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FED ER AL RESERVE BANK O F NEW YORK j" Circular No. 6975*1 L July 21, 1972 J REGULATION Q Changes in D eferred-Interest Deposit A rrangem ents for Incom e Tax Purposes To the M em ber B anks of the Second Federal Reserve D istrict: Following is the text of a letter from the Board of Governors of the Federal Reserve System to the A m erican Bankers A ssociation: T h is refers to y o u r le tte r of M a rc h 9, 1972, a s k in g th e B o a rd to give co n sid eratio n to w aiv in g an y in te re st p en a lty th a t m ay apply if b an k s a n d cu sto m e rs w ish to m ake ch an g es in d efe rred in te re s t deposit ag re em e n ts in th e lig h t of c e rta in am en d m e n ts to th e F e d e ra l incom e ta x reg u la tio n s. B an k s an d cu sto m e rs have e n te re d in to d ep o sit ag re em e n ts w ith m a tu ritie s ex ceed in g one y e a r th a t pro v id e for the p ay m en t of in te re st only a t th e m a tu rity of th e obligation. B y v irtu e of a d m in istra tiv e ru lin g s issued by the In te rn a l R e v en u e S ervice p rio r to J u n e 1970, th e cu sto m e r w as n o t re q u ire d to in clu d e an y of th e in te rest in h is g ro ss incom e u n til th e y e a r it w as paid o r m ade available a t m a tu rity , an d b an k s w ere p e rm itte d to re p o rt the in te re st fo r F e d e ra l incom e ta x p u rp o ses on an ac cru al basis. The^ ad v a n ta g e of th ese a rra n g e m e n ts to th e c u sto m e r w as th e o p p o rtu n ity to d efer in te re st incom e to m inim ize h is overall ta x liability. Federal R egister O n D ecem ber 28, 1971, th e I n te rn a l R e v en u e S ervice p u b lish ed in th e (3 6 F ed . R eg. 24995) am en d m e n ts to th e F e d e ra l incom e ta x re g u la tio n s u n d e r sections 1232 a n d 6049 of th e In te rn a l R ev en u e C ode re la tin g to bon d s an d o th e r evidence of in d eb ted n ess w ith “ o rig in a l issu e d isc o u n t.” T h ese reg u la tio n s apply to d efe rred in te re st C D s p u rch a sed an d d efe rred in te re s t d ep o sits m ade in ca le n d ar y e a rs b eg in n in g J a n u a ry 1, 1971. A lth o u g h no in te re s t is p aid o r m ad e available to th e d ep o sito r u n til th e m a tu rity of th e d eposit o bligation, the re g u la tio n s re q u ire a d ep o sito r to include a p o rtio n of th e d e fe rre d in te re st in h is g ro ss incom e each y e a r o v er th e te rm of th e obligation. T h e calcu latio n of th e p o rtio n allocable to each y e a r involves an a p p o rtio n in g of th e to tal in te re st to be received on a p ro -ra ta (s tra ig h t-lin e ) m on th ly basis. F o r F e d e ra l ta x p u rp o se s, b an k s m u st re p o rt in te re st as p aid to th e d e p o sito r on th e sam e basis. Y ou a re concerned w ith th e effect o f R e g u la tio n Q on situ atio n s w h e re : ( 1 ) b an k s am en d dep o sit c o n tra c ts o r su b stitu te c u rre n t in te re st dep o sit a rra n g e m e n ts fo r d efe rred in te re st d ep o sit a rra n g e m e n ts in o rd e r to p e rm it d ep o sito rs to receive in te re st on an an n u a l o r m o re fre q u e n t basis so as to avoid th e com plex o rig in al issue d isc o u n t in te re st incom e co m p u tatio n an d in clu sio n ru les, an d ( 2 ) a d ep o sito r m akes a n ea rly w ith d raw a l fro m his dep o sit in o rd e r to p a y th e ta x on d e fe rre d in te re st re q u ire d to be re p o rte d by th e o rig in a l issue d isco u n t reg u la tio n s. Y ou ask w h eth e r th e action ta k e n by b an k s an d d ep o sito rs in th ese situ atio n s involves a n “ em erg en cy ” w ith d raw a l u n d e r the p ro v isio n s of section 2 1 7 .4 (d ) of R e g u la tio n Q an d , if so, w h eth e r th e B o a rd w ould be w illing to w aive th e in te re st p en a lty specified in th a t section. T h e sh o rt a n sw e r to th ese qu eries is th a t th e situ atio n does n o t p ro v id e a basis fo r an “ em erg en c y ” w ith d ra w a l as co n tem p late d by the R eg u la tio n . S ectio n 2 1 7 .4 (d ) of R e g u la tio n Q rela tes to p ay m en t of the of a tim e d ep o sit p rio r to m a tu r ity ; n e ith e r th a t section n o r an y o th e r section of R e g u la tio n Q p rev e n ts a b an k a n d its cu sto m e r from re n e g o tia tin g th e te rm s of th e c o n tra c t re la tin g to th e freq u en cy an d d ates o f p ay m en t of in te re st on a deposit. p cip l rin a C onversion from a d e fe rre d in te re st dep o sit a rra n g e m e n t to a c u rre n t in te re st d ep o sit a rra n g e m e n t affects only in te re st p ay m en ts on th e obligation. T h e d e p o sito r w ould receive in te re st a t a n e a rlie r date th a n h ad been ag re ed u p o n a t th e tim e he e n te re d into th e co n tra ct. A s long as th e p rin cip al of th e deposit is left u n d istu rb e d an d th e m a tu rity of th e ob lig atio n is u n ch an g ed , co n v ersio n to c u rre n t in te rest a rra n g e m e n ts does not co n stitu te a p ay m en t, in p a rt o r in full, of a dep o sit p rio r to m a tu rity a n d is n ot g o v ern e d by th e pro v isio n s of section 2 1 7 .4 (d ) . W ith resp ect to early w ith d ra w a l by th e d e p o sito r in o rd e r to receive fu n d s to p ay th e u n an ticip ate d ta x liability, it is not necessary to d istu rb th e of th e deposit. It is ev id en t th a t the ad d itio n a l ta x liability re su ltin g fro m the o rig in al issue d isco u n t reg u la tio n s w ill be th a n th e in te re st ea rn ed (b u t p cip l rin a less ( over) n o t p a id ) on th e d eposit. In o th e r w o rd s, th e in te re s t ea rn ed w ill be m o re th a n sufficient to cover th e ad d itio n a l ta x liability, a n d th e ban k a n d cu sto m er m ay ag re e th a t th e d ep o sito r w ill be p aid th e in te re st ea rn e d in o rd e r to co v er th a t liability. Since th e re is no necessity to reach th e p rin cip al of th e deposit, section 2 1 7 .4 (d ) w o u ld n o t apply. T h e B o a rd is of th e view th a t, in th e c irc u m sta n ce s of th is case, eq u ity re q u ire s a n ad d itio n a l fo rm of relief. B a n k c u sto m e rs e n te re d in to th ese c o n tra cts on th e a ssu m p tio n th a t fav o rab le ta x tre a tm e n t w ould rem a in available. T h e B o ard believes th a t a sig n ifican t p u rp o se of such c o n tra c ts h as th e re fo re been fru s tra te d by th e changes in the incom e ta x re g u la tio n s. C o n seq u en tly , th e B o a rd h as concluded, on th e basis of th e d o c trin e of fru s tra tio n of th e c o n tra c t, th a t th e re w ould be no v io latio n of R e g u la tio n Q if d e p o sito rs o r b an k s te rm in a te th e ir d ep o sit a g re e m e n ts e n te re d in to p rio r to th e effective d ate of th e am en d ed I R S re g u la tio n s an d affected th ereb y . T e rm in a tio n of th e d ep o sit ag re em e n ts on th is basis does n o t involve th e p ro v isio n s of section 2 1 7 .4 (d ) of R e g u la tio n Q . T h e B o a rd w ishes to m ake clear th a t its view s a re lim ited to th is p a rtic u la r situ a tio n an d a re n o t in te n d e d to estab lish a g en e ral ru le w ith resp e ct to th e te rm in a tio n of dep o sit c o n tra c ts in th e ev en t of o th e r ch an g es in ta x re g u la tio n s th a t m ay affect them . P lease in fo rm those of your depositors who m ay be affected of the B oard of G overnors’ views on this m atter. A lfred H a y e s, President.
@FedFRASER