Medicare Program; Reporting of Interest From Zero Coupon Bonds

DEPARTMENT OF HEALTH AND HUMAN SERVICES

Health Care Financing Administration

42 CFR Part 413

[BPD-647-F]

RIN 0938-AH11

Medicare Program; Reporting of Interest From Zero Coupon Bonds

AGENCY: Health Care Financing Administration (HCFA), HHS.

ACTION: Final rule.

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SUMMARY: This final rule requires Medicare providers to report all

interest expense and interest income from zero coupon bonds in the cost

reporting period in which the interest was accrued. This final rule is

necessary to add provisions to the Medicare regulations that

specifically address the reporting by providers of interest expense and

income from zero coupon bonds.

EFFECTIVE DATE: This regulation is effective on August 15, 1996.

FOR FURTHER INFORMATION CONTACT: Ann Pash, (410) 786-4615.

SUPPLEMENTARY INFORMATION:

I. Background

Section 1861(v)(1)(A) of the Social Security Act (the Act) defines

reasonable cost for any service under Medicare as the cost actually

incurred, excluding any cost unnecessary in the efficient delivery of

needed health services. That section of the Act also provides that

reasonable costs must be determined in accordance with regulations that

establish the methods to be used and the items to be included for

purposes of determining which costs are allowable for various types or

classes of institutions, agencies, and services. In addition, section

1861(v)(1)(A) of the Act specifies that regulations implementing the

principles of reasonable cost payment may provide for the use of

different methods in different circumstances. This section of the Act

is implemented by regulations at 42 CFR part 413. In particular,

Sec. 413.24 establishes the methods to be used and the adequacy of data

needed to determine allowable costs for various types or classes of

institutions, agencies, and services.

[[Page 37012]]

Under Medicare, providers are paid for inpatient and outpatient

services that they furnish to beneficiaries under Part A (Hospital

Insurance) or Part B (Supplementary Medical Insurance). Currently, most

hospitals are paid for their hospital inpatient operating costs and

capital-related costs under the prospective payment systems in

accordance with sections 1886 (d) and (g) of the Act and regulations at

42 CFR part 412. Under these systems, Medicare payment is made at a

predetermined, specific rate for inpatient operating costs and

inpatient capital-related costs for each hospital discharge based on

the information contained in actual bills submitted. Section

1886(f)(1)(A) of the Act requires us to maintain a system for reporting

costs of hospitals paid under the prospective payment systems. This

provision is implemented by regulations at Sec. 412.52. Section 412.52

requires all prospective payment system hospitals to meet the cost

reporting requirements of Secs. 413.20 and 413.24, which include

submitting a cost report for each 12-month period.

Hospital outpatient units and hospitals and hospital units that are

excluded from the prospective payment systems, as well as most other

providers, are generally paid an amount based on the reasonable cost of

items and services furnished to beneficiaries, in accordance with

section 1861 (v)(1)(A) of the Act, the regulations at 42 CFR part 413,

and the Provider Reimbursement Manual. These cost-based providers are

subject to the same cost reporting requirements of Secs. 413.20 and

413.24 and thus must maintain financial records and statistical data

sufficient for the proper determination of costs payable under the

Medicare program and submit cost reports on an annual basis.

For cost-based providers (and for prospective payment hospitals

during the capital prospective payment system transition period),

interest expense on capital indebtedness such as loans for acquiring

facilities and equipment or for making capital improvements and on

current indebtedness is an allowable cost as set forth at

Secs. 413.130(a)(7) and 413.153. Interest must be necessary--that is,

incurred on a loan made to satisfy the financial need of a provider,

and for a purpose reasonably related to patient care. It must also be

proper--that is, incurred at a rate not in excess of that which a

prudent borrower would have to pay in the money market when the loan

was made.

One source of financing for providers is the sale of zero coupon

bonds. Similarly, one source of provider investment income is the

purchase of zero coupon bonds. The name ``zero coupon bond'' is derived

from the fact that there are no coupons issued with these bonds. Zero

coupon bonds are issued by government agencies, corporations (including

Medicare providers), and banks at a price substantially below the face

value of the bond. The difference between the purchase price of a zero

coupon bond and the face amount payable at maturity reflects the actual

amount of interest and is neither a discount nor an adjustment to the

interest rate as with most other bonds. All interest is actually paid

when the bond is presented for redemption, at face value, on the date

of maturity.

II. Policy Changes

A. Interim Policy

As discussed in detail in our December 13, 1993 proposed rule (58

FR 65150), on December 22, 1989, we issued a Regional Office memorandum

for distribution to all intermediaries that allowed providers to choose

which method they would use to report interest expense or income from

zero coupon bonds--either at maturity in a lump sum, or each year as

the interest accrues, as long as their treatment of interest expense is

consistent with their treatment of interest income.

We stated that this interim policy would apply to all zero coupon

bonds issued or purchased on or after December 22, 1989, as well as to

any zero coupon bond interest reported on cost reports that could be

amended or reopened as of December 22, 1989. Thus, a provider's options

under the interim policy are as follows:

Bonds Issued before December 22, 1989: For interest from

zero coupon bonds issued before December 22, 1989, that is reportable

on cost reports that could be amended or reopened as of December 22,

1989, a provider could request amendment or reopening and specify the

method to be used for reporting interest expense and income on zero

coupon bonds. Conversely, by not requesting an amendment or reopening,

a provider could choose to continue the method already in use.

Bonds Issued on or after December 22, 1989, and before

February 22, 1991: For all zero coupon bonds issued on or after

December 22, 1989, but before February 22, 1991, a provider could

choose the method it would use to report interest expense or income, as

discussed above. Therefore, in cases where a provider's cost reports

are not amended, or cost report determinations are not reopenable, on

or after December 22, 1989, the provider's preference would be

evidenced by the choice the provider exercises for the first zero

coupon bonds issued or purchased on or after December 22, 1989, but

before February 22, 1991. In either case, once the provider has

exercised its choice, the method of reporting interest accrued on all

zero coupon bonds issued or purchased from that date through February

21, 1991, should be consistent with that choice.

B. Current Policy (Applicable to Bonds Issued on or after February 22,

1991)

We revised the Medicare Provider Reimbursement Manual (Transmittal

No. 358) in February 1991 to establish our current policy. In

developing the manual issuance, we concluded that it was not

appropriate to continue to permit the provider to report accrued

interest in a lump sum at maturity because the interest accrues during

the life of the bond. We now require that, for zero coupon bonds issued

or purchased by providers on or after February 22, 1991, all interest

expense and income must be reported in the cost reporting period in

which the interest accrues.

Neither the policy enunciated in our December 22, 1989, Regional

Office memorandum nor the one in the Provider Reimbursement Manual has

been set forth in regulation.

III. Provisions of the Proposed Rule

On December 13, 1993, we published in the Federal Register (58 FR

65150) a proposed rule to add to the Medicare regulations at 42 CFR

413.153 provisions that specifically address the reporting by providers

of interest expense and interest income from zero coupon bonds. We also

proposed to add the definition of ``zero coupon bond'' to the

regulations.

Under our proposal, for zero coupon bonds issued on or after the

effective date of a final regulation, interest expense incurred to

finance capital-related costs would be an allowable expense, and

interest income earned for investment purposes would be an allowable

offset, in the cost reporting period in which the interest accrues. We

proposed that earned interest from zero coupon bonds must be offset

against all allowable interest expense as set forth in

Sec. 413.130(g)(2). In addition, interest expense must meet the

definition of ``necessary'' in Sec. 413.153(b)(2)(iii).

For cost reporting purposes, we proposed to require the use of the

effective interest method rather than the straight line method. Under

the straight line method, the interest for a computation period is

computed by dividing the total interest payable (the

[[Page 37013]]

value at maturity less the amount paid) by the number of compensation

periods. This method recognizes the average interest expense or income

for each compensation period.

Under the effective interest method, we indicated that in each

computation period (as specified by the bond instrument) we would apply

the interest rate to the sum of the face amount and the accrued

interest from prior periods. If the interest computation period

involves portions of more than one cost reporting period, the amount of

interest for that computation period would be apportioned to each cost

reporting period. This method recognizes the actual accrual of interest

expense or income for each interest computation period (as specified by

the bond instrument) throughout the life of the bond to maturity. A

constant effective yield rate is determined and applied to the book

value (outstanding loan balance including prior accrued interest) of

the bond at the beginning of each period to determine the total

interest for the period. We also proposed to set forth in the

regulations under proposed Sec. 413.153(f)(3)(iv) an example of the

computation of interest using the effective interest method.

IV. Analysis of and Responses to Public Comments

We received two letters of comment on the December 22, 1993

proposed rule. These comments and our responses are discussed below.

Comment: One commenter questioned whether the effective date of the

final regulation would be the February 22, 1991, effective date of the

manual provisions. The commenter also wanted us to explain the current

applicability of the interim policies in the Regional Office memorandum

dated December 22, 1989, and in the Provider Reimbursement Manual for

the interim period before the effective date of this final rule. The

commenter stated that if the final rule has an effective date other

than February 22, 1991, the manual provisions would be inconsistent

with the regulation.

Response: This final rule is effective on August 15, 1996 and

applies to bonds issued on and after that date. This date is not

inconsistent with the effective dates of HCFA's prior policies

addressing reimbursement for zero coupon bond interest. The

reimbursement policies in existence before the effective date of this

final rule apply to cost reporting periods that precede the

promulgation of this final rule, and the policies continue in force

only with respect to bonds issued before August 15, 1996. The December

22, 1989 memorandum provided that for interest from zero coupon bonds

issued before December 22, 1989 (that is reportable on a cost report

that can be reopened on or after December 22, 1989), a provider could

request amendment or reopening to specify the method of reporting the

interest expense and income on the zero coupon bonds.

The memorandum did not establish a time limitation on these

requests. However, in order to effectuate an orderly implementation of

this rule, we are requiring providers to submit requests for reopening

or amendment within 60 days of publication of this final rule, that is

by September 16, 1996. Any request received after that date will not be

considered timely and will not be honored.

The provisions of this final rule supersede any agency policy that

is inconsistent with the regulation's terms.

Comment: One commenter stated that while the preamble and the

regulation text of the proposed rule referred to interest expense

incurred to finance capital-related costs, section 213(A) of the

Provider Reimbursement Manual refers to ``issuing zero coupon bonds for

a purpose related to patient care.'' The commenter asked for consistent

use of language as the Manual wording implies that interest expense for

operating purposes, such as working capital, is also an allowable cost.

Response: The language in section 213(A) of the Manual is correct.

Zero coupon bonds may be used to provide funds for either capital-

related costs or operating costs, as long as the costs are for a

purpose related to patient care. We have revised Sec. 413.153(f)(1) to

clarify that interest expense incurred to provide funds for ``patient

care-related costs'' is an allowable expense.

Comment: One commenter suggested that in the final rule we

reference a specific exception to our general policy on the liquidation

of liabilities, established at section 2305 of the Provider

Reimbursement Manual, since the actual payment of interest expense will

not be made until the bonds mature.

Response: Section 2305 of the Manual requires that short-term

liabilities be liquidated within 1 year of the end of the cost

reporting period in which the liability is incurred, subject to certain

specified exceptions. With zero coupon bonds, the interest accrues

during the life of the bond but is not payable until maturity or

redemption of the bond. Since there are no specified interest payments

due during the life of the bond, the liability for payment does not

occur until the bond matures or is redeemed. There is no short-term

liability. We note, in section 2305, that it does not apply to zero

coupon bonds until they mature or are redeemed.

Comment: One commenter objected to the language in

Sec. 413.153(f)(2), which specified that earned interest from zero

coupon bonds must be offset against all allowable interest expense. The

commenter's concern was that in the case of a bond defeasance (an

advance refunding of debt) there are specific guidelines regarding the

treatment of costs associated with advance refunding and with the

allocation of investment income. These guidelines are laid out in the

Provider Reimbursement Manual in sections 2806.G.1, 233, and 213. The

commenter believed that the proposed regulations are in conflict with

specific instructions for bond defeasance.

Response: The commenter is correct. In an advance refunding of debt

(which includes bond defeasance), the investment income is offset

against the interest expense of both the refunded debt and the

refunding debt and is included in determining the gain or loss on the

advanced refunding rather than included with other investment income

and prorated under Sec. 413.130(g)(2). We agree that some changes in

the language of the regulations are needed to better reflect the

treatment of investment income in an advance refunding. We have removed

the reference to ``all'' in Sec. 413.153(f)(2) and revised the section

to indicate that if zero coupon bonds are purchased with the proceeds

of an advance refunding, offset of the investment income is required

under Sec. 413.153(b)(2)(iii), but the investment income is not

prorated under Sec. 413.130(g)(2).

Comment: One commenter raised a question about the current

applicability of the section of the memorandum dated December 22, 1989,

that allowed a provider, under certain circumstances, to reopen or

amend a cost report to specify the method to be used for reporting

interest expense and income on zero coupon bonds issued before December

22, 1989.

Response: The memorandum dated December 22, 1989, provided that for

interest from zero coupon bonds issued before December 22, 1989, that

is reportable on a cost report that can be reopened on or after

December 22, 1989, a provider could request amendment or reopening to

specify the method of reporting the interest expense and income on the

zero coupon bonds. The memorandum did not contain a time limitation on

the requests. However, in order to effectuate an orderly implementation

of these provisions, we are requiring providers to submit request for

reopenings or amendments

[[Page 37014]]

within 60 days of publication of this final rule. Any request received

after that date will be considered not timely filed and will not be

honored.

V. Provision of the Final Regulations

This final rule adopts the provisions of the proposed rule as

final, with the following minor revisions:

In Sec. 413.153(f)(1), we have changed the phrases

``capital-related cost'' to ``patient care-related cost'' and to

``provide funds'' rather than ``finance''.

In Sec. 413.153(f)(2), we deleted the word ``all'',

rewrote part of the section for clarity, and added an appropriate

cross-reference provision for handling zero coupon bonds purchased with

the proceeds of an advance refunding of debt.

VI. Regulatory Impact

We generally prepare a regulatory flexibility analysis that is

consistent with the Regulatory Flexibility Act (RFA) (5. U.S.C. 601

through 612) unless we certify that a final rule will not have a

significant economic impact on a substantial number of small entities.

For purposes of the RFA, we consider providers to be small entities.

Also, section 1102(b) of the Act requires us to prepare a

regulatory impact analysis for any final rule that will have a

significant impact on the operations of a substantial number of small

rural hospitals. Such an analysis must conform to the provisions of

section 603 of the RFA. For purposes of section 1102(b) of the Act, we

define a small rural hospital as a hospital with fewer than 50 beds

located outside a metropolitan statistical area.

In the December 22, 1993 proposed rule, we concluded that the

proposed rule changes would not have a significant economic impact on a

substantial number of small entities, and would not have a significant

impact on the operations of a substantial number of small rural

hospitals. As discussed above, we received two letters of comments on

the proposed rule, neither of which objected to our conclusion that

these changes will not have a significant impact. This final rule

adopts the provisions at the proposed rule with only minor technical

changes. Therefore, we have determined, and certify, that this final

rule will not have a significant economic impact on a substantial

number of small entities. Also, this final rule will not have a

significant impact on the operations of a substantial number of small

rural hospitals. Therefore, we have not prepared a regulatory

flexibility analysis or a rural hospital impact analysis.

In accordance with the provisions of Executive Order 12866, this

final regulation was not reviewed by the Office of Management and

Budget.

Under the provisions of Public Law 104-121, we have determined that

this final rule is not a major rule.

VII. Collection of Information Requirements

Under the Paperwork Reduction Act of 1995, agencies are required to

provide 60-day notice in the Federal Register and solicit public

comment before a collection of information requirement is submitted to

the Office of Management and Budget (OMB) for review and approval. In

order to fairly evaluate whether an information collection should be

approved by OMB, section 3506(c)(2)(A) of the Paperwork Reduction Act

of 1995 requires that we solicit comment on the following issues:

Whether the information collection is necessary and useful

to carry out the proper functions of the agency;

The accuracy of the agency's estimate of the information

collection burden;

The quality, utility, and clarity of the information to be

collected; and

Recommendations to minimize the collection burden on the

affected public, including automated collection techniques.

The overall recordkeeping and information collection burden

associated with filing the provider cost report has been approved by

OMB through August 31, 1996 under OMB No. 0938-0050.

In the December 13, 1993, proposed rule (58 FR 65150), we indicated

that there would be no additional reporting burden on those providers

who have zero coupon bonds and solicited comments. No comments were

received.

Section 413.153 defines when interest expense is an allowable cost

and how interest income is treated. The changes to this section

represent a clarification of the current policy on interest expense and

income as it applies to zero coupon bonds. It does not change the

information collection and recordkeeping requirements. The information

and recordkeeping required is that which is already required to file a

cost report and approved by OMB as indicated above.

List of Subjects in 42 CFR Part 413

Health facilities, Kidney diseases, Medicare, Puerto Rico,

Reporting and recordkeeping requirements.

42 CFR chapter IV, part 413, is amended as follows:

PART 413--PRINCIPLES OF REASONABLE COST REIMBURSEMENT; PAYMENT FOR

END-STAGE RENAL DISEASE SERVICES; OPTIONAL PROSPECTIVELY DETERMINED

PAYMENT RATES FOR SKILLED NURSING FACILITIES

A. The authority citation for part 413 is revised to read as

follows:

Authority: Secs. 1102, 1861(v)(1)(A), and 1871 of the Social

Security Act (42 U.S.C. 1302, 1395x(v)(1)(A), and 1395hh).

Subpart G--Capital-Related Costs

B. Section 413.153 is amended by adding paragraphs (b)(4) and (f)

to read as follows:

Sec. 413.153 Interest expense.

* * * * *

(b) Definitions--* * *

(4) Zero coupon bonds. Zero coupon bonds are issued by government

agencies, corporations, and banks at a price substantially below the

face value. The difference between the purchase price and the face

value reflects the actual amount of interest and is neither a discount

nor an adjustment to the interest rate as with other bonds. Interest is

paid at maturity when the bond is redeemed at face value.

* * * * *

(f) Zero coupon bonds--(1) Interest on bonds issued on or after

August 15, 1996. For zero coupon bonds issued on or after August 15,

1996, interest expense incurred to provide funds for patient care-

related costs is an allowable expense, and interest income earned for

investment purposes is an allowable offset, in the cost reporting

period in which the interest accrues.

(2) Interest income offset. Interest income from zero coupon bonds

must be offset against allowable interest expense as prescribed in

paragraph (b)(2) of this section and in Sec. 413.130(g)(2). If zero

coupon bonds are purchased with the proceeds of an advanced refunding

of debt, offset of the investment income is required under

Sec. 413.153(b)(2)(iii), but the investment income is not prorated

under Sec. 413.130(g)(2).

(3) Use of effective interest method. (i) Interest expense and

interest income from zero coupon bonds that are reported as they accrue

must be amortized using the effective interest method. This method

recognizes the actual accrual of interest expense or income for each

interest computation period (as specified by the bond instrument)

throughout the life of the bond.

[[Page 37015]]

(ii) A constant effective yield rate is determined and applied to

the book value (outstanding loan balance including prior accrued

interest) of the bond at the beginning of each period to determine the

total interest for the period.

(iii) If the interest computation period involves portions of more

than one cost reporting period, the amount of interest for that

computation period shall be apportioned to each cost reporting period.

(iv) An example of the computation of interest using the effective

interest method follows:

Facts

Life of zero coupon bond: 15 years.

Value at maturity: $50,000.

Bondholder pays $6,996 for the bond.

Annual interest rate is 13.5506% compounded semi-annually.

From the table below, interest for the first year would be $980.11

($474.00 plus $506.11).

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Col. 4

Col 2 Book value

Book value Col. 3 end of

Col 1 Six-month periods beginning Effective period

of period interest* (columns 2

+ 3)

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1 $6,996.00 $474.00 $7,470.00

2 7,470.00 506.11 7,976.11

3 7,976.11 540.40 8,516.51

4 8,516.51 577.02 9,093.53

29 43,855.94 2,971.37 46,827.31

30 46,827.31 3,172.69 50,000.00

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*Computed by multiplying the book value at the beginning of each period

(Column 2) by 6.7753% (the annual interest rate of 13.5506% 2 =

6.7753%).

(Catalog of Federal Domestic Assistance Program No. 93.773,

Medicare--Hospital Insurance; and Program No. 93.774, Medicare--

Supplementary Medical Insurance Program)

Dated: February 23, 1996.

Bruce C. Vladeck,

Administrator, Health Care Financing Administration.

[FR Doc. 96-17895 Filed 7-15-96; 8:45 am]

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