Internal Revenue Service
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 Rev. Rul. 78-37

1978-1 C.B. 54

Sec. 163
Sec. 1232

IRS Headnote

Interest; certificates of deposit; original issue discount. The income tax treatment of original issue discount on certificates of deposit issued after 1970 by commercial banks is unaffected by the July 5, 1973, amendment of Regulation Q of the Board of Governors of the Federal Reserve which altered the provision for withdrawals by holders of time deposits.

Full Text

Rev. Rul. 78-37

Advice has been requested regarding the treatment of original issue discount (OID) by commercial banks on certificates of deposit (hereinafter referred to as CDs) issued after December 31, 1970 where withdrawals are permitted under new Regulation Q of the Board of Governors of the Federal Reserve, 12 CFR, Part 217 (1974). Clarification is also requested with respect to the treatment of the discount by the holders of such CDs issued with original issue discount.

The terms of the CDs issued by a commercial bank have not changed from those CDs issued under the old Regulation Q. In this connection some CDs issued by the bank provide that a portion of the OID will be credited to the certificate holder's account on December 31 each year prior to the year in which the CD matures, whereas the other CDs provide that no OID will be credited prior to the maturity of the CDs.

Regulation Q, prior to its amendment on July 5, 1973, provided that a time deposit could be paid before maturity only in an emergency when it was necessary to prevent great hardship to the depositor. Under the amended provisions of Regulation Q, effective July 6, 1973, this emergency provision was deleted, and a member bank is now permitted to pay interest on the amount withdrawn at a rate not to exceed the maximum rate prescribed for a savings deposit during the period the funds have remained on deposit, less 3 months interest. See 12 CFR section 217.4(d) (1974).

Section 1.163-4(a) of the Income Tax Regulations provides, in part, that where an obligation is issued by a corporation with original issue discount, the amount of such discount is deductible as interest but must be prorated or amortized over the life of the obligation. For purposes of this section the term "obligation" shall have the same meaning as in section 1.1232-1. In general, the amount of original issue discount equals the excess of the amount payable at maturity over the issue price of the obligation. Section 1.163-4(d) provides, in part, that this section shall apply to deposits made on or after January 1, 1971, in the case of certificates of deposit, time deposits, bonus plans, and other deposit arrangements.

Example (4) of section 1.163-4(b) of the regulations states as follows:

On January 1, 1971, a commercial bank which uses the calendar year as its taxable year, issued a certificate of deposit for $10,000. The certificate of deposit is not redeemable until December 31, 1975, except in an emergency as defined in, and subject to the qualifications provided by, Regulation Q of the Board of Governors of the Federal Reserve. See 12 CFR sec. 217.4(d). The stated redemption price at maturity is $13,382.26. The certificate is an obligation to which section 1232(a)(3)(A) applies (see paragraph (d) of sec. 1.1232-1), and the original issue discount with respect to the certificate (as determined under section 1232(b)(1) without regard to the one-fourth-of-1-percent limitation in the second sentence thereof) is $3,382.26 (i.e., redemption price, $13,382.26, minus issued price, $10,000). Y shall treat $3,382.26 as the total amount to be amortized over the life of the certificate.

Regulation Q referred to in this example is the regulation in force prior to its amendment on July 5, 1973.

Section 1.163-4 of the regulations (including example (4) quoted above) does not distinguish between banks using the cash or accrual method of accounting. The general rule for the taxable year of the deduction set forth in section 1.461-1(a) has been superseded, in part, by section 1.163-4 with respect to interest deductions by banks on obligations representing time deposits issued with original issue discount after December 31, 1970.

Section 1232(a)(3) of the Code provides that original issue discount on any bond or evidence of indebtedness issued by a corporation after May 27, 1969, must be included in the gross income of the holder ratably over the period such holder held such bond or other evidence of indebtedness during the taxable year.

Section 1.1232-1(a) of the regulations states, in part, that section 1232 of the Code applies to any bond, debenture, note, or certificate or other evidence of indebtedness (referred to in this section as an obligation).

Section 1.1232-1(d) of the regulations provides, in part, that for purposes of section 1232 of the Code, the term "other evidence of indebtedness" includes certificates of deposits, time deposits, and other deposit arrangements with banks. However, it further provides that section 1232 shall not apply to such deposits made prior to January 1, 1971.

Section 1.1232-3A(b)(2) of the regulations provides, in part, that section 1232(a)(3) of the Code shall not apply to any obligation in respect of which the period between the date of original issue and the stated maturity date is 1 year or less.

Example (1) of section 1.1232-3A(e)(3) of the regulations in illustrating the application of section 1232 of the Code to CDs states as follows:

A is a cash method taxpayer who uses the calendar year as his taxable year. On January 1, 1971, he purchases a certificate of deposit from X bank, a corporation, for $10,000. The certificate of deposit is not redeemable until December 31, 1975, except in an emergency as defined in, and subject to the qualifications provided by, Regulation Q of the Board of Governors of the Federal Reserve. See 12 CFR sec. 217.4(d). The stated redemption price at maturity is $13,382.26. The terms of the certificate do not expressly refer to any amount as interest. A's certificate of deposit is an obligation to which section 1232 and this paragraph apply. A shall include the ratable portion of original issue discount in gross income for 1971 as determined under section 1232(a)(3). Thus, if A holds the certificate of deposit for the full calendar year 1971, the amount to be included in A's gross income for 1971 is $676.45, that is, 12/60 months, multiplied by the excess of the stated redemption price ($13,382.26) over the issue price ($10,000).

Example (3) of section 1.1232-3A(e)(3) of the regulations provides as follows:

Assume the same facts as in example (1), except that the certificate provides for the payment of interest in the amount of $200 on December 31 of each year and $2,000 plus $10,000 (the original amount) payable upon redemption at December 31, 1975. Thus, if A holds the certificate of deposit for the full calendar year 1971, A must include in his gross income for 1971 the $200 interest payable on December 31, 1971, and $400 of original issue discount, that is, 12/60 months multiplied by the excess of the stated redemption price ($12,000) over the issue price ($10,000).

Regulation Q referred to in these examples is the regulation in force prior to its amendment on July 5, 1973.

Although the emergency requirement has been removed from Regulation Q, as amended, the requirement that both the depositor and the bank must agree to an early redemption of the CD remains unchanged. Section 217.4(e) of new Regulation Q. Thus, the depositor does not have a unilateral right of early withdrawal, as the bank may, in its discretion, not permit redemption before maturity. However, the Federal income tax consequences as to the manner the original issue discount is taken into account by both the issuer and the holders of the CDs must be determined by the terms of the CD and the agreement between the parties. As stated above, the terms of the CDs in question, after the amendment to Regulation Q, have remained the same.

Accordingly, notwithstanding the change in Regulation Q, the stated terms of the CDs would not necessitate a change in the treatment of "original issue discount" by either the issuer or the holder of the CD from that provided in section 1.163-4 of the regulations and section 1232(a)(3) of the Code. The issuer will continue to deduct a ratable monthly portion of the "original issue discount" (redemption price over issue price) over the term of the CD if issued after December 31, 1970. The holder of such CD must include a ratable portion of the original issue discount in income each year except, as noted above, where the period between the date of original issue and the stated maturity date is 1 year or less.

Where, as in example (3) of section 1.1232-3A(e)(3) of the regulations, the CD provides for the payment of interest on December 31 of each year prior to the year the CD matures, the holder must include in gross income each year the interest credited to the holder's account (whether withdrawn or not). The issuer, correspondingly, will treat as a deductible expense each year such interest as credited to the holder's account.

For treatment of accrual of interest by a commercial bank on CDs (that are not issued with original issue discount) that actually or constructively pay interest annually or more frequently, see Rev. Rul. 76-308, 1976-2 C.B. 133, amplifying Rev. Rul. 71-63, 1971-1 C.B. 143.