United States of America, Appellant, v. Neal Pharmacal Company, Appellee, 789 F.2d 1283 (8th Cir. 1986)

The issue in this appeal is what rate of interest on deferred payments of delinquent federal taxes will provide the United States with the present value of its claim as required under 11 U.S.C. § 1129(a) (9) (C) (1982) for confirmation of the debtor's reorganization plan.¹ 

Background

Neal Pharmacal Company (the debtor) filed for reorganization under Chapter 11 of the Bankruptcy Code on February 2, 1983. On May 11, 1983, the Internal Revenue Service (the government or the IRS) filed a proof of claim in the bankruptcy proceedings for unpaid withholding and social security taxes plus interest and other additions, totalling $45,574.13. Of this claim, $31,465.39 was secured by liens against the debtor's property.²  Under the debtor's proposed reorganization plan, the government was to receive deferred cash payments over a five year period of a value, as of the effective date of the plan, equal to the amount of its tax claim plus quarterly interest payments on the unpaid balance at the rate paid on thirteen-week treasury bills at the time of each quarterly payment.

The government objected to the debtor's plan, contending that the interest rate proposed by the debtor would not provide the government with cash payments equal to the value of its claim as of the effective date of the plan as required by 11 U.S.C. § 1129(a) (9) (C).³  Instead, the government argued, it was entitled to the rate established by 26 U.S.C. § 6621 (1982) for payment on delinquent tax claims under 26 U.S.C. § 6601 (1982). The section 6621 rate is based on a six-month average of the prime rate quoted by commercial banks to large businesses. 26 U.S.C. § 6621(c). After a hearing, the bankruptcy court rejected the government's objection and, on March 15, 1984, filed an order modifying and confirming the debtor's plan.⁴  The government sought review of the bankruptcy court's order in district court, contending that the bankruptcy court erred in determining the proper interest rate to be applied to deferred tax payments under section 1129(a) (9) (C). The district court⁵  affirmed the bankruptcy court's confirmation order on the ground that the bankruptcy court's determination of the proper discount rate was not clearly erroneous, 46 B.R. 721. This appeal followed.

Discussion

Section 1129(a) (9) (C) provides that a debtor seeking confirmation of a reorganization plan under Chapter 11 may only defer the payment of priority tax claims if the creditor who is forced to accept the deferred payments receives interest on its claim in an amount that renders the deferred payments equivalent to the present value of its claim.⁶  In re Southern States Motor Inns, Inc., 709 F.2d 647, 650 (11th Cir. 1983), cert. denied, 465 U.S. 1022, 104 S. Ct. 1275, 79 L. Ed. 2d 680 (1984). Although this court has not yet considered what interest rate will provide a creditor with the present value of its claim within the meaning of section 1129(a) (9) (C), we have discussed the method for determining what interest rate on deferred payments would provide a creditor with the present value of its claim within the meaning of 11 U.S.C. § 1129(b) (2) (A) (i) (II) (1982). In construing language virtually identical to the language of section 1129(a) (9) (C), this court stated:

The appropriate discount rate must be determined on the basis of the rate of interest which is reasonable in light of the risks involved. Thus, in determining the discount rate, the court must consider the prevailing market rate for a loan of a term equal to the payout period, with due consideration for the quality of the security and the risk of subsequent default.

In re Monnier Bros., 755 F.2d 1336, 1339 (8th Cir. 1985) (quoting 5 Collier on Bankruptcy p 1129, at 1129-65). Courts considering this issue under section 1129(a) (9) (C) have uniformly adopted the market rate approach discussed in Monnier Bros., although the decisions vary as to what interest rate best approximates the "prevailing market rate" for a loan of comparable risk and term. See, e.g., Southern States, 709 F.2d 647 (Sec. 6621 rate applied because although evidence established that market rate was higher than Sec. 6621 rate, government did not request higher rate); In re Connecticut Aerosols, 42 B.R. 706 (D. Conn. 1984) (rate established by 28 U.S.C. § 1961(a) for interest on judgments in federal court best estimate of market rate); In re Fi-Hi Pizza, Inc., 40 B.R. 258 (Bankr.D. Mass. 1984) (Sec. 6621 rate plus 2.5 percentage points for risk component best approximation of prevailing market rate); In re Bay Area Services, 26 B.R. 811 (Bankr.M.D. Fla .1982) (current prevailing prime rate plus ten percent adjustment for inflation best estimate of prevailing market rate).

We must agree with the government that Monnier Bros. requires rejection of the rate proposed by the debtor and approved by the bankruptcy court. Relying on its earlier opinion in In re Mart Corp., No. 82-00622(1) (Bankr.E.D. Mo. filed June 21, 1983), the bankruptcy court concluded that only the creditor's borrowing cost should be considered in determining the proper interest rate under section 1129(a) (9) (C). The bankruptcy court therefore adopted as the most accurate estimate of the government's borrowing cost the debtor's proposal that the government receive interest on its deferred payments at the current rate paid on thirteen week treasury bills at the time of each quarterly payment. The bankruptcy court's sole reliance on the government's cost of borrowing without consideration of the risk of nonpayment, the length of the payment period, and the existence of collateral is clearly contrary to the prevailing market rate approach referred to in Monnier Bros. and adopted by other courts that have considered the issue under section 1129(a) (9) (C).⁷ 

We also reject the bankruptcy court's finding that a floating rate of interest would better accommodate flucuations in interest rates in general, and would thus better provide the government with the present value of its claim. That section 1129(a) (9) (C) contemplates the use of a fixed interest rate is evident in its requirement that present value be determined "as of the effective date of the plan." 11 U.S.C. § 1129(a) (9) (C). Moreover, the use of a floating interest rate would be administratively difficult and would complicate a determination of the feasibility of the debtor's reorganization plan, a prerequisite for confirmation. Cf. In re Fisher, 29 B.R. 542, 551-52 (Bankr.D. Kan. 1983) (rejecting floating rate in present value analysis under similar language in Chapter 13). We therefore hold that the bankruptcy court erred in finding that the government would receive the present value of its claim if paid interest on the deferred payments at the rate paid on thirteen week treasury bills at the time of each quarterly payment.⁸ 

Having found that the bankruptcy court erred in its determination of the proper interest rate, we now address the more difficult issue: what rate best approximates the prevailing market rate in the case of deferred payments of a federal tax priority claim. This inquiry is complicated by the fact that there is no "market" for the type of involuntary loan involved in the case of deferred payments of federal taxes because the IRS is not in the business of lending money. The government urges us to adopt the rate established by 26 U.S.C. § 6621,⁹  the rate the government charges taxpayers on delinquent tax liabilities, as the minimum interest rate in all cases involving deferred payments of federal tax claims. The government argues that since it is entitled to receive interest from delinquent taxpayers at the section 6621 rate, that is the rate at which the government would make a loan to a third party and thus is the prevailing market rate for a similar loan. Unless it receives at least the section 6621 rate, the government argues, it will not be afforded the present value of its claim as required by section 1129(a) (9) (C). Although we agree that the section 6621 rate may be a relevant factor in determining the proper interest rate under section 1129(a) (9) (C), we reject the government's contention that the section 6621 rate should be the exclusive measure of the rate that will provide the government with the present value of its claim.

As the government notes in its brief, the interest rate paid by taxpayers on delinquent tax claims is designed to eliminate the incentive for taxpayers to "borrow" from the IRS by delaying the payment of their taxes.¹⁰  See S.Rep. No. 494, 97th Cong., 2nd Sess. 306, reprinted in 1982 U.S.Code Cong. & Ad.News 781, 1047-48; S.Rep. No. 1357, 93d Cong., 2d Sess., reprinted in 1974 U.S.Code Cong. & Ad.News 7478, 7495-96. In other words, by charging taxpayers interest on delinquent tax liabilities at the prevailing market rate for a similar loan, taxpayers will presumably not benefit by delaying the payment of their taxes. Therefore, because the section 6621 rate is an attempt to approximate the prevailing market rate for a similar loan, it is clearly relevant to a determination of the proper interest rate on deferred payments of a tax claim.

Because of the method by which the section 6621 rate is determined (based on six month average of the prime rate, adjusted semi-annually), however, it may often lag behind the actual prevailing market rate. Several courts that have rejected the section 6621 as the prevailing market rate on deferred payment of taxes, including the bankruptcy court in this case, have noted this lag as one reason for their decision. See Southern States, 709 F.2d at 651-52; Connecticut Aerosols, 42 B.R. at 710; Bay Area Services, 26 B.R. at 814; In Re Moore, 25 B.R. 131, 134 (Bankr.N.D. Tex. 1982). The 1982 amendments to section 6621 do reduce the potential for variance between the section 6621 rate and the prevailing market rate because the section 6621 rate is now calculated on a semi-annual rather than an annual basis and now reflects a six month average of the prime rate rather than the prime rate for one specific month. See Fi-Hi Pizza, 40 B.R. at 271; Moore, 25 B.R. at 134 (dicta). Even with these amendments, however, the section 6621 rate in effect on the date of a confirmation hearing will have been established from three and one-half to nine and one-half months earlier. See Southern States, 709 F.2d at 652. Thus, before relying on the section 6621 rate, courts must consider the extent to which current interest rates in general at the time of confirmation have significantly changed since the section 6621 rate was last determined.

Several courts have also criticized the use of the section 6621 rate in bankruptcy cases because it ignores variations between the length of the payment period, the quality of the security, if any,¹¹  and the risk of default. See Southern States, 709 F.2d at 652; Connecticut Aerosols, 42 B.R. at 710; see also Fi-Hi Pizza, 40 B.R. at 271-72 (adding 2.5 percentage points to section 6621 rate to compensate for risk of default). Variations in these factors may be relatively slight in the case of tax priority claims under section 1129(a) (9) (C) because that section deals with only unsecured loans that must be paid within a six year period. Nevertheless, the potential variations are not so insignificant that a single interest rate would be appropriate in all cases. Southern States, 709 F.2d at 652 n. 6. Moreover, although some courts have suggested that the risk of nonpayment is minimal in the case of a reorganizing debtor because the bankruptcy court may not confirm a reorganization plan without first finding that the plan is feasible, see, e.g., Fisher, 29 B.R. at 544-45, the risk of default for a reorganizing debtor may be at least as great as that of a nonreorganizing corporate debtor of comparable size and structure. Courts must therefore consider the risk that the debtor will not be able to complete the reorganization in determining the prevailing market rate on deferred payments of federal tax claims. In short, before concluding that the section 6621 rate will provide the government with the present value of its federal tax claim, the court must first consider the payment period, the quality of the security, if any, and the risk of default in the particular case.¹² 

One final fact convinces us that the section 6621 rate, although clearly relevant to determining the prevailing market rate under section 1129(a) (9) (C), cannot be adopted as a per se rule. As the Eleventh Circuit recently noted in Matter of Southern States Motor Inns, Inc.:

[T]he phrase "value, as of the effective date of the plan" appears in several other subsections of Sec. 1129 as well as in Chapter 13, see 11 U.S.C. §§ 1129(a) (7) (B), (a) (9) (B) (i), (b) (2) (A) (i) (II), (b) (2) (B) (i), (b) (2) (C) (i), 1325(a) (4), (a) (5) (B) (ii), and applies to a wide variety of claims. Neither the statute nor the legislative history suggests that "value" as used in Sec. 1129(a) (9) (C) should be determined simply by reference to Sec. 6621 while "value" as used in the other sections should be determined by an analysis of market rates, and we seriously doubt that Congress intended that the Sec. 6621 rate should be used to determine value in all of these sections.

Southern States, 709 F.2d at 652 n. 6. We recognize that applying a uniform interest rate as the government urges us to do might save both time and money. This is especially true in the context of determining the present value of deferred tax payments under section 1129(a) (9) (C) because that section only deals with unsecured loans that must be paid back within six years. See Southern States, 709 F.2d at 652 n. 6. The language of section 1129(a) (9) (C), however, clearly compels us to conclude that the determination of what interest rate will provide the government with the present value of its claim must be made on a case by case basis.

Conclusion

In summary, we hold that when a plan of reorganization requires a governmental unit to receive a section 507(a) (7) tax priority claim in deferred payments, the debtor must pay the governmental unit interest on the deferred payments at the "prevailing market rate" for loan with a term equal to the payout period in the particular case, with due consideration to the existence and quality of any security and the risk of subsequent default. In determining the "prevailing market rate," the interest taxpayers must pay on delinquent tax claims under 26 U.S.C. § 6621 is clearly relevant because that rate represents an attempt by Congress to charge taxpayers the prevailing market rate on delinquent tax liabilities. Courts must also consider, however, the extent to which the section 6621 rate lags behind market rates in general and whether the section 6621 rate reflects the risk, quality of any security, and term applicable in the particular case.

On the record before us, we are unable to determine the appropriate rate of interest in this case. We therefore remand to the district court with directions that it enter an order remanding the case to the bankruptcy court. On remand, the bankruptcy court should hold a hearing at which time both parties can present evidence as to the prevailing market rate¹³  on a comparable loan. The bankruptcy court should then determine the appropriate interest rate in light of this evidence and the factors set forth in this opinion.