Fifth Circuit Joins Chorus on Interest Rates Owed for Tax Claims

Journal Issue

Mar 2000

Column Name

Journal HTML Content

The Fifth Circuit recently joined three other courts<a href="#2" name="2a">2</a> in finding that a market rate of interest, not a statutory
rate, should be applied to the payment of unsecured tax claims under §1129(a)(9)(C).<a href="#3" name="3a">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lambert, 194
F.3d 679 (5th Cir. 1999)</a>. As such, the Fifth Circuit's ruling would appear to put to rest arguments by any
taxing authority that the statutory rate<a href="#4" name="4a">4</a> of interest would be the rate of interest paid on priority tax claims
under §1129(a)(9)(C).

The use of a market rate of interest gives rise to an evidentiary hearing at confirmation should the
debtor and government taxing authority not agree on an applicable rate of interest. The United States has
long contended that a statutory rate of interest (usually the rate applicable to delinquent federal tax
payments, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §6621</a> not only approximates market rate, but ensures uniform treatment of priority
tax claims in chapter 11 cases. Further, by employing the statutory rate, the court does not need to waste
resources on conducting evidentiary hearings to determine market rates on a case-by-case basis.

<h3>The Decisions on §1129(a)(9)(C)</h3>

Prior to the Fifth Circuit's decision in Lambert, circuit case law regarding the applicable rate of
interest under §1129(a)(9)(C) developed in the 1980s. The first circuit court to consider the issue was the
Eleventh Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Southern States Motor Inns Inc., 709 F.2d 647 (11th Cir. 1983), cert. denied, 465 U.S. 1022 (1984)</a>.
In Southern States, the bankruptcy court found that the §6621 rate of interest, less a one percent
deduction for the "rehabilitation aspects" of the plan, was applicable to deferred payments of tax claims
under §1129(a)(9)(C). <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 649</a>. The "rehabilitation aspects" were to reduce the discount rate by one
percent on the payment of priority tax claims to ensure that the plan was feasible. The district court
affirmed. The Eleventh Circuit found that the usage of §6621 rate of interest "does not necessarily
correspond with the prevailing market rate of interest" for two reasons: First, the rate of interest under
§6621 lagged up to two years behind the market rate. Second, the §6621 rate ignored "variations between
the length of the payout period, the quality of the security and the risk of subsequent default." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 652</a>.

Further, the Eleventh Circuit noted that nowhere in the legislative history had Congress concluded that
a statutory rate should apply. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 650</a>. Rather, the operative phrase to consider was "value as of the
effective date of the plan," which, the Eleventh Circuit concluded, denoted a market rate of interest when
payment was made over time.

The Eighth Circuit similarly found in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Neal Pharmacal Co., 789 F.2d 1283 (8th Cir.
1986)</a> that the rate under §6621 could be considered, but was not dispositive as to payment of tax
claims, relying on the Eleventh Circuit's holding in Southern States. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1285</a>. The court stated that
it had previously construed the applicable rate of interest under §1129(b)(2)(A)(i)(II) as market rate of
interest, and, by analogy, could apply the same analysis to payment of priority tax claims under
§1129(a)(9)(C). The Eighth Circuit did, however, reject several findings by the bankruptcy court that the
United States had argued were contrary to §1129(a)(9)(C). Specifically, the court reasoned that the rate
of interest should not be a function of the government's cost of borrowing without consideration of the
risk of non-payment. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1286</a>. The court also rejected a floating rate of interest, finding that a fixed
rate should apply. Moreover, the Eighth Circuit noted the fallacy in stating that a market rate of interest
should apply to government tax claims. The Eighth Circuit found there is no market for these types of
claims because the IRS is not a consensual creditor nor is the IRS in the business of lending money. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

Also, the Eighth Circuit, like the Eleventh, found that although the §6621 rate of interest is relevant in
determining the market rate, the §6621 rate lags too far behind the current market rate to be comparable
to market rate.

The court also criticized the holding of several lower courts that §6621 was inapplicable because it
somehow contained a punitive element (penalty) on which an interest rate could not be based. Id. at 1288,
n.12.<a href="#5" name="5a">5</a> Finally, the court acknowledged that the reference to "quality of the security" inapplicable to priority
tax claims because priority tax claims by definition are not secured by notices of federal tax liens under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. § 6323.</a><a href="#6" name="6a">6</a>

The Ninth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Camino Real Landscape Maint. Contractors Inc., 818 F.2d 1503 (9th Cir.
1987)</a>, also considered what rate of interest on deferred payments of federal taxes should be used, holding
that "the debtor must pay the government interest at the rate the debtor would pay a commercial lender for
a loan of equivalent amount and duration, considering the risk of default and any security." The Ninth
Circuit correctly found that the interest rate was actually a "discount rate" that would ascribe value as of
the effective date of the plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1505</a>. The court recognized that the rate of interest must be based on
the debtor's cost of borrowing, not on the government's cost. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1506</a>, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Pharmacal, 789 F.2d
1286</a>. The court also found that the debtor's characteristics (ability to borrow), not the government's,
determine the interest rate.

The Ninth Circuit did recognize that the §6621 rate of interest could apply if the rate tracks market
rate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1507</a> (emphasis added). Nonetheless, the Ninth Circuit held that the interest rate the
reorganizing debtor should pay should be the equivalent of a loan the debtor would have to obtain in an
open market. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1508</a>.

<h3>Too Much Deference in Lambert?</h3>

The Fifth Circuit's decision in Lambert involved the Mississippi State Tax Commission's argument
that Mississippi's statutory rate of interest on tax obligations (12 percent) should apply to the repayment
of priority tax claims under §1129(a)(9)(C). The Fifth Circuit relied exclusively on the holdings of Neal
Pharmacal and Southern States, finding that Congress did not designate a particular rate of interest to
be used under §1129(a)(9)(C), nor did Congress mandate that a statutory rate be applied. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 194
F.3d at 681</a>. The court also agreed with the circuit courts in finding that the §6621 rate does not
approximate "market rate" because of the lag in adjusting the rate to current market rates.<a href="#7" name="7a">7</a> Further, like
the other courts, the Fifth Circuit held that a statutory rate of interest does not consider variations between
length of payout, quality of security and the risk of subsequent default.

The Mississippi Tax Commission countered by arguing that (1) the statutory rate no longer lags
market rate; (2) §1325(a)(5)(B)(ii) uses a statutory rate of interest on the payment of secured tax claims,
and the language of §1325(a)(5)(B)(ii) is identical to §1129(a)(9)(C); and (3) because the taxing authority is a non-consensual creditor and does not loan
money, the best way to approximate present value is to use the statutory rate.

The Fifth Circuit discounted the Commission's arguments by finding that the statutory rate will always
lag somewhat behind market rates of interest, the interest rate under §1325 relates to secured claims and
not unsecured priority claims, and that the best way to approximate payment of unsecured obligations
through bankruptcy is to provide comparable interest on unsecured loans based on the debtor's
creditworthiness and ability to pay.

<h3>Are There Other Components to This Inquiry?</h3>

While interest rates have been the main focus of the courts regarding the application of §1129(a)(9)(C)
to the payment of tax claims, there are other components that the courts should consider when determining
appropriate interest rates. To begin with, the effective date on which repayment will commence will affect
the interest rate. The Bankruptcy Code does not require a specific effective date on which plan payments
should begin. Further, the frequency of payments also affects the appropriate rate of interest.<a href="#8" name="8a">8</a> Additionally,
few courts have considered the fact that priority tax claims are non-dischargeable claims. As such, the tax
must be paid or the liability remains after discharge. (If the chapter 11 debtor is a corporation, there is
responsible officer liability for the trust fund portion of any business taxes). Finally, because priority tax
claims are not considered a class of claims under §1123(a)(1), and, therefore, not entitled to a vote, the
ability of a taxing authority to contest its proposed treatment of its claims is limited because it does not cast
a vote.

Due to advances in technology and the reporting of financial information and data, arguments
regarding the correlation between statutory rates of interest and market rate are not as valid as they were
in the 1980s given that statutory rates are calculated more frequently than previously before and the
market rate for interest has remained relatively stable. Also, taxing authorities are arguably one of the
largest participants in the bankruptcy process and understand the consequences of asserting a statutory
rate of interest. There will be occasions when the taxing authorities will assert that the statutory rate is
the correct rate of interest even though it is less than market rate. The courts should defer to such
requests. Conversely, taxing authorities are now free to assert a higher rate of interest when the statutory
rate lags behind the market rate.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The views expressed in this article are the author's, and do not necessarily reflect the views of the Department of Justice or the Internal Revenue Service (IRS). <a href="#1a">Return to article</a>

<a name="2">2</a> The Seventh Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of Chicago, Milwaukee, St. Paul & Pacific R. Co., 830 F.2d 758 (7th Cir.
1987)</a>, found under the Bankruptcy Act that the applicable rate of interest for the payment of government priority tax claims in
railroad reorganizations was one that was "fair and equitable" to all unsecured creditors determined at a market rate. <a href="#2a">Return to article</a>

<a name="3">3</a> Section 1129(a)(9)(C) provides, "with respect to a claim of a kind specified in §507(a)(8) of this title, the holder
of such claim will receive on account such claim deferred cash payments, over a period not exceeding six years after the date of assessment
of such claim, of a value, as of the effective date of the plan, equal to the allowed amount of such claim." <a href="#3a">Return to article</a>

<a name="4">4</a> The United States argues that the statutory rate of interest on the payment of priority tax claims under §1129(a)(9)(C) should
be defined under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §6621(b)</a>, which is the federal short-term rate plus 3 percentage points. That is the rate of interest
a taxpayer would be charged for the underpayment of taxes. Lower courts have found that to be the applicable rate of interest, but the
holdings have not been uniform. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Architectural Design Inc., 59 B.R. 1019 (W.D. Va. 1986)</a> (statutory
rate applies); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Milspec Inc., 82 B.R. 811 (Bankr. E.D. Va. 1988)</a> (market rate—case-by-case approach); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Connecticut Aerosols Inc., 31 B.R. 883 (Bankr. D. Conn. 1983)</a>, aff'd, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 706 (D. Conn. 1984)</a>

(federal judgment rate); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re General Dev. Corp., 147 B.R. 610 (Bankr. S.D. Fla. 1992)</a> (rate of interest on
medium-quality, low-risk, unsecured loan with 18-month maturity). The statutory rate is determined on a quarterly basis. <a href="#4a">Return to article</a>

<a name="5">5</a> Section 6621 relates only to interest and does not contain a penalty component. <a href="#5a">Return to article</a>

<a name="6">6</a> Neal Pharmacal did involve both the IRS' secured and priority tax claims, and the Eighth Circuit noted the distinction. Priority tax
claims, while not secured by notices of federal tax claims, do attain a "statutory lien" status under §§6621 and 6621 of the I.R.C.
that would attach to the taxpayer's collateral, but would not be enforceable against third parties. <a href="#6a">Return to article</a>

<a name="7">7</a> The Fifth Circuit joined the other courts in noting that usage of a statutory rate could be disadvantageous to taxing authorities because
the statutory rate could be less than the market rate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 681</a>. It would seem that if the taxing authority is willing to take
the risk of a lower rate, it should be allowed to do so. Moreover, if the statutory rate were used, the taxing authority would be getting
exactly what it believes it is entitled to receive on delinquent taxes, bankruptcy or not. <a href="#7a">Return to article</a>

<a name="8">8</a> Cf. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gregory Boat Co., 144 B.R. 361 (Bankr. E.D. Mich. 1992)</a> (single payment at the end of six years
or payment other than on a monthly basis is permissible); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mason and Dixon Lines Inc., 71 B.R. 300 (Bankr. M.D.N.C.
1987)</a> (monthly installments required). <a href="#8a">Return to article</a>

Journal Authors

Craig A. Gargotta

Journal Date

Wednesday, March 1, 2000 - 12:00