Rev. Rul. 83-84
1983-1 C.B. 97.
Internal Revenue Service
Revenue Ruling
ACCOUNTING METHODS; INTEREST; RULE OF 78'S
Published: June 6, 1983
SECTION 446. - -GENERAL RULE FOR METHODS OF ACCOUNTING, 26 CFR 1.446-1: General rule for methods of accounting
(Also Sections 163, 451, 461; 1.163-1, 1.451-1, 1.461-1.)
Accounting methods; interest; Rule of 78's. Even though a loan agreement provides that interest shall be earned in accordance with the Rule of 78's, no deduction for interest will be allowed for any year in excess of the economic accrual of interest. Rev. Ruls. 72-100 and 72-562 modified and superseded; Rev. Ruls. 74-395 and 79-228 modified; Rev. Rul. 74-607 clarified.
ISSUES
What is the proper method of accounting for interest on indebtedness when the terms of that indebtedness state that interest is earned in accordance with the Rule of 78's computation?
FACTS
The Rule of 78's is a method of allocating interest on a loan among time periods during the term of the loan. In substance, under this method, the amount of interest allocable to each period is determined by multiplying the total interest payable over the life of the indebtedness by a fraction, (a) the numerator of which is the number of periods remaining on such indebtedness at the time the calculation is made and (b) the denominator of which is the sum of the periods' digits for the term of the indebtedness.
For example, a taxpayer that uses the accrual method of accounting borrows $100,000, payable in 30 annual installments of $12,414 each. The total interest on the loan will be $272,420 (30 x $12,414 = $372,420; $372,420 - $100,000 = $272,420). The terms of the loan state that interest is earned in accordance with the Rule of 78's computation, and the taxpayer computes its annual interest deduction using the Rule of 78's. The effective rate of interest on this loan is 12 percent. The table shows the overall transaction.
LAW AND ANALYSIS
Interest is defined as the amount charged for the use or forbearance of money. See Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), XI-1 C.B. 274; Deputy v. duPont, 308 U.S. 488 (1940), 1940-1 C.B. 118. No method of accounting for interest is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. Section 446(b) of the Internal Revenue Code and section 1.446-1(a)(2) of the Income Tax Regulations. Moreover, the term "method of accounting" includes not only the overall method of accounting of the taxpayer but also the accounting treatment of any item. Section 1.446-1(a)(1).
Table 1
-------------------------------------------------------------------------------
Years Unpaid Balance Payments Economic accrual of Rule of 78's
(amount interest (Fraction/Interest)
borrowed, (Principal/Interest)
plus
interest
economically
accrued,
minus
payments) at
Beginning of
Period
-------------------------------------------------------------------------------
1 $100,000 $12,414 $ 414 $12,000 30/465 $ 17,575
2 99,586 12,414 464 11,950 29/465 16,990
3 99,122 12,414 519 11,895 28/465 16,404
4 98,603 12,414 582 11,832 27/465 15,818
5 98,021 12,414 651 11,763 26/465 15,232
6 97,370 12,414 730 11,684 25/465 14,646
7 96,640 12,414 817 11,597 24/465 14,061
8 95,823 12,414 915 11,499 23/465 13,474
9 94,908 12,414 1,025 11,389 22/465 12,889
10 93,883 12,414 1,148 11,266 21/465 12,303
11 92,735 12,414 1,286 11,266 20/465 11,717
12 91,449 12,414 1,440 10,974 19/465 11,131
13 90,009 12,414 1,613 10,801 18/465 10,545
14 88,396 12,414 1,806 10,608 17/465 9,959
15 86,590 12,414 2,023 10,391 16/465 9,374
16 84,567 12,414 2,266 10,148 15/465 8,788
17 82,301 12,414 2,538 9,876 14/465 8,202
18 79,763 12,414 2,842 9,572 13/465 7,616
19 76,921 12,414 3,183 9,231 12/465 7,030
20 73,738 12,414 3,565 8,849 11/465 6,444
21 70,173 12,414 3,993 8,421 10/465 5,859
22 66,180 12,414 4,472 7,942 9/465 5,272
23 61,708 12,414 5,009 7,405 8/465 4,687
24 56,699 12,414 5,610 6,804 7/465 4,101
25 51,089 12,414 6,283 6,131 6/465 3,515
26 44,806 12,414 7,037 5,377 5/465 2,930
27 37,769 12,414 7,882 4,532 4/465 2,343
28 29,887 12,414 8,828 3,586 3/465 1,757
29 21,059 12,414 9,887 2,527 2/465 1,172
30 11,172 12,414 11,172 1,242 1/465 586
--------- ------------ ----------- ----------
Totals $372,420 $100,000 $272,420 $272,420
-------------------------------------------------------------------------------
An agreement between a borrower and a lender with respect to any one year of a loan is not independent of the agreement with respect to any other year of the loan. In general, the substance of a loan agreement is that the same rate of interest applies to each taxable year of the loan, regardless of any contrary formulas that may be stated in the agreement.
The amount of interest attributed to the use of money for a period between payments is determined by applying the "effective rate of interest" on the loan to the "unpaid balance" of the loan for that period. The unpaid balance of a loan is the amount borrowed plus interest earned minus amounts paid. The effective rate of interest is a measure of the cost of credit, expressed as a yearly rate, that relates the amount and timing of values received to the amount of timing of payments made, and is thus a reflection of the cost of the amount borrowed for the time it is actually available. See Conf. Rep. No. 97- 760, 97th Cong., 2d Sess. 553 (1982), 1982-39 I.R.B. 4, 41; S. Rep. No. 97- 494 (Vol. 1), 97th Cong., 2d Sess. 209 (1982); Supplement I to Regulation Z issued by the Federal Reserve System, 12 CFR Sections 226.6 and 226.40 (1979). Therefore, the effective rate of interest, which is a uniform rate over the term of the loan and is based on the amount of the loan and the repayment schedule provided in the loan agreement, when applied to the unpaid balance of the indebtedness for a given period, will produce the true cost of that indebtedness for that period. That cost is referred to as the economic accrual of interest for that period. See sections 1232A and 163(e) of the Code, which contain rules regarding the computation of interest on a loan issued with original issue discount and apply the concept of economic accrual of interest, and the Senate Finance Committee Report to the Tax Equity and Fiscal Responsibility Act of 1982, section 213(a). S.Rep. No. 97-494 (Vol. 1), 97th Cong., 2d Sess. 209 (1982).
Generally, under the cash receipts and disbursements method of accounting, expenditures are to be deducted for the taxable year in which actually made. Section 1.446-1(c)(1)(i) of the regulations. Any interest paid on a loan in excess of the amount of interest that has economically accrued is not deductible in the year of payment. Rather, it must be accounted for as a deferred expense item and deducted in years subsequent to the year of payment. Section 461(g) of the Code; Rev. Rul. 68-643, 1968-2 C.B. 76.
Generally, under an accrual method of accounting, deductions are allowable for the taxable year in which all the events have occurred that establish the fact of the liability giving rise to such deduction, the amount thereof can be determined with reasonable accuracy and the expense relates to the current period. Section 1.461-1(a)(2) of the regulations; Rev. Rul. 79-410, 1979-2 C.B. 213; c.f., Rev. Rul. 74-607, 1974-2 C.B. 149. Accordingly, no deduction will be allowed to the extent that the debtor's liability or payment is for interest that does not economically accrue in the current year. To the extent that such interest pertains to a subsequent period, it must be allocated to that period. See also Section 446(b) of the Code; Rev. Rul. 68-643.
The Rule of 78's represents a purely mechanical formula for allocating interest among periods. Because interest is earned by application of the effective rate of interest over the term of the loan, any agreement that provides that interest is earned in another manner, such as under the Rule of 78's computation, lacks economic substance because it fails to reflect the true cost of borrowing. No tax effect will be given to the Rule of 78's provision. Accordingly, a taxpayer that uses the accrual method of accounting may deduct in each year the interest that economically accrues and may not deduct any additional interest attributable to the Rule of 78's computation.
See Rev. Proc. 83-40, page 22, this Bulletin, for an administrative exception to the application of the rules set forth herein for certain short-term consumer loans.
Prior Revenue Rulings
Rev. Rul. 72-100, 1972-1 C.B. 122, recognized the Rule of 78's method of computing interest on installment loans as an acceptable method for short-term installment loans (60 months or less). Rev. Rul. 74-607, 1974-2 C.B. 149, which clarified Rev. Rul. 72-100, erroneously viewed the Rule of 78's in the context of a short-term installment loan as a method of applying the effective rate of interest to the unpaid balance of the loan. Rev. Rul. 79-228, 1979-2 C.B. 200, reiterated the Service's acceptance of the Rule of 78's method, in the context of Rev. Rul. 72-100.
Rev. Rul. 74-395, 1974-2 C.B. 46, holds that a commitment fee for the Federal National Mortgage Association's assumption of a construction loan is deductible as interest. The ruling, citing Rev.Rul. 72-100, also states that if the loan instrument requires that prepaid interest is subject to the Rule of 78's, that method of determining the amount of annual deductions would be used.
Furthermore, Rev. Rul. 72-100 discussed a situation in which the loan agreement provided that the Rule of 78's would apply to the computation of interest if the loan were repaid before maturity. In such a situation, repayment before maturity is a condition to the application of the Rule of 78's. Such provision would not fix the liability for interest unless the loan were repaid before maturity. Note, however, the administrative exception for certain short-term consumer loans described in Rev. Proc. 83-40.
HOLDING
No deduction for interest will be allowed for any year in excess of the amount of the economic accrual of interest.
EFFECT ON OTHER REVENUE RULINGS
This ruling modifies and supersedes Rev. Rul. 72-100, in which the Service gave limited recognition to the Rule of 78's as an acceptable method of computing interest. Similarly, Rev. Rul. 72-562, 1972-2 C.B. 231, which clarified Rev. Rul. 72-100, is modified and superseded.
Rev. Rul. 74-395 is modified consistent with the above discussion to the extent it sanctions the use of the Rule of 78's for amortizing prepaid interest if the loan agreement so provides. The Rule of 78's is in no circumstances a proper method for amortizing prepaid interest that is paid in a lump sum. Rev. Rul. 74-607 is clarified consistent with the above discussion. The holding of Rev. Rul. 79-228 is reaffirmed but the underlying rationale is modified to remove any implication that the Rule of 78's is a proper method of computing and reporting interest.
Rev. Rul. 83-84, 1983-1 C.B. 97.