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United States Court of Appeals,

Fifth Circuit.

No. 94-41125.

SOUTHWEST TEXAS ELECTRICAL COOPERATIVE, INC., PetitionerAppellant,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Oct. 19, 1995.

Appeal from the United States Tax Court.

Before SMITH, BARKSDALE and BENAVIDES, Circuit Judges.

JERRY E. SMITH, Circuit Judge:

Southwest Texas Electrical Cooperative, Inc. ("petitioner"),

received a low-interest federal loan to finance an improvement of

its facilities. At the time of construction, petitioner needed and

withdrew only one-half of the approved loan amount; it later

withdrew the remainder, however, and invested it in Treasury Notes.

The Tax Court found that interest income from the Treasury Notes is

debt-financed and therefore subject to federal taxation. We

affirm.

I.

Petitioner, a tax-exempt rural electrical cooperative,

received a $5.148 million loan from the Rural Electrification

Administration ("REA") to finance an expansion and upgrade of its

facilities. The REA permitted petitioner to draw on the approved

loan funds only as reimbursement for construction costs it had

already incurred. Petitioner made six REA loan draws from
 

1Petitioner also received a concurrent loan from the

National Rural Utilities Cooperative Finance Corporation ("CFC")

and drew $601,900 on the CFC loan in July and September 1985. 

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September 1983 through June 1985, totaling $2.574 million.1

Although petitioner was entitled to withdraw the remaining $2.574

million by July 1986, it chose not to do so, in part because its

financial condition had improved and in part because further debt

would have had a negative effect on its financial indicators.

The REA notified petitioner in March 1989 that its eligibility

for the remaining approved funds would expire in August 1989.

Petitioner requested the $2.574 million in early May 1989 and

received it on May 16, 1989, at an interest rate of five percent.

Petitioner's motivations for borrowing the funds included

uncertainty over whether it could receive another REA loan and the

costs it had already incurred in applying for the loan. Petitioner

placed the borrowed funds in its General Fund Account on May 17,

1989, and withdrew $2,575,735.25 from that account the next day to

purchase two United States Treasury Notes paying more than nine

percent interest.

Petitioner received interest income on the Treasury Notes in

the amount of $146,096.61 in 1989 and $230,938.49 in 1990. It also

incurred related expenses (including interest payments on the REA

loan) of $86,222.29 in 1989 and $134,812.53 in 1990. Petitioner

reported that it had no taxable income in 1989 and 1990; the

Commissioner of Internal Revenue ("the Commissioner") disagreed and

assessed deficiencies for those years, contending that the interest

income from the Treasury Notes, less related expenses, is taxable
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as business income unrelated to petitioner's tax-exempt purpose.

The Tax Court upheld the deficiencies.

II.

A.

The parties agree that (1) petitioner is generally exempt from

federal income tax under 26 U.S.C. § 501(a); (2) 26 U.S.C. §§

501(b) and 511(a) require petitioner to pay taxes on its "unrelated

business taxable income"; and (3) interest income counts as

"unrelated business taxable income" when it is both earned on

property that is not substantially related to petitioner's tax

exempt purpose, see 26 U.S.C. §§ 512(a)(1) and 513(a), and

debt-financed. See 26 U.S.C. §§ 512(b)(4) & 514(a). The parties

further agree that the improvement of petitioner's facilities is

substantially related to its tax-exempt purpose, and the purchase

of Treasury Notes is not. Accordingly, the question presented is

whether the $2.574 million in debt financing should be attributed

to the facilities or to the purchase of the Treasury Notes.

Petitioner contends that the debt financing should be

attributed to the facilities. The REA approved the loan for the

sole purpose of financing construction. Under the terms of the

loan agreement, petitioner expended general operating funds for the

construction and received corresponding reimbursement from the REA.

Petitioner argues that the legislative history of 26 U.S.C. § 514

evidences an intent to permit non-profit organizations to make

tax-free investments with their own funds, taxing passive

investments only when they are made with borrowed funds. Because
 

2See, e.g., Kern County Elec. Pension Fund v. Commissioner,

96 T.C. 845, 1991 WL 106265 (1991), aff'd, 988 F.2d 120 (9th

Cir.1993); Mose & Garrison Siskin Memorial Found., Inc. v.

United States, 790 F.2d 480 (6th Cir.1986); Elliot Knitwear

Profit Sharing Plan v. Commissioner, 614 F.2d 347 (3d Cir.1980). 

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the REA releases funds only upon proof of completed construction,

taxing investments made with general funds only because those funds

have been replenished by REA loans could have the effect of taxing

investments that Congress intended to exempt.

The Commissioner conceded at oral argument that the REA loan

proceeds would be attributable to the construction and not the

Treasury Notes if petitioner had drawn on the loan proceeds at the

time of construction. The Commissioner argues that petitioner lost

this tax advantage by its lengthy delay in drawing on the loan,

however. Other circuits have found that § 514 taxes income from a

passive investment when a taxpayer borrows money for the purpose of

making such an investment; the Commissioner argues that this case

falls within those holdings because petitioner made the loan draw

three and one-half years after completing construction and

immediately invested the proceeds in Treasury Notes.

B.

We review the Tax Court's legal conclusions de novo. We

defer to its fact findings unless they are clearly erroneous.

Estate of Clayton v. Commissioner, 976 F.2d 1486, 1490 (5th

Cir.1992).

This is a case of first impression. While other circuits have

held or assumed that indebtedness incurred for the purpose of

making passive investments is attributable to those investments,2
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reimbursement loans arguably present a different question. The

parties agree that a taxpayer that receives loan funds before

incurring construction expenditures can use the loan proceeds to

finance construction directly while simultaneously investing its

own money tax-free; a similar taxpayer that receives loan funds

only after incurring construction expenditures must use its own

money to pay construction bills and then use the reimbursement

funds for the investment. If we were to hold broadly that the

latter investment is debt-financed merely because the specific

dollars used to make it are traceable to a lender, we would grant

different tax consequences to similar transactions.

C.

We need not resolve the difficulties presented by

reimbursement loans, however, because petitioner's arguments amount

to an attempt to restructure this transaction after the fact. As

noted above, petitioner's Treasury Notes are subject to federal

taxation only if they are debt-financed. Property is debt-financed

if it is held to produce income and there is an "acquisition

indebtedness" attributable to it. See 26 U.S.C. § 514(b)(1).

"Acquisition indebtedness" is defined as follows:

[T]he term "acquisition indebtedness" means, with respect to

any debt-financed property, the unpaid amount of—

(A) the indebtedness incurred by the organization in

acquiring or improving such property;

(B) the indebtedness incurred before the acquisition or

improvement of such property if such indebtedness would

not have been incurred but for such acquisition or

improvement; and

(C) the indebtedness incurred after the acquisition or
 

3The Commissioner further argues that the indebtedness

cannot be attributed to the facilities under § 514(c)(1) because

(1) that subsection applies only to debt-financed property; and

(2) the electrical facilities are substantially related to

petitioner's tax-exempt functions, so § 514(b)(1)(A)(i) therefore

excludes them from the definition of debt-financed property. We

do not reach this argument. 

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improvement of such property if such indebtedness would

not have been incurred but for such acquisition or

improvement and the incurrence of such indebtedness was

reasonably foreseeable at the time of such acquisition or

improvement.

26 U.S.C. § 514(c)(1).

Petitioner made a business decision to finance the remaining

construction by spending its own funds, not by drawing on the

remainder of the approved loan; petitioner subsequently decided to

borrow the remainder and invest it in Treasury Notes. Accordingly,

petitioner incurred the indebtedness not for financing the

construction, but for making arbitrage profits on federal lending

and borrowing rates.

Petitioner contends that § 514(c)(1)(C) attributes the

indebtedness to the facilities because petitioner would not have

been eligible for the loan but for the construction. Although

petitioner is correct that the indebtedness could not have been

incurred but for the construction, it does not follow that the

indebtedness "would not have been incurred but for" the

construction. See § 514(c)(1)(C) (emphasis added). In fact, the

record shows that petitioner not only would not have incurred the

debt for the construction, but that in fact it did not.3

Conversely, the indebtedness must be attributed to the

Treasury Notes, as it "would not have been incurred but for such
 

4Petitioner argues that it needed the loan proceeds to

restore necessary working capital. This claim is belied by the

fact that petitioner invested the proceeds in Treasury Notes two

days after receiving them and still holds the Notes. 

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acquisition." See § 514(c)(1)(B). Petitioner argues that because

its primary motivation for taking the loan was to secure financing

for future (and presumably tax-exempt) monetary needs, purchase of

the Treasury Notes was not a "but for" cause of the indebtedness.

Petitioner concedes that it drew on the loan only after deciding to

invest the proceeds in Treasury Notes, however. Petitioner's

additional motivations are irrelevant, as it incurred indebtedness

with the intention of immediately investing it in Treasury Notes.

Petitioner's further contention that the Treasury Notes were

purchased from general funds, not indebtedness, is unavailing.

Petitioner cannot evade taxes by depositing funds in a bank account

before forwarding them to their intended use. See 26 C.F.R. §

1.514(c)-1(a)(2) (example 2) (providing that when working capital

is reduced by a non-exempt investment, any indebtedness needed to

restore working capital to the amount necessary to conduct

tax-exempt operations is attributed to the non-exempt investment).4

III.

Years after deciding that its construction projects did not

require further federal financing, petitioner received federal

funds at five percent interest and immediately invested it for more

than nine percent interest. While such arbitrage is an excellent

business opportunity, it is not exempt from federal taxation.

The decision of the Tax Court is AFFIRMED.
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