Bank fee credits had different reporting results based on how customers used them

Plain-English summary

A bank offered commercial customers credits based on their deposit balances that could offset banking-service fees, with some programs also covering third-party services or paying interest on unused balances. The IRS treated the deposit arrangements as compensation-related below-market loans but found that credits used for the bank's services qualified for an exemption because applying the imputed-interest rules would have no significant federal tax effect. The same result applied when the bank itself subcontracted with a vendor to provide ancillary banking services. When a customer selected and contracted directly with a third-party vendor, however, credits used to pay that vendor were reportable interest unless the customer was an exempt recipient. Stated interest paid on unused hybrid-account balances was also reportable to nonexempt recipients.

Ruling snapshot

• Question: Were fee credits earned on commercial deposit accounts subject to information reporting as interest or other income?
• Outcome: Mixed. Most credits used for bank-provided or bank-contracted services were not reportable, but customer-contracted vendor payments and stated interest were reportable when paid to nonexempt recipients.
• Key authorities: IRC §§ 61(a)(4), 6041, 6049, and 7872; Temp. Treas. Reg. § 1.7872-5T

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201426002 Third Party Communication: None
Release Date: 6/27/2014 Date of Communication: Not Applicable
Index Number: 6041.00-00, 6049.00-00,
7872.00-00 Person To Contact:
-------------------, ID No. ------------------
----------------------------- Telephone Number:
-------------------------- ---------------------
------------------------------------ Refer Reply To:
CC:PA:02
PLR-121576-13
Date:
March 31, 2014

Legend

Taxpayer = -----------------------------

Dear -----------------------------:

   This ruling replies to your letter dated May 7, 2013, and subsequent

correspondence dated June 27, 2013, and November 19, 2013, submitted on behalf of
Taxpayer in which you request that the Internal Revenue Service rule that fee credits
earned by certain account holders are not subject to reporting under either section 6041
or section 6049 of the Internal Revenue Code (Code).

Facts:

    Taxpayer is a bank as defined under section 581 of the Code. Taxpayer offers

two different fee credit programs under which its commercial account holders and tax
exempt recipients (“customers”) receive an allowance (“fee credit”) that can be used to
offset certain fees for banking services. Both fee credit programs are offered for
demand deposit accounts used for daily business operations. The services for which
the fee credits may be used include the following: check processing, transaction
processing, wire transfers, account analysis, deposit and withdrawals, posting of debits
and credits and payment of checks.

    Under both fee credit programs, the fee credit is calculated by applying a fee

credit rate to the investable balance. The investable balance is the account ledger
balance minus float (a portion of the balance unavailable to the customer while
deposited items clear). Fee credit rates are most frequently determined by Taxpayer
using a rate committee that determines the rate for a specific customer type based on
PLR-121576-13 2

market rates and competitive factors. Fee credits may also be based on indexed rates,
such as Libor or 90-day T-Bill and are subject to Taxpayer’s discretion.

   Under the first program (the “Noninterest Fee Credit Program”), excess or

unused fee credits are not paid in cash and may not be withdrawn by the customer.
However, certain government, nonprofit, educational and healthcare account holders
can use excess or unused fee credits to pay for banking services provided by third party
vendors through vendor contracts with Taxpayer. The services are ancillary to the
customers’ banking relationship with Taxpayer and include armored car services,
courier services, check supplies, and lock boxes. But in certain cases, the customer,
rather than Taxpayer, contracts directly with the third party vendor to provide services
with respect to the customer’s account.

   Under the second program (the “Hybrid Fee Credit Program”), the fee credits

may only be used to offset fees for banking services up to a set limit. Taxpayer pays
interest on any unused account balance not required to offset fees. Taxpayer concedes
that any stated interest paid on the unused account balance is interest for purposes of
sections 6041 and 6049 of the Code.

    Taxpayer represents that fee credit programs are extremely common in the

banking industry, and has offered empirical evidence supporting that representation.
Taxpayer and other banks offer the fee credit programs to encourage banking
relationships with commercial customers as well as to provide an incentive to customers
to maintain large balances. They are also used to manage a bank’s interest expense, a
significant element to which shareholders and market analysts look when evaluating
banking institutions.

    Taxpayer also represents that developing systems capable of reporting the

amount of fee credits actually used by customers would be a large and costly
administrative burden. Furthermore, a majority of the customers who receive the fee
credits are exempt recipients for purposes of the reporting rules under sections 6041
and 6049. Therefore, any system established for reporting fee credits developed by
Taxpayer would be used for only a small number of customers. Taxpayer states that if
it actually paid interest on the deposits and charged the customers a fee for the banking
services it provides, the income and deductions generated by the transaction would
offset one another. The interest income received by a customer would be offset by a
deduction for the bank fees, and the service fee income received by Taxpayer would be
offset by a deduction for interest paid to the customer.

Law:

   Interest generally is includible in a recipient’s gross income under section

61(a)(4) of the Code and section 1.61-7 of the Income Tax Regulations (regulations).
The term interest means amounts paid for the use or forbearance of money, which
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includes amounts, whether or not designated as interest, paid on savings accounts and
other deposit arrangements.

   Section 6041(a) of the Code requires information returns from persons engaged

in and making payment in the course of a trade or business of rent, salaries, wages,
premiums, and income of $600 or more in a taxable year. Section 6041(a) allows
certain exceptions, including payments to which section 6049(a) applies.

  Section 6049(a)(1) requires information returns for payments of interest

aggregating $10 or more to any other person during the taxable year.

   Section 7872 recharacterizes a below-market loan as an arm’s-length

transaction in which the lender made a loan to the borrower in exchange for a
note requiring the payment of interest at a statutory rate. As a result, the parties
are treated as if the lender made a transfer of funds to the borrower, and the
borrower used these funds to pay interest to the lender. The transfer to the
borrower is treated as a gift, dividend, contribution of capital, payment of
compensation, or other payment depending on the substance of the transaction.
The interest payment is included in the lender’s income and generally may be
deducted by the borrower. See H.R. Conf. Rept. No. 98-861, at 1015 (1984),
1984-3 C.B. (Vol. 2) 1, 269.

  Section 7872(f)(5) of the Code defines a demand loan as any loan which is

payable in full at any time on demand of the lender. The legislative history of section
7872 indicates that the term “loan” should be interpreted broadly. Any transfer of
money that provides the transferor with a right to repayment may be a loan. For
example, advances or deposits of all kinds may be treated as loans. H.R. Conf. Rept.
No. 98-861, at 1018 (1984), 1984-3 (Vol. 2) C.B. 1, 272.

   Congress intended that section 7872 of the Code would apply only to the below-

market loans enumerated in subparagraphs (A) through (F) of section 7872(c)(1): gift
loans, compensation-related loans, corporation-shareholder loans, tax avoidance loans,
and loans to qualified continuing care facilities. H.R. Conf. Rept. No. 98-861, at 1018,
1019 (1984), 1984-3 (Vol. 2) C.B. 272. Under section 7872(c)(1)(E), to the extent
provided in regulations, a loan that is not a gift loan, compensation-related loan,
corporation-shareholder loan or qualified continuing care facility loan may still be subject
to section 7872 if the interest arrangement has a significant effect on the tax liability of
the borrower or the lender.

   Section 7872(c)(1)(B) of the Code, concerning compensation-related loans

provides, in part, that section 7872 shall apply to any below-market loan directly or
indirectly between an independent contractor and a person for whom such independent
contractor provides services. The imputed transfer in a compensation-related loan is
treated as a payment of compensation from the lender to the borrower.
PLR-121576-13 4

    Section 7872(c)(1)(D) of the Code provides that section 7872 shall apply to any

below-market loan one of the principal purposes of the interest arrangements of which
is the avoidance of any Federal tax.

   Section 7872(i)(1)(C) of the Code provides that the Secretary shall prescribe

regulations exempting from the application of this section any class of transactions the
interest arrangements of which have no significant effect on any Federal tax liability of
the lender or borrower.

   Section 1.7872-5T(b) of the Temporary Income Tax Regulations lists

transactions that are exempt from section 7872 of the Code because the interest
arrangements of such loans do not have a significant effect on the Federal tax liability of
the borrower or lender, provided that they do not have a principal purpose of tax
avoidance. See section 1.7872-5T(a).

   Section 1.7872-5T(b)(2) of the regulations exempts from the provisions of section

7872 of the Code accounts or withdrawable shares with a bank (as defined in section
581), or an institution to which section 591 applies, or a credit union, made in the
ordinary course of its business.

   Section 1.7872-5T(b)(14) of the regulations exempts from the provisions of

section 7872 of the Code those loans the interest arrangements of which the taxpayer is
able to show have no significant effect on any Federal tax liability of the lender or the
borrower, as described in section 1.7872-5T(c)(3).

   Section 1.7872-5T(c)(3) of the regulations provides that whether a loan will be

considered a loan the interest arrangements of which have a significant effect on any
Federal tax liability of the lender or the borrower will be determined according to all the
facts and circumstances. Among the factors to be considered are (i) whether items of
income and deduction generated by the loan offset each other, (ii) the amount of such
items, (iii) the cost to the taxpayer of complying with the provisions of section 7872 of
the Code if such section were applied, and (iv) any non-tax reasons for deciding to
structure the transaction as a below-market loan rather than a loan with interest at a
rate equal to or greater than the AFR and a payment by the lender to the borrower.

Analysis:

   In the present situation, the deposit held by Taxpayer in a customer’s account is

a loan from the customer to Taxpayer. In lieu of paying interest on the deposit,
Taxpayer provides banking services to the customer through the use of bank fee
credits. The loan is a compensation-related loan under section 7872(c)(1)(B) of the
Code.
PLR-121576-13 5

  Section 7872 of the Code does not give rise to taxable income, however, if the

loan qualifies for an exemption under section 1.7872-5T(b) of the temporary regulations,
and the loan is not recharacterized as a tax avoidance loan under section 7872(c)(1)(D).

   In the present situation, Taxpayer, a bank under section 581 of the Code, pays

the fee credits on certain commercial demand deposit accounts of its customers in the
ordinary course of its business. See section 1.7872-5T(b)(2) of the temporary
regulations. Under the facts and circumstances test described in section 1.7872-
5T(c)(3), the fee credit programs have no significant effect on any Federal tax liability of
the lender or the borrower under section 1.7872-5T(b)(14).

    The items of income and deduction generated by the loan would offset each

other if section 7872 of the Code were applied to the fee credits with respect to both
Taxpayer and its customers. The imputed interest income received by a customer
would be offset by a deduction for the bank fees and charges that are reduced by the
fee credits. Likewise, the service fee income received by Taxpayer would be offset by a
deduction for imputed interest deemed paid to the customer. The costs to Taxpayer of
complying with section 7872 of the Code would be significant and would have little if any
Federal tax impact. Developing systems capable of tracking the amount of fee credits
actually used by customers would be a large and costly administrative burden.
Furthermore, as noted above, most customers in the fee credit programs are exempt
recipients under the reporting rules. Therefore, the costs for Taxpayer to comply with
the provisions of section 7872 outweigh the benefits of requiring Taxpayer to comply
with the provision if it were applied.

  Taxpayer has offered a number of non-tax reasons for structuring the transaction

as a below-market loan. The fee credit programs encourage banking relationships with
commercial customers and provide an incentive to customers to maintain large
balances. Taxpayer has represented that fee credit programs are industry wide and are
used to manage Taxpayer’s interest expense, a significant element to which
shareholders and market analysts look when evaluating banking institutions. For the
reasons discussed above, the application of section 7872 of the Code to the fee credit
programs would not have a significant effect on the tax liability of Taxpayer or its
customers.

   The fee credit programs will be classified as tax avoidance loans under section

7872(c)(1)(D) of the Code if a principal purpose of Taxpayer or the customers of using
the below-market arrangement of the loan is to avoid tax. Tax avoidance is a principal
purpose of the interest arrangement if it is a principal factor in the decision to structure
the transaction as a below-market loan, rather than as a loan requiring the payment of
interest at a rate that equals or exceeds the AFR and a payment by the lender to the
borrower. See H.R. Rep. No. 98-861, at 1019; 1984-3 (Vol. 2) C.B. 273.
PLR-121576-13 6

   The fee credit program used by Taxpayer does not have tax avoidance as a

principal purpose. Taxpayer has offered a number of non-tax reasons for structuring
the transaction as a below-market loan. Furthermore, because the items of income and
deduction for both parties would offset each other if the transaction were not structured
as a below-market loan, there is no tax to be avoided. Therefore, tax avoidance is not a
principal purpose of the fee credit program. Accordingly, for the reasons explained
above the fee credit program is not subject to tax under section 7872 of the Code.

    In contrast, section 7872 of the Code does not apply to the fee credits earned in

lieu of interest that the account holder uses to pay for third party vendor services if the
account holder selects and contracts the third party vendor. This situation is not a
compensation-related loan described in section 7872(c)(1)(B) because Taxpayer does
not directly or indirectly provide the services. Therefore, the fee credits earned in lieu of
interest that are used to pay the third party vendor for services result in interest income
to the customer under section 61(a)(4). Accordingly, in this case, payments made by
Taxpayer to third party vendors on behalf of its account holders are reportable as
interest under section 6049 unless the account holder is an exempt recipient.

Conclusion:

   Below-market loans as described above that are made pursuant to the

Noninterest Fee Credit Program and the Hybrid Fee Credit Program are compensation-
related loans under section 7872 of the Code but qualify for exemption under section
1.7872-5T of the temporary regulations. Because these loans will not generate imputed
interest under section 7872, there is no reportable interest under section 6049 or other
reportable income under section 6041. However, fee credits used to pay third party
vendors selected and contracted by the account holder give rise to interest income
under section 61(a)(4) reportable under section 6049.

Holdings:

   (1) The fee credits earned and used to offset Taxpayer’s bank fees with respect
       to “Noninterest Bearing Accounts” in the first program are not subject to the
       information reporting requirements imposed by sections 6049 or 6041 of the
       Code;
   (2) Fee credits that are used to pay a third party vendor in lieu of interest where
       Taxpayer subcontracts directly with the vendor to provide ancillary banking
       services are not subject to information reporting (under either section 6049 or
       section 6041 of the Code) to the account holder, whether or not the account
       holder is an exempt recipient;
   (3) Fee credits that are used to pay a third party vendor in lieu of paying the
       account holder interest are reportable as interest on Form 1099-INT where
       the account holder selects and contracts with the third party vendor unless
       the account holder is an exempt recipient;

PLR-121576-13 7

   (4) The fee credits described above, with the exception of interest on any unused
       balances, earned and used to offset Taxpayer’s bank fees with respect to
       “Hybrid Accounts” are not subject to the information reporting requirements
       imposed by sections 6049 and 6041of the Code; and
   (5) The stated interest on any unused balances paid to “Hybrid Accounts” is
       subject to Form 1099-INT reporting under section 6049 when paid to a non-
       exempt recipient.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination.

                                   Sincerely,




                                   Pamela Wilson Fuller
                                   Senior Technician Reviewer
                                   (Procedure & Administration)

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