General Explanation
Current Law
(1)
Measuring the Interest in Deferred Pay
ment Transactions
Section 483 of the Internal
enue Code requires that a
minimum amount of interest be staRev
ted
transactions involving the sale or excin deferred payment
purpose of this rule is to prevent par hange of property. The
understating the interest element of ties to a transaction from
stating the "purchase price" of acquira transaction, and overin which market forces do not result ed assets, in circumstances
in an economic allocation.
If interest is not stated at the minimu
regulations (currently 9 percent, sim m rate fixed in the
imputed under section 483 (currently ple interest) interest is
at a 10 percent rate,
compounded semiannually)
A
max
imu
m
test rate of 6 percent, and
imputation rate of 7 percent, is provid
estate transactions involving $500,000 ed for related party real
or less.
Where imputed interest arises because
of the parties' failure
to provide adequate interest,
sec
tio
n
483
interest among the deferred payments 'bas allocates the imputed
amounts of the payments, without regard ed on the relative
elapsed prior to any payment, and, the to the period of time
the amount of interest "earned" at therefore, without regard to
time payments are made.
Section 482 provides for the
utation of interest in
borrowing transactions between comimp
mon
where adequate interest is not provid ly controlled businesses
interest test rate is employed in deted. Currently, a simple
ermining the safe-harbor
interest rate under section 482.
(2)
Time for Inclusion or Deduction of Def
erred Interest
In general, the Code tre
the parties to a discount
borrowing transaction as if ats
the
ann
ual accrual of discount were
actually paid each year to the lender
lender to the borrower. Assume, for , and then re-loaned by the
borrowed $100 from Lender, at a 10 perexample, that Borrower
with interest compounding annually but cent annual interest rate,
payable in a
p sum at
the end of 2 years.
s, the agreement provides forlumthe
of $121 at the end of Thu
the second year. At the end of year payment
1, $10
of interest is considered to hav
rued ($100 x 10 percent).
Applying the 10 percent rate to etheaccloa
outstanding at the end of year 1, int n balance considered
during year 2. Thus, under the Code, erest of $11 would accrue
Lender would include $10 in
- 2 -
income in year 1, and $11 in
2; Borrower would deduct the
same amounts at the same time.yearUnde
the current Code
provisions, original issue discount r("OI
is considered to
arise with respect to a bond in cases ofD")
two
s: (i) where a
bond is issued for cash in an amount less thantype
the
redemption
price of the bond (the case illustrated above),
and
(ii) where a
bond is issued in exchange for property
but
only
if
the bond,
or the property received in exchange for the bond
,
is
publ
icly
traded. Thus, OID does not arise in cases where
a
bond
(whi
ch is
not publicly traded) bearing economic discount is
issu
ed
in
exchange for property such as real estate or mach
rules also are inapplicable to bonds issued by a inery. The OID
natural person.
Reasons for Change
(1) Mismeasurements of Interest in Deferred Paym
ent
Transactions
The simple interest test rate currently provided
under
section 483 does not reflect a proper econ
omic
comp
utat
ion of
interest. In economic terms, unpaid interest itse
lf gives rise
to a further interest charge because
any forebear
of the
payment of cash
whether denominated interest orance
prin
cipal
requires compensation to the lender. As a result,
the
use of a
simple interest formulation in the context of defe
rred
paym
ents
(which does not provide for the payment of interest
on
unpa
id
interest) allows taxpayers to understate, sometime
s dramatically,
the interest element of the transact
ion.
For
exam
ple,
an
obligation that nominally bears simple interest of
9
perc
ent per
year payable at the end of 30 years in fact bears
inte
rest
of
4-1/2 percent per year using a proper economic comp
utation.
Where the interest component of a defe
payment
transaction is understated, the tax basis rred
of
the
acquired asset
is concomitantly overstated,
the result that excess
investment tax credits ("ITC")with
and
lerated cost recovery
allowances ("ACRS") may be claimed. acce
We
have seen a substantial
number of recent transactions that exploit
this flaw in the
operation of section 483. In some cases a tax
s of more than
five times the established fair market value of basi
the
property is
claimed. The excess basis represents interest in
economic terms
and should be deducted only as it accr
over the life of the
obligation. However, by virtue of the ues
defe
ctive operation of the
section 483 test rate, that excess is transfor
med into inflated
ITC and ACRS allowances having a materially high
er present value
than the interest deductions (although the understa
interest element of the transaction may be subject tement of the
to challenge
by the Internal Revenue Service).
- 3 (2) Allocation of Income and Deductions
to Taxable Periods
Because section 483 spreads
ted interest over deferred
payments solely in proportion to impu
the
amount of the payments (not
taxing into account the time of payment)
to structure transactions that accelerat,e taxpayers may be able
interest charges into the year the transactmultiple years'
Frequently, these transactions involve the ion occurs.
nondepreciable property, such as corporate purchase of
transactions typically provide for one paym stock. These
months, and a second payment (in approxima ent at the end of six
tely the same
nt)
due far in the future
such as at the end of 30 years. amou
The
payments bear no stated interest. (Because
the end of 30 years has very little present the payment due at
economic cost or
value, the bulk of the purchase price is refl
due in six months.) Section 483 imputes inte ected in the payment
rest in the
transaction in an amount equal to roughly
onepayments. It then allocates one half of the half of the total
imputed inte
the payment due in six mont
In effect, the interest rest to
allocation rules of sectionhs.
function to allow taxpayers to
claim current deductions for 483
full
y one-half of the cost of a
nondepreciable asset. Moreover, by
posing of the note at the
proper time, the seller of the properdis
ty
avoid having the
payment at the end of six months treated can
as interest.
(3) Consequences of Failure to Apply Sect
ion 1232A where
Economic Discount is Present
OID does not arise in four types of transact
ions in which
"discount" bonds are issued:
(i) The purchase of real estate or personal
perty
(such as machinery) for a discount obligapro
tio
n that
is not publicly traded.
(ii)
The issuance of a discount bond in exchange
for
services.
(iii) The issuance of a discount bond in a
reorganization transaction (neither "leg" of whi
ch is
publicly traded).
(iv) The issuance of a discount bond by a
natural
person.
Transactions (i) and
are very common feat
of tax
shelter offerings. In all(ii)
of the above cases, tax ures
avoidance
opportunities result from provisions in the
interest will "accrue" each year but not be bond that stated
The issuer of the bond, who uses the accrual paid until maturity.
accounting, will claim annual interest dedu method of
ctions, while cash
- 4 -
method holders defer income inclusions until maturity
obligation. The revenue loss to the Government from of the
transactions is substantial and is increasing dramaticthe
shelter transactions employing this structure prolifer ally as tax
the reorganization exception to section 1232 (for publate. When
securities) was repealed by the Technical Corrections icly traded
1982, the Conference Report took note of this problem, Act of
stating
that if the Treasury was unable to deal administrati
vely
with the
mismatching of income and deductions in these transact
ions
,
further corrective legislation may be appropriate in
the
near
future. House Rep. No. 97-986, 1983-1 C.B. at 502.
In addition to the asymmetrical treatment of issuers
and
holders, discount bonds issued in tax shel
ter
tran
sact
ions
of the
type described above frequently embody a non-economic
comp
utat
of interest
i.e., straight-line interest, or simple interestion
payable on a deferred basis. Both computations acce
lerate
interest deductions by improperly identifying the peri
the interest charge is allocable. Cash method holders od to which
obligations are, of course, indifferent to these timi of the
ng concerns
because they defer inclusion until maturity. Although
noneconomic interest calculations is largely proscrib the use of
Rul. 83-84, 1983-1 C.B. 97, we understand that severaled by Rev.
recent tax
shelter offerings have taken positions inconsistent
with
the
ruling.
The fact that the current section
A rules do not apply to
bonds issued by natural persons clearly1232
offe
rs tax shelter
opportunities. The complexity of the OID rule
mandates that
these rules not be applied to routine transactsions
entered into
by individuals, however.
Proposals
(1) The allocation between interest and principal (pur
chase
price) in deferred payment transactions woul
d
be
impr
oved
by
the
use of a compound interest test rate
ion 483. This change
would conform the interest computationin tosect
economically proper
computation, similar to that currently provanided
under section
1232A and Rev. Rul. 83-84.
(2) Unstated interest determined unde section 483 woul
d be
required to be taken into account by the rpart
ies
to
the
transaction in accordance with the
odic inclusion rules of
section 1232A (and the parallel ruleperi
for
deductions in section
163(e)).
(3) The scope of the periodic inclusion rules of sect
ion
1232A would be broadened to include the purc
hase
of
nontrad
ed
property for discount bonds (which are non-traded).
Four
exceptions to the expanded OID rules would be provided
:
- 5 -
(i)
sales of farms by individuals otr by small
businesses for a price of $1,000,000 or less,
(ii)
sales of principal residences by individuals,
(iii)
(iv)
sales of services or the right to the use of
property where payment is not deferred for a
period of one year after liability with respect to
the services is accruable (provided that deferred
payments for services subject to section 404 in
all events would be excepted from the expanded OID
rules), and
sales involving total payments of $250,000 or
less.
(4) Purchasers and sellers in the above excepted transactions
would report interest income and deductions according to the
general rules governing cash and accrual method taxpayers (or the
rules currently provided in section 483, if interest is imputed
under that section). It is believed that the exceptions provided
will cover virtually all cases in which the taxpayers involved
might have difficulty dealing with the complexity of the OID
rules.
(5) The "natural person" issuer exception to sections 1232A
and 163(e) would be repealed.
(6) The restriction in section 1232A that limits the income
accrual requirement for OID bonds held by cash basis taxpayers to
bonds that constitute capital assets in the hands of the taxpayer
would be repealed. The exception to section 483 for sales of
ordinary income property also would be repealed.
(7) The section 483 structure would be revised by (i)
providing for differing interest rates depending on the maturity
of the obligation (short, medium, and long maturities), and (ii)
allowing the rate to adjust automatically at prescribed intervals. Thus, the section 483 test rate would be adjusted at
six-month intervals to equal 120 percent of the yield-to-maturity
of Treasury instruments having a similar maturity. Under this
approach, the section 483 rate would correspond roughly to the
lowest rate at which a good credit risk could borrow. Parallel
changes would be made to the section 482 rules for determining
arm's length interest rates between commonly controlled parties.
The maximum section 483 rate of 7 percent for real estate
transactions between related parties involving $500,000 or less
would be preserved (see section 483(g)).
The proposals would be effective for transactions entered
into after December 31, 1984.
- 6 -
Effects of Proposals
(1)
Section 483 Allocation Between Interest and Principal
The use of a self-adjusting, compound interest test rate,
instead of simple interest, would greatly restrict taxpayers'
ability to understate the interest in a deferred payment
transaction. Thus, the purchaser generally would not be able to
overstate ACRS allowances and ITC, and the seller generally would
not be able to convert ordinary interest income that would be
taxed when earned into capital gain that will be taxed on a
deferred basis.
The use of a compound interest computation and self-adjusting
rate structure in the safe harbor rates under section 482
similarly would ensure that adequate interest is provided in
borrowings between commonly controlled businesses, and would
prevent avoidance of the revised section 483 rules. The section
267 rules
which generally require matching of interest income
and deductions between related parties
would not defer
deductions for accrued OID because the OID is required to be
included in the holder's income currently.
(2)
Repeal of Non-Traded Property Exception to Section
1232(b)(2)
By repealing generally the "non-traded" property exception of
section 1232(bj(2), deferred payment purchases of real estate and
personal property, as well as the issuance of discount bonds in a
reorganization would become subject to the OID rules in cases of
two types:
(i)
(ii)
interest adequate to satisfy section 483 is
provided, but is not payable at least annually, and
the interest provided (if any) does not satisfy the
section 483 test rate.
In all cases in which OID is created, purchasers and sellers
(or issuers and holders of bonds issued in a reorganization)
would be required to take OID into account using the constant
interest computation, irrespective of their method of accounting.
(3)
Deferred Payment Obligations Issued for Services
In general, deferred payment obligations issued in exchang
for services will not come within the expanded OID rules. In ethe
context of qualified plans of deferred compensation,
tax-exemption for the trust coupled with deferred income
inclusions are an essential feature of the plan, and application
- 7 -
of the OID rules is not appropriate. Payments to employees
pursuant to a non-qualified plan of deferred compensation
governed by section 404(a), as well as payments to nonemployees
governed by section 404(d) are not deductible until the year
in
which actual payment occurs. This matching" rule for
non-qualified plans generally prevents distortions of the type
reached by the OID rules (although the shifting of investment
income between the service provider and the recipient is not
prevented by a matching rule).
(4) Natural Person Exception
Individuals rarely issue or receive long-term debt
obligations that do not require current payments of interest. In
order to minimize the impact of the proposals on individuals,
however, the expanded OID rules would not apply to cases where
individuals sell their farms or residences or enter into
relatively small transactions (total payments of $250,000
or
less) and take back discount deferred payment obligations. The
only identified circumstance in which individuals issue discount
bonds in other than tax motivated transactions appears to involve
the issuance of negative amortization mortgages (which provide
that some portion of the current interest is added to
l
and paid on a deferred basis). The proposed OID rules principa
would
apply to negative amortization mortgages and thus entitle the
homeouyer to deduct interest costs more rapidly than under
current law. (The impact on mortgage lenders is discussed
below.)
Repeal of the natural person exception would overrule the
applicability of the Battlestein line of cases
which generall
bar an interest deduction for a cash method taxpayer where the y
interest is paid with funds borrowed from the lender
whenever
an individual is the issuer of an OID obligation. Thus, a
current deduction for the accruing but unpaid interest would be
allowed to the individual issuer, it is noted that pending
legislation would require a bank/mortgageholder to provide an
annual report of the deductible interest, eliminating possible
concern about individuals' need to make complex computations in
the context of negative amortization mortgages.
(5) Capital Asset Limitation of Section 1232A
Section 1232A requires holders of OID bonds to accrue income
currently only if the bond is a capital asset in the hands of the
taxpayer. If the taxpayer uses the accrual method of accounting,
these annual accruals are required without regard to section
1232A. Expanding the category of obligations that will give rise
to OID
and expanding the number of cases in which taxpayers
would be permitted to claim deductions for bond discount
underscores the need for elimination of the capital asset
- 8 -
limitation on income accruals by lenders and sellers.
Originally, section 1232 was concerned more with the proper
character of payments, rather than the proper timing of income
inclusions and deductions. In an environment of higher interest
rates, however, timing issues acquire greater significance; as a
result, a general exception to the periodic inclusion rules for
non-capital assets no longer is appropriate.
Repeal of the capital asset limitation in section 1232A
necessitates elimination of the exception to section 483 for
sales of ordinary income property (section 483(f)(3)). If the
exception were not repealed, sellers of inventory could avoid
current inclusions of interest income merely by failing to
identify the interest provided in deferred payment transactions.
This rule should not affect most dealers who sell property on the
installment method because interest is specifically stated in
most transactions.
Revenue Estimate
Fiscal Years
1985
583
1986
1987
($ Mi 11 ions)
1000
1400