Rev. Rul. 79-72

ISSUE

What are the federal income tax consequences to the issuer and holder of a nonnegotiable time deposit certificate with a maturity of 6 months when the term of the certificate overlaps the end of the taxable year?

FACTS

M, a mutual savings bank that deducts interest under section 591 of the Code, is a calendar year taxpayer that issued a nonnegotiable time deposit certificate on September 1, 1978. This time deposit certificate, also referred to as a money market certificate, has many of the characteristics of a 6-month Treasury bill. It must be issued in minimum denominations of $10,000 with a 6-month (26 week) maturity. The maximum permissible rate of interest that may be paid will be tied to the average (auction) yield for the 6-month Treasury bill in the most recent auction. M is permitted to pay an interest rate on these money market certificates that is one-quarter of one percent more than the average discount yield on 6-month Treasury bills.

A, the certificate holder, purchased the time deposit certificate from M for $10,000. A is a calendar year taxpayer that uses the cash receipts and disbursements method of accounting. This time deposit certificate provides that M will pay the certificate holder $10,000 plus interest credited when the certificate is redeemed at maturity on March 1, 1979. The certificate holder is guaranteed interest at the rate of 9 percent per annum if the certificate is held for a period of 26 weeks after the date of issue. In the event an amount is withdrawn from the certificate account prior to its maturity, interest will be paid on the amount withdrawn at the passbook rate of 5 percent. If the amount withdrawn reduces the certificate account balance below $10,000, the entire account will be treated as having been withdrawn as of the date of such withdrawal and interest will be paid on the entire amount at the 5 percent rate. In addition, early withdrawal requires that the certificate holder forfeit 3 months interest at the passbook rate. If the amount withdrawn has been on deposit for 3 months or less, all interest must be forfeited. See section 329.4(d) of the Federal Deposit Insurance Corporation Regulations, 12 CFR 329.4(d).

Pursuant to section 329.4(f) of the Federal Deposit Insurance Corporation Regulations, M has provided A with a written statement providing that A may not withdraw funds prior to maturity without M's consent, and that if such consent is given, a penalty will be assessed in accordance with section 329.4(d). Such consent is regularly granted by M upon a certificate holder's request.

A made no withdrawals during 1978.

LAW AND ANALYSIS The applicable sections of the Code and Income Tax Regulations are 1232, 1.1232-1, and 1.1232-3; 1.163-4; 591 and 1.591-1; 1.451-1; and 6049.

Section 1232 of the Code provides rules for the treatment of bonds and other evidences of indebtedness issued with original issue discount. Section 1.1232-1(d) of the regulations provides that the term "other evidence of indebtedness" includes certificates of deposit with banks, domestic building and loan associations, and similar financial institutions.

Section 1.1232-3(b)(1)(i) of the regulations provides that for purposes of section 1232 the term "original issue discount" means the difference between the issue price and the stated redemption price at maturity.

Section 1.1232-3(b)(1)(iii)(a) of the regulations provides that the term "stated redemption price at maturity" means the amount fixed by the last modification of the purchase agreement, including dividends, interest, and any other amounts, however designated, payable at that time. If any amount based on a fixed rate of simple or compound interest is actually payable or will be treated as constructively received under section 451 and the regulations thereunder at fixed periodic intervals of 1 year or less during the entire term of the obligation, any such amount payable at maturity shall not be included in determining the stated redemption price at maturity.

Section 1.1232-3A(b)(2) of the regulations provides that section 1232(a)(3) of the Code shall not apply to any obligation in respect of which the period between the date of original issue and the stated maturity date is one year or less. Under section 1232(a)(3), the ratable monthly portion of original issue discount multiplied by the number of complete months an obligation was held during the taxable year must be included in the holder's gross income.

Section 591 of the Code provides that in the case of mutual savings banks and certain other savings organizations, there shall be allowed as deductions amounts paid to, or credited to the accounts of, depositors or holders of accounts as dividends or interest on their accounts, if such amounts paid or credited are withdrawable on demand subject only to customary notice of intention to withdraw.

Under section 1.591-1(b) of the regulations, if a mutual savings bank maintains a bonus plan, or issues shares, or accepts deposits, subject to fines, penalties, forfeitures, or other withdrawal fees, it may deduct under section 591 of the Code the total amount credited as dividends or interest upon such shares or deposits, notwithstanding that as a customary condition of withdrawal such association has the right, pursuant to by-law, contract, or otherwise, to retain or recover a portion of the total amount invested in, or credited as earnings upon such shares or deposits of such bonus account, as a fine, penalty, forfeiture, or other withdrawal fee. However, if the provisions of paragraph (a) of section 1.163-4 (relating to deductions for original issue discount) apply to deposits made with respect to a certificate of deposit the provisions of section 1.591-1(b) shall not apply.

Section 1.163-4(a)(1) of the regulations provides that if an obligation is issued by a corporation with original issue discount, the amount of such discount is deductible as interest and shall be prorated or amortized over the life of the obligation. See also Rev. Rul. 73-220, 1973-1 C.B. 297 and Rev. Rul. 73-221, 1973-1 C.B. 298.

Section 1.163-4(a)(3) of the regulations provides that in any taxable year in which an amount of original issue discount that was deducted as interest under this section is retained or recovered by the taxpayer, such as, for example, by reason of a fine, penalty, forfeiture, or other withdrawal fee, such amount shall be includible in the gross income of such taxpayer for such taxable year.

Section 1.451-2(a) of the regulations provides that income although not actually reduced to a taxpayer's possession is constructively received in the taxable year during which it is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time, or so that it could have been drawn upon during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. The fact that the taxpayer would, by not withdrawing the earnings until a later date, receive a higher rate of earnings than would be payable if the earnings are withdrawn during the taxable year is not a substantial limitation or restriction. Section 1.451-2(a)(2).

In the present situation, the certificate issued by M to A does not provide for "any amount based on a fixed rate of simple or compound interest that is actually payable or will be treated as constructively received under section 451 and the regulations thereunder at fixed periodic intervals of one year or less during the entire term of the obligation." Section 1.1232-3(b)(1)(iii)(a) of the regulations. Rather, the certificate provides for a single payment of a fixed rate of interest upon maturity and not at fixed periodic intervals during the term of the certificate. Thus, the interest payable at maturity is included in determining the stated redemption price at maturity, pursuant to section 1.1232-3(b)(1)(iii)(a). Because the stated redemption price at maturity exceeds the issue price (by the amount of interest payable at maturity by M), the certificate is issued with original issue discount. However, because the term of the certificate is not more than 1 year ratable inclusion rules of section 1232(a)(3) of the Code are not applicable to A.

Although the fixed rate of interest with which the certificates are issued is not payable at fixed periodic intervals during the term of the certificates, certificate holders may withdraw funds from a certificate account during the term of the certificate. If this is done, the certificate account loses its character as a certificate of deposit (only to the extent of the withdrawal if at least $10,000 remains in the account), and takes on the characteristics of a regular passbook savings account. Thus, the amount of interest paid on early withdrawals is not a payment by M of original issue discount but is merely the payment of interest.

Because a certificate holder may receive interest at the regular passbook rate (less penalty) at any time during the term of a certificate, such interest is "otherwise made available" to the holder within the meaning of section 1.451-2(a) of the regulations. Further, the receipt of this amount of interest is subject to no substantial limitations or restrictions. The requirement of M's consent for early withdrawal is not a substantial limitation inasmuch as this consent is regularly granted by M. Thus, the holder of a certificate whose term overlaps the end of the taxable year constructively receives interest at the regular passbook rate (less penalty) as of the end of the taxable year.

HOLDINGS

1. The 6-month certificate is issued by M with original issue discount that is deductible ratably by M under section 1.163-4 of the regulations over the term of the certificate.

2. A, the holder of the certificate, constructively received interest at the rate of 5 percent per annum as of December 31, 1978, less 3 months' interest at the rate of 5 percent.

3. M must report the interest constructively received by A during 1978 on information returns, Form 1096 and 1099, in accordance with section 6049 of the Code.

4. If the total amount of interest actually received by A is less than the amount of original issue discount, the difference must be included in M's gross income in the taxable year of payment.

Although the factual situation contained in this revenue ruling concerns a 6-month nonnegotiable "money market" certificate issued by a mutual savings bank, the holdings set forth above also apply to issuers and holders of other comparable obligations including any nonnegotiable certificate with an original maturity of one year or less that provides for a single payment of a fixed rate of interest upon maturity rather than at fixed periodic intervals during the term of the certificate and that is issued by any financial institution that is subject to the interest rate limitations of the Federal Deposit Insurance Corporation, Federal Reserve Board, Federal Home Loan Bank Board, or National Credit Union Administration, Holdings 1 and 4 do not apply in the case of credit unions exempt from tax under section 501(c)(14) of the Code.

TRANSITION RULES

1. Financial institutions that issued information statements and filed Forms 1099 with the Service for 1978.

If a financial institution files Forms 1099 with the Service for 1978 and furnishes information statements to certificate holders with respect to short-term nonnegotiable time deposit certificates described in this revenue ruling issued before January 1, 1979, whose terms overlap the end of the taxable year, on a basis inconsistent with Revenue Ruling 79-72 the Service will not require the filing of corrected Forms 1099, and information statements for 1978, provided that Forms 1099 and information statements for 1979 report the entire balance of the interest on the certificates that was not reported on the Forms 1099 and information statements for 1978.

2. Financial institutions that have not filed Forms 1099 with the Service and did not issue information statements to certificate holders.

If, consistent with its past practice of reporting interest on such certificates only at maturity, a financial institution has not filed Forms 1099 with the Service with respect to short-term nonnegotiable time deposit certificates described in this revenue ruling issued before January 1, 1979, whose terms overlap the end of the taxable year, and has not issued information statements to holders of such certificates the Service will not require the filing of any Forms 1099 with respect to such certificates for 1978 or the issuance of any information statements to the certificate holders for 1978 provided the Forms 1099 and information statements for 1979 report the entire amount of interest paid on such certificates.

3. Certificate holders.

The Service will not disturb the treatment by cash method calendar year taxpayers of the interest income with respect to short-term nonnegotiable time deposit certificates described in this revenue ruling for 1978 provided that the interest income for 1978 and 1979 is reported in accordance with the information statements received from the issuing institutions and that the entire amount of interest income on the certificates is included as taxable income by the taxpayer.

¹ Also released as News Release IR 2109, dated March 7, 1979.