Rev. Proc. 84-30

SECTION 1. PURPOSE AND SCOPE

The purpose of this revenue procedure is to provide an expeditious procedure for taxpayers to obtain consent 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 using the Rule of 78's method with respect to consumer loans described in Rev. Proc. 83-40, 1983-1 C.B. 774. See Rev. Proc. 84-27, which provides a mandatory procedure for changing an accounting method from the Rule of 78's method for loans that are not described in Rev. Proc. 83-40 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. 84-28, which provides a mandatory procedure for changing an accounting method from the Rule of 78's method for loans, for which the interest computed under the Rule of 78's exceeds the loan payments during any year of the term of the loan.

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.

.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 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 and deductions using the Rule of 78's method to the "prescribed method." See section 2.03 above. Such consent is granted for any tax year ending on or after December 31, 1983, for which the taxpayer requests a change (i.e., year of change) by filing a current Form 3115 in the manner described in section 6 and by otherwise complying with the provisions of this revenue procedure.

.02 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 section 3.03 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.

.03 Section 481 adjustment period.

1 When the change to the "prescribed method" is made in accordance with section 3.01, the period for taking into account the section 481(a) adjustment referred to in section 3.02 (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 subparagrapah, 3.03-1(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 For an example of the application of the rules prescribed in this revenue procedure, see section 7.

3 In applying sections 3.03-1(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 amount 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 3.03-1(b) of Rev. Proc. 84-30.

(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 "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.

4 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.

.04 Net Operating Loss Carryovers and Net Operating Losses.

1 No part of any (consolidated or separate) net operating loss carryover (NOL 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.

.05 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 any part 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.

.06 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 3.02) relates at any time prior to the expiration of the adjustment period referred to in section 3.03, 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 3.02) relates, at any time prior to the expiration of the adjustment period referred to in section 3.03, 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 3.02) relates, at any time prior to the expiration of the adjustment period referred to in section 3.03, 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 of 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).

.07 Conformity. Taxpayers electing to change from the Rule of 78's method to the "prescribed method" under this revenue procedure must keep their books and records, including financial statements and statements for credit purposes, for the year of change and for later years on the "prescribed method".

.08 Reporting to borrowers. If a lender changes from the Rule of 78's method to the "prescribed method" under this revenue procedure and if the lender reports to the borrower the amount of interest that the borrower has paid during a year, the lender must continue to use the Rule of 78's computation in reporting the amount of interest to the borrower with respect to loans in existence at the beginning of the year of change.

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 may effect the change in their methods of accounting for any 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 the tax year that the taxpayer requests a change in method. For example, a domestic corporation whose tax year ends on December 31, 1983, may effect the change described in this revenue procedure for the 1983 tax year on a timely filed return, no later than September 15, 1984. At the same time 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 In order to assist in the processing of these changes in method 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. 84-30".

SEC. 7. EXAMPLE

For 11 years a financial institution, that reports its income on a calendar year basis, has used the Rule of 78's method for reporting interest income for loans that have terms of 5 years or less and that are described in Rev. Proc. 83-40. The taxpayer wants to change to the "prescribed method" of reporting interest for the tax year ending on December 31, 1983. In each year 1976 through 1982, the taxpayer made 10 loans of $10,000 each payable in 5 annual installments. For the loans made in 1976, 1977, and 1978, the annual payment was $2,638 for each loan. The total interest on each of these loans was $3,190 (5 x $2,638 = $13,190; $13,190 $10,000 = $3,190). The effective rate of interest was 10 percent. For the loans made in 1979 and subsequent years, the annual payment was $2,774 for each loan. The total interest on each of these loans was $3,870 (5 x $2,774 = $13,870; $13,870 $10,000 = $3,870). The effective rate of interest was 12 percent. The terms of all these loans state that interest is earned by the lender in accordance with the Rule of 78's computation. All loans made during 1978 and earlier years had been paid off by January 1, 1983. During the four years (1979 through 1982), for which there were still loans outstanding as of January 1, 1983, the taxpayer included a total of $103,200 as interest computed under the Rule of 78's method. If the taxpayer had used the "prescribed method" for computing its interest income during those four years, the total interest income would have been $99,940. The difference in interest income using the two methods is $3,260. Table 1 shows the interest computed under the Rule of 78's method, and Table 2 shows the interest computed under the "prescribed method."

With the taxpayer's timely filed federal income tax return for 1983, the taxpayer filed a current Form 3115 in accordance with the provisions set forth in sections 3 and 6.01 of this revenue procedure. By changing to the "prescribed method" commencing with the 1983 tax year and continuing to use that method, the taxpayer will eventually have a double inclusion of interest income in the amount of $3,260. Thus, under section 481(a) of the Code, an adjustment is necessary solely by reason of the change in method of accounting in order to prevent the $3,260 from being duplicated, i.e., included again in income. If the taxpayer had made the change to the "prescribed method" for the tax years 1980, 1981, or 1982, the amount of the adjustment would have been $2,550, $2,880, or $3,140 respectively (see Table 3 for the computations). The percent of the section 481(a) adjustment attributable to the 1, 2, or 3-tax year period preceding the year of change is determined as follows:

                          1-tax year period

SEC. 8. MISCELLANEOUS

.01 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 (Form 3115) 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.

.02 Notwithstanding the provisions of section 8.01 above, if, prior to April 2, 1984, a taxpayer timely filed a form 3115 with the Commissioner to change from the Rule of 78's method to the "prescribed method" and filed its federal income tax return for the requested year of change, the taxpayer may comply with this revenue procedure by attaching a Form 3115 to an amended return for that year and by otherwise complying with the conditions of this revenue procedure. The amended return must be filed no later than the extended time 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 example, no later than September 15, 1984, for a domestic corporation whose tax year ends December 31, 1983).

SEC. 9. 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.