Rev. Proc. 84-28

SECTION 1. PURPOSE AND SCOPE

The purpose of this revenue procedure is to provide a mandatory procedure for taxpayers to change their method of accounting for interest on indebtedness when they have been reporting interest income or deductions in accordance with the Rule of 78's computation.

This revenue procedure applies to lenders and borrowers, who report interest income or who claim interest deductions with respect to loans using the Rule of 78's method, for those loans in which the interest computed using the Rule of 78's exceeds the loan payments during any year of the term of the loan. See Rev. Proc. 84-27 for a mandatory procedure for changing the method with respect to loans, which are not described in Rev. Proc. 83-40, 1983-1 C.B. 774, and for which the interest computed under the Rule of 78's does not exceed the loan payments during any year of the term of the loan. See Rev. Proc. 84-30 with respect to consumer loans coming within the administrative exception of Rev. Proc. 83-40. For consumer loans described in Rev. Proc. 83-40, the change is not mandatory. However, taxpayers proposing to change their method of accounting for such loans for any tax year must do so by complying with the provisions of Rev. Proc. 84-30.

SEC. 2. BACKGROUND

.01 The Rule of 78's is described in Rev. Rul. 83-84, 1983-1 C.B. 97, as a method of allocating interest on a loan among time periods during the term of the loan. Under this method, the amount of interest allocable to each period is determined by multiplying the total interest payable over the life of the indebtedness by a fraction, (a) the numerator of which is the number of periods remaining on such indebtedness at the time the calculation is made and (b) the denominator of which is the sum of the periods' digits for the term of the indebtedness.

.02 Rev.Rul. 83-84 indicates that the Rule of 78's represents a purely mechanical formula for allocating interest among periods. Because interest is earned by the lender by application of the effective rate of interest over the term of the loan, any agreement between a borrower and a lender that provides that interest is earned in another manner, such as under the Rule of 78's computation, lacks economic substance because it fails to reflect the true cost of borrowing. Rev.Rul. 83-84 indicates further that no tax effect will be given to the Rule of 78's provision.

.03 Rev.Rul. 83-84 states that an agreement between a borrower and a lender with respect to any one year of a loan is not independent of the agreement with respect to any other year of the loan. In general, the substance of a loan agreement is that the same rate of interest applies to each tax year of the loan, regardless of any contrary formulas that may be stated in the agreement. The amount of interest attributable to the use of money for each period between payments is determined by applying the "effective rate of interest" on the loan to the "unpaid balance" of the loan for that period. The unpaid balance of a loan is the amount borrowed plus interest earned minus amounts paid. The effective rate of interest is a measure of the cost of credit, expressed as a yearly rate, that relates the amount and timing of values received to the amount and timing of payments made, and is thus a reflection of the cost of the amount borrowed for the time it is actually available. See Conf.Rep. No. 97-760, 97th Cong., 2d Sess. 553 (1982), 1982-2 C.B. 600, 639; S.Rep. No. 97-494 (Vol. 1), 97th Cong., 2d Sess. 209 (1982); Supplement I to Regulation Z issued by the Federal Reserve System, 12 CFR Sections 226.6 and 226.40 (1979). Therefore, the effective rate of interest, which is a uniform rate over the term of the loan and is based on the amount of the loan and the repayment schedule provided in the loan agreement, when applied to the unpaid balance of the indebtedness for a given period, will produce the true cost of that indebtedness for that period. This true cost of borrowing is sometimes referred to as the economic accrual of interest. (For purposes of this revenue procedure the economic accrual of interest is hereinafter referred to as the "prescribed method.")

.04 Rev. Proc. 83-40 states that in a typical short-term consumer loan transaction, the Internal Revenue Service will accept the Rule of 78's method for computing the borrower's interest deduction and the lender's interest income as a matter of administrative convenience. The administrative exception for short-term consumer loans applies only when there is a self-amortizing loan that requires level payments, at regular intervals at least annually, over a period not in excess of five years (with no balloon payment at the end of the loan term), and when the loan agreement between the borrower and the lender provides that interest is earned, or upon the prepayment of the loan interest is treated as earned, in accordance with the Rule of 78's method. As indicated above under "PURPOSE AND SCOPE", any change in method of accounting regarding loans described in Rev. Proc. 83-40 is not a mandatory change. However, taxpayers proposing to change their method for such loans must do so by complying with the provisions of Rev. Proc. 84-30.

.05 Section 446(e) of the Internal Revenue Code and section 1.446-1(e) of the Income Tax Regulations provide that in order to change a method of accounting for federal income tax purposes the taxpayer must obtain the consent of the Commissioner. Section 1.446-1(e)(3)(i) requires that in order to obtain such consent an application must be filed within 180 days after the beginning of the tax year in which the taxpayer desires to make the change. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to a change in its method of accounting in accordance with section 446(e).

.06 Section 481(a) of the Code requires that those adjustments necessary to prevent amounts from being duplicated or omitted be taken into account when the taxpayer's taxable income is computed under a method of accounting different from the method used to compute taxable income for the preceding tax year. Section 481(c) and section 1.481-5 of the regulations provide that the adjustment required by section 481(a) may be taken into account in determining taxable income in the manner and subject to the conditions agreed to by the Commissioner and the taxpayer.

SEC. 3. APPLICATION

.01 Consent. In accordance with section 1.446-1(e)(3)(ii) of the regulations, the 180-day rule is waived and under section 1.446-1(e)(2)(i) consent is hereby granted to taxpayers to change a method of accounting with respect to interest on indebtedness from the method of computing interest income or deductions using the Rule of 78's method to the "prescribed method." See section 2.03 above. Such consent is granted for the first tax year ending on or after December 31, 1983, and the change shall be made in accordance with the provisions of this revenue procedure, including the adjustment under section 481(a) of the Code described in section 3.03 below.

.02 Year of change. Pursuant to the consent granted in section 3.01, both the lender and borrower to whom this revenue procedure applies and who are using the Rule of 78's method of accounting for computing interest income or deductions must change such method of accounting to the "prescribed method" on their federal income tax returns for the first tax year ending on or after December 31, 1983.

.03 Section 481(a) adjustment. An adjustment is required to prevent amounts of income and deduction from being duplicated within the meaning of section 481 of the Code and the regulations thereunder when the change in method of accounting is made pursuant to the provisions set forth in this revenue procedure. Such adjustment, whether positive or negative, referred to as the "section 481(a) adjustment," shall be taken into account in computing taxable income and in computing corporate earnings and profits. As to taxable income, the adjustment is made in the manner provided in sections 3.04-3.07 below. As to corporate earnings and profits, the adjustment is made in the manner provided in Rev. Proc. 79-49, 1979-2 C.B. 528. The change in method of accounting shall be considered to be a change in method of accounting initiated by the taxpayer.

.04 Period for positive section 481(a) adjustment.

1 When the section 481(a) adjustment results in an increase in taxable income and the change to the "prescribed method" is made in accordance with section 3.02, the period for taking into account the section 481(a) adjustment referred to in section 3.03 (adjustment period) is generally to be determined as follows:

(a) When the entire amount of the section 481(a) adjustment is attributable to the tax year immediately preceding the year of change (first preceding year), the total adjustment is to be taken into account in computing taxable income for the year of change. The amount attributable to the tax year immediately preceding the year of change is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the change to the "prescribed method" had been made in the preceding year.

(b) When (a) above does not apply and 67 percent or more of the amount of the section 481(a) adjustment is attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change, the highest percent attributable to the 1, 2, or 3-tax year period will be taken into account ratably over a 3-tax year period beginning with the year of change. Any remaining balance will be taken into account ratably over an additional period equal to the remainder of the number of tax years the taxpayer has continuously used the Rule of 78's method. However, the total adjustment period shall not exceed six tax years. This subparagraph, 3.04-1(b), only applies if the taxpayer has used the Rule of 78's method for more than three tax years. If the Rule of 78's method has been used for no more than four tax years, 75 percent shall be substituted for 67 percent. An amount attributable to the 1, 2, or 3-tax year period is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the change to the "prescribed method" had been made at the beginning of the preceding 1, 2, or 3-tax year period.

(c) In all other situations in which (a) and (b) above do not apply, the section 481(a) adjustment will be taken into account ratably over the number of years (not to exceed six) the taxpayer has continuously used the Rule of 78's method.

2 In applying sections 3.04-1(a) or (b), if a taxpayer's books and records do not contain sufficient information to compute the section 481(a) adjustment attributable to the 1, 2, or 3-tax year period immediately preceding the year of change, the taxpayer may reasonably estimate the amounts and attach and sign (or have signed by an officer who has personal knowledge of the facts) the following statement to the Form 3115, Application for Change in Accounting Method:

Under penalty of perjury, I hereby certify that:

(a) the books and records of (name of the taxpayer) do not contain sufficient information to permit a computation of the section 481(a) adjustment attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change as required by section 3.04-1(b) of Rev. Proc. 84-28.

(b) Based on the information that is contained in the records, to the best of my information and belief, the entire amount of the section 481(a) adjustment for the year of change (indicate either "is" or "is not," as the case may be) attributable to the tax year immediately preceding the year of change, and 67 percent (or 75 percent in applicable cases) or more of the section 481(a) adjustment for the year of change (indicate "is" or "is not," as the case may be) attributable to the 1-tax year period, 2-tax year period, or 3-tax year period immediately preceding the year of change.

3 A cooperative within the meaning of section 1381(a) of the Code shall take the total amount of the section 481(a) adjustment into account in computing taxable income for the year of change.

.05 Change in subsequent year for positive section 481(a) adjustment.

1 Under certain circumstances, a taxpayer who has a positive section 481(a) adjustment and who does not change to the "prescribed method" for the first tax year ending on or after December 31, 1983, may not use this revenue procedure to make the change for a later year. The provisions of this revenue procedure are not available to such a taxpayer who has been contacted in any manner by a representative of the Service for the purpose of scheduling an examination of its federal income tax return(s). If a taxpayer has not been contacted by the Service for the purpose of scheduling an examination of its return(s), consent is hereby granted to the taxpayer to change to the "prescribed method" for tax years subsequent to the required tax year set forth in section 3.02. The change must be made on the taxpayer's timely filed federal income tax return for such subsequent year.

2 The section 481(a) adjustment will be taken into account ratably over a number of years, which depends on the number of years that the section 481(a) adjustment would have been taken into account if the taxpayer had made the change for the first tax year ending on or after December 31, 1983. If the taxpayer had made the change for the first tax year ending on or after December 31, 1983, and if the section 481(a) adjustment would have been taken into account over (a) four through six tax years, (b) three tax years, or (c) two or less tax years, then, when the taxpayer makes the change for a subsequent tax year, the number of years over which the section 481(a) adjustment is taken into account shall be (a) three tax years, (b) two tax years, or (c) one tax year, respectively. See Examples C and D, contained in section 7 of this revenue procedure.

.06 Period for negative section 481(a) adjustment.

1 When the section 481(a) adjustment results in a decrease in taxable income and the change to the "prescribed method" is made in accordance with section 3.02, the period for taking into account the section 481(a) adjustment referred to in section 3.03 (adjustment period) is generally to be determined as follows:

(a) When the entire amount of the section 481(a) adjustment is attributable to the tax year immediately preceding the year of change (first preceding year), the total adjustment is to be taken into account in computing taxable income for the year of change. The amount attributable to the tax year immediately preceding the year of change is the difference in the amount of the adjustment determined under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the change to the "prescribed method" had been made in the preceding year.

(b) In all other situations, the section 481(a) adjustment will be taken into account ratably over the number of years (not to exceed three) the taxpayer has continuously used the Rule of 78's method.

2 A cooperative within the meaning of section 1381(a) of the Code shall take the total amount of the section 481(a) adjustment into account in computing taxable income for the year of change.

.07 Change in subsequent year for negative section 481(a) adjustment. If the taxpayer fails to change to the "prescribed method" in accordance with the consent granted in section 3.01 of this revenue procedure, consent is hereby granted to change to the "prescribed method" for tax years subsequent to the required tax year set forth in section 3.02. The change must be made on the taxpayer's timely filed federal income tax return for such subsequent year, and the section 481(a) adjustment will be taken into account ratably over the number of years the taxpayer continuously has used the Rule of 78's method, not to exceed six tax years.

.08 Under examination. This revenue procedure does not apply to a lender or a borrower who uses the Rule of 78's method and whose reported interest income or claimed interest deduction exceeds the loan payments made during any of the tax years of the loan, if an issue concerning the amount of reported interest income or claimed interest deduction has been raised and is pending on April 2, 1984, in connection with the examination of the taxpayer's federal income tax return. In such situations, the provisions of section 481 of the Code will be applied by the examining agent, i.e., those adjustments necessary to make the change in method will be taken into account in one tax year.

.09 Net Operating Loss Carryovers and Net Operating Losses.

1 No part of any (consolidated or separate) net operating loss carryover available at the beginning of the year of change may be used as an offset against the portion of the positive section 481(a) adjustment taken into account in the year of change. This condition will not apply to tax years subsequent to the year of change.

2 Any portion of any net operating loss arising in the year of change or in any subsequent year in the adjustment period that is attributable to the negative section 481(a) adjustment may not be carried to those 3 tax years preceding the year of change, to which section 172 of the Code otherwise would require it first to be carried.

.10 Investment credit or any other credits. No part of any (consolidated or separate) investment credit carryover or any other credit carryover available at the beginning of the year of change may be used to reduce the federal income tax liability resulting from, or attributable to, the inclusion in income of a portion of the section 481(a) adjustment in the year of change. This restriction does not apply, however, to a credit arising in the year of change.

.11 Ceasing to engage in the trade or business.

(a) With respect to a corporation:

If a corporate taxpayer ceases to engage in the trade or business to which the section 481(a) adjustment (section 3.03) relates at any time prior to the expiration of the adjustment period, the taxpayer shall take into account in that year the balance of the adjustment not previously taken into account in computing taxable income. See Rev. Rul. 80-39, 1980-1 C.B. 112, which holds that if a division of a corporation, for which a change in method of accounting had been granted, ceases to operate the trade or business for which the change in method was granted, the remaining section 481(a) adjustment applicable to the business conducted by that division of the corporation must be taken into account in the year the corporation ceases to engage in that trade or business. For purposes of this condition, the taxpayer is not considered to have ceased the trade or business if the cessation is the result of a transaction to which section 381 of the Code applies, but in that case the acquiring corporation shall continue to be subject to this revenue procedure as though it were the acquired corporation.

(b) With respect to a partnership:

In the event a partnership terminates or ceases to engage in the trade or business (within the meaning of section 708 of the Code) to which the section 481(a) adjustment (section 3.03) relates at any time prior to the expiration of the adjustment period, the balance of the section 481(a) adjustment not previously taken into account in computing the partnership's income or deductions shall be taken into account in the year of cessation. A partnership ceasing to engage in the trade or business includes the incorporation of the trade or business in a transaction to which section 351 applies (see Rev. Rul. 77-264, 1977-2 C.B. 187).

(c) With respect to a sole proprietor:

If a sole proprietor ceases to engage in the trade or business to which the section 481(a) adjustment (section 3.03) relates at any time prior to the expiration of the adjustment period, the balance of the adjustment not previously taken into account in computing taxable income shall be taken into account in the year of cessation. A sole proprietor ceasing to engage in the trade or business includes the incorporation of such trade or business in a transaction to which section 351 of the Code applies (see Rev. Rul. 77-264). A sole proprietorship does not cease to engage in that trade or business when the individual taxpayer sells a partial interest in the proprietorship and continues to be actively engaged in the management of the business that is subsequently operated as a partnership. The section 481(a) adjustment remaining at the time the partnership is formed is taken into account by the partnership as though there had been no change in ownership (see Rev. Rul. 66-206, 1966-2 C.B. 206).

SEC. 4. RECORDS

Taxpayers must maintain adequate records so that the Service may, upon examination, verify the data concerning the change in method of accounting.

SEC. 5. COMPLIANCE WITH CONDITIONS

Taxpayers making a change from the Rule of 78's method to the "prescribed method" without complying with all the conditions of this revenue procedure will be deemed to have made the change without obtaining the consent of the Commissioner.

SEC. 6. MANNER OF EFFECTING THE CHANGE

.01 Taxpayers to which this revenue procedure applies must effect the change in their methods of accounting for their first tax year ending on or after December 31, 1983, pursuant to the provisions set forth in this revenue procedure by filing a current Form 3115, Application for Change in Accounting Method, in duplicate. The original of the Form 3115 shall be attached to the taxpayer's timely filed federal income tax return for such year, or to an amended return for such year filed no later than the extended time period prescribed in section 6081 of the Code and the regulations thereunder whether or not the taxpayer has, in fact, been granted an extension of time for filing its income tax return for such year. For example, a domestic corporation, whose tax year ends December 31, 1983, must effect the change described in this revenue procedure on the original timely filed return for 1983, or on an amended return for the 1983 tax year filed no later than September 15, 1984. Similarly, an individual, whose tax year ends December 31, 1983, must effect the change described in this revenue procedure on the timely filed return for 1983, or on an amended return for the 1983 tax year filed no later than August 15, 1984. At the time the original of the Form 3115 is filed with the federal income tax return, a copy of the Form 3115 shall be filed with the National Office addressed to the Commissioner of Internal Revenue Service, Attention: CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. In addition to the information required on Form 3115, the taxpayer must provide (1) a computation of the section 481(a) adjustment and (2) the period over which the section 481(a) adjustment will be taken into account and the basis for such conclusion. The National Office will sample the Form 3115's to determine whether the requirements of this revenue procedure have been followed. The National Office or the District Director may advise the taxpayer of required adjustments to the change in method of accounting for interest income and deductions.

.02 Taxpayers described in section 3.05 or section 3.07 must also follow the procedures set forth in section 6.01 regarding the place for filing of the original and the copy of the Form 3115 with respect to the tax year for which the change to the "prescribed method" is made. Such taxpayers must also furnish with the Form 3115 the additional information set forth in section 6.01 above regarding the section 481(a) adjustment and its adjustment period.

.03 In order to assist in the processing of these changes in methods of accounting and to ensure proper handling, reference to this revenue procedure shall be made a part of the Form 3115 by either typing or legibly printing the following statement at the top of Page 1 of Form 3115: "FILED UNDER REV.PROC. 84-28".

SEC. 7. EXAMPLES

Example A.

LP, a limited partnership that uses the accrual method of accounting and reports its income on a calendar year basis, borrowed $100,000 on January 1, 1977, payable in 30 annual installments of $12,414 each. The total interest on the loan will be $272,420 (30 x 12,414 = $372,420; $372,420 $100,000 = $272,420). The terms of the loan state that interest is earned by the lender in accordance with the Rule of 78's computation, and the taxpayer computed its annual interest deduction for six years using the Rule of 78's. The effective rate of interest is 12 percent. The table appearing in the "Law and Analysis" section of Rev. Rul. 83-84 describes the overall transaction. During the six years LP deducted a total of $96,665 in interest based on the Rule of 78's method. If LP had used the "prescribed method" for computing its deductions for interest during those six years, the total interest deduction would have been $71,124. The difference in the interest deduction using the two methods is $25,541. The following table shows the interest computed under the two methods for the first six years.

                                Table

                          1-tax year period

Example B

The facts are the same as Example A except that LP's federal income tax returns filed for 1980 and 1981 were under examination by the Service and an issue concerning the amount of a claimed interest deduction has been raised and is pending on April 2, 1984. Since LP's claimed interest deductions for the years under examination ($15,818 and $15,232) exceeded the actual loan payments of $12,414 during each of those years, this revenue procedure does not apply to it. The provisions of section 481 of the Code will be applied by the examining agent to change LP's method of accounting for interest as of January 1, 1980. See section 3.08 of this revenue procedure.

Example C

The facts are the same as Example A except that LP ignores the mandatory requirement of section 3.02 of this revenue procedure, i.e., the taxpayer does not change to the "prescribed method" for 1983. If LP has not been contacted by the Service for purposes of scheduling an examination, LP may change to the "prescribed method" for any year subsequent to 1983 by complying with sections 3.05 and 6.02 of this revenue procedure. The section 481(a) adjustment must be taken into account ratably over three tax years. See section 3.05-2.

Example D

LP, a limited partnership that uses the accrual method of accounting and reports its income on a calendar year basis, borrowed money on January 1, 1981. The terms of the loan state that interest is earned by the lender in accordance with the Rule of 78's computation, and the taxpayer computed its annual interest deduction for two years using the Rule of 78's method. If LP had made the change to the "prescribed method" for its 1983 tax year, the amount of the section 481(a) adjustment would have been taken into account ratably over two years (one-half in 1983 and one-half in 1984). LP does not change to the "prescribed method" for 1983. If LP has not been contacted by the Service for purposes of scheduling an examination, LP may change to the "prescribed method" for any year subsequent to 1983 by complying with sections 3.05 and 6.02 of this revenue procedure. The total section 481(a) adjustment must be taken into account in the year of change. See section 3.05-2.

SEC. 8. MISCELLANEOUS

Where a taxpayer's change in method of accounting falls within the scope set forth in section 1 of this revenue procedure, that taxpayer must use this revenue procedure to effectuate such change in method of accounting and may not use the provisions of Rev. Proc. 80-51, 1980-2 C.B. 818. Thus, the original of the application for permission to change the method of accounting described in this revenue procedure, if filed with the National Office under the general provisions of Rev. Proc. 80-51, will not be considered a valid application. Any such original applications erroneously filed with the National Office will be returned without processing and with instructions to comply with this revenue procedure.

SEC. 9. ALTERNATIVE PROCEDURE FOR CERTAIN INDIVIDUAL BORROWERS

Individual borrowers, who previously reported interest expense based upon the Rule of 78's method, may have difficulty computing the amount of interest that economically accrues in order to comply with the provisions of this revenue procedure. Many of these taxpayers may qualify to use the alternative procedure, contained in Rev. Proc. 84-29, for computing allowable interest deductions. One of the requirements that must be met in order to qualify for the alternative procedure contained in Rev. Proc. 84-29 is that the proceeds of the loan were not used for investment purposes or to purchase items in connection with a trade or business. See Rev. Proc. 84-29 for complete details.

SEC. 10. INQUIRIES

Inquiries regarding this revenue procedure may be addressed to the Commissioner of Internal Revenue, Attention CC:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.