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Yoram Keinan

Yoram Keinan

Original Issue Discount

Yoram Keinan

January 26, 2022
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  1. 2 Historical Background • Some taxpayers use the cash method

    of tax accounting, others use the accrual method of tax accounting. (recall §448 imposes limits on use of the cash method) • On a loan that pays interest at least annually, cash versus accrual makes a difference of at most one year in the timing of interest inclusion or deduction. – E.g., loan that pays annual interest on 1/31 • The tax system has been willing to tolerate the potential mismatch between a borrower’s deduction and a lender’s inclusion.
  2. 3 Discount Loans • On a loan where a significant

    amount of the interest is in the form of original issue discount (OID), the timing mismatch can be greater. – E.g., cash-method taxpayer holding a 5-year zero-coupon bond could defer interest for 5 years • If the discount is not recognized currently as a form of interest, then there can also be a character difference, because the holder of a discount bond could sell the bond just before maturity for a gain equal to the amount of the accrued discount. – If the bond is a capital asset, ordinary interest income could potentially be converted to long-term capital gain.
  3. OID – General Rule • The holder of a debt

    instrument with OID includes the OID in income over the term of the debt as it accrues economically under the constant yield method. – OID is treated as interest – OID is accounted for on an accrual basis regardless of the holder’s method of tax accounting – Basis is increased for the amount of accrued OID • The issuer generally deducts a corresponding amount pursuant to §163(e). • The OID rules are the foundation for the other tax rules governing debt, such as the market discount and bond premium rules. 4
  4. Major Exceptions to the OID Rules (§1272(a)(2)) • Tax-exempt obligations

    • U.S. savings bonds • Short-term debt instruments (instruments that have fixed maturity dates of one year or less from date of issue) – Cash method taxpayers must treat all discount on short-term government obligations as ordinary income when the obligation matures. – For short-term nongovernment obligations, the amount treated as ordinary income is limited to the OID that accrued while the holder held the obligation. • Loans between natural persons (not in lenders t/b and ≤ $10K) • Obligations with de minimis OID (§1273(a)(3)) – Generlly ¼ of 1% (0.0025 or 25 bps) times number of complete years to maturity 5
  5. OID – Key Terms • Original Issue Discount (OID) (§1273(a)(1))

    • Stated Redemption Price at Maturity (SRPM) (§1273(a)(2)) • Qualified Stated Interest (QSI) (§1273(a)(2) & Reg. §1.1273- 1(c)) • Issue Price (IP) (§1273(b)) – Adjusted IP (§1272(a)(4)) • Yield to Maturity (YTM) (Reg. §1.1272-1(b)(1)(i)) 6
  6. OID – Original Issue Discount • Generally, OID is the

    excess of what a borrower is obligated to repay over the amount borrowed. • More precisely, OID is the excess of the “stated redemption price at maturity” over the “issue price.” (§1273(a)(1)) • OID can arise in a number of different circumstances – Debt issued at a discount to its par value – or “true discount” – Stepped interest rates – Investment units (in a sense, a form of true discount) – Payment-in-kind (PIK) interest payments – Imputed interest on certain debt issued for property 7
  7. SRPM – Stated Redemption Price at Maturity • SRPM is

    the sum of all payments due under a debt instrument other than QSI. (§1273(a)(2)) – Payments need not be made at maturity. – Payments need not be redemption payments – this can lead to confusion about what constitutes OID. • If all of the stated interest on a debt instrument is QSI, then the SRPM is equal to the stated principal amount. 8
  8. QSI – Qualified Stated Interest • QSI is stated interest

    that is: – Unconditionally payable; – In cash or property (other than debt of the issuer); – At least annually; and – At a single fixed (or qualified variable) rate. (§1273(a)(2) & Reg. §1.1273-1(c)) • Interest is “unconditionally payable” only if: – Reasonable remedies exist to compel timely payment; or – The debt instrument provides terms and conditions that make the likelihood of a late payment or nonpayment remote. • Most traded notes and bonds call for QSI, so most OID is true discount. 9
  9. 10 IP – Issue Price (Reg. §1.1273-2) • The Issue

    Price (IP) is determined in accordance with the following three elements: – the nature of the proceeds from the issuance (i.e., cash or property); – if property is received, whether it is publicly traded; and – whether the debt is publicly traded.
  10. 11 Debt Issued for Cash • With respect to debt

    instruments issued for cash, the IP is the amount of cash received. • If the publicly-offered debt is issued for cash over a period of time rather than all at once, the IP is the first price at which a “substantial amount” of the debt instruments are sold. (§1273(b)(1)) – There is no bright-line rule for what constitutes a substantial amount.
  11. 12 Publicly-Traded Debt Issued for Property • If the debt

    is publicly traded and issued for non- publicly-traded property, then the IP is the fair market value (i.e., the trading price) of the debt. • An instrument is viewed as traded on an established market (i.e., publicly traded) if it traded on an established market at any time during the 31-day period ending 15 days after the issue date. Reg. §1.1273-2(f). – The rationale is that the trading price is an objective (and therefore reliable) measure of the fair market value and hence can be used to determine the IP.
  12. 13 Non-Publicly-Traded Debt Issued for Publicly- Traded Property • If

    the debt instrument is not publicly traded, but is issued for publicly-traded property, then the IP is the fair market value of the publicly-traded property. • Property is tested for public trading during the 31- day period ending 15 days after the issue date.
  13. 14 Public Trading • The definition of public trading was

    significantly revised in regulations issued in November 2012. Reg. §1.1273-2(f). • Under both the old and new regulations, the focus is not on trading but on the public availability of price information with respect to the debt. • If debt is SEC registered, all trades are publicly reported, so the debt is publicly traded unless trading is “frozen.” • Under the 2012 regulations, even “indicative quotes” are enough to cause a debt instrument to be considered publicly traded. As a result, syndicated bank debt is often viewed as publicly traded. – Sales prices of executed transactions – Firm quotes from identified persons – Indicative quotes are quotes from at least one broker, dealer, or pricing service that is not a firm quote
  14. 15 Non-Publicly-Traded Debt Issued for Non- Publicly-Traded Property • For

    non-publicly-traded debt issued for non-publicly- traded property, the rules of §1274 generally apply: – If the debt has adequate stated interest (ASI), then its IP is its stated principal amount (SPA) – Adequate stated interest generally means interest at least equal to the applicable Federal rate (AFR) – If the debt does not have adequate stated interest, then its IP is the imputed principal amount (IPA), which is lower than the stated principal amount. This generally gives rise to OID, which causes the YTM on the debt to increase to the AFR.
  15. True Discount • True discount means that a debt instrument

    is issued for an amount less than the principal (face) amount • Examples – Zero-coupon bonds – Publicly-traded debt issued below par – Non-traded debt with stated interest below the AFR – Points paid by the borrower to the lender (generally applicable only to loans to individuals for personal use, such as residential mortgage loans and retail installment sales contracts) – Debt issued as part of an investment unit (debt and warrant) 16
  16. Stepped Interest Rates • A debt instrument can have OID

    if it provides for interest rates that step up or down. Only interest that is unconditionally payable at a single fixed rate constitutes QSI. If the rate varies, only the minimum rate constitutes QSI. See Reg. §1.1272-1(j), Ex. 9. • Example: a 10-year debt instrument provides for 6% interest for 3 years, and then 8% interest for the remaining 7 years – Only 6% interest is QSI – YTM will be between 6% and 8% – Debt will accrue interest at a constant yield over its entire term • An interest holiday causes all of the interest on the debt to fail to qualify as QSI (unless so short as to fall within a special de minimis rule). 17
  17. Investment Units • Debt instrument issued with other separately-traded property

    rights (e.g., warrants), typically sell for a price equal to the principal amount of the debt. • Purchase price is allocated between the debt and the property rights based on the relative FMVs of each. (§1273(c)(2)) – The amount allocated to the property right generally is taken to be its FMV, so the OID on the debt is equal to the FMV of the property right. – The amount allocated to the debt becomes the IP of the debt. – In effect, the debt instrument is issued with true discount equal to the FMV of the property right. • A convertible debt instrument is similar to a debt with a separate warrant, but convertible debt is a single financial instrument. In spite of this economic similarity to an investment unit, the tax law does not view the conversion feature on convertible debt as a separate derivative; instead, the conversion feature generally is ignored and convertible debt does not have OID (assuming it was issued for its face amount). 18
  18. Payment-in-Kind Interest • Payment-in-kind (PIK) interest involves the payment of

    interest with the issuance of new bonds (so called “baby bonds”) (Reg. §1.1275-2(c)(3)) – The right to pay in kind is treated as an option to defer the interest payment to maturity – PIK interest is not considered a payment on the debt and is not QSI – i.e., it is not unconditionally payable, at least annually, at a single fixed rate, in cash or property (other than debt of the issuer) – Because PIK interest is not QSI, it is included in the SRPM, and therefore creates OID • PIK bonds are aggregated with the original bond • In practice, the issuance of PIK bonds means that the principal amount of the debt is increased by the amount of the accrued interest. See Reg. §1.1272-1(j), Exs. 7 & 8. 19
  19. De Minimis OID • If OID with respect to a

    debt instrument is less than ¼ of 1 percent (i.e., 25 basis points) of the instrument’s SRPM multiplied by the number of full years from the issue date to the maturity date, then the amount of OID on the instrument is considered to be zero and all stated interest is treated as QSI. §1273(a)(3); Reg. §1.1273-1(d). 20
  20. Example • 10-year bond • Face amount = $1,000 •

    Issue Price = $980 • All interest is QSI (thus, SRPM is $1,000) • Potential OID = $20 • De minimis amount: 10  $1,000  0.25% = $25 • Thus, the bond has de minimis OID. 21
  21. Holder’s Treatment of De Minimis OID • A holder of

    a debt instrument with de minimis OID does not accrue the OID but instead recognizes gain when stated principal payments are received. Reg. §1.1273-1(d)(5). • The amount of gain recognized is equal to the product of the total amount of de minimis OID and a fraction the numerator of which is the amount of the principal payment and the denominator of which is the total stated principal amount of the instrument. Thus, if principal is paid in full in one payment, then the gain included is simply the de minimis OID amount. 22
  22. Four Steps in OID Accrual • The four steps of

    OID accrual are: (Reg. §1.1272-1(b)) – Determine the YTM – Determine the accrual period – Determine the OID allocable to each period – Determine the daily portions of OID • In practice, it is necessary to determine the accrual period first, because the YTM depends on the accrual period. 24
  23. Accrual Period • An “accrual period” is the interval of

    time with respect to which the accrual of OID is measured. An accrual period can be one year or less (e.g., 6 months, or every quarter, month, day, etc.). Reg. §1.1272-1(b)(1)(ii). • Accrual periods may vary in length over the term of the instrument, so long as each scheduled payment of principal or interest occurs at the beginning or the end of an accrual period. • Short-term obligations (1 year or less) are subject to a separate set of rules, discussed later. • The issuer and holder can use different accrual periods. • In practice, the payment intervals determine the accrual periods. 25
  24. YTM – Yield to Maturity • The YTM is the

    discount rate that, when applied to all principal and interest payments to be made under the debt instrument, produces a PV amount equal to the IP. – The YTM is constant over the term of the debt instrument. – Calculators and spreadsheets typically are used to calculate YTM. – In general, it is not possible to solve for the YTM in “closed form,” i.e., an equation in which the YTM is on the left and the variables based on the terms of the instrument are on the right. Thus, programs generally use an iterative process to compute the YTM. 26
  25. OID Allocable to Each Accrual Period • OID allocated to

    each period is equal to: AIP × YTM – QSI • AIP is the adjusted issue price of the instrument at the beginning of the accrual period. • YTM is the yield to maturity, per period. • QSI is the amount of qualified stated interest allocable to the period. 27
  26. AIP – Adjusted Issue Price • AIP at the beginning

    of the first accrual period is simply the IP of the instrument. • For any subsequent period, the AIP is the IP – (i) increased by the amount of OID previously included in the holder’s income, and – (ii) decreased by the amount of any payment previously made on the instrument, other than payments of QSI. (§1272(a)(4)) 28
  27. Example • Issue Date: January 15 • Term: 15 years

    • Face: $100,000 • Issue Price: $86,235.17 • Stated Interest: 10%, payable semiannually • YTM: 12%, compounded semiannually 29
  28. Example (cont’d) • First period accrual: $86,235.17  6% =

    $5,174.11 • First period OID: $5,174.11 – $5,000 = $174.11 • Adjusted Issue Price: $86,235.17 + $174.11 = $86,409.28. 30
  29. Example (cont’d) • Second period accrual: $86,409.28  6% =

    $5,184.56. • Second period OID: $5,184.56 – $5,000 = $184.56. • Adjusted Issue Price: $86,409.28 + $184.56 = $86,593.84. 31
  30. The Complete Picture – Pt. 1 Number of Periods 30

    Yield to Maturity 12% Issue Price ($86,235.17) Stated Interest Rate 10% Redemption Price 100,000.00 Period Accrual QSI OID AIP 1 $5,174.11 5,000.00 $ $174.11 $86,409.28 2 5,184.56 5,000.00 184.56 86,593.84 3 5,195.63 5,000.00 195.63 86,789.47 4 5,207.37 5,000.00 207.37 86,996.83 5 5,219.81 5,000.00 219.81 87,216.64 6 5,233.00 5,000.00 233.00 87,449.64 7 5,246.98 5,000.00 246.98 87,696.62 8 5,261.80 5,000.00 261.80 87,958.42 9 5,277.51 5,000.00 277.51 88,235.92 10 5,294.16 5,000.00 294.16 88,530.08 32
  31. The Complete Picture – Pt. 2 Period Accrual QSI OID

    AIP 11 5,311.80 5,000.00 311.80 88,841.88 12 5,330.51 5,000.00 330.51 89,172.40 13 5,350.34 5,000.00 350.34 89,522.74 14 5,371.36 5,000.00 371.36 89,894.10 15 5,393.65 5,000.00 393.65 90,287.75 16 5,417.27 5,000.00 417.27 90,705.02 17 5,442.30 5,000.00 442.30 91,147.32 18 5,468.84 5,000.00 468.84 91,616.16 19 5,496.97 5,000.00 496.97 92,113.13 20 5,526.79 5,000.00 526.79 92,639.91 21 5,558.39 5,000.00 558.39 93,198.31 22 5,591.90 5,000.00 591.90 93,790.21 23 5,627.41 5,000.00 627.41 94,417.62 24 5,665.06 5,000.00 665.06 95,082.68 25 5,704.96 5,000.00 704.96 95,787.64 26 5,747.26 5,000.00 747.26 96,534.89 27 5,792.09 5,000.00 792.09 97,326.99 28 5,839.62 5,000.00 839.62 98,166.61 29 5,890.00 5,000.00 890.00 99,056.60 30 5,943.40 5,000.00 943.40 100,000.00 33
  32. Daily Portions • A holder of an OID debt instrument

    is required to include in income for a given tax year the sum of the “daily portions” of OID for each day the holder held the instrument during the year. • The issuer is allowed a corresponding deduction for the aggregate daily portions of OID for each day the debt was outstanding during the year. 34
  33. Daily Portions (cont’d) • The daily portions of OID for

    any day within an accrual period is simply the total amount of OID for the period divided by the number of days in the period. • For this purpose, the holder can apply any reasonable counting convention (e.g., actual day count or 30/360), and count the issue date or the maturity date, but not both. • If an accrual period falls within a single tax year, then there is no need to compute daily portions. Otherwise, it is necessary to prorate the total amount between the two affected years in proportion to the number of days in each year. 35
  34. §451(b) (12/22/2017) – Book/Tax Conformity • For accrual method taxpayers,

    income is includible when all the events have occurred which fix the right to receive such income and the amount can be determined with reasonable accuracy. §451(b)(1)(C); Reg. §1.451-1(a). • TCJA §451(b)(1)(A) provides that the “all events” test is met with respect to items of gross income no later than when the taxpayer takes the item of gross income into account as revenue for financial accounting purposes in an applicable financial statement. – Timing provision intended to increase financial accounting/tax conformity • Effect is to accelerate some income for tax purposes – Income is now recognized at the earliest of due, paid, earned, or recognized as revenue in an applicable financial statement. – For example, unbilled receivables for partially performed services are included before services are complete and ready to be billed. – Accelerates revenue from sale of gift cards and credit card fees (e.g., late payment, cash advance, and interchange fees (and reverses Capital One Financial Corp. v. Commissioner, 133 T.C. 136 (1999)) 36
  35. Does §451(b) Apply to OID/Market Discount? • Legislative history –

    Holders must apply revenue recognition rules under §451 before applying the OID and market discount (so they are not excepted from from §451(b)). – §451(b) does not affect the realization requirement; thus, recognition is required only after realization occurs • Final regulations issued in December 2020 (T.D. 9941) – Adopts 2 sets of proposed regulations – Prior guidance obsoleted, except Rev. Proc. 2013-26, relating to the safe harbor method of accounting for OID on a pool of credit card receivables, which will be modified not to apply to any specified fees, including specified credit card fees – Effective for tax years beginning on or after Jan. 1, 2021 37
  36. Does §451(b) Apply to OID/Market Discount? (cont’d) • Summary of

    final regulations – Reg. §1.451-3(a)(13) & -3(d)(5) provides a non-exhaustive list of special methods of accounting to which §451(b) does not apply, including: • Tax hedging rules (Reg. §1.446-4) • MTM (§475) • Tax integration rules (Reg. §1.1275-6 and Reg. §1.988-5) • OID and de minimis OID (§1272 and regs; §1273 and regs) • CPDIs (Reg. §1.1275-4), VRDIs (Reg. §1.1275-5), and inflation-indexed debt (Reg. §1.1275-7) • Accrued market discount and de minimis market discount (§1276 and §1278(b)) – Special rule for certain specified fees on debt instruments (generally credit card fees) 38
  37. General Rule • “If a principal purpose in structuring a

    debt instrument or engaging in a transaction is to achieve a result that is unreasonable in light of the purposes of §163(e), §§1271 through 1275, or any related section of the Code, the Commissioner can apply or depart from the regulations under the applicable sections as necessary or appropriate to achieve a reasonable result.” Reg. §1.1275-2(g)(1). • Note that the OID anti-abuse rule applies in addition to §7701(o) – the economic substance doctrine. 40
  38. What is an Unreasonable Result? (Reg. §1.1275-2(g)(2)) • Whether a

    result is unreasonable depends on all the facts and circumstances, though a significant fact is whether the debt is expected to have a substantial effect on the issuer’s or holder’s US tax liability. • In the case of a CPDI, another significant fact is whether the result was achievable without the application of the CPDI regs and any related provisions. • A result is not unreasonable in the absence of an expected substantial effect on the PV of a taxpayer’s tax liability. 41
  39. Examples • Regs have 3 examples: (Reg. §1.1275-2(g)(3)) – Increasing-rate

    note with an early call option that is deemed exercised but not expected to be exercised. (abusive) – Substantial modification of a non-publicly-traded CPDI to take it out of noncontingent bond method and into Reg. §1.1275-4(c). (abusive) – Issuer chooses to issue a convertible note rather than an investment unit. Motivation in part is to avoid giving the holders OID accruals. (not abusive) 42
  40. Further Applications • Three other instances in which IRS has

    considered the rule – – Rev. Rul. 2000-12, bonds with offsetting interest reset features (abusive) – Rev. Rul. 2002-31, contingent convertible debt instruments (not abusive) – AM 2007-14, convertible debt with hedge (not abusive). • In Rev. Rul. 2003-97, debt + forward contract investment unit, the IRS did not invoke the rule. 43
  41. Food for Thought – Short Bond • A buys a

    zero-coupon bond at original issue for 60 and immediately lends it to B, who sells it to C. B is obligated to return an identical bond to A upon 5 days’ notice. (see §1058 securities lending rules)) • When the bond’s AIP is 95, A asks for a return of the bond. B buys the bond in the market and gives it to A. • A holds the bond while the last 5 of OID accrues. A claims that no OID accrued to it during the term of the securities loan to B. Hence, A claims its basis in the bond is 65 and it has 35 of capital gain. • Abusive? 44