[Federal Register Volume 61, Number 137 (Tuesday, July 16, 1996)]
[Rules and Regulations]
[Pages 37011-37015]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-17895]


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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).

------------------------------------------------------------------------
                                                                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)   
------------------------------------------------------------------------
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 
------------------------------------------------------------------------
*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]
BILLING CODE 4120-01-P