Section 482 of the Internal Revenue Code gives broad authority

to the Internal Revenue Service to reallocate income, deductions and credits in order to prevent the distortion of income between tax paying entities and to publish regulations providing guidelines for inter-entity business activity. Among other provisions, the regulations published under Section 482 of the Internal Revenue Code deal with interest rates for loans between business entities subject to common control. For example, if a taxpayer were to loan funds or sell property to a wholly owned corporation, the provision would be applicable. Similarly, if one corporation were to loan funds or sell property to another corporation, with the two corporations subject to common ownership, the provisions would apply.

Specified minimum rates under this provision have been applicable to transactions under this section since 1964. Before 1975, the specified interest rate was to range between four and six percent. Between 1975 and August of 1980, the interest rate was to range between six and eight percent. Effective August 29, 1980, proposed 41/ regulations have specified an interest rate of 11-13 percent.

There are two problems, as we see it, with the proposed regulations under Section 482: (1) There has been confusion as to the applicability of the 11-13 percent rate, with the belief by some that the rate applies to transactions between related parties, and (2) the specified interest

rate is substantially above the interest rate specified under the general rule of Section 483 for deferred payment obligations.

Not

until the 1980 regulations were proposed were the rates significantly different from the deferred payment rates. While we have no difficulty with a rule requiring the same rate of interest between controlled entities as would apply otherwise, we have some

difficulty with a rule requiring a substantially higher interest rate for transactions between controlled entities.

Therefore, it is suggested: (1) That the Internal Revenue Service make it clear as to the scope of application of the regulations under Section 482, and (2) that the interest rate specified under Section 482 parallel the rates applicable under Section 483, as has traditionally been the case.

STATEMENT BEFORE THE SENATE IRS OVERSIGHT SUBCOMMITTEE

April 27, 1981

Paul R. Hasbargen

Professor and Extension Economist

University of Minnesota

"The rich rules over the poor, and the borrower is a slave to the lender." (Prov. 22.7)

This is wisdom. But, is it necessary for a government agency to issue and implement regulations that will lead to an increase in the bondage of debtors? By forcing some borrowers to pay above-market interest rates, the announced changes in sections 482 and 483 of the Internal Revenue Code will discriminate against some new entrants into the business world.

It is the low equity, beginning farmer who most often is granted a low interest rate when buying a farm. Consequently, one effect of these changes is in direct conflict with one agricultural policy objective of this nation--to preserve its family-farm oriented agricultural structure.

A major hurdle that the aspiring farmer must overcome is to get control of adequate land resources. A farm may be either rented or purchased. The purchase alternative has the advantage of more security. However, it has the disadvantage of higher cash flow requirements. The magnitude of this disadvantage has been increasing rapidly in recent years because of government actions that have led to escalating inflation rates. High, persistent inflation rates lead to expectations that such rates will continue. This expectation is bid into interest rates.

The interest rate, therefore, has two components--the real, market interest rate, plus the inflation premium. The real interest rate has for many years hovered near the 3 percent level. See graph 1, where bond yields and inflation rates (as measured by the GN deflator) are plotted over a period of years. Note that the inflation rate has increased sharply since 1965. The increased inflation rate has pushed bond prices to their current high levels because, of course, higher interest rates are necessary in order that savers (bond holders) get a positive rate of interest after adjusting for the declining purchasing power of the dollar.

As nominal interest rates increase, the cash flow deficits associated with farm land purchases also increase. Because, the real return to land-like the real return to bonds--hovers near the 3 percent level. Therefore, as higher inflation rates pushed nominal interest rates from 5 percent to

9 percent, the increasing annual cash flow deficits during the early years of farm loan repayments have made the farm land purchase alternative progressively more and more prohibitive for beginning farmers. This concept is portrayed in graph 2.

-2

Not only does the interest cost of a land purchase increase with higher inflation rates--the annual principle repayment also increases. This occurs because expectations of continued inflation get capitalized into higher land prices. These higher land prices are justifiable if the expected inflation rate continues.* But, the distribution of returns to land is skewed by inflation--with large returns 10 to 20 years after purchase in contrast to low returns during the early years of the purchase that are not adequate to match normal mortgage or contract-for-deed repayment schedules. Thus, the high interest rates and the high land prices currently observed in the market place are both direct results of recent high inflation levels.

Therefore, the growing cash flow deficit problem faced by purchasers of farmland is a direct result of government actions (including those of the Federal Reserve Board) which have fostered higher inflation rates and expectations that these higher rates will continue. Future government actions will bring about changes in these expectations. Will these future actions perpetuate current inflation levels or bring them under control? Is it not the intent of congress and this administration to lower future inflation rates? If so, this committee should be made aware of the fact that we are, today, discussing proposed regulations by an agency of government (the IRS) that, in effect, forces a certain viewpoint about future inflation rates--that they will remain high--upon all citizens who draw up sales contracts.

This viewpoint is, in fact, contrary to the expressed goals and economic projections developed by the executive branch of government--to which this agency is responsible to. President Reagan's message to congress giving his "Program For Economic Recovery" (House Document No. 97-21) included a projection of the Consumer Price Index dropping from 11.1 percent in 1981 to 4.2 percent in 1986. The new imputed levels of interest rates also conflict with the judgement of the market-place as to the appropriate interest rate on contract-for-deed land sale transactions. It was apparently based on prevailing interest rates in lending institutions such as the Federal Land Bank. Their rates have increased to over 10 percent--but they will decline again if the rate of inflation declines. And, given the Land Bank's policy of variable interest rates, current borrowers would get the benefit of any future decline in inflation/interest rates.

However, the typical contract-for-deed has no such stipulation. The interest rate agreed upon is maintained through the life of the contract--usually 10 to 20 years. Also, many contract-for-deed payments do not permit prepayment without penalty as do institutional loans. Furthermore, equity in a contractfor-deed often does not qualify for collateral for a loan. Consequently, the market place for these loans is not the same as the Federal Land Bank and a lower interest rate should be expected to prevail in the market place.

What rate has prevailed?

*

See tables 1 and 2 of attached article "Land Prices: Why So High? Will They Go Higher?", Minnesota Agricultural Economist, No. 662, August-SeptemberOctober 1980, Agricultural Extension Service, University of Minnesota.

Table 1. Maximum bid price based on land productivity and alternative annual growth rates in net income over the next 30 years (excludes land appreciation considerations)

*These bid prices are generated by a computer program that has been provided with the following set of assumptions about other variables: a 9 percent after-tax rate of return, financing for 30 years at 9.5 percent interest, and a low income tax bracket. The effects of changing the values of these variables will be discussed later.

Table 2. Maximum bid price on land that earns $60, including inflation projections and present (after-tax) value of the land 30 years from now, to obtain an after-tax return of 9 percent

*These combinations are not rational since the two inflation measures are likely to be closely correlated. However, if expectations for escalating inflation rates become widespread, one should project a higher future land price increase than an income growth increase, therefore, pushing down the competitive rate of return below the current 3.0-3.5 percent.