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F ederal Reserve Bank of Dallas DALLAS, TEXAS 75222 Circular No. 72-155 July 24, 1972 CONSIDERATIONS IN WAIVING OF INTEREST PAYMENT To All Member Banks and Others Concerned in the Eleventh Federal Reserve D istrict: The Board of Governors of the Federal Reserve System has recently considered the waiving of any interest payment that may apply under Regulation Q if banks and customers wish to make changes in deferred interest deposit agreements in the light of certain amendments to the Federal Income Tax Regulations. The views arrived at are stated below, and we request that member banks inform any affected customers of these views. Banks and customers have entered into deposit agreem ents w ith m aturities exceeding one year th a t provide fo r the payment of interest only a t the m aturity of the obligation. By virtue of adm inistra tive rulings issued by the Internal Revenue Service prior to June, 1970, the customer was not required to include any of the interest in his gross income until the year it was paid or made available at m aturity, and banks were perm itted to report the interest for Federal income tax purposes on an accrual basis. The advantage of these arrangem ents to the customer was the opportunity to defer interest income to min imize his overall tax liability. On December 28, 1971, the Internal Revenue Service published in the Federal Register (36 Fed. Reg. 24995) amendments to the Federal income tax regulations under section 1232 and 6049 of the Internal Revenue Code relating to bonds and other evidence of indebtedness w ith “original issue dis count.” These regulations apply to deferred interest CDs purchased and deferred interest deposits made in calendar years beginning Jan u ary 1, 1971. Although no interest is paid or made available to the depositor until the m aturity of the deposit obligation, the regulations require a depositor to include a portion of the deferred interest in his gross income each year over the term of the obligation. The calculation of the portion allocable to each year involves an apportioning of the total interest to be received on a pro-rata (straight-line) monthly basis. F or Federal tax purposes, banks m ust report interest as paid to the depositor on the same basis. You are concerned with the effect of Regulation Q on situations where: (1 ) banks amend deposit contracts or substitute current interest deposit arrangem ents for deferred interest deposit arrangem ents in order to perm it depositors to receive interest on an annual or more frequent basis so as to avoid the complex original issue discount in terest income computation and inclusion rules, and ( 2 ) a depositor makes an early w ithdraw al from his deposit in order to pay the tax on deferred interest required to be reported by the original issue discount regulations. You ask w hether the action taken by banks and depositors in these situations involves an “emer gency” w ithdraw al under the provisions of section 217.4(d) of Regulation Q and, if so, w hether the Board would be willing to waive the interest penalty specified in th a t section. The short answer to these queries is th a t the situation does not provide a basis fo r an “emergency” withdraw al as contemplated by the Regulation. Section 217.4(d) of Regulation Q relates to payment of the 'principal of a time deposit prior to m atu rity ; neither th a t section nor any other section of Regulation Q prevents a bank and its customer from renegotiating the term s of the contract relating to the frequency and dates of payment of interest on a deposit. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) Conversion from a deferred interest deposit arrangem ent to a current interest deposit arrangem ent affects only interest payments on the obligation. The depositor would receive interest at an earlier date than had been agreed upon at the time he entered into the contract. As long as the principal of the deposit is left undisturbed and the m aturity of the obligation is unchanged, conversion to current interest arrangem ents does not constitute a payment, in p a rt or in full, of a deposit prio r to m aturity and is not governed by the provisions of section 217.4(d). W ith respect to early withdrawal by the depositor in order to receive funds to pay the unanticipated tax liability, it is not necessary to disturb the principal of the deposit. It is evident th a t the additional tax liability resulting from the original issue discount regulations will be less than the interest earned (but not paid) on the deposit. In other words, the interest earned will be more than sufficient to_ cover the additional tax liability, and the bank and customer may agree th a t the depositor will be paid the interest earned in order to cover th a t liability. Since there is no necessity to reach the principal of the deposit, section 217.4 (d) would not apply. The Board is of the view that, in the circumstances of this case, equity requires an additional form of relief. Bank customers entered into these contracts on the assumption th at favorable tax treatm ent would rem ain available. The Board believes th a t a significant purpose of such contracts has therefore been fru strated by the changes in the income tax regulations. Consequently, the Board has concluded, on the basis of the doctrine of fru stratio n of the contract, th a t there would be no violation of Regulation Q if depositors or banks term inate th eir deposit agreem ents entered into prior to the effective date of the amended IRS regulations and affected thereby. Term ination of the deposit agreem ents on this basis does not involve the provisions of section 217.4(d) of Regulation Q. The Board wishes to make clear th a t its views are limited to this p articular situation and are not intended to establish a general rule with respect to the term ination of deposit contracts in the event of other changes in tax regulations th a t may affect them. Yours very truly, P. E. Coldwell, President
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