Interest netting encounters less than "global" enthusiasm from the IRS and Treasury.

With the July 22, 1998, enactment of the Internal Revenue Service Restructuring and Reform Act of 1998 (Public Law No. 105-206), interest netting finally became a reality. On March 16, 1999, the Internal Revenue Service released Rev. Proc. 99-19, 1999-13 I.R.B. 10, which provides guidance to taxpayers on how to request global interest netting for interest accruing in periods beginning prior to July 22, 1998. But what does this really mean to the taxpayer? More important, what actions must be taken prior to December 31, 1999, to ensure each taxpayer receives maximum benefit afforded by this legislation?

This article discusses the current status of interest netting with respect to IRS positions and issues that still need to be resolved. In addition, actions that should be taken prior to December 31, 1999, are discussed. It is anticipated that the IRS will issue a revenue procedure or announcement in the near future with respect to interest netting on years on which the tax will not be determinable prior to the expiration of the transition period. For a more complete discussion of the new legislation and the background leading to its enactment, see Kathy L. Everidge, Taxpayer Actions Required to Take Advantage of Long-Awaited Interest Netting Legislation, 50 Tax Executive 261 (1998).

The new law establishes a net interest rate of zero on equivalent amounts of overpayment and underpayment that exist for any tax and any period for interest accruing on or after October 1, 1998. In addition, the statute provides a special "transition" rule for overlapping periods of underpayment and overpayment with interest accruing before that date. In order to obtain benefit from this rule, the taxpayer must reasonably identify and establish such periods and request that the netting procedure be applied prior to December 31, 1999. There are still many issues remaining to be resolved with respect to interest--both for pre-enactment periods and post-enactment periods.

Rev. Proc. 99-19

Rev. Proc. 99-19 was issued on March 16, 1999, to provide guidance to taxpayers on how to request interest netting for interest accruing before October 1, 1998. In order to qualify for interest netting during the transition period, taxpayers must submit a Form 843, Claim for Refund and Request for Abatement, indicating the type of tax and type of return covered by the request, identifying the taxable periods of mutual indebtedness, and, if possible, providing a computation of the amount of interest to be credited, refunded, or abated.

Taxpayers filling out Form 843 should:

* Label the top of the Form 843 "Request for Net Interest Rate of Zero Under Rev. Proc. 99-19."

* Place a dollar amount on Line 2 (if available).

* Indicate the type of tax and type of return covered by the request on Line 3. More than one box on this line may be checked if more than one type of return is covered by the request. Types of taxes and returns on those taxes for which there is no box available should be written on that line.

* Identify the taxable period for which the taxpayer overpaid and underpaid its tax liability on Line 5. Separate Forms 843 for each taxable period covered by the request are not required. On Line 5, the taxpayer should also state when the tax was paid if the underpayment is no longer outstanding and state when the refund was received if the overpayment is no longer outstanding.

* Also on Line 5, the taxpayer must identify and establish the period(s) for which the overpayment and underpayment overlapped. Background materials such as copies of examination reports, notices, or prior interest computations should be provided. Line 5 should also contain a statement from the taxpayer that the periods of equivalent underpayment and overpayment have been used only once in a request to obtain a net interest rate of zero.

* Finally, on Line 5, the taxpayer should provide, if possible, a computation of the amount of interest to be credited, refunded, or abated to provide a net interest rate of zero for the periods of overlap. The IRS cautions that the amounts used in a computation are subject to verification by the IRS and may be subject to adjustment for purposes of computing the net interest rate of zero.

* File the form at the IRS Service Center where the taxpayer filed its most recent federal income tax return.

A Form 843 is not required if interest netting is requested in connection with a return or returns of the taxpayer currently under consideration by any office of the IRS. The taxpayer must instead furnish a letter or written statement to such office on or before December 31, 1999, that states the net interest rate of zero under section 6621(d) is requested, indicates the type of tax and types of returns that affect the interest computation for the taxable period under consideration, states when and for what time periods the refund or payment affecting the interest computations for the taxable period under consideration was made, and states that the equivalent amounts of overpayment or underpayment have not previously been applied in an interest netting computation.

Further guidance with respect to the handling of such notifications is not yet available. Prudent business judgment, however, suggests that the taxpayer obtain a signed and dated receipt from the applicable IRS office acknowledging the receipt of the letter or written statement. In addition to a separate letter or written statement, taxpayers entering into agreements such as partial agreements at the examination level, closing agreements on specific issues, etc., should consider including in such agreements a provision to provide for the most comprehensive netting possible for years covered by such agreements.

   Example: A partial agreement on a 1993-1994 cycle could be reached at the
   Examination level. The current agreement results in an insignificant
   adjustment, but the most likely final result will be a significant
   overassessment; however, until the years are finally resolved at Appeals
   (or beyond), no refund will be issued. The 1995-1996 examination cycle has
   not yet commenced. Because the taxpayer is not in the Coordinated
   Examination Program, later cycles may well not be examined. There could,
   however, be a later adjustment on the 1995, 1996, or 1997 years that the
   taxpayer wants to have netted against the refund from the 1993 and 1994
   years for interest computation purposes.

Language should be incorporated stating that the agreement is conditioned on the taxpayer being allowed to use the final tax overpayments (or underpayments) in a netting computation involving subsequent years. Such agreements should be as specific as possible given the facts available at the time such agreements are required.

IRS Processing

According to IRS sources, approximately 100 of their employees have been trained to date with respect to "net rate interest netting." The IRS has stated that it intends to restrict the personnel working the transition period interest netting (pre-enactment) claims to a small group, which will probably be located at the Ogden Service Center. To date, all pre-enactment claims for interest netting are being held in suspense. For interest accruing post-enactment, it is anticipated that interest netting claims will be worked by Restricted Interest Examiners nationwide. The IRS is considering establishing a group that will travel to various locations to review such claims for accuracy and consistency.

Limitations

Several rules contained in Rev. Proc. 99-19 limit the relief the new law provides to taxpayers during this transition period.

For taxpayers wishing to apply the transition rule and obtain a refund for interest accruing in periods beginning before July 22, 1998, Rev. Proc. 99-19 requires that the statute of limitations must have been open on July 22, 1998, for both the year of the overpayment and the year of the underpayment. The requirement prevents taxpayers from taking advantage of interest netting for interest accruing in such periods even though the statute of limitations on an underpayment or overpayment year was open, if the statute of limitations on the overlapping year was closed. IRS sources have stated that for interest accruing in periods beginning after July 22, 1998 (i.e., on or after October 1, 1998), only one of the years must be open.

The new guidance also exempts from interest netting --in periods both pre- and post-enactment--any underpayment or overpayment on which interest is not "allowable" or "payable." If a provision in the Code "excuses" the IRS from paying interest on an overpayment, that overpayment cannot be netted with an overlapping underpayment of another tax period for interest computation purposes. For example, under section 6611(e), the IRS is not required to pay interest on a refund if it is paid within 45 days of the filing of an original income tax return. Consequently, since interest is not technically allowable on the refund, netting would not be permitted should there be a coexisting underpayment on another tax year with accrued interest during the same time period.

   Example: Calendar year corporate taxpayer filed its 1997 income tax return
   timely on full extension on September 15, 1998, reflecting an overpayment
   of $1 million. Taxpayer receives its refund on October 15, 1998. Because
   the refund is made within 45 days of the filing of the return, Taxpayer
   receives the $1 million without interest. From March 15, 1998, to October
   15, 1998, the IRS had interest-free use of $1 million of Taxpayer's funds.
   Taxpayer subsequently files an amended return for its 1996 tax year
   reflecting an additional $1 million tax due. Taxpayer files this return on
   October 15, 1998, and pays the tax and related deficiency interest due.
   Taxpayer owes deficiency interest from March 15, 1997 to October 15, 1998,
   the date of payment. From March 15, 1998, to October 15, 1998, the IRS has
   interest-free use of the Taxpayer's 1997 $1 million overpayment. Taxpayer
   had use of the IRS's $1 million 1996 deficiency amount during that same
   time period; however, Taxpayer owes deficiency interest for such period and
   the IRS has interest-free use of Taxpayer's funds. This is a serious
   inequity.

The statute states that interest netting will apply to all types of tax and all years of the "same taxpayer." This term has not yet been defined. There are many examples where the "same taxpayer" should not just refer to the taxpayer with the same taxpayer identification number. With respect to affiliated entities, there are many examples of circumstances when interest netting should be allowed. With respect to a subsidiary included in a consolidated return, there are many types of taxes that must be paid at the subsidiary level. Under Treas. Reg. [sections] 1.1502-6, each subsidiary is jointly and severally liable for the consolidated income tax liability; for these taxpayers, there is no logical reason why netting would not be permitted between the consolidated income tax return and the subsidiary excise tax return to the extent there are overlapping overpaymerits and underpayments.

Another type of relationship that should qualify for interest netting involves a related supplier and a foreign sales corporation (FSC). The FSC is excluded from the consolidated return by operation of section 1504(b). There are many instances, however, when an IRS audit adjustment to the FSC results in a correlative dollar-for-dollar adjustment to the related supplier. The interest rate differential could result in the payment of significant sums if interest netting were not applicable. This would be true even though the same tax year for each entity is adjusted by tax overpayment and underpayment amounts which net to zero. Although the IRS may have difficulty identifying all such situations that should qualify for "same taxpayer" treatment, the taxpayer should be able to bring such matters to the attention of the IRS and be allowed the benefits of interest netting during periods of mutual indebtedness.

Expiration of Transition Period

The most difficult issue to be addressed at this time relates to how taxpayers are going to preserve their right to interest netting on years the tax will not be finally determined prior to December 31, 1999. In Rev. Proc. 99-19, the IRS recognized that the specificity of submissions for such years would be an issue. It specifically states:

   The Treasury Department and the Service recognize that by December 31,
   1999, some taxpayers may not be able to provide a final computation of how
   the net interest rate of zero applies to interest accruing before October
   1, 1998. For example, a taxpayer may not be able to provide this final
   computation by December 31, 1999, because the Service's examination of the
   taxable years involved has not been completed or commenced.

Comments were requested from the taxpaying public regarding this matter by May 14, 1999. Tax Executives Institute and many other commentators favor a very liberal interpretation of any required submission. [Editor's Note: TEI's comments are reproduced elsewhere in this issue.] Many large corporate taxpayers have years dating back to the 1980s (and some to the 1970s) with various issues at court levels or Appeals. Because of the complexities involved, many taxpayers will be unable to determine which years will finally result in overpayments or underpayments, much less establish period(s) for which the overpayments and underpayments overlap or provide computations. In many instances, numerous scenarios for each year might more accurately provide the results anticipated once all related issues are resolved. For this reason, the most generic form of notification, if any notification must be made, should be required to be filed with the IRS by December 31, 1999. It is not known at this time, however, when the IRS will issue additional guidance with respect to (a) the filings that must be made by December 31, 1999, to protect the taxpayer's ability to apply interest netting to all interest accruing before October 1, 1998, and (b) the manner interest netting will be requested for interest accruing on or after October 1, 1998.

Summary

Taxpayers should be encouraged by the progress made to date:

* Interest netting is the law of the land prospectively from the date of enactment.

* Relief was provided for interest accruing prior to date of enactment.

* All types of taxes may be considered in determining periods of overlapping underpayments and overpayments.

* For post-enactment claims, the IRS is taking the position that only the year on which the interest is being adjusted must be open under the applicable statute of limitations.

More work remains:

* The statute of limitations for pre-enactment periods should only have to be open on the year for which the interest adjustment is being requested.

* Interest netting should be applicable during any period in which there are overlapping overpayments and underpayments, irrespective of whether interest was accruing during such period on the overpayment or underpayment.

* The "same taxpayer" definition should be reasonably interpreted to include affiliated taxpayers.

The IRS should adopt a policy in favor of extending netting to all situations involving mutual indebtedness for years open on July 22, 1998, without the need of filing of protective claims or, if some type of request is required, the IRS should permit taxpayers to submit a simple statement to the IRS by December 31, 1999, requesting interest netting for pre-enactment periods. Administrative relief should further be considered for taxpayers who may miss this deadline because they are unaware at such date that interest netting may have any effect on such periods.

In order to be prepared for what may well be an eleventh-hour announcement, taxpayers should review their own situation now to be sure that they have all the facts necessary to make the right submissions prior to December 31, 1999. Transcripts of accounts should be reviewed, and all open years--and years with transactions still open in accordance with the applicable statute of limitations--should be reviewed. Claims should be filed to the extent possible. For years on which final tax determinations have not been made or will be changed by subsequent events, taxpayers should assemble all facts regarding such transactions pending the announcement by the IRS as to the level of detail that will be required to preserve the right to obtain interest netting. Once that announcement is made, the taxpayer will be able to make the appropriate submission in a timely fashion.

Because of the IRS's and Treasury's reluctance to fully embrace the fairness of interest rate equalization (i.e., interest netting) during periods of mutual indebtedness, legislation may still be the best way to finally resolve many of the open issues. In addition to monitoring the IRS actions with respect to the transition period, taxpayers should continue to work to ensure that interest netting is implemented in the manner it was intended--i.e., to the extent that there are overlapping underpayments and overpayments, the taxpayer is not required to pay a toll charge.

KATHY L. EVERIDGE is a partner at Ernst & Young LLP, and is the firm's National Director, IRS Accounts and Interest Services. She received her B.S. degree in accounting and her M.S. degree in taxation from the University of North Texas. Ms. Everidge is a member of the AICPA and the Texas Society of CPAs.3