Proposed reduction of interest rate on corporate tax refunds.

As part of its package to finance the Uruguay Round agreement of the General Agreement on Tariffs and Trade (GATT), the Department of the Treasury has proposed a reduction in the interest rate paid on certain tax refunds. As approved by the Senate Committee on Finance (and presented by the Administration to the Committee on Ways and Means), the interest rate on corporate tax refunds in excess of $10,000 would be reduced by one-and-a-half percent--to the federal short-term rate plus one-half a percentage point.

For the reasons set forth below, Tax Executives Institute strongly opposes the proposal and urges the Ways and Means Committee to reject it. As you know, TEI is the principal association of corporate tax executives; our nearly 5,000 members represent the largest 2,500 corporations in North America.

Background

Under section 6621(a)(1) of the Internal Revenue Code, the interest rate on tax refunds (or overpayments) is the federal short-term rate (sometimes called "applicable federal rate" or "AFR") plus two percentage points. In contrast, pursuant to section 6621(a)(2), the interest rate on tax underpayments is the federal short-term rate plus three percentage points, except in respect of so-called large corporate underpayments, where the interest rate is the federal short-term rate plus five percentage points. The Treasury proposal would reduce the interest rate on tax refunds to the federal short-term rate plus one-half a percentage point, thereby introducing a two-and-a -half point differential between the affected tax refunds and tax underpayments--and a four-and-a-half percentage point differential where the underpayment amount exceeds $100,000 and the "hot interest" provisions of section 6621(c) come into play.

TEI has long opposed the interest rate differential as both unfair and perverse and has previously testified in favor of taxpayer rights legislation that would eliminate the difference between the refund rate and the underpayment rate. Rather than vindicating taxpayer rights, the Treasury proposal would exacerbate the differential--and the ensuing unfairness.

Discussion

The interest-rate differential was enacted in 1986 as a result of Congress's concern that the interest rate prescribed in the Internal Revenue Code may have caused taxpayers "either to delay paying taxes as long as possible to take advantage of an excessively low rate or to overpay to take advantage of an excessively high rate." In addition, Congress pointed out that financial institutions and other commercial entities do not ordinarily borrow and lend money at the same rate. See Staff of the Joint Committee on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 1279 (1987).

TEI believes the concept underlying the interest rate differential was seriously flawed when the provision was enacted and remains flawed today. The flaws will only be magnified if the Administration's unprincipled lowerinterest rate proposal is adopted.

When the interest rate was determined every two years (as it was before enactment of the Economic Recovery Tax Act of 1981), the spread between the section 6621 rate and the market rate may have become substantial and therefore arguably encouraged taxpayer "gaming." With the changes adopted in 1981 and 1982 (requiring frequent adjustments of the rate and the daily compounding of interest), however, the potential for any significant differential was eliminated. Moreover, the Tax Equity and Fiscal Responsibility Act of 1982 changed the time period when interest on refunds would commence running, thereby eliminating the limited ability of taxpayers to "overpay to take advantage of an excessively high rate."

Quite candidly, the notion that an interest rate differential is justified because "financial institutions" borrow and lend money at different rates is without merit. The government should never view itself (or strive to be viewed by taxpayers) as a lending institution. Serving as a bank is not, or should not be, part of the government's covenant with the people. Taxpayers have no freedom to negotiate interest rates and terms with the government, as they might with a commercial establishment.

What is more, since many tax adjustments in the corporate world result in deductions or other items simply "rolling over" from one year to another, thereby producing an underpayment in the first year and an overpayment in the subsequent year, the differential operates to penalize taxpayers. For example,

assume that a taxpayer underpays its tax liability for 1993 by $100 and overpays its liability for 1994 by the same amount because of its erroneous decision to deduct an item in the earlier, rather than the later, year. Assume further that the error was discovered in 1996. Finally, for illustration purposes, assume that (before factoring in the Treasury proposal) the interest rate on tax deficiencies during all periods is 8 percent, that the interest rate on tax overpayments is 7 percent, and that interest is not compounded. In this situation, the taxpayer would owe interest of $24 in respect of its 1993 underpayment ($8 in each of 1994, 1995, and 1996), and the taxpayer would be entitled to refund interest of $14 on its 1994 overpayment ($7 in each of 1995 and 1996). Thus, the IRS would receive net interest of $10, even though the underpayment existed for only one year (thus entitling the IRS to $8 of interest).

In other words, even assuming that the one-percent differential were justifiable, the IRS would realize an undeserved windfall of $2.(1) If the Treasury's proposal were adopted the government's windfall in this situation would more than double (to $5) because the refund rate would be slashed to 5.5 percent. Perhaps most important, TEI believes that the current interest rate differential--let alone the Administration's proposed exacerbation of it--undermines one of the basic goals of tax reform: restoring faith in the fairness of the tax system. Other provisions of the Code provide adequate safeguards against any taxpayer manipulation of interest rates, and consequently, the differential is unnecessary as well as unfair.

Conclusion

For the foregoing reasons, TEI urges the rejection of the proposal to reduce the tax refund rate.

(1)Section 6402 authorizes the IRS to "net" the interest amounts in such situations, thereby ameliorating the harsh effects of the interest-rate differential. The goal of netting would be to put the parties (the government and the taxpayer) in the same economic position they would have been in had the overpayment been immediately applied to pay (or pay down) the underpayment. Under a fair netting regime, the IRS in the example would be entitled to only $8 of interest--the $2 windfall would be eliminated. Notwithstanding the statutory provision and the mandates contained in the legislative histories of both the 1986 and 1990 Acts that the IRS develop "comprehensive crediting procedures," no such procedures have been developed. See H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-785 (1986) (Conference Report); H.R. Rep. No. 101-964, 101st Cong., 2d Sess. 1101 (1990) (Conference Report). The need for comprehensive crediting procedures will be even more pronounced should the Administration's proposal be adopted.