What is an Imputed Interest Rate?

An imputed interest rate is an estimated interest rate used instead of the established interest rate associated with a debt. An imputed rate is used because the established rate does not accurately reflect the market rate of interest, or there is no established rate at all. The imputed rate approximates the rate used for a note having an independent borrower and lender, and with comparable terms and conditions. This situation most commonly arises when funds are loaned between related parties, where no interest rate has been charged at all.

Why Use an Imputed Interest Rate?

There are several reasons why an imputed interest is used, which are as follows:

IRS requirement. The Internal Revenue Service and other tax collection agencies use the imputed interest concept in order to derive interest revenue on loans that have been issued at below-market rates, as well as on zero-coupon bonds. Otherwise, the parties associated with these debt instruments would have minimal or no taxable income related to these borrowing arrangements.
Improved reporting accuracy. By using an imputed interest rate, you can more accurately reflect the components of an exchange transaction, so that the resulting face amount of a note reasonably represents the present value of the consideration paid.

Selecting a justifiable imputed interest rate is a matter of some importance, since an incorrect interest rate that is applied to a sufficiently large and long-term debt can result in the inaccurate acceleration or deferral of earnings.