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It is not uncommon for a related or “friendly” party to wish to make a loan at a lower interest rate than is available in an arm’s length open market transaction. This is often the case when loans are made between relatives, business owners and their businesses, and employers and their employees. However, if the lender does not charge enough interest, the transaction may give rise to unforeseen and unintended tax liabilities. The applicable federal rate (“AFR”) is a statutory interest rate that sets the minimum amount of interest that must be charged on any loan.1 If the interest rate on a loan is below the AFR, the lender is treated as if it had received additional income equal to any forfeited interest that would have been received if the loan rate had been fixed at the AFR.2 This amount is called “imputed interest” and a loan that earns interest at a rate below the AFR is called a “below market loan”. Because imputed interest is treated as income, the lender must pay tax on the imputed interest.3 The borrower can generally deduct any amount of interest charged to the lender.4
Tax law divides loans into two categories: (1) demand loans and (2) term loans.5 A demand loan is a loan repayable in full at any time at the request of the lender.6 A term loan is a loan that is not a demand loan.seven Term loans are divided into short-term, medium-term and long-term loans. A loan with a term of three years or less is a short-term loan, a loan with a term between 3 and 9 years is a medium-term loan and a loan with a term of more than nine years is a long term loan. to lend.8
Each month, the Internal Revenue Service (“IRS”) issues a tax ruling listing the short, medium, and long-term AFR in effect as of that month. To ensure that a term loan will not qualify as a below-market loan, the lender simply needs to charge interest at the applicable exchange rate in the monthly tax ruling in which the loan is granted.9 For example, if a shareholder lends Acme Corporation $1,000 in July 2017, payable in full in July 2018, the shareholder must charge interest at a rate of 1.22% (the short-term rate effective July 2017) .ten Even if the short-term rate increases in subsequent months, the parties do not need to adjust the loan rate; the 1.22% rate can be locked in for the duration of the loan.
The determination of the AFR is more complicated in the context of demand loans. The AFR for a demand loan is the prevailing short-term rate for each semi-annual period of the loan.11 The two semester periods extend from January 1 to June 30 and from July 1 to December 31. Thus, the calculation of the AFR for a demand loan requires the parties to adjust the interest rate of the loan at least semi-annually, and is sometimes referred to as a “variable rate”. rate.” For example, if a shareholder lends Acme Corporation $1,000, payable on demand, on January 1, 2017, the loan must bear interest at a rate of 0.96% (the short-term semi-annual rate for January 2017) until June 30, 2017.12 On July 1, 2017, the loan rate is to be adjusted to 1.22% (the semi-annual short-term rate for July).13 The interest rate on the loan must be adjusted in this way every January 1 and July 1 until the loan is repaid in full.14
However, not all demand loans start in January or July. If a call loan commences in another month, the interest rate charged for the first term of the loan is either the short-term AFR (compounded semi-annually) for (a) the month in which the loan begin ; or (b) the first month of such semi-annual period (January or July).15 The parties can choose the lower of these two rates.16 Suppose that in February 2017, Acme Corporation needs shareholder cash again. The rate for the first period of the loan can be either (i) 1.04%, the semi-annual short-term rate for February;17 or (ii) 0.96%, the semi-annual short-term rate for January (the first month of the semi-annual period). In July (start of a new semi-annual period), if the loan has not been repaid, the rate must be adjusted to the July short-term semi-annual rate of 1.22%.
Since calculating the AFR for a demand loan requires the application of a semi-annual variable rate, imposing a fixed rate on a demand loan may result in the loan being characterized as a below-market loan. . In the examples given above, if on January 1 the shareholder made a loan to Acme Corporation at a fixed interest rate of 1.0%, the loan would be considered a below-market loan as of July 1. The semi-annual short-term rate for January was 0.96. percent, which was lower than the 1.0% fixed rate charged, but became 1.22% on July 1, which was higher than the 1.0% fixed rate charged. Therefore, if the parties decide to apply a fixed rate on a demand loan, the loan documents must provide that the interest rate will always be the higher between the fixed rate indicated and the special rate for demand loans. , as set forth in the Internal Revenue Code. (“Code”) and its regulations.
If a loan has an indefinite maturity, it may not clearly meet the Code’s definition of a term loan or a demand loan. Therefore, the application of AFR to such a loan is not entirely clear. A loan that matures on a liquidity event, such as the sale of a business, is an example of an indefinite loan. A loan maturing on the sale of a business has no set term to which the short, medium or long-term mechanical rate can be applied because it is not known when the business will be sold. At the same time, the loan is not repayable on the demand of the lender, but rather on the occurrence of a specified future event.
Congress recognized this problem and gave the Treasury Department the authority to treat loans with indefinite maturity as demand loans “to the extent permitted by regulation.”18The Treasury Department has not exercised this authority, and neither the proposed rule nor the final rule specify how the AFR should be applied to loans with indefinite maturity. This led the Tax Court to KTA-Tator, Inc. c. Commissioner 19 consider loans with indefinite maturity to be term loans. She argued that because the Treasury Department has not yet passed regulations treating indefinite-term loans as demand loans, and because the Code defines term loans as any loan that is not a demand loan, indefinite term loans are term loans by virtue of not being demand loans.20The court, perhaps conveniently, did not have to deal with the question of whether the short-term, medium-term or long-term rate applied because it decided that the loan in question did not did not have an indefinite expiry date. Instead, the court found that the loan was repayable on demand and therefore a demand loan.
Nowadays, KTA-Tator is the only decision to solve this problem. However, Tax Court decisions generally do not constitute binding precedent for federal courts.21 Therefore, it is unclear whether a federal court would agree with the Tax Court’s conclusion. The legislative history of the act points out that “it is often impossible to treat a loan with an indefinite maturity as a term loan, since section 7872 requires calculation of the present value of payments due under such a loan “.22 More fundamentally, if open-ended loans are treated as term loans, how do the parties decide whether the short-term, medium-term or long-term rate is applicable without knowing the duration of the loan? This is the question KTA-Tator left unanswered.
One option is to include a retrospective provision in the loan terms. Such a provision would provide that once the loan matures and the term of the loan is known, the parties recalculate whether sufficient interest has been charged over the term of the loan by looking at the rate applicable on the date the loan has been executed. For example, if a loan executed on July 1, 2017 matures on July 1, 2023, the parties will take the medium-term AFR on July 1, 2017 and compare it to the rate actually applied. If the rate charged was lower than the applicable AFR, the loan documents would require the borrower to pay the lender any lost interest to avoid violating the Code.
Using the long-term rate for an indefinite loan will ensure compliance with the AFR because, as the highest rate in the AFR regime, a lender could not have charged interest beyond the amount provided by the long-term rate. Of course, the downside of this strategy is to charge a relatively high interest rate to a party to whom the lender may wish to grant preferable loan terms. Beyond incorporating a look-back provision or charging the long-term rate, a lender will need to base their decision on what rate to charge by assessing the level of risk they are willing to accept. The short-term or mid-term rate could be used, but if the loan does not mature within the applicable period, the lender will have interest charged. Another strategy would be to treat an indefinite loan as a demand loan and continually adjust the short-term rate every semi-annual period, as detailed above. This strategy, however, would contravene the only decision on file and would require the taxpayer to convince a court that KTA-Tator should not be followed.
Special thanks to Taylor Cammack for her help in researching and writing this article.
1 See in general IRC §§ 1274, 7872.
2 IRC § 7872(a).
3 IRC §§ 1, 61(a)(4).
See H. Conf. Rep. 98-861, at 1015 (1984), 1984-3 CB (Vol. 2), 1, 269; IRC § 163.
5 IRC § 7872(f)(2).
6 IRC § 7872(f)(5).
7 IRC § 7872(f)(6).
8 IRC § 1274(d).
See IRC §§ 7872(f)(2)(A), 1274(d).
See Rev. Rule. 2017-14, Table 1, https://www.irs.gov/pub/irs-drop/rr-17-14.pdf
11 IRC § 7872(f)(2)(B). Note that interest must be compounded semi-annually for term loans and demand loans. SeeIRC § 7872(f)(2)(A)–(B). For simplicity, this article ignores the effects of compound interest.
See Rev. Rule. 2017-2, 2017-2 IRB 364, https://www.irs.gov/pub/irs-drop/rr-17-02.pdf
See Rev. Rule. 2017-14, 2017-27 IRB 2, https://www.irs.gov/pub/irs-drop/rr-17-14.pdf
14 IRC § 7872(e)(2)(A) permits the use of a “blended annual rate” for demand loans with a fixed principal amount outstanding for an entire calendar year. The weighted annual rate is the product of (1) half of the January semi-annual short-term TAF multiplied by (2) half of the July semi-annual federal short-term TAF. See Rev. Rule. 86-17, 1986-1 CB 377.
15 Prop. Reg. § 1.7872–(b)(3).
16 Prop. Reg. § 1.7872–(b)(3); Prop. Reg. § 1.7872(c)(3) Ex. (5)(i).
See Rev. Rule. 2017-4, 2017-6 IRB 776, https://www.irs.gov/pub/irs-drop/rr-17-04.pdf
18 IRC § 7872(f)(5).
19 KTA-Tator, Inc. v. Commissioner, 108 TC 100 (1997).
Identifier. at 104.
21See, for example, Nico v. Commissioner, 67 TC 647, 654 (1977), partly aff’d and partly rev’d, 565 F.2d 1234 (2d Cir.).
22 S. Rept. 99-313, at 958 (1986), 1986-3 CB (Vol. 3) 1, 958.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.