Rev. Rul. 86-17

1986-1 C.B. 377, 1986-6 I.R.B. 286.

FORGONE INTEREST DETERMINATION

Published: February 10, 1986

Section 7872.-Treatment of Loans with Below-Market Interest Rates

(Also Section 1274.)

  Forgone interest determination. For purposes of section 7872(e)(2) of the Code, the applicable rate for purposes of determining 'foregone interest' on certain below-market loans outstanding from January 1, 1985 to December 31, 1985 is 9.24 percent.

  Section 7872(a)(1) of the Internal Revenue Code provides that in the case of certain below-market loans, an amount known as the foregone interest shall be treated as transferred from the lender to the borrower, and retransferred by the borrower to the lender as interest.

  In the case of a demand loan, section 7872(e)(1)(A) of the Code defines the term 'below-market loan' to mean any demand loan in which interest is payable on the loan at a rate less than the applicable federal rate.

  Section 7872(e)(2) of the Code defines the term 'foregone interest' to mean, with respect to any period during  a calendar year in which the loan is outstanding, the excess of (A) the amount of interest which would have been payable on the loan for the period if interest accrued on the loan at the applicable federal rate and was payable annually on the last day of such calendar year, over (B) any interest payable on the loan properly allocable to this period. For purposes of this revenue ruling the amount described in section 7872(e)(2)(A) is called the 'section 7872(e)(2)(A) amount.'

  Section 1274(d) of the Code, as amended by section 101(b)(1) of the 1985 imputed interest simplification act (the Act), Pub. L. No. 99-121, 1985-48 I.R.B. 11, provides that the applicable federal short-term, mid-term, and long- term rates shall be deter-mined each month.  The applicable federal rates are relevant under several Code provisions, including  sections 1274 and 483. These sections relate to certain transactions in which a debt instrument is issued in exchange for property and, when applicable, they generally provide the minimum interest rate that must be stated in the debt instrument in order to avoid having interest imputed for federal income tax purposes at a higher rate than the stated rate.

  Prior to the amendment of section 1274(d) by section 101(b)(1) of the Act, the applicable federal rates were determined semiannually, and monthly determinations were computed under the alternate method provided by section 1.1274-6T of the Temporary Income Tax Regulations.  The method prescribed by section 1274(d) as amended reflects this prior alternate method.  Each month the Internal Revenue Service publishes a revenue ruling containing the applicable federal rates, including a short-term applicable rate based on semiannual compounding.

  In the case of a below-market demand loan of a fixed principal amount that remains outstanding for the entire calendar year, the section 7872(e)(2)(A) amount equals the sum of:  (1) The product of one-half of the January short- term rate based on semiannual compounding times the principal amount of the loan; and (2) the product of one-half of the July short-term rate based on semiannual compounding times the sum of the principal amount of the loan and the amount described in (1) above.

  To allow easier computation of the section 7872(e)(2)(A) amount for loans described in the preceding paragraph, the Internal Revenue Service is publishing  in this revenue ruling a 'blended annual rate.'  For these loans, the section 7872(e)(2)(A) amount can be computed by multiplying the blended annual rate by the fixed principal amount that remained outstanding for the entire calendar year.

  To determine foregone interest on these loans from January 1 through December 31, 1985, the blended annual rate is 9.24 percent. This rate is derived from:

(1) The January 1985 short-term rate based on semiannual compounding (9.56 percent), as set forth in Rev. Rul. 85-21, 1985-1 C.B. 286; and (2) the July 1985 short-term rate based on semiannual compounding (8.51 percent), as set forth in Rev. Rul. 85-91, 1985-26 I.R.B. 4.

  Therefore, for the period January 1, 1985, through December 31, 1985, in the case of a below-market demand loan of a fixed principal amount that remains outstanding for the entire calendar year, foregone interest for purposes of section 7872 of the Code is equal to the excess of 9.24 percent of the outstanding principal over any interest payable on the loan properly allocable to 1985.

  In the future the blended annual rate will be published annually with the applicable federal short-term, mid-term and long-term rates for the month of July.

Rev. Rul. 86-17, 1986-1 C.B. 377, 1986-6 I.R.B. 286.