The Fifth Circuit recently joined three other courts² 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).³ In re Lambert, 194 F.3d 679 (5th Cir. 1999). As such, the Fifth Circuit's ruling would appear to put to rest arguments by any taxing authority that the statutory rate⁴ 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, 26 U.S.C. §6621 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.

The Decisions on §1129(a)(9)(C)

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 In re Southern States Motor Inns Inc., 709 F.2d 647 (11th Cir. 1983), cert. denied, 465 U.S. 1022 (1984). 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). Id. at 649. 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." Id. at 652.

Further, the Eleventh Circuit noted that nowhere in the legislative history had Congress concluded that a statutory rate should apply. Id. at 650. 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 United States v. Neal Pharmacal Co., 789 F.2d 1283 (8th Cir. 1986) 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. Id. at 1285. 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. Id. at 1286. 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. Id. 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.12.⁵ 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 26 U.S.C. § 6323.⁶

The Ninth Circuit in In re Camino Real Landscape Maint. Contractors Inc., 818 F.2d 1503 (9th Cir. 1987), 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. Id. at 1505. The court recognized that the rate of interest must be based on the debtor's cost of borrowing, not on the government's cost. Id. at 1506, citing Neal Pharmacal, 789 F.2d 1286. 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. Id. at 1507 (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. Id. at 1508.

Too Much Deference in Lambert?

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. Lambert, 194 F.3d at 681. 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.⁷ 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.

Are There Other Components to This Inquiry?

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.⁸ 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.

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Footnotes

¹ 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). Return to article

² The Seventh Circuit in In the Matter of Chicago, Milwaukee, St. Paul & Pacific R. Co., 830 F.2d 758 (7th Cir. 1987), 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. Return to article

³ 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." Return to article

⁴ 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 26 U.S.C. §6621(b), 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., In re Architectural Design Inc., 59 B.R. 1019 (W.D. Va. 1986) (statutory rate applies); In re Milspec Inc., 82 B.R. 811 (Bankr. E.D. Va. 1988) (market rate—case-by-case approach); In re Connecticut Aerosols Inc., 31 B.R. 883 (Bankr. D. Conn. 1983), aff'd, 42 B.R. 706 (D. Conn. 1984) (federal judgment rate); In re General Dev. Corp., 147 B.R. 610 (Bankr. S.D. Fla. 1992) (rate of interest on medium-quality, low-risk, unsecured loan with 18-month maturity). The statutory rate is determined on a quarterly basis. Return to article

⁵ Section 6621 relates only to interest and does not contain a penalty component. Return to article

⁶ 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. Return to article

⁷ 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. Id. at 681. 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. Return to article

⁸ Cf. In re Gregory Boat Co., 144 B.R. 361 (Bankr. E.D. Mich. 1992) (single payment at the end of six years or payment other than on a monthly basis is permissible); In re Mason and Dixon Lines Inc., 71 B.R. 300 (Bankr. M.D.N.C. 1987) (monthly installments required). Return to article