The Taxation of Interest Swaps and the Financial Service Charge: Toward a Consistent Approach

Abstract

The Supreme Court has defined interest as "compensation for the use or forbearance of money."' This definition, and its subsequent interpretation by the courts, requires a direct link between the payment of "compensation" and the "use of money." This link has created a distortion in the current U.S. tax treatment of the administrative cost component of interest and its "financial service charge" substitute, and ambiguity with regard to the taxation of interest swaps.
Economically, interest consists, in part, of compensation given to a saver-lender for forgoing current consumption in favor of an ability to consume more in the future ("time preference") and compensation for forgoing a typical preference for liquidity. Interest also reflects compensation for the risks of default and inflation, and reimbursement of the lender's administrative costs. The U.S. tax system has adopted a consistent approach by treating all the interest components alike, and generally, by not bifurcating a fixed amount of interest into its different economic components. This approach can be demonstrated, for example, with regard to the taxation of the inflation component. An exception to this approach however, is the tax treatment of an "abnormal" risk of default under the "junk-bond" provision of the Code.