November 26, 2003

Internal Policy Directive 2003-5
SINGLE BUSINESS TAX
DEFINITION OF INTEREST

How is "interest" defined under the Michigan Single Business Tax Act?

"Interest" is defined as a charge allowed by law or fixed by the respective parties for the use or forbearance of money, a charge for the loan or forbearance of money, or a sum paid for the use or forbearance of money, or for the delay in payment of money.

The following factors must be present before a charge can qualify as "interest":

1. A debtor-creditor relationship must exist between the two parties.
2. The charge must be based on a percentage of an account balance and not a flat fee.
3. It must be a rate fixed pursuant to contract or law.
4. It must reflect the time value of money.

In addition, purchase discounts taken do not qualify as interest. Furthermore, subvention payments do not qualify as interest because they are not made for the use or forbearance of money. Moreover, generally accepted accounting principles are not controlling when determining if a charge qualifies as "interest".

MCL 208.9(4)(f) requires the addition of interest paid to the extent deducted in arriving at federal taxable income to the SBT base. Furthermore, MCL 208.9(7)(b) allows a deduction for interest included at arriving at federal taxable income. As a result it is necessary to define the term "interest" as it is used in the SBTA.

The SBTA does not provide guidance on the definition of "interest" other than specifically excluding "payments or credits made to or on behalf of a taxpayer by a manufacturer, distributor, or supplier of inventory to defray any part of the taxpayers floor plan interest, if these payments are used by the taxpayer to reduce interest expense in determining federal taxable income". MCL 208.9(4)(f).

Pursuant to MCL 208.2(2) a term used in the SBTA that is not defined differently, shall have the same meaning as when used in a comparable context in the laws of the United States relating to federal income taxes in effect for the tax year unless a different meaning is clearly required. Accordingly, we should first look to the Federal Internal Revenue Code’s (IRC) definition of "interest". However, the IRC does not provide a definition. As a result, the federal rules regarding characterization of income do not apply when determining if compensation paid qualifies as "interest".

Because the IRC does not define "interest", Michigan case law provides the most persuasive precedent. In Town & Country Dodge, Inc v Dep't of Treasury, 420 Mich 226, 362 NW2d 618 (1984) the Michigan Supreme Court held, " [n]otwithstanding the uniqueness of the SBTA, we assume that since the SBTA does not define the term "interest," the legislature intended that the word was to be construed according to its ordinary and primarily understood meaning." The court went on to define "interest" as "compensation allowed by law or fixed by the respective parties for the use or forbearance of money, a charge for the loan or forbearance of money, or a sum paid for the use of money, or for the delay in payment of money."

Consequently, for SBTA purposes, "interest" can fairly be defined as a charge, allowed by law or agreed to by the parties, for a loan, use or forbearance of money. Various factors must be considered when making a determination.

Because "interest" is defined as a charge allowed by law or fixed by the parties for the use or forbearance of money, a charge for the loan or forbearance of money, or a sum paid for the use or forbearance of money, or for the delay in payment of money, it is entirely reasonable to embrace a finding that a debtor – creditor relationship must exist before the transfer of money between two parties can be considered "interest". Moreover, Letter Ruling 1989-60 states the charge or payment must be based on a percentage of an account balance and not a flat fee to be considered "interest". This position is consistent with the holding in Perry Drug Stores, Inc v Department of Treasury, 229 Mich App 453, 582 NW2d 533 (1998) requiring that a charge reflect the time value of money in order to qualify as interest. A charge based on a flat fee remains the same regardless of the length of time a party takes advantage of the use or forbearance of money and does not reflect the time value of money.

Michigan Courts have ruled that money, which qualifies as interest in the hands of one party, can lose the characterization of "interest" in a transfer to another party if it is not done for the purpose of a loan, use or forbearance of money.

A fundamental error made by appellants, under any factual scenario thus far proposed, is the assumption that monies that are concededly interest in the hands of the financial institutions retain that character when returned or rebated to the appellants. In the ordinary sense of the word, money paid as interest does not retain that characteristic (as being interest) unless it too, when it is returned or rebated, is paid for the use of or forbearance or delay of use of money.

Town & Country Dodge, 420 Mich at 244.

The court in Town & Country Dodge, supra also held that generally accepted accounting principles are not controlling when determining if money qualifies as "Interest". In addition the Michigan Supreme Court has ruled that purchase discounts taken do not qualify as "interest". Perry Drug Stores, supra.

1) American Sportsman sells fishing boats. Joe Fishfinder agrees to purchase one for $14,000, but needs financing. The salesperson at American Sportsman directs Joe to First Bank of Baytown, where Joe signs a note for $14,000 in principal plus 12% interest for a period of 60 months. First Bank, on its own accord, then pays American Sportsman a $100 finder-fee for directing business to them.

The 12% Joe pays to First Bank is interest. It meets all the conditions discussed above. What First Bank pays to American Sportsman is not interest. It is a flat fee and is not for the use, loan or forbearance of money. There is no creditor-debtor relationship and the rate is not set by law or contract.

2) Car-Zone manufactures a line of exclusive cars and trucks, which they sell to retailers. Purchasers may arrange financing through Car-Zone’s 100% owned subsidiary, Money-Zone. Times are tough. In order to boost sales, Money-Zone offers a 0% interest option. The customer signs a note and Car-Zone later pays Money-Zone a fee based on the purchase price to offset Money-Zone’s costs.

The customer pays no interest in this example. The payment from Car-Zone to Money-Zone to offset their cost is not interest; it is a subvention payment. It is not for the use or forbearance of money and there is no creditor-debtor relationship.

3) Bigelow’s Furniture Warehouse periodically offers an incentive to customers allowing "No interest for one year". The terms of the contract waive any and all interest, providing the customer makes payment in full within 12 months. In addition, a contract must be signed with Discount Finance Co. Should full payment not be made within 12 months, interest is due at 15% on all future payments PLUS for the previous 12-month period.

To illustrate, suppose a customer purchases a $2,000 sofa and makes payments of $100 per month. At the end of the 12-month period, $800 in principal is still due. The customer now owes interest not only on the remaining $800, but the interest from the 12-month period as well.

History has shown that less than half of the purchasers pay timely. However, those that do pay timely, pay no interest whatsoever. Bigelow therefore agrees, in these cases, to pay Discount Finance a fee to offset their costs and supplement their loss of interest income.

The charges paid by the customer to Discount Finance that exceed principal are interest. The fee paid by Bigelow to Discount Finance is not. It does not involve a debtor-creditor relationship.

4) Corporation A is a parent holding company for 2 wholly owned manufacturing subsidiaries. (Alpha Manufacturing and Omega Manufacturing).

Corporation A obtains all the necessary funds for the working capital requirements of the two subsidiaries. All notes payable are between Corporation A and the financial institutions that provide funding.

Corporation A does not have notes with Alpha Mfg. or Omega Mfg. to allocate the loan proceeds. Rather, it prorates the interest expense to the two subsidiaries by way of cost allocation for book and federal income tax purposes. Neither Alpha or Omega Mfg. make payments to Corporation A with regard to the working capital and the cost allocation is simply an accounting entry.

The parent has interest expense that should be added back for SBT purposes, but the 2 subsidiaries do not because a creditor-debtor relationship does not exist involving the subsidiaries and the cost allocation is not pursuant to contract or law.

5) Corporation A is a parent company for a wholly owned subsidiary, Corporation B. Corporation A sells products to its customers via a Corporation A credit card at 12% interest. Corporation B, pursuant to a receivables agreement, buys the right to receive payments from Corporation A’s charge accounts, which includes accrued and charged interest but not future interest.

The 12% payment above principle is interest income in the hands of Corporation A as it is money paid for the loan, use or forbearance of money. The same 12% payment is not interest in the hands of Corporation B as it is no longer for the loan, use, or forbearance of money.

6) Same facts as 5) above, except that the receivables agreement now includes the right to the future non-accrued 12% payment.

Corporation A does not have interest income from the future 12% payment. Corporation B has interest income on the future 12% payment.