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Interest capitalization under section 263A(f): possible use of mandated interest rate.

On April 3, 1992, Tax Executives Institute submitted the following comments to the Department of the treasury on the mandatory use of a surrogate interest rate in lieu of a taxpayer's specific interest rate for purposes of section 263A(f). The comments, which were prepared under the aegis of its Federal Tax Committee whose chair is David F. Nitschke of the Amerada Hess Corporation, were prepared in response to a request from the Treasury Department and supplemented the comments TEI submitted in December 1991 on the uniform capitalization of interest. (Those earlier comments were reprinted in the January-February 1992 issue of The Tax Executive.)

Thank you for soliciting the views of the Tax Executives Institute concerning the determination of the appropriate interest rate under section 263A(f) of the Code. As we understand it, the Treasury Department and the Internal Revenue Service are considering a proposal to provide a uniform interest rate that would be used in the calculation of the amount of interest expense to be capitalized on property produced by taxpayers. The possibility of mandating the use by all taxpayers of a single, uniform interest rate - in lieu of prescribing rules for self determination of a taxpayer's specific cost of indebtedness - was first broached at the public hearing on the proposed regulations under section 263A(f).


As the principal association of corporate tax executives, TEI'S nearly 4,800 members are employed by 2,000 of the leading companies in North America and represent a cross-section of the business community. TEI is dedicated to the development and implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of tax administration and compliance. Above all, the Institute is committed to maintaining a tax system that works. Our members are charged with the responsibility of implementing the rules affecting their companies' tax liabilities and provide a balanced and important perspective on the issue of the determination of the appropriate interest rate to use for purposes of section 263A(f).


a. Proposal. TEI applauds the Treasury for recognizing the complexity of the avoided cost interest calculation set forth in Prop. Reg. [section] 1.263A(f)-2 and for soliciting taxpayer's views on simplifying certain aspects of those calculations. In particular, we understand that the Treasury is considering substituting a uniform rate, such as the applicable federal rate (AFR) (or, perhaps, AFR plus "one or two"), in lieu of taxpayer's individual determinations of their specific weighted average interest rate under Prop. Reg [section] 1.263A(f)-2(c)(5)(iii). To calculate the amount of interest capitalized, the mandated interest rate would be applied to the accumulated production expenditures in excess of the amount of indebtedness traced to the production expenditures.(1) The interest amount determined would then be added to the interest expense attributable to indebtedness traced to the accumulated production expenditures. To the extent a taxpayer elected not to trace debt, the mandated, uniform interest would presumably apply to all accumulated production expenditures.

b. Mandatory Substitution. Mandating the use of the long-term AFR - especially with a "plus" factor of 100 to 200 basis points - as a surrogate for a taxpayer's weighted average interest rate causes considerable concern to TEI. Our concerns stem from: (1) the mandatory substitution of an external interest rate in lieu of the taxpayer's specific cost of funds and (2) the likely exacerbation of the propensity of the proposed regulations to overcapitalize interest.

TEI believes that if the government were to propose a single, uniform interest rate for purposes of the section 263A(f) calculations, the use of that rate must be elective, just as the proposed regulations allow an election not to trace indebtedness for purposes of making the calculations. To avoid whipsaws against the government when a taxpayer's internal cost of funds falls below the selected AFR, the election should be deemed an accounting method requiring consent of the Commissioner to change. An informal survey of a number of members indicated support for a proposal for an elective as opposed to a mandatory substitution of AFR for the taxpayer's own weighted average interest rate.

c. Economic Effects. Clearly, support for this proposal is dependent upon the benefit of administrative ease exceeding the cost of potential excess capitalization of interest. The TEI members who expressed preliminary support for some simplification of the rate strongly opposed any "plus" factor being added to the long-term AFR. Nearly all members who responded indicated that - despite the questionable policy decision to exclude noninterest bearing liabilities from the denominator of the interest rate determination and the corresponding increase in the rate of interest capitalization - their weighted average rates approached, but did not exceed, the long-term AFR.(2) Indeed, one very large multinational corporation indicated that it could support a long-term AFR surrogate rate, even though such a rate would impose a temporary penalty, but that member's support evaporated at the suggestion of "AFR plus."

The proposed regulations are already biased in favor of overcapitalization of interest through the interaction of a project's start and stop dates with the computation and measurement periods of Prop. Reg. [section] 1.263A(f)-2. Another source of the proposed regulations' bias is the excessive period required to establish the suspension of a project to cease capitalization of interest to that project. When these sources of excessive capitalization are combined with a potentially adversely high surrogate rate ae such as long-term AFR Ee support for a mandatory surrogate rate dwindles substantially. TEI, thus, cannot support such a proposal.

d. Alternative Simplification. TEI believes that, rather than propounding a substitute interest rate, Treasury should consider our previous recommendation that taxpayers who are required to calculate an internal interest rate in accordance with U.S. generally accepted accounting principles under Financial Accounting Statement No. 34 be permitted to elect to use that interest rate.(3) Indeed, the propriety of the suggestion has been confirmed by anecdotal reports of members that have recalculated the effect of excluding noninterest bearing indebtedness from the denominator of their prior year interest calculations under Notice 88-99: the recalculated rates approximate the taxpayer's rates under FAS No. 34.

Finally, a number of members commented that there are other areas of the proposed regulations that are more deserving of simplification. For example, the de minimis thresholds are too low to provide meaningful relief. TEI believes the thresholds can be raised substantially to reduce the scope of the number of projects for which calculations need be made without substantially diminishing revenue to the fisc.


The Institute is pleased to have the opportunity to submit these supplemental comments of our views on the proposed simplification of the weighted average interest rate through a mandated application of a uniform applicable federal rate. These comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David F. Nitschke. If you should have any questions concerning these comments, please do not hesitate to call either Mr. Nitschke at (908) 750-6782, or Jeffery P Rasmussen of the Institute's professional staff at (202) 638-5601.

(1) The interest rate applied to accumulated production expenditures funded by "traced indebtedness" would, however, remain the specific rate applicable to such indebtedness. (2) The reasons that member's weighted average interest rates are less than the long-term AFR are at least twofold: many of TEI'S members are among the beat credit risks and thus enjoy the economic advantage of lower costs of funds; and, more important, the mix of interest-bearing debt is carefully managed by corporate treasury staffs to minimize the average rate. In other words, the weighted average interest rate on the mix of short-, intermediate-, and long-term indebtedness of many members is generally below the long-term AFR that has been suggested as the surrogate rate. (3) Our proposal assumes that all of a taxpayer's indebtedness (excluding lease obligations) that bears explicit or OID interest will be included as either "traced" or "other" indebtedness in the capitalization calculation.
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Publication:Tax Executive
Date:May 1, 1992
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