FAQs: What are AFRs for tax purposes?

The applicable federal rates (AFRs) are used for a number of federal tax provisions. For example, Code Sec. 1274 uses AFRs to determine whether a debt instrument has original issue discount (OID or imputed interest). This determination requires the calculation of the present value of payments made on the debt instrument; present value is calculated using a discount rate equal to the AFR, compounded semi-annually.

Determining AFRs

AFRs are based on the average market yield on outstanding marketable obligations of the United States government. Under Code Sec. 1274(d), the AFR includes the federal short-term rate (based on the interest rates for debt instruments of three years or less); the federal mid-term rate (based on the rates for debt instruments of three to nine years); and the federal long-term rate (based on the rates for debt instruments exceeding nine years).

The IRS computes AFRs for each calendar month and publishes them in a revenue ruling. As an example, Rev. Rul. 2014–1, published January 6, 2014, provided the AFRs for January 2014. AFRs may be compounded (and therefore applied) monthly, quarterly, semiannually, or annually. In addition, some amounts are calculated using a higher percentage of the basic AFR. The monthly revenue rulings provide AFRs equal to 110 percent of the base AFR, 120 percent, 130 percent, 150 percent, and 175 percent.

Applying AFRs

The Tax Code uses AFRs to determine appropriate amounts under a multitude of provisions. These include:

• The present value of an annuity, life interest, term of years interest, remainder interest, or reversionary interest under Code Sec. 7520;
• Loans with below-market interest rates, under Code Sec. 7872 (the applicable rate depending on the term of the loan);
• Insurance reserves under Code Sec. 807, as well as insurance provisions under Code Secs. 811 and 812;
• The present value of golden parachute payments under Code Sec. 280G (120 percent of the AFR, compounded semiannually);
• Payments for the use of property or services under Code Sec. 467;
• Unrelated business income and debt-financed income under Code Sec. 514; and
• The recharacterization of gain from straddles under Code Sec. 1058.

The AFR revenue rulings also provide adjusted AFRs, which are used to determine the Code Sec. 382 limits on NOLs following ownership changes, and to determine OID on tax-exempt obligations under Code Sec. 1288.

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