Rev. Rul. 77-27, 1977-1 C.B. 23

Industrial development bonds; exempt small issue; capital expend­itures. Expenditures incurred by a nonexempt corporation for research and experimental activities with re­spect to a proposed facility to be financed by the industrial develop­ment bonds of a political subdivi­sion of a state are capital expendi­tures within the meaning of section 103(b)(6)(D) of the Code, even though the corporation elects to treat such expenditures as deducti­ble expenses under section 174.

Rev. Rul. 77-27

Advice has been requested whether, under the circumstances described be­low, expenditures for research and ex­perimental activity will be “capital expenditures” within the meaning of section 103 (b) (6) (D) of the Internal Revenue Code of 1954 for purposes of determining if the exempt small issue limitation of $5,000,000 will be ex­ceeded.


A political subdivision’ of a state proposes to issue industrial develop­ment bonds as defined in section 103 (b) (2) of the Code in the amount of $4,500,000 to finance the acquisition of land, factory building, and equip­ment located in county M to be used by X corporation, a nonexempt per­son. Prior to the issuance of the bonds, the political subdivision plans to make an election to have the bonds treated as a $5,000,000 exempt small issue under section 103 (b) (6)(D). There will be no prior exempt small issues outstanding at the time the bonds will be issued.

X currently owns and operates a manufacturing facility in city N, an incorporated municipality located in county M. During the three years prior to the issuance of the bonds, X will have expended $550,000 for research and experimentation with respect to the proposed facility to be located in county M. The research and develop­ment activities will consist of experi­mentation with respect to the products to be produced in the new facility and the development -of equipment to be used in the manufacture of such prod­ucts. X will elect to treat the research and experimental expenditures as de­ductible expenses under the provisions of section 174 of the Code.

Section 103 (a) (1) of the Code provides that gross income does not include interest on the obligations of a state, a territory, or a possession of the United States, or any political subdivi­sion of any of the foregoing, or of the District of Columbia.

Section 103(b)(1) of the Code pro­vides that, except as otherwise pro­vided in section 103 (b), any industrial development bond shall be treated as an obligation that is not an obligation described in section 103(a)(1).

Section 103 (b) (6) (A) of the Code provides that section 103 (b) (1) shall not apply to any obligation issued as part of an issue the aggregate author­ized face amount of which is $1,000,000 or less and substantially all of the proceeds of which are to be used for the acquisition, construction, recon­struction, or improvement of land or property of a character subject to the allowance for depreciation, or to re­deem part or all of a prior issue that was issued for such purposes.

Section 103 (b) (6) (D) of the Code provides, in part, that the issuer may elect to issue an exempt small issue of $5,000,000 or less in lieu of the $1,000,000 described in section 103(b)(6)(A). For purposes of determining the aggregate face amount of such issue, there must be taken into account the face amount of the bonds to be issued, the outstanding face amount of any prior exempt small issues, and the aggregate amount of capital expendi­tures with respect to facilities paid or incurred during the 6-year period be­ginning three years before the date of such issue and ending three years after such date (and financed otherwise than out of the proceeds of outstand­ing issues to which section 103(b)(6)(A) applied). The facilities to be taken into account are those located in the same incorporated municipality or located in the same county (but not in any incorporated municipality) the principal user of which is or will be the same person or two or more re­lated persons.

Section 1.103-10(b)(2)(ii) (e) of the Income Tax Regulations provides, in part, that an expenditure is a section 103(c)(6)(D) (now section 103(b)(6)(D)) capital expenditure if the capital expenditure is properly chargeable to the capital account of any person or State or local govern­mental unit (whether or not such per­son is the principal user of the facility or a related person) determined, for this purpose, without regard to any rule of the Code that permits expendi­tures properly chargeable to capital account to be treated as current expenses.

Section 174 of the Code provides, in general, that a taxpayer may treat research or experimental expenditures in connection with a trade or busi­ness as expenses that are not chargeable to the taxpayer’s capital account. Such expenditures are allowable as a deduction in the taxable year paid or incurred or, under certain circum­stances, they may be deferred and amortized.

Although, in the instant case, X will elect to treat its expenditures for research and experimentation with re­spect to the proposed manufacturing facility as deductible expenses under section 174 of the Code, the provisions of section 1.103-10(b)(2)(ii) (e) of the regulations will apply for pur­poses of determining whether such ex­penditures are capital expenditures under section 103(b)(6)(D).

Accordingly, the expenditures by X for research and experimentation will be capital expenditures within the meaning of section 103(b)(6)(D) of the Code. Since the sum of the face amount of the proposed bond issue ($4,500,000) and the aggregate amount of the capital expenditures ($550,000) will exceed the $5,000,000 limitation for an exempt small issue, the political subdivision may not elect to have the bonds treated as an ex­empt small issue under section 103(b)(6)(D).