Taxpayer actions required to take advantage of long-awaited interest netting legislation.
Under prior law, if a taxpayer had an underpayment of tax from one year and an overpayment of tax from a different year that were outstanding at the same time, the IRS typically "offset" the overpayment against the underpayment and applied the appropriate rate of interest to the resulting net underpayment or overpayment. If either the underpayment or overpayment had been satisfied, however, the IRS would not typically offset the two amounts, but rather would assess or credit interest on the full underpayment or overpayment at the statutorily mandated underpayment or overpayment rate. This had the effect of assessing the underpayment at the higher underpayment rate and crediting the overpayment at the lower overpayment rate. This resulted in a net interest charge to the taxpayer, even if the amounts of the overpayment and underpayment were the same.
Example: The Government owes a corporate taxpayer
$10 million for 1995 and the taxpayer owes
the Government $10,000,000 for 1996. As of March
15, 1997, when the 1996 tax liability became due,
there is a mutual indebtedness between the Government
and the taxpayer until such amounts are
refunded or paid, respectively. If the debts are not
offset or netted, however, the taxpayer could pay
a whopping 4-1/2 percent differential ($450,000 a
year) on the interest it pays on the $10 million it
owes for 1996 as compared with the interest it
receives on the $10 million the Government owes
the taxpayer for 1995 even though there is no true
net debt (as of March 15, 1997) owed to the Government.(2)
Congress previously directed the IRS to implement the most comprehensive netting procedures that are consistent with sound administrative practice. The Taxpayer Bill of Rights 2(3) required the Treasury Department to submit a report to the congressional tax-writing committees on: (1) the legal and policy issues relating to the netting of interest of federal overpayments and underpayments; and (2) the administrative practices of IRS in that regard. On April 18, 1997, the Treasury study was released. The study concluded that "global" interest netting would be consistent with the intent expressed by Congress. The study added, however, that additional legislation was necessary to achieve this policy goal. It continued that because of administrative difficulties associated with global net ting, such netting should be authorized only if certain limitations were imposed. The following restrictions were recommended:
(1) Global interest netting should be implemented legislatively through an interest equalization approach rather than a credit/offsetting approach. This approach would not involve the offsetting of credits between years; rather, the interest rate would be adjusted to the extent taxpayers and IRS have overlapping periods of indebtedness. In effect, if the taxpayer is charged one rate on a $1 million deficiency for a two-year period, the taxpayer would receive the same rate on a $1 million overpayment to the extent that the $1 million deficiency and overpayment exist during the same time period (i.e., there is a period of mutual indebtedness.) The study further stated that at least one of the tax years involved must be a non-zero balance tax year.
(2) Global interest netting should be limited to income taxes only. The study stated that allowing global netting across different kinds of taxes would be difficult to administer and require significant additional resources. The necessity of locating and analyzing additional data for inclusion of these additional types of taxes in the calculations would increase the complexity of the netting regime.
(3) Global interest netting should apply only to tax years that are not barred by statute. The study stated that since principal amounts of underpaid or overpaid taxes in barred years are not considered in adjusting taxpayers' other tax year accounts, it does not make sense to consider the interest that was charged or paid with respect to those underpayments or overpayments. The administrative difficulties of including barred years in the computations were also cited. The study further stated that limitations on IRS computer systems, particularly relating to barred years, would increase the difficulty of interest netting computations if the barred years were considered. The availability of prior IRS interest computations was also cited as problematic.
(4) Global netting should only be performed at a taxpayer's request and the taxpayer should bear the burden of computing the interest netting amounts and providing the supporting documentation.
(5) Global netting generally should be performed only once. In effect, once a tax year is included in a global netting computation, the netted interest amount would be reflected and would generally not be subject to future adjustment. Additional adjustments could be made in certain circumstances provided the taxpayer was able to provide explicit documentation supporting the additional amount.
Because the legislative history of the new law is scant, the Treasury study, as well as the comments that were filed with the Treasury concerning the study, provides guidance on how the IRS will address issued raised by the new legislation.(4)
The New Law
As recommended by the Treasury Department, 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.(5) Hence, Treasury's recommendations that interest netting apply only to income taxes and only to situations in which there is at least one "non-zero" balance tax year were not adopted.
Example: Assume that following an examination
of its 1998 return, a corporate taxpayer is determined
to have overpaid its 1998 taxes by $5,000.
Previously, the taxpayer established by an amended
return that it had underpaid its 1999 taxes by
$7,000. The taxpayer has paid the 1999 underpayment,
plus interest determined at the underpayment
rate. The statute of limitations has not
run with respect to either 1998 or 1999. In determining
the amount of the refund owed the taxpayer
with regard to the 1998 overpayment, the
period for which the 1999 underpayment was outstanding
must be taken into account. For all periods
in which the underpayment and overpayment
run concurrently (i.e., from the due date of the
1999 return until the underpayment
was paid), the interest rate on the
$5,000 overpayment and $5,000 of the
underpayment must be the same so
that the net interest rate of zero applies.
The interest rate on the remaining
$2,000 of the underpayment that
was originally calculated at the short
term federal rate plus three percent
would not be affected.(6)
The provision generally applies to interest for periods beginning after the date of enactment. Until such time as procedures are implemented that allow for the automatic application of this provision by the IRS, Congress instructed the Treasury to promptly and carefully consider any taxpayer's request to have interest charges recalculated in accordance with this provision. It is expected that the Secretary will extend the statute of limitations where necessary to allow for the consideration of such requests.? Until such time as IRS establishes a methodology for automatically identifying periods of mutual indebtedness, it is up to the taxpayer to ensure that the appropriate periods to be used in the computations are identified.
For overlapping periods of underpayment and overpayment with interest accruing prior to date of enactment, there is a special "transition" rule that applies for periods beginning before the date of enactment if the taxpayer reasonably "identifies and establishes" such periods and if the taxpayer requests that the section be applied to such periods. Such requests must be made not later than December 31, 1999.
No specific references to statutes of limitation are made within the new statute itself. As a result, the applicable statutes of limitation should control. Deficiency interest(8) refunds are controlled by the general statutes of limitation for claims for refund under section 6511 of the Internal Revenue Code.(9) Requests for additional amounts of allowable interest(10) are controlled by the provisions of 28 U.S.C. [subsections] 2401 and 2501. In other words, the taxpayer has six years from the date of allowance of a refund to file suit for the correct amount of interest thereon.(11)
While the legislative history is silent on how the IRS will implement netting, various action steps would be prudent.
Open Years with Completed Transactions
* Identify all periods during which there is a mutuality of indebtedness.
* Determine if there is an open statute of limitation for filing a claim for overcharged deficiency interest or underpaid allowable interest.
* File all claims by December 31, 1999, irrespective of any other statutes of limitation normally associated with the years at issue.
Open Years with Pending Transactions
* For all years with pending IRS transactions; i.e., refunds or deficiency assessments, determine if there are periods of mutual indebtedness during the years involved in the transactions themselves and other years or periods.
* Determine the appropriate interest computations assuming netting principles are applicable. In order to ensure that such procedures are applied for periods prior to the date of enactment of the new legislation, such periods must be identified and the IRS notified that the taxpayer requests such treatment prior to December 31, 1999. (This action may result in the payment of certain deficiencies prior to the actual determination of the final liability in certain instances.)
Example: A corporate taxpayer receives a refund on its 1987 tax year based on a court decision on June 30, 1999. The tax refund consists of a tax overpayment of $1 million as of March 15, 1988, the original due date of the 1987 tax return, plus allowable interest from March 15, 1988, to June 30, 1999, the date of the refund. On July 31, 1999, the taxpayer reaches agreement on a $1 million deficiency on the 1989 tax year and tenders payment of the tax and appropriate deficiency interest that day. Generally, deficiency interest is due on the deficiency from the original due date of the 1989 return, March 15, 1990, to the date of payment, July 31, 1999.
In determining the appropriate deficiency interest due on the 1989 deficiency of $1 million the taxpayer requests that IRS apply the netting procedures to the period of mutual indebtedness. The period of mutual indebtedness is from March 15, 1990, the date the liability for the $1 million deficiency on the 1989 tax year first arises, to June 30, 1999, the date the overpayment of $1,000,000 for the 1987 tax year is refunded to the taxpayer. Because the refund on the 1987 tax year was made at the allowable interest rate, deficiency interest on the 1989 tax year will be charged at the allowable interest rate for the period of mutual indebtedness. From March 15, 1990, to June 30, 1999, the deficiency interest on the 1989 tax year will be computed at the allowable interest rate. From June 30, 1999, to July 31, 1999, the date of payment on the 1989 tax year, deficiency interest will be computed at the applicable deficiency interest rate.
The rate of interest to be charged or paid will depend on the rate of interest previously paid or charged. If allowable interest on the refund was computed at the lower rate in accordance with section 6621(a)(1), that lower rate would be charged on the deficiency for the period of mutual indebtedness. If the payment of a deficiency was the first action and a refund was later computed taking into account the previously paid deficiency interest during a period of mutual indebtedness, allowable interest on a refund would be paid at the rate originally paid by the taxpayer, including the "hot interest" rate applicable under section 6621(c).
The window of opportunity for the taxpayer to request the netting procedure for periods before the date of enactment may prompt taxpayers to make payments prior to the final determination of tax on certain years. In the example above, if the taxpayer did not reach agreement on the 1989 tax year and hence took no action before December 31, 1999, the taxpayer would owe deficiency interest on the $1 million from March 15, 1990, to the date of enactment of the netting provisions at the appropriate deficiency interest rate. During the period from March 15, 1990, to date of enactment, the rate differential could be as high as 4-1/2 percent. If the taxpayer believes that there is any likelihood that the $1 million deficiency will eventually be assessed, it may be in its best interest to make an advance payment of such amount using the netting procedure prior to December 31, 1999. If a final determination results in no tax deficiency, the payment will be refunded. These are the types of situations which must be closely analyzed to determine the best course of action for the taxpayer. (The decision to make advance payments includes factors outside the realm of this discussion; e.g., choice of forum, etc.)
In the absence of guidance on how the statute of limitations applies with respect to this legislation, taxpayers should act as soon as possible to avoid losing the ability to include certain periods in netting computations. In addition, the taxpayer bears the burden -- at least for the time being -- of properly computing the interest and submitting such computations, with supporting documentation, to IRS.
Based on informal discussions with a group of IRS technicians, an approach similar to the following may be implemented by IRS:
1. The taxpayer identifies the accounts and tax periods to be considered in the interest netting computations. (Please note that interest computations should be corrected on each single tax period prior to applying netting procedures.)
2. The taxpayer prepares the interest netting computations primarily using information obtained from IRS documents, such as transcripts, Revenue Agent Reports, Appeals documents, court documents, and Forms 2285.
3. The interest computations are made on commercially available software that is frequently used by IRS personnel in making their own computations.
4. The taxpayer presents the computations, with supporting documentation, to the IRS and requests global interest netting.
5. IRS interest computation specialists reviews the computations, including the proper interest start and amounts are confirmed, the interest computation specialists will run the interest computation on their own software for confirmation.
6. Discrepancies will then be discussed and resolved with the taxpayer.
In previous discussions with the IRS, there have been indications that certain senior interest technicians would be designated to work the interest netting computations. No announcement has been made by IRS with respect to this issue.
Among other issues awaiting resolution by the IRS is the question of how interest-free periods and interest suspensions should be factored into global netting calculations. Complications will be created if special rules regarding interest-free periods or interest suspensions are factored into the netting computation.
Example: If the IRS fails to issue a notice and
demand for the payment of a deficiency within 30
days after the filing of a waiver of restrictions on
assessment (e.g., Form 870) interest is suspended
by section 6601(c) on the underpayment until the
notice and demand is issued. Under global interest
netting, to the extent there is mutual indebtedness,
the taxpayer should not receive refund
interest on an overpayment while interest is suspended
on the deficiency. Conversely, the IRS
should not be allowed to use the 45-day interest-free
period in section 6611(e) to collect interest on
an underpayment while for the same periods not
allow interest on an equivalent amount of overpayment.
In essence, to the extent there is mutual
indebtedness, neither the taxpayer nor the Government
should be disadvantaged by the use of
these special interest-free periods and interest
suspensions. Generally, these rules were designed
for administrative convenience and should not limit
the application of global interest netting. Neither
the statute nor the legislative history, however,
specifically addresses the issue.
In the absence of statutory language or legislative history on such complicated issues, the 1997 Treasury study and related comment letters are instructive. In these documents, the period of mutual indebtedness was the focal issue -- not the specific rate of interest, including a "zero" rate for certain "interest free" or "interest suspension" periods.
Through the persistence of taxpayers and Congress, interest netting has become a reality. There are many practical issues to be resolved regarding its implementation, particularly with respect to interest accruing prior to date of enactment. Strategic interest planning is more critical than ever to ensure that each taxpayer pays net interest to the Government only during periods when there is a true liability. In recent months, courts have repeatedly ruled in favor of the taxpayer with respect to the overriding principle that interest should be paid only for the time period during which one party has use of the other party's funds.(11) Interest netting is reflective of this overriding principle.
Over the next few months, the IRS will respond to requests for application of the interest netting rules. Various groups will continue to monitor this activity to ensure the implementation accomplishes the goals intended by the legislation -- that the interest rate during periods of mutual indebtedness is zero. Taxpayers must be diligent in reviewing all accounts to determine whether there are overlapping time periods of overpayments and underpayments for periods prior to the date of enactment. Statutes of limitation must be considered. Any actions involving pre-enactment periods must be taken prior to December 31, 1999.
Interest netting will require some additional computations and analysis, particularly on the part of the taxpayer. The result, however, should be a reduction of the overall interest rate paid by many taxpayers on deficiencies. This rate reduction translates into an increase in the taxpayer's bottom line.
(1) IRS Restructuring and Reform Act of 1998, H.R. 2676, 105th Cong., 2nd Sess (1998).
(2) For examples further describing offsetting and netting and demonstrating the inequities caused by the IRS's failure to implement global netting, see K. Everidge, Treasury's Global Interest Netting Study Recommends Unnecessary Limitations That Would Perpetuate Inequities for Taxpayers, 49 Tax Executive 215 (1997).
(3) Public Law No. 104-168, 110 Stat. 1453 (July 30, 1996).
(4) For a full discussion of the Treasury study, see K. Everidge, supra note 2, at 219.)
(5) The new law adds a new section 6621(d) to the Internal Revenue Code, which provides, as follows: "(d) ELIMINATION OF INTEREST ON OVERLAPPING PERIODS OF TAX OVERPAYMENTS AND UNDERPAYMENTS.--To the extent that for any period, interest is payable under subchapter A and allowable under subchapter B on equivalent underpayments and overpayments by the same taxpayer of tax imposed by this title, the net rate of interest under this section on such amounts shall be zero for such period." In addition, the law amends section 6601(f) (relating to satisfaction by credits) to provide that it does not apply to the extent that section 6621(d) applies." Finally, the legislation contains the following language captioned "EFFECTIVE DATES":
(1) IN GENERAL-Except as provided under paragraph (2), the amendments made by this section shall apply to interest for periods beginning after the date of the enactment of this Act.
(2) SPECIAL RULE-The amendments made by this section shall apply to interest for periods beginning before the date of the enactment of this Act if the taxpayer
() reasonably identifies and establishes periods of such tax overpayments and underpayments for which the zero rate applies, and
() not later than December 31, 1999, requests the Secretary of the Treasury to apply section 6621(d) of the Internal Revenue Code of 1986, as added by subsection (a), to such periods.
(6) H.R. Rep. No. 105-364, 10th Cong., 2d Sess. 64 (1998).
(7) H.R. Rep. No. 105-364, supra note 6, at 64.
(8) I.R.C. [sections] 6601.
(9) Section 6601(e)(1) states: "Interest prescribed under this section on any tax shall be paid upon notice and demand, and shall be assessed, collected, and paid in the same manner as taxes.... "See Proudfoot Co. v. United States, 72-1 U.S.T.C. [paragraph] 9256 (Ct. Cl. 1972) (interest is to be treated as part of the tax for refund purposes and comes within the rule that the claim for credit or refund must be filed within three years from the time the return was filed or within two years from the time the tax was paid).
(10) I.R.C. [sections] 6611.
(11) Rev. Rul. 56-506, 1956-2 C.B. 959; Barnes v. United States, 56-1 U.S.T.C. [paragraph] 9241 (Ct. Cl. 1956).
(12) Sequa Corp. v. United States, 95 Civ. 2086 (KMW) (June 10, 1998); The May Department Stores Co. v. United States, 36 Fed. Cl. 680 (1996)
(*) Notes appear on page 265.
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 M.S. degree in taxation from the University of North Texas. Ms. Everidge is a member of the AICPA and Texas Society of CPAs.
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|Author:||Everidge, Kathryn L.|
|Date:||Jul 1, 1998|
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