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March 2, 2015

Proposed Change to the Adjusted Applicable Federal Rates

In the March 2, 2015 Federal Register the IRS and Treasury published proposed regulations making good on their intention announced in Notice 2013-4 to change the way in which they calculate the adjusted applicable federal rates ("AFRs").

  • The adjusted AFRs are used in interest imputation and original issue discount calculations where interest on the underlying obligation is exempt from federal income tax (e.g., a tax-exempt municipal bond). I.R.C. § 1288. In addition, the adjusted long-term AFR is used by Internal Revenue Code section 382 in computing the limitation on utilization of net operating loss carryovers following a corporate "change of ownership." The statutory provisions and legislative history mandate that the "adjustment" is to reflect the yield differential arising from the exemption from federal income taxation of interest on the obligation.

  • Historically, the IRS and Treasury adjusted the regular AFRs (short-term, mid-term and long-term) by comparing the market yield on the highest-grade tax-exempt obligations (prime, general obligation tax-exempt bonds and notes) to the market yield on U.S. Treasury obligations with comparable maturities. From 1990 (the earliest year for which we've retained data) through the late 1990s, this approach produced an adjusted long-term AFR that, as a percentage of the regular long-term AFR, was usually in the high 70s to mid 80s. In the late 1990s and early 2000s, that percentage started to increase to the high 80s to mid to upper 90s. The premise of this approach was that the comparable tax-exempt bonds had lower yields than U.S. Treasuries primarily, if not exclusively, because interest on those obligations was exempt from federal income tax.

  • However, the premise behind the historical calculation method broke down completely with the financial turmoil beginning around 2008. In times of financial stress owning the monetary printing press is apparently a big deal in credit risk analysis. The IRS and Treasury now admit that during this period there really were no tax-exempt obligations with credit characteristics comparable to U.S. Treasuries. Adjusted long-term AFRs well in excess of long-term AFRs became the rule rather than the exception. The adjusted long-term AFR for March 2009 was 178 percent of the regular long-term AFR. This change in the market's perception of credit risk prompted the IRS to issue Notice 2013-4 announcing that it and Treasury would begin studying changing the way in which they determined the adjusted AFRs but also stating that the adjusted long-term AFR could never exceed the regular long-term AFR. Since Notice 2013 was issued the adjusted long-term AFR has been at least 95 percent, and most often 100 percent of the regular long-term AFR.

  • In its explanation for the proposed regulations, Treasury indicates that its analysis of data from 1986 (when AFRs were first introduced) through 2007 shows a strong correlation between the difference between market yields on U.S. Treasuries and credit-comparable tax-exempt obligations and the highest individual marginal federal income tax rate. Treasury observes that on average over that period the reduction in yield on account of the tax exemption is 59 percent of the highest individual marginal federal income tax rate (and not 100 percent because, according to Treasury, although maximum marginal rate individuals may be the heaviest buyers of tax-exempt bonds, municipal issuers find it necessary to find buyers with lower marginal tax rates).

  • The proposed regulations thus set the adjusted AFR at a percentage of the comparable regular AFR equal to (i) 100 percent, minus (ii) 59 percent of (A) the maximum rate of tax under Internal Revenue Code section 1, plus (B) the maximum rate of tax under Internal Revenue Code section 1411 (the Obamacare Medicare tax on net investment income) applicable to individuals. Under current-law rates, that percentage is 74.39 percent, derived as follows:

    1.0 - [.59 * (.396 + .038)] = 1.00 - (.59 * .434) = 1.00 - .2561 = .7439

    Accordingly, if an AFR for a given month were five percent, the corresponding adjusted AFR for that month would be 3.72 percent.

    The 74.39 percent figure is lower than the historical percentage for the long-term rates for any month from 1990 through 2007. Although this result may be due to tax rates being higher today than during that period, one significance of the new methodology, if adopted, is likely to be lower adjusted long-term AFRs to be used in computing the limitation on post-change utilization of pre-change net operating loss carryovers under Internal Revenue Code section 382.

Available Material

For further information please contact Brian Wainwright (Palo Alto).

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