Treasury's global interest netting study recommends unnecessary limitations that would perpetuate inequities for taxpayers.

• Author: Everidge, Kathy L.

The Taxpayer Bill of Rights 2 required the Department of the Treasury to submit a report to the congressional tax-writing committees on: (1) the legal and policy issues relating to the netting of interest of federal overpayments and underpayments; and (2) the administrative practices of the Internal Revenue Service in that regard. On April 18, 1997, the long-awaited netting study was released.

The Treasury study concludes that "global" interest netting would be consistent with the intent expressed by Congress in the past. The study adds, however, that additional legislation would be necessary to achieve this policy goal and, because of administrative difficulties associated with global netting, such netting should be authorized only if certain limitations are adopted. This article describes the problems caused by the lack of global interest netting, the conclusions and recommendations of the Treasury study, and the outlook for change. It explains why limitations on a solution to the interest netting problem suggested by Treasury are not warranted, and would perpetuate inequities currently being experienced by many large corporate taxpayers.

Problems Caused by the Lack of

Global Interest Netting

Since 1986, taxpayers -- particularly corporate taxpayers -- have been charged interest rates on underpayments that are higher than the rates the same taxpayers receive on overpayments. The rate differential has grown from 1 to 4-1/2 percent. For example, if the Government owes a corporate taxpayer $100 for 1985 and the taxpayer owes the Government $100 for 1986, then as of March 15, 1987, when the 1986 tax liability became due, there is a mutual indebtedness between the Government and the taxpayer until such amounts are refunded or paid, respectively. If the debts are not offset or netted, however, the taxpayer could pay a whopping 4-1/2 percent differential on the interest it pays on the $100 it owes for 1986 as compared with the interest it receives on the $100 the Government owes the taxpayer for 1985 even though there is no true net debt (as of March 15, 1987) owed to the Government. Beginning with the enactment of the interest rate differential and continuing with each rate adjustment that has expanded the differential, Congress has repeatedly instructed the IRS to implement the most comprehensive interest netting procedures that are consistent with sound administrative practice.

The following definitions of terms may help clarify the differences between the IRS's current practices and the "global" interest netting that is necessary to prevent inequities caused by the interest rate differential:

Offsetting is a collection mechanism statutorily prescribed in section 6402 of the Internal Revenue Code that allows the IRS to apply any overpayment of the taxpayer to an outstanding liability of the taxpayer for any type of tax or any tax period prior to refunding any balance to the taxpayer.

Netting is the concept of equalizing interest rates between overpayments and underpayments during any time period when there is a mutuality of indebtedness, i.e., when there is no true debt.

If a taxpayer has a group of years with both overpayments and underpayments simultaneously processed by the IRS, the IRS will generally "offset" the overpayments and underpayments. The IRS has implemented "netting," however, only in cases where the taxpayer temporarily has underpayments and overpayments with respect to a single tax year -- a procedure referred to as "annual netting." See Rev. Proc. 94-60, 1994-2 C.B. 774. If overpayments and underpayments on multiple years are not processed together or if advance payments are made, interest will be paid to the taxpayer at the lower rate while the same taxpayer pays deficiency interest at the higher rate. This is because the IRS does not net interest if an overpayment or underpayment was previously in existence but has been satisfied as of the time the netting computation is performed (i.e., the deficiency has already been fully paid by the taxpayer and/or the overpayment has already been fully refunded by the Government, so that one of the taxpayer's tax accounts has a balance of zero). This broader form of interest netting is referred to by the IRS as "global netting."

The following examples will further describe offsetting and netting and demonstrate the inequities caused by the IRS's failure to implement global netting. Each example assumes a six-percent simple overpayment rate and a seven-percent simple underpayment rate. The demonstrated economic detriments would increase dramatically due to compounding, "hot interest" (an additional two percent imposed in respect of many corporate liabilities), and the reduced overpayment rate (a reduction of one-and-a-half percent for many corporate overpayments). When multiple years are closed out together and there are both overpayment and underpayment years, the IRS will generally offset the overpayment years against the underpayment years and issue a bill or refund for only the net amount. (If a refund year will be sent to the Joint Committee on Taxation staff for review, it is possible that the IRS will assess and try to collect the assessment prior to the allowance of the refund.)

Example 1: Simultaneous

Closing of Multiple Years

Assume the 1985 and 1986 tax years are closed out simultaneously at the Examination level. The 1985 year results in an overpayment of $100 and 1986 results in an underpayment of $100. In the normal course of business, the IRS will offset the overpayment of $100 for 1985 against the underpayment of $100 for 1986, as of the original due date of such amount. The taxpayer will receive a refund of the allowable interest accrued from March 15, 1986, on the $100 applied to the 1986 liability on March 15, 1987. Assuming the refund is made on March 15, 1995, the taxpayer will receive $6 ($100 x 6% x 1) plus $3 ($6 x 6% x 8) for a total of $9 ($6 + $3). (The taxpayer should include a statement on the Form 870 or 870-AD saying that the agreement is based on such application of overpayments/ underpayments.)

If there is not an assessed liability on the taxpayer's account at the point in time an overpayment is allowed (a transaction internal to the IRS), a refund will...