IRS has issued final regs that provide a new method to be used to adjust the applicable Federal rates (AFRs) under Code Sec. 1288 (adjusted AFRs) for tax-exempt obligations and to determine the long-term tax-exempt rate and the adjusted Federal long-term rate under Code Sec. 382. For tax-exempt obligations, the regs affect the determination of original issue discount under Code Sec. 1273 and of total unstated interest under Code Sec. 483. The regs also affect the determination of the Code Sec. 382 and Code Sec. 383 limitations on the use of certain operating loss carryforwards, tax credits, and other attributes of corporations following ownership changes.
Background on AFRs. IRS determines the short-term, mid-term, and long-term AFRs used in determining the imputed principal amount of certain obligations (in general, nonpublicly traded debt instruments that are given in consideration for the sale or exchange of nonpublicly traded property), for computing total unstated interest on certain deferred payments subject to Code Sec. 483, and for various other purposes. (Code Sec. 1274(d)) Which AFR is used depends on the term of the debt instrument and the time of the sale or exchange. The short-term AFR is used if the instrument’s term is three years or less, the mid-term AFR is used if the term is over three but not over nine years, and the long-term AFR is used if the term is over nine years. (Code Sec. 1274(d)) During each calendar month, IRS determines and publishes the rates that apply during the following calendar month.
In applying Code Sec. 483 or Code Sec. 1274 to a tax-exempt obligation (as defined in Code Sec. 1275(a)(3)), “appropriate adjustments” are made to the AFR to take into account the tax exemption for interest on the obligation. (Code Sec. 1288(b))
Background on Code Sec. 382. When a corporation has undergone an “ownership change” under Code Sec. 382(g), there is an annual limit on the amount of the corporation’s taxable income that can be offset by certain net operating loss (NOL) carryforwards and other tax attributes. Additionally, under Code Sec. 383, there is a limit (determined by reference to the annual limit under Code Sec. 382) on the amount of the corporation’s income tax liability that can be offset by certain tax credits and other tax attributes. The Code Sec. 382 limit for a tax year ending after an ownership change generally equals the product of (A) the value of the stock of the corporation immediately prior to the ownership change, and (B) the long-term tax-exempt rate. (Code Sec. 382(b)(1))
The long-term tax-exempt rate is the highest of the adjusted Federal long-term rates in effect for any month in the three-calendar-month period ending with the calendar month in which the ownership change occurs. (Code Sec. 382(f)(1)) The term “adjusted Federal long-term rate” means the Federal long-term rate determined under Code Sec. 1274(d) (with certain modifications), as adjusted for differences between rates on long-term taxable and tax-exempt obligations. (Code Sec. 382(f)(2))
The relevant legislative history indicates that the adjusted Federal long-term rate is to be computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years, and that, for purposes of Code Sec. 382, the long-term tax-exempt rate should be lower than the long-term Federal rate.
IRS has determined the adjusted AFRs and the adjusted Federal long-term rate in the same manner since ’86. The adjusted Federal long-term rate under Code Sec. 382(f)(2) is equal to the long-term adjusted AFR with annual compounding under Code Sec. 1288(b) in the same month.
Since ’86, the adjusted Federal long-term rate and each adjusted AFR have been determined by multiplying the corresponding AFR by a fraction known as the “adjustment factor.” The numerator of the adjustment factor is a composite yield of the highest grade tax-exempt obligations available, which are prime, general obligation tax-exempt bonds, and the denominator is a composite yield of U.S. Treasury obligations with maturities similar to those of the tax-exempt bonds. Each of the composite yields is measured over a one-month period.
From ’86 to 2007, this ratio (and, as a result, the ratios of adjusted AFRs and adjusted Federal long-term rates to AFRs) was, on average, approximately equal to one minus 59% of the maximum individual tax rate under Code Sec. 1. That relationship was relatively stable over the period; the ratio of the spread between the yields to the maximum individual tax rate under Code Sec. 1 generally did not vary by more than a few percentage points. IRS believes that this historical market data provides the best indication of the effect of a tax exemption on market yields.
Purpose behind adjustment of rates no longer being served. The adjustment factor uses prime, general obligation tax-exempt bonds in the numerator because, at the time the adjustment factor was created, those obligations were of a comparable credit quality with U.S. Treasury obligations. However, there is now a difference in perceived credit risk between U.S. Treasury obligations and even the highest grade tax-exempt bonds, and that difference affects the relative yields of each in a way that offsets the effect of the tax exemption for the tax-exempt bonds. The effects of this “credit spread” were initially negligible, but the spread between U.S. Treasury obligations and other types of obligations, including tax-exempt bonds, has grown significantly over the past few years.
As a result, since 2008, market yields of prime, general obligation tax-exempt bonds have often exceeded those of comparable U.S. Treasury obligations, and the adjusted AFRs and adjusted Federal long-term rate have often exceeded the corresponding AFRs. Those results show that the adjustment factor no longer serves its intended purpose of making adjustments to reflect tax exemption but not credit quality. The rates are also inconsistent with the Congress’s express intent that the adjusted Federal long-term rate and long-term tax-exempt rate be lower than the Federal long-term rate.
In early 2013, IRS announced in Notice 2013-4, 2013-9 IRB 527, that it was considering changes to the method used to determine the AFRs under Code Sec. 1288(b) and the adjusted Federal long-term rate under Code Sec. 382(f)(2). The Notice described a number of the options being considered and requested comments on them. In the meantime, IRS would continue to use the current adjustment factor, but with certain modifications: the adjusted AFRs and the long-term tax-exempt rate would continue to be calculated using the adjustment factor, except that the adjustment factor would equal one (1) for any month in which the adjustment factor would otherwise be greater than one or in which the denominator of the adjustment factor would otherwise be less than or equal to zero (see Weekly Alert ¶ 17 02/07/2013).
Shortly thereafter, IRS issued proposed regs, which proposed the use of historical market data to create an appropriate adjustment factor based on individual tax rates (see Weekly Alert ¶ 25 03/05/2015).
Final regs. The final regs adopt the proposed regs without substantive change.
Under the final regs, to effectuate legislative intent, the adjusted Federal long-term rate under Code Sec. 382(f) continues to be determined in the same manner as the adjusted AFRs under Code Sec. 1288, with an adjustment to take into account the effect of tax exemption on market yields. Under the final regs, the adjustment factor is one minus the product of a tax rate and a fixed percentage. The fixed percentage is the amount by which that combined tax rate must be multiplied to reflect the historical relationship between the maximum tax rate and the spread between yields of taxable and tax-exempt obligations; the spread is less than 100% of the maximum tax rate because, for example, issuers of tax-exempt bonds need to attract purchasers with effective tax rates lower than the maximum individual tax rate. IRS determines the adjusted AFRs and the adjusted Federal long-term rate for each month from the appropriate AFRs for that month using the adjustment factor that results from the following calculation: 100% – [(a combined tax rate) × (a fixed percentage)].
Specifically, under the final regs, the tax rate in the adjustment factor is the sum of the maximum individual rate under Code Sec. 1 and the maximum individual rate under Code Sec. 1411 (the net investment income tax, i.e., the 3.8% surtax on certain unearned income of higher-income individuals) for the month to which the rate applies. (Reg. § 1.382-12(c)(2)(ii), Reg. § 1.1288-1(b)(2)(ii))
Illustration: Using current maximum individual tax rates under Code Sec. 1 and the maximum individual rate under Code Sec. 1411, the combined tax rate in the calculation is 43.4% (that is, 39.6% + 3.8%). (T.D. 9763, 04/25/2016)
Under the final regs, the fixed percentage in the adjustment factor is 59%. (Reg. § 1.382-12(c)(2)(i), Reg. § 1.1288-1(b)(2)(i)) That is because the yield on tax-exempt obligations from February of ’86 to July of 2007 was lower than that of comparable taxable obligations by, on average, 59% of the maximum individual rate in effect under Code Sec. 1.
Thus, the adjustment factor under current tax rates is 74.39%. To get this result, start with 100%, and subtract the product of (a) 43.4% (i.e., the sum of the 39.6% current maximum individual rate under Code Sec. 1 and the 3.8% current maximum individual rate under Code Sec. 1411) and (b) 59%. 100% − (43.4% × 59%) = 100% − 25.61% = 74.39%.
If an AFR for a given month were 5%, under current tax rates, the corresponding adjusted AFR would be 3.72%—the product of 74.39% and 5%. If that 5% AFR were the Federal long-term rate for debt instruments with annual compounding, the adjusted Federal long-term rate under Code Sec. 382 would likewise be 3.72%.
Effective date. These final regs apply to determine the adjusted AFRs, adjusted Federal long-term rate, and long-term tax-exempt rate beginning with the rates determined during August 2016 that apply during September 2016.
References: For applicable federal rates in general, see FTC 2d/FIN ¶ J-4181 ; United States Tax Reporter ¶ 12,714.01 ; TaxDesk ¶ 153,030 ; TG ¶ 12428 .