Rev. Rul. 63-57

Advice has been requested whether a taxpayer, who is engaged in the small loan business and employing the cash receipts and disbursements method of accounting, can defer reporting of interest income in respect of payments received on a loan, made at discount, until after its principal (the sum he actually advanced to the borrower) has been recovered, where the loan note provides that any payments thereon shall be applied first to principal.

The taxpayer's manner of doing business is typified by the receipt of a $696 note executed by a borrower and payable over a period of 12 months at the rate of $58 per month on which the taxpayer lends him $600 in cash. Each note received by the taxpayer contains a provision which reads, `It is hereby agreed any payments made on this note shall be applied first to the principal.'

In the stated example, the $600 actually advanced by the taxpayer to the borrower is the principal of the loan, and the additional amount of $96 included in the face amount of the loan note is compensation for use of the money loaned (interest thereon).

The agreements between the borrowers and the taxpayer-lender, as to the application of payments with respect to the loans, were bona fide and at arm's length. The taxpayer credited all payments made by a borrower with respect to a loan to its principal until that was fully paid and thereafter to interest thereon. Thus, the taxpayer did not report a realization of interest income from a particular loan until after the principal thereof had been recovered.

I.T. 2526, C.B. IX-1, 123 (1930), holds that, under the cash receipts and disbursements method of accounting, a pro rata portion of each monthly payment received on a loan, made at a discount, should be considered as realized discount (interest). However, the factual situation in that ruling is clearly distinguishable from that in the instant case, because that ruling does not involve a bona fide and arm's length agreement, entered into between the debtor and creditor when the loan was made, as to the time that discount (interest) included in the face amount of the loan is to be paid, as does the instant case. I.T. 3489, C.B. 1941-2, 71, and S.M. 3820, C.B. IV-2, 32 (1925), as modified by G.C.M. 14839, C.B. XIV-1, 73 (1935), are also distinguishable from the instant case for the same reason.

In Huntington-Redondo Company v. Commissioner , 36 B.T.A. 116 (1937), acquiescence, C.B. 1937-2, 14, the petitioner, employing the cash receipts and disbursements method of accounting, in 1932 received a payment of $64,715.97 from a trustee on behalf of its vendeedebtor which it allocated $57,011.79 to the sale price of land it had sold to the latter in 1927, $5,337.84 to interest on a loan thereto in 1930, and $2,366.34 to interest on loans thereto in 1931. Before the end of its calendar taxable year 1932, it reallocated the $64,715.97 payment ($63,314.92 to principal of the 1931 loans, and $1,401.05 to interest thereon) pursuant to an apparently bona fide and arm's length written agreement by it and the vendee-debtor on December 22, 1932, as to allocations of payments to it from the trustee, including the $64,715.97 payment.

It was there held that the $64,715.97 payment should be treated, for Federal income tax purposes, in accordance with such agreement. See also E. P. Greenwood v. Commissioner , 34, B.T.A. 1209 (1936), acquiescence, C.B. 1937-1, 11, holding similarly; and Robert Hays Gries v. Commissioner , Tax Court Memorandum Opinion dated May 26, 1950, wherein the Huntington-Redondo Company decision was followed and G.C.M. 2861, C.B. VII-1, 255 (1928), was cited.

In Lee Friend et ux v. Commissioner , Tax Court Memorandum Opinion dated June 8, 1961, citing George S. Groves v. Commissioner , 38 B.T.A. 727 (1938), it was conversely held that where the petitioner, employing the cash receipts and disbursements method of accounting, made a payment in his taxable year 1954 of $7,500 to a creditor, whom he owed $7,500 principal and $1,312.50 accrued interest thereon, and they evidently intended under a simultaneous settlement stipulation that the entire payment was of principal, no interest paid deduction was allowable to him on account of such payment. See also J. W. Sefton, Jr. v. Commissioner , 292 Fed.(2d) 399 (1961), holding that where the petitioner, employing the cash receipts and disbursements method of accounting, paid $142,500 in compromise settlement of a pending judgment of $156,966.88 that included $39,533.49, `interest but only $1,201.48 was designated as interest in the parties' settlement agreement, which was viewed as realistic rather than arbitrary, he could deduct as interest paid only the latter amount.

In view of the foregoing, it is held that where a borrower and a lender designate, in a bona fide and arm's-length agreement, that loan installment payments by the borrower on a loan, made at a discount, shall be applied first to loan principal, the lender, employing the cash receipts and disbursements method of accounting, is not required to report any portion of such payments as interest income until after the amount he actually advanced to the borrower has been recovered. Conversely, no interest paid deduction will be allowed the borrower, on the cash receipts and disbursements method of accounting, until after the amount he actually received has been repaid.

Consistently, the nonacquiescence in Ishmael S. O'Dell et ux v. Commissioner , 26 T.C. 592 (1956), C.B. 1956-2, 10, has been withdrawn and acquiescence substituted therefor, on page 4, this Bulletin.

I.T. 2526, C.B. IX-1, 123 (1930); I.T. 3489, C.B. 1941-2, 71; and S.M. 3820, C.B. IV-2, 32 (1925), as modified by G.C.M. 14839, C.B. XIV-1, 73 (1935), distinguished.