer) that executed a five-year revolving credit agreement (the Revolver) with a consortium of lenders. Taxpayer was required to pay the commitment fee on a quarterly basis, in arrears, on the last day of each calendar quarter and on the termination date of the Revolver. The commitment fee was determined based on the average daily unused amount of the total commitment during the most recent previous quarter multiplied by a percentage that varied based upon the Taxpayer's credit rating at that time. A failure to pay the fee would constitute an event of default under the Revolver.

Discussion

As an initial matter, the IRS explained that the commitment fees at issue are commonly and frequently incurred in the type of business conducted by the Taxpayer and helpful to the development of the Taxpayer's business. Therefore, the IRS viewed the fees as a category of ordinary and necessary expenses incurred in carrying on a trade or business. For capital expenditures, however, the IRS noted that Section 263's capitalization rules may apply to prevent a current deduction for an item of expense under Section 162. As such, the commitment fees are deductible as an expense under Section 162(a), subject to the capitalization rules of Section 263(a).

In considering whether the commitment fees were subject to the capitalization rules of Section 263, the IRS advised that: (1) the commitment fees were not paid to acquire an intangible in a purchase or similar transaction and thus, were not subject to capitalization rules under Treas. Reg. Section 1.263(a)-4(c); (2) the commitment fees did not create or enhance a separate or distinct intangible asset and were more in the nature of a fee necessary to maintain (rather than to enhance) the Revolver, so they were not subject to capitalization under Treas. Reg. Section 1.263(a)-4(b)(1)(iii); and (3) the commitment fees were not paid in the course of investigating or otherwise pursuing a transaction, so they were not subject to Treas. Reg. Section 1.263(a)-4(b)(1)(v).

The IRS also considered whether the commitment fee payments created an option, which would require the fees to be capitalized under Treas. Reg. Section 1.263(a)-4(d)(2)(i)(C)(7).³ Based on all of the facts and circumstances, the IRS concluded that the commitment fee did not create an option within the meaning of Treas. Reg. Section 1.263(a)-4(d). Even if the commitment fee were paid to create an option, the FAA continued, the option would properly relate to the three-month period preceding the payment date and therefore, the Taxpayer's method of currently deducting the fee would result in a clear reflection of income.

In sum, the IRS determined that Taxpayer was not required to capitalize the commitment fees under Section 263 and could deduct the expenses under Section 162 for the tax year in which they were incurred under Section 461.

Implications

The FAA's rationale for allowing the taxpayer to currently deduct its commitment fees is unclear, particularly its basis for distinguishing Revenue Ruling 81-160. The Revenue Ruling concluded that the payment of a standby commitment fee was "similar to the cost of an option." The absence of any rationale may be significant to non-US investors, who rely in part on Revenue Ruling 81-160 for avoiding withholding tax on the payment of commitment fees. It is also not clear why the FAA concluded that each quarterly payment related only to the quarter for which it was made, since it appears that the taxpayer's failure to pay one payment would have resulted in a default under the agreement, thus preventing the taxpayer from drawing down funds in future quarters.

Additional guidance would be welcomed in light of a variety of other types of debt-related fees that may be incurred in connection with a lending transaction (e.g., the other fees that were not addressed by the FAA). Additionally, the labels of such fees are commonly used interchangeably, so the assigned labels do not necessarily convey why the fee was paid and to whom it was paid, leaving the substance of the payment and resulting tax treatment to be independently determined and analyzed by debt issuers and their tax advisors on a transaction-by-transaction basis.

Likewise, additional guidance would be welcome for recipients of debt-related fee income given the current IRS focus on the tax accounting of fees for purposes of determining whether holders of debt investments have effectively connected income or should be subject to withholding. In this regard, we note that the IRS Priority Guidance Plan includes guidance on the treatment of fees related to debt instruments and other securities.

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ENDNOTES

¹ A commitment fee generally refers to a periodic fee (stated as a percentage) on the undrawn portion of the lender's committed amount (although some commitment fees are structured as a single upfront payment). Such fees may also be described as an unfunded fee, ticking fee, line-of-credit fee or a standby charge. They are paid at the end of the relevant period and calculated for each day of the period as an amount equal to the product of the stated percentage and the undrawn portion of the commitment amount. See generally,Shapiro, D., Yaghmour, M., et. al., A Tax Field Guide to Debt-Related Fee Income, 143 Tax Notes 1027 (June 2, 2014) (Shapiro & Yaghmour).

² The IRS noted that Taxpayer paid other debt-related fees (e.g., credit fees and fronting fees) but the FAA does not address those fees.

³ Treas. Reg. Sections 1.263(a)-4(d)(2) through (d)(9) provides categories of intangibles, including financial interests (e.g., options), for which the expenses incurred to create such intangibles must be capitalized under Section 263. Treas. Reg. Section 1.263(a)-4(d)(1).