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Treasury's global interest netting study recommends unnecessary limitations that would perpetuate inequities for taxpayers.

The Taxpayer Bill of Rights 2 required the Department of the Treasury 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 the Internal Revenue Service in that regard. On April 18, 1997, the long-awaited netting study was released.

The Treasury study concludes that "global" interest netting would be consistent with the intent expressed by Congress in the past. The study adds, however, that additional legislation would be necessary to achieve this policy goal and, because of administrative difficulties associated with global netting, such netting should be authorized only if certain limitations are adopted. This article describes the problems caused by the lack of global interest netting, the conclusions and recommendations of the Treasury study, and the outlook for change. It explains why limitations on a solution to the interest netting problem suggested by Treasury are not warranted, and would perpetuate inequities currently being experienced by many large corporate taxpayers.

Problems Caused by the Lack of

Global Interest Netting

Since 1986, taxpayers -- particularly corporate taxpayers -- have been charged interest rates on underpayments that are higher than the rates the same taxpayers receive on overpayments. The rate differential has grown from 1 to 4-1/2 percent. For example, if the Government owes a corporate taxpayer $100 for 1985 and the taxpayer owes the Government $100 for 1986, then as of March 15, 1987, when the 1986 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 on the interest it pays on the $100 it owes for 1986 as compared with the interest it receives on the $100 the Government owes the taxpayer for 1985 even though there is no true net debt (as of March 15, 1987) owed to the Government. Beginning with the enactment of the interest rate differential and continuing with each rate adjustment that has expanded the differential, Congress has repeatedly instructed the IRS to implement the most comprehensive interest netting procedures that are consistent with sound administrative practice.

The following definitions of terms may help clarify the differences between the IRS's current practices and the "global" interest netting that is necessary to prevent inequities caused by the interest rate differential:

Offsetting is a collection mechanism statutorily prescribed in section 6402 of the Internal Revenue Code that allows the IRS to apply any overpayment of the taxpayer to an outstanding liability of the taxpayer for any type of tax or any tax period prior to refunding any balance to the taxpayer.

Netting is the concept of equalizing interest rates between overpayments and underpayments during any time period when there is a mutuality of indebtedness, i.e., when there is no true debt.

If a taxpayer has a group of years with both overpayments and underpayments simultaneously processed by the IRS, the IRS will generally "offset" the overpayments and underpayments. The IRS has implemented "netting," however, only in cases where the taxpayer temporarily has underpayments and overpayments with respect to a single tax year -- a procedure referred to as "annual netting." See Rev. Proc. 94-60, 1994-2 C.B. 774. If overpayments and underpayments on multiple years are not processed together or if advance payments are made, interest will be paid to the taxpayer at the lower rate while the same taxpayer pays deficiency interest at the higher rate. This is because the IRS does not net interest if an overpayment or underpayment was previously in existence but has been satisfied as of the time the netting computation is performed (i.e., the deficiency has already been fully paid by the taxpayer and/or the overpayment has already been fully refunded by the Government, so that one of the taxpayer's tax accounts has a balance of zero). This broader form of interest netting is referred to by the IRS as "global netting."

The following examples will further describe offsetting and netting and demonstrate the inequities caused by the IRS's failure to implement global netting. Each example assumes a six-percent simple overpayment rate and a seven-percent simple underpayment rate. The demonstrated economic detriments would increase dramatically due to compounding, "hot interest" (an additional two percent imposed in respect of many corporate liabilities), and the reduced overpayment rate (a reduction of one-and-a-half percent for many corporate overpayments). When multiple years are closed out together and there are both overpayment and underpayment years, the IRS will generally offset the overpayment years against the underpayment years and issue a bill or refund for only the net amount. (If a refund year will be sent to the Joint Committee on Taxation staff for review, it is possible that the IRS will assess and try to collect the assessment prior to the allowance of the refund.)

Example 1: Simultaneous

Closing of Multiple Years

Assume the 1985 and 1986 tax years are closed out simultaneously at the Examination level. The 1985 year results in an overpayment of $100 and 1986 results in an underpayment of $100. In the normal course of business, the IRS will offset the overpayment of $100 for 1985 against the underpayment of $100 for 1986, as of the original due date of such amount. The taxpayer will receive a refund of the allowable interest accrued from March 15, 1986, on the $100 applied to the 1986 liability on March 15, 1987. Assuming the refund is made on March 15, 1995, the taxpayer will receive $6 ($100 x 6% x 1) plus $3 ($6 x 6% x 8) for a total of $9 ($6 + $3). (The taxpayer should include a statement on the Form 870 or 870-AD saying that the agreement is based on such application of overpayments/ underpayments.)

If there is not an assessed liability on the taxpayer's account at the point in time an overpayment is allowed (a transaction internal to the IRS), a refund will be made to the taxpayer and the liability will be assessed separately. Once the refund is made, the taxpayer will not have an opportunity to have it reapplied to the liability to avoid the possible economic detriment due to the interest rate differential.

Example 2: Normal Billing/Refunding

Procedures When Years Are Not

Closed Out Simultaneously

Assume a refund claim for the 1986 year results in an overpayment of $100 that is refunded on March 15, 1995. Allowable interest is paid from March 15, 1987, to March 15, 1995. The taxpayer will receive allowable interest of $48 (6% x 8 years). The taxpayer is assessed a deficiency of $100 on the 1987 year. The deficiency is not assessed until March 16, 1995, the day after the refund on 1986 is made. The IRS assessed deficiency interest of $49 ($100 x 7% x 7 years) for the period from March 15, 1988, to March 16, 1995. Note that the taxpayer owed the IRS $100 and the IRS owed the taxpayer $100 for the period from March 15, 1988, through March 15, 1995; nevertheless, the taxpayer paid $49 to the IRS for that period and the IRS paid the taxpayer $42 ($100 x 6% x 7), a $7 ($49 - $42) economic detriment to the taxpayer. This detriment is based solely on the one-percent rate differential.

Many times taxpayers make advance payments on accounts prior to the final resolution of all issues. If another account becomes overpaid at a date prior to the date of the advance payment, the taxpayer is not allowed to pay the liability using the funds available at the earlier date. This results in the taxpayer paying more deficiency interest than would have been due if the advance payment had not been made.

Example 3: Inequities Caused by the IRS's

Failure to Allow "Netting" When Years Are

Simultaneously Closed

Assume the taxpayer has 1985 and 1986 under examination. The taxpayer anticipates a deficiency on 1986 of $200. No change is anticipated on 1985. The taxpayer makes a payment of $200 on March 15, 1994, plus accrued deficiency interest, from March 15, 1987, to March 15, 1994, of $98 ($200 x 7% x 7 years). The examination is completed and there is a $200 overpayment on 1985 and a $200 underpayment on 1986. The $200 on 1985 will be refunded with allowable interest, from March 15, 1986, to the date of the refund, of $108 ($200 x 6% x 9 years). The taxpayer has received net interest of $10 ($108 - $98). If the advance payment had not been made, the IRS would first have applied the $200 refund from 1985 to 1986. Allowable interest from March 15, 1986, to March 15, 1995 would have been computed as follows: $12 ($200 x 6% x 1 year) plus $6 ($12 x 6% x 8 years) equals $18 ($12 + $6). The taxpayer receives $8 ($18 - $10) less because of the advance payment due to the one-percent rate differential charged by the IRS from March 15, 1987, to March 15, 1994.

In Northern States Power Co. v. United States, 73 F. 3d 764 ([8.sup.th] Cir.), cert. denied, 117 S. Ct. 168 (1996), the interest rate differential between underpayments and overpayments cost the taxpayer almost $500,000. In that case, the only case litigated to date on this specific issue, the taxpayer was at all times a creditor of the Government. In a case involving several years, the taxpayer had made payment on certain years in order to take the issue to the same court. At the end of the protracted litigation process, the taxpayer was owed a refund -- in fact, in analyzing the five years at issue, the taxpayer had overpaid the tax and owed less than originally reported on the returns at issue -- when the facts were considered in the aggregate. In other words, the taxpayer was, since the filing of the initial return for the group of years, at all times a creditor of the Government. The absence of netting, however, cost Northern States half a million dollars.

The Treasury Study

The Treasury study states that interest netting was "urged" by Congress. The study further states that the IRS does not have the requisite legal authority to implement interest netting -- and recommends legislation to provide for a prospective implementation of limited application. Under the proposed legislation recommended in the study, interest netting would be limited to income tax years only, available only if all years considered are "open," available only upon taxpayer request, and performed only once with respect to the account for any tax year.

Legal Issues

One of the basic concepts that Congress and the courts have repeatedly endorsed is that each taxpayer's income tax liability for a single tax year is a separate and distinct liability. In addition to the distinct liability of tax, the study further states that interest on the overpayment of tax to a taxpayer and interest on an underpayment of tax due to the Government are separate and distinct items as well. Specifically, section 6601 of the Code provides for interest on underpayments and section 6611 provides for interest on overpayments.

Prior to 1986 and the implementation of the interest rate differential between overpayments and underpayments, section 6402 was enacted to give the IRS the ability to offset outstanding liabilities with overpayments prior to refunding any overpayment to the taxpayer. (Section 6402 was, in actuality, a collection mechanism; it is much easier to collect an unpaid amount from funds already held by the IRS than to collect them from the taxpayer.) If such an offset is made, section 6601(f) provides:

If any portion of a tax is satisfied by credit of an overpayment, then no interest shall be imposed under this section on the portion of the tax so satisfied for any period during which, if the credit had not been made, interest would have been allowable with respect to such overpayment.

When overpayments and underpayments are offset, interest is only due on the net deficiency or overpayment.

For interest accruing after 1986, offsetting provided true economic benefit to the taxpayer. To the extent overpayments and underpayments existed during the same time period and were subsequently offset, the taxpayer was not subject to the interest rate differential. In the study, the following statement is made with respect to the current the IRS offsetting policy: "It is the IRS's policy to maximize offsetting, and the resulting interest savings to taxpayers, whenever there is a true offsetting situation, i.e., whenever overpayments and underpayments are simultaneously outstanding." If for any reason the offset is not made, however, the rate differential would produce an economic detriment to the taxpayer.

The Treasury study concludes that global interest netting is not authorized by section 6402 or the regulations thereunder. Section 6402(a) now applies only when credit is made against "outstanding" liabilities. The regulations under section 6402 provide that overpayments can be credited only against "outstanding" liabilities. Treas. Reg. [Sections] 301.6402-1. Since a liability that has been paid is not "outstanding," and since global netting relies on crediting overpayments against previously paid liabilities for interest netting purposes, the study concludes that global interest netting is not authorized by the regulations. The court in Northern States Power agreed with this analysis, and the holding of that case reflects the IRS's view of the law with respect to interest netting.

Policy Issues

Tax policy issues involving interest netting are also discussed in the Treasury study. The report notes that global netting involves several different -- and sometimes competing -- tax policies. In 1986, a rate differential was first implemented. Congressional committee reports highlight Congress's perception that such a single rate was out of line with general interest rates in the economy. In fact, the reports reflect a congressional decision that the IRS should act more like "financial institutions, commercial operations, or other entities" that "borrow and lend money at differing rates." The study states:

It follows from the analogy to financial or commercial institutions that the Government, like any other commercial entity in the marketplace, should charge a higher interest rate on the money it lends (underpayments) than on the money it borrows (overpayments), which is precisely what Congress enacted.

In the private sector, it is not unusual for the taxpayer to have a loan to the bank while maintaining a savings account at the same institution. The two are not "netted." Even during periods of mutual indebtedness, the interest on the two amounts continues to accrue at the different contractual rates. In certain situations involving offsetting, the IRS does net, despite Congress's seeming recognition of the need for a rate differential.

The Treasury study points to Congress's acting three times in the last eleven years to increase the differential between interest paid on refunds and interest charged on deficiencies. In each case, Congress reiterated one or more of the traditional rationales for interest, including the time value of money, incentives for prompt payment, and operating the tax administration process more like other financial functions in the economy. At the same time, however, Congress simultaneously urged netting to ameliorate the effect of the very interest differentials it has repeatedly adopted. The Treasury study concludes that "Congress has implicitly endorsed several long-term policy shifts without explicitly examining the fundamental premises underlying them."

The final policy consideration cited in the study relates to the potential effect of interest netting on revenue. The limitations proposed to be applied to its implementation will modify such effect.

With respect to the mandate of Congress to implement interest netting, the study explains that the mandate did not expand the authorization of interest netting to any greater extent than was authorized under existing law. The implication here is that netting only was to be applied in the situation when an offset was made -- i.e., where there was an actual crediting of overpayments against outstanding liabilities.

Two approaches were reviewed with respect to global netting. The first approach is the credit/offset approach. This approach is basically an extension of the current offsetting methodology. Under this approach, an overpayment could be credited to an underpayment irrespective of whether the underpayment is outstanding at the time of such application. This application of credits would bring section 6601(f) into play and interest netting would automatically occur. The study concludes, however, that "[t]he credit/ offset approach cannot be implemented... because current law does not provide the authority to apply a previously refunded overpayment as a credit against a deficiency, or an overpayment as a credit against a previously paid deficiency."

The interest rate equalization approach does not rely on offsets. Rather it is a methodology by which interest is only charged on underpayments or paid on overpayments when there is a true underpayment or overpayment. This approach is similar to that taken in Rev. Proc. 94-60, 1994-2 C.B. 774, and is similar to an approach followed in a revenue procedure previously submitted to the IRS by the Commissioner's Advisory Group. Because this methodology does not directly rely on section 6402 or 6601(f), the Treasury study states:

Interest equalization cannot be implemented in a multi-year (global netting) situation under current law... While the general purpose of an interest equalization method is to net interest during a period of mutual indebtedness, the netting is ultimately accomplished by reducing the amount of underpayment interest below the rate set by section 662 1, or by paying more overpayment interest than is allowed under section 6621. This is tantamount to charging or paying interest at an incorrect rate under the statute. There simply is no authority in sections 6601, 6611, or 6621 permitting this approach.

Administrative Issues

Although conceptually global netting is largely the same as offsetting, the Treasury expressed a number of administrative concerns about global netting. First, the addition of zero-balance years would substantially increase the amount of data that must be gathered and analyzed. Second, data on zero-balance years are much more difficult to obtain owing to the IRS's document retention practices. For example, because of the limited data storage capacity of the IRS's Master File, the IRS must routinely archive data for inactive accounts. It takes an account "off-line" shortly after it is fully paid, moves the account to a lower level of storage after a couple years of inactivity, and eventually moves it to archives. Third, in addition to the information on the Master File for a particular taxpayer, the tax returns and back-up documentation for previous computations must be obtained before a new netting computation can be performed. To perform a global interest netting computation for a large corporate taxpayer, a technician would need the return and supporting schedules, current transcripts, the Revenue Agent's Report and related workpapers, previous interest computation worksheets and Forms 2285 ("Restricted interest on concurrent determinations of deficiencies and overpayments"), any pertinent court decisions, settlement memoranda, Appeals audit statements, and similar documents. Finally, even if all of this documentation were available, the time required for the analysis in a multiple year global netting computation would still be extensive. One commentator estimated that in the usual case of a large corporate taxpayer, 300 to 400 staff-hours typically would be required to complete the review and computations.

Recommendations

In conclusion, the Treasury study states:

The IRS recognizes that Congress has repeatedly instructed it to implement the most extensive interest netting procedures possible consistent with sound administrative practice and the various provisions.... If the legal issues presented by global interest netting are resolved by Congress through enactment of express statutory authority, the IRS believes that it can implement global interest netting fairly and equitably only if certain limitations are provided.

Because of the administrative difficulties associated with global netting, the following restrictions were recommended:

* Global interest netting should be implemented legislatively through an interest equalization approach rather than a credit/offset approach. This approach would not involve the offsetting of credits between years; rather, the interest rate would be adjusted to the extent taxpayers and the IRS have overlapping periods. 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 states that at least one of the tax years involved must be a non-zero balance tax year.

* Global interest netting should be limited to income taxes only. The study states 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.

* Global interest netting should apply only to tax years that are not barred by statute. The study states 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 are also cited as substantial. The study further states that limitations on the IRS computer systems, particularly relating to barred years, would increase the difficulty of interest netting computations if the barred years are considered. The availability of prior the IRS interest computations is also cited as problematic.

* 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.

* 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 will be reflected and will generally not be subject to future adjustment. Additional adjustments could be made in certain circumstances if the taxpayer were able to provide explicit documentation supporting the additional amount.

The Treasury study concludes that the suggested restrictions -- other than the first one indicating the need for a legislative change -- could be implemented by regulations and suggests that a further condition for global netting be accepted: That the Treasury be granted the authority to prescribe regulations in these areas to reflect the restrictions.

The study also suggests that additional monies be appropriated to the IRS to enable it to ensure adequate resources are available to work on the computations. The IRS contends that the global interest netting calculations will involve significant administrative complexity, specifically citing the difficulty of the collection of the data necessary for the computation. In order to make the computations, documentation from each of the years included in the netting application will be needed.

Outlook for Change

The inclusion of these limitations in the implementation of interest netting perpetuates the inequities of the interest rate differential during certain periods when there is undoubtedly mutual indebtedness. As discussed in greater detail below, the limitations are not necessary to ensure that netting is "administratively feasible" since most of the detailed work involved will be done by the taxpayer.

* In response to the study, Treasury's proposed Taxpayer Bill of Rights 3 (TBOR3) includes a provision that interest netting be statutorily implemented by implementing a zero interest rate on underpayments and overpayments during periods of mutual indebtedness. Interest netting would only apply to interest amounts accruing after date of enactment of the bill. The prospective enactment of interest netting, however, would not relieve the existing economic detriment imposed on taxpayers. Because of the protracted period during which audits, appeals, and court actions may take place, it would be years before the taxpayer would not have to worry about timing and "interest strategy" that would include all interest amounts up until the date of the act implementing interest netting. This result is not acceptable.

In addition, the applicability of interest netting only to situations in which there is at least one "non-zero" balance is inequitably restrictive. A "zero" balance account has nothing to do with the statute of limitations. It merely means that all assessments on an account have been satisfied and nothing is currently due to or from the taxpayer. As long as the statute of limitations for allowable or deficiency interest is open on the account on which the actual adjustment is to be made, a zero balance account should not preclude the taxpayer from filing a claim for underpaid allowable interest or overcharged deficiency interest.

* The restriction of interest netting to income taxes is unnecessary. The study cites administrative burdens as the primary difficulty in including only such taxes in the calculations, yet the administrative burden of assembling the data and preparing the computations is placed upon the taxpayer. If the taxpayer can assemble the data and prepare the computations, the IRS will only have to review and verify the computations based on the data put forth by the taxpayer.

* The consideration of years barred by statute in the determination of the proper interest rate to be charged or paid in an open year is not tantamount to reopening the statute of limitations on the closed year. In fact, this approach is clearly consistent with certain tax computations. For example, if a net operating loss is carried forward from Year 1 and deducted in Year 10, the IRS may make any adjustments to Year 1 after the statute of limitations is closed. Although the tax on Year 1 may not be increased, the adjustments may be made to Year 1 in order to determine the correct net operating loss to be deducted in Year 10, an open year. In applying global interest netting, any year closed by the statute of limitations could be considered in determining periods of mutual indebtedness that include an open year. For example, if 1991, a closed year, and 1994, an open year, had a co-existing overpayment and underpayment from March 15, 1995, to March 15, 1997, the rate on the 1994 overpayment would be determined by the rate charged for that period on the 1991 year. This does not constitute the reopening the 1991 year, but rather the consideration of a closed year to determine the correct amount due on an open year.

* The requirement that taxpayers specifically request interest netting applications and provide the proper documentation to support the computations is not the best answer. If this approach is necessary to accommodate the IRS resource constraints, taxpayers should be able to provide the requisite support. A Government with the sophistication and technological know-how to send men to the moon and land a space probe on Mars can surely design a computer system that can accomplish even the most complex interest netting transactions. Until such a system is designed, taxpayers may be forced to affirmatively request interest netting.

* The recommendation for a general requirement that a tax account be included in a netting computation only once because of documentation issues should not be followed. Because the taxpayer is responsible for providing the computations and supporting documentation, multiple transactions involving the same year should not create additional complexity for the IRS, since -- once again -- the burden is on the taxpayer.

Conclusion

The publication of the Treasury study represents a small step on the road to making global interest netting a reality. There are still many hurdles to clear in order to implement interest netting that will significantly ameliorate the existing economic detriment that now exists. There is currently a great deal of momentum to include some form of interest netting legislation in forthcoming tax legislation. The global netting proposal included in TBOR3, however, is not sufficient to correct the existing inequities. Taxpayers must work to ensure that legislation is enacted and that the restrictions on interest netting urged by the Treasury study are not included in such legislation.

Until these obstacles are overcome, taxpayers must continue to focus on interest planning in the same manner as tax planning. In many instances, interest strategy may be more important than tax strategy because tax strategy includes many "timing" adjustments that may only defer taxes until a later date. Interest strategy -- properly implemented -- reduces the rate paid on a deficiency or increases the rate received on a refund. This results in a permanent increase in a taxpayer's bottom line.
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Author:Everidge, Kathy L.
Publication:Tax Executive
Date:May 1, 1997
Words:4732
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