Rev. Rul. 72-100

Advice has been requested regarding the proper method of accounting, within the meaning of section 446 of the Internal Revenue Code of 1954, for reporting interest income on installment loans made at a discount where it is provided that in the event of prepayment of the loan the portion of the discount (interest) earned by the lender is to be computed under the Rule of 78's method. Advice has also been requested as to the amount of interest paid or accrued by the borrower on such loans for purposes of the deduction for interest paid or accrued on indebtedness provided by section 163 of the Code. Situations typical of those with respect to which advice has been requested are described below.

Situation (1). M is engaged in the general commercial banking business, computes its taxable income under an accrual method of accounting and uses a calendar year accounting period. In the course of its business M makes discounted installment loans. On November 30, 1970, M loaned to A, an accrual method, calendar year individual, $681 in consideration of the execution by A of a note to M in the amount of $720, payable in 12 monthly installments of $60 beginning on December 31, 1970, and thereafter on the last day of each month until November 30, 1971. A did not repay any part of the loan during 1970, but made the first installment payment on January 2, 1971.

Situation (2). N is engaged in the general commercial banking business, computes its taxable income under the cash receipts and disbursements method of accounting and uses a calendar year accounting period. In the course of its business N, on November 30, 1970, made an installment loan of $2,990 to B, a cash method, calendar year individual. In consideration therefor, B executed a note to N in the amount of $3,600, payable in 60 monthly installments of $60 beginning on December 31, 1970, and thereafter on the last day of each month until November 30, 1975. B paid N $60 on December 31, 1970.

The installment notes executed by A and B each provide that, if the loan is repaid in full before maturity, the portion of the total interest of $39 on A's note and $610 on B's note earned by the lender is to be computed on a sum-of-the months digits method, hereinafter referred to as the Rule of 78's. In Situations (1) and (2), there are no other provisions relating to the accrual or payment of interest.

Under the Rule of 78's method as applied to the note described in Situation (1), 12/78ths of the total interest is earned in the first month of the loan, 11/78ths is earned in the second month, and so on. Thus, if the note described in Situation (1) were fully repaid by A on December 31, 1970, M would have earned 12/78ths of the total interest or $6. If the note were fully repaid by A on January 31, 1971, M would have earned 23/78ths of the total interest or $11.50.

Under the Rule of 78's method as applied to the note described in Situation (2), 60/1830ths of the total interest is earned in the first month of the loan, 59/1830ths is earned in the second month, and so on. Thus, if the note described in Situation (2) were fully repaid by B on December 31, 1970, N would have earned 60/1830ths of the total interest or $20. If the note were fully repaid by B on January 31, 1971, N would have earned 119/1830ths of the total interest or $39.67.

With respect to accrual method lenders, section 1.451-1(a) of the Income Tax Regulations provides, in part, that: "* * * income is includable in gross income when all the events have incurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy." With respect to accrual method borrowers, section 1.461-1(a)(2) of the regulations provides, in part, that "* * * an expense is deductible for the taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy."

In James Bros. Coal Co. v. Commissioner, 41 T.C. 917 (1964), the Tax Court of the United States rejected the taxpayer's claim that it is proper to accrue an interest deduction on the basis of a formula similar to the Rule of 78's method. However, the court noted that it had not been presented with the terms of the note involved, and said that in the absence of proof of any contrary arrangement between the lender and borrower the interest is to be accrued on the straight-line basis.

Revenue Ruling 67-316, C.B. 1967-2, 171, discusses Gunderson Bros. Engineering Corp. v. Commissioner, 42 T.C. 419 (1964), acquiescence, C.B. 1967-2, 3, and Luhring Motor Company, Inc. v. Commissioner, 42 T.C. 732 (1964), acquiescence, C.B. 1967-2, 3. In those cases, the Tax Court of the United States held that because of the purchaser's right to abatement of finance charges included in an installment contract of sale, the accrual method seller's right to receive discounted finance charges became fixed only through the passage of time without prepayment. Under circumstances similar to those cases, Revenue Ruling 67-316 holds that finance or carrying charges included in an installment contract of sale shall be accrued ratably over the period of the contract. "Ratably" as used therein means, as a liability to repay the charges, under the method incorporated in the loan contract, is relieved by the passage of time. In Gunderson a state statute fixed the amount of the finance charge (on a modified Rule of 78's method) which the taxpayer was entitled to retain out of each payment in the event of early payment, and the taxpayer computed its income for tax purposes on the same basis. In Luhring the taxpayer used the straight-line method of reporting interest and abated the charges upon prepayment on the same basis.

In general, the interest on a discounted installment loan is to be included in the gross income of an accrual method lender as the lender acquires a fixed right to receive such interest and is to be deducted by an accrual method borrower as the borrower incurs a fixed obligation to pay the interest. In situation (1), as of the end of the calendar year 1970, M had acquired a fixed right to receive $6 of the total interest of $39. Accordingly, the Service will generally require that M include in its gross income for the calendar year 1970 interest of $6 with respect to the loan. Likewise, A had incurred a fixed obligation to pay $6 of the interest and may accrue interest expense for such calendar year in the amount of $6 for purposes of the deduction allowed by section 163 of the Code.

With respect to cash method lenders, section 1.446-1(c)(1)(i) of the regulations provides in part that: "* * * all items which constitute gross income * * * are to be included for the taxable year in which actually or constructively received." See also section 1.451-1(a) of the regulations. With respect to cash method borrowers, section 1.461-1(a)(1) of the regulations provides, in part, that: "* * * amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid."

Revenue Ruling 70-647, C.B. 1970-2, 38, holds that the general rule relating to the treatment of payments on an indebtedness requires that partial payments in satisfaction of an indebtedness be applied toward the reduction of interest then toward principal, but that this rule does not apply when it can be inferred from the circumstances that the parties understood that a different allocation of the payments would be made.

In Situation (2) there are no circumstances indicating that the parties did not intend the general rule to apply. Therefore, the first payment of $60 made by B on December 31 should be considered a payment of the $20 of accrued interest and the balance of $40 will be considered to have been applied to the repayment of principal. Accordingly, N should include in its gross income for the calendar year 1970 interest of $20 with respect to the loan and B will be considered to have paid interest of $20 for such calendar year for purposes of the deduction allowed by section 163 of the Code.

Under section 446(e) of the Code, the consent of the Commissioner of Internal Revenue is required before a taxpayer changes his method of accounting for Federal income tax purposes. See section 1.446-1(e) of the regulations, relating to requirements respecting the adoption or change of methods of accounting. A consistent method of reporting interest on discounted installment loans is considered to be a method of accounting.

Accordingly, for Federal income tax purposes, a taxpayer may not change his method of accounting for interest on installment loans made at a discount without first obtaining the permission of the Commissioner.

Revenue Ruling 64-278, C.B. 1964-2, 120, holds that permission will ordinarily be granted to a bank or similar taxpayer, using the cash receipts and disbursements method of accounting, to change to the "liquidation method" of reporting interest on loans made at a discount. The liquidation method is a composite method which has the effect of apportioning the interest income on the loans over the terms of such loans on a straight-line basis. Revenue Ruling 64-278 is modified to hold that, where a specific agreement, established practice of the lender, applicable law, or directive of an appropriate regulatory body, apportions the interest to be paid on the loan on a method other than the straight-line method, the liquidation method of reporting interest on loans made at a discount may not be applied.

Under the authority of section 7805(b) of the Code, the conclusions of this Revenue Ruling regarding the reporting of income on discounted installment obligations will not be applied to require a change in a taxpayer's method of accounting where (1) the taxpayer has consistently used a method other than the Rule of 78's method in determining taxable income and under that method at the end of any fraction of the term of the loan at least as much interest would be included in gross income as under the straight-line method, and (2) in his taxable years ending after the publication of this Revenue Ruling the amount of interest included in gross income on any loan in any taxable year is not less than the amount of interest reported with respect to that loan in all reports (including consolidated financial statements) to shareholders, partners, other proprietors, beneficiaries and for credit purposes in such taxable year.

The right of the borrower to compute his interest deduction on a loan under the Rule of 78's method is not affected by the lender's use of a different method in reporting interest income on the loan.

Since the principles set forth in I.T. 2526, C.B. IX-1, 123 (1930), and I.T. 3489, C.B. 1941-2, 71 are restated herein, they are superseded. Revenue Ruling 64-278 is modified.