The amount of interest income that a company receives is considered by the IRS to be fully taxable ordinary income, which falls into the highest tax bracket. For that reason, the IRS uses the imputed interest concept to make sure that all interest income is recognized. Under this concept, a company must record interest income (or expense, if it is paying for the associated debt) at the current market rate at the time a debt instrument is initiated. If not, the IRS will assume (or impute) a higher interest rate that is 110% of the interest rate paid on whatever type of Treasury debt has approximately the same number of years to maturity as the debt instrument in question. This higher rate is called the Applicable Federal Rate.
This rule also applies to installment sales, so the interest portion of these payments must also be broken out if the total amount of a series of installment payments exceeds $3,000. The general rule to see if an installment sale requires the calculation of imputed interest is if the total of all payments due more than six months after the date when the sale occurred is greater than the present value of the payments, plus the present value of any interest charges noted in the installment sale contract.
Another variation on the imputed interest concept is the Original Issue Discount (OID). This applies to situations when an investor buys a bond, note, or other long-term debt instrument at a price that is lower than its eventual redemption price. The difference between its purchase price and the final redemption price at maturity is the OID. The IRS requires the investor to recognize the income from the OID as it accrues over time, irrespective of the presence of any interest income actually received from the issuer of the debt.