What is Imputed Interest?

Imputed interest is the estimated interest rate on debt, rather than the rate contained within the
debt agreement. Imputed interest is used when the rate associated with a debt varies markedly
from the market rate . It is also used by the IRS to collect taxes on debt securities that pay
minimal or no interest.

When two parties enter into a business transaction that involves payment with a note, the default
assumption is that the interest rate associated with the note will be close to the market rate of
interest. However, there are times when no interest rate is stated, or when the stated rate departs
significantly from the market rate.

If the stated and market interest rates are substantially different, it is necessary to record the
transaction using an interest rate that more closely accords with the market rate. The rate that
should be used is one that approximates the rate that would have been used if an independent
borrower and lender had entered into a similar arrangement under comparable terms and
conditions. This guidance does not apply to the following situations:

 Receivables and payables using customary trade terms that do not exceed one year

 Advances, deposits, and security deposits

 Customer cash lending activities of a financial institution

 When interest rates are affected by a governmental agency (such as a tax-exempt bond )

 Transactions between commonly-owned entities (such as between subsidiaries )