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expenses; Investments incurred no interest expense. During 1999
and 2000, Investments owned almost $14 million in tax-exempt
obligations; Peoples owned virtually none. During 2001 and 2002,
Investments owned over $17 million in tax-exempt obligations,
which represented more than 80 percent of the tax-exempt
obligations owned by Investments and Peoples combined.
The Internal Revenue Code provides (as further discussed
below) that the amount of a financial institution’s interest
expense allocated to tax-exempt interest, and thus rendered
nondeductible, is computed by multiplying the otherwise allowable
interest expense by a fraction prescribed in the statutes. The
fraction’s numerator (numerator) equals “the taxpayer’s average
adjusted [bases] * * * of [tax-exempt] obligations”. See secs.
265(b)(2)(A), 291(e)(1)(B)(ii)(I). The fraction’s denominator
(denominator) equals the “average adjusted [bases] for all assets
of the taxpayer”. See secs. 265(b)(2)(B), 291(e)(1)(B)(ii)(II).
On the consolidated returns filed by petitioner’s affiliated
group for the subject years, Peoples included its adjusted basis
in its Investments’ stock in Peoples’ calculation of the
denominator. Peoples’ basis in its Investments’ stock equaled
Investments’ basis in Investments’ assets. For each subject
year, Peoples included all of the tax-exempt obligations that
were purchased by Peoples and that were outstanding as of the end
of the year in Peoples’ calculation of the numerator. Some of
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Last modified: March 27, 2008