Yoram Keinan Taxation of Financial Instruments

Class 4

Transcript

1. Short-Term Obligations (IRC §§1281 – 1283)
2. Short-Term Obligation (STO): Definition (IRC §1283) • A debt instrument, • With a fixed maturity date no more than 1 year from the issue date, • Other than a tax-exempt obligation.
3. Tax Treatment of Short-Term Obligations • STOs are not directly subject to the OID or market discount rules but rather to a separate set of rules found in IRC §§1281-83. • The particular tax treatment of a short-term obligation depends on (i) whether it is a government or non-government obligation; and (ii) whether certain elections (discussed below) are made.
4. Overview • On short-term government obligations, for holders subject to §1281, all discount must be accrued – no distinction is made between OID and market discount. • On short-term nongovernment obligations, affected holders must accrue OID but not market discount. • Holders exempt from the accrual rules must treat gain on sale as ordinary to the extent of accrued discount.
5. Scope of Section 1281 • IRC §1281 applies to all short-term obligations held by: (i) accrual-method holders; (ii) banks; and (iii) regulated investment companies and common trust funds. • In addition, IRC §1281 applies to any short-term obligation (i) held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business; (ii) identified as part of a hedging transaction, or (iii) which is a stripped bond or coupon held by the person who stripped the bond or coupon. Finally special rules apply to partnerships, S corporations, trusts, and other pass-through entities.
6. Exception for Banks on Cash-Basis Method • A cash-method bank (less than $5M in receipts) that makes short-term loans to customers in the ordinary course of its trade or business is not required to accrue interest on these loans. • See Security Bank Minnesota v. Comm’r; U.S. Bancorp v. Comm’r; Rev. Proc. 2001-25; Rev. Proc. 99-49.
7. Short-Term Government Obligation (“STGO”): Definition (IRC §1271(a)(3)(B)) • Obligation of the United States or any of its possessions, or a state, or any political subdivision thereof, or the District of Columbia. • With a fixed maturity date not more than 1 year from the issuance date. • Does not include tax-exempt obligations.
8. Accrual of Interest on a Short-Term Government Obligations • A taxpayer must accrue “acquisition discount” on a STGO. IRC §1281(a)(1). • “Acquisition discount” is the excess of the obligation’s SRPM over the taxpayer’s basis in the obligation. IRC §1283(a)(2). • The issue price of the STGO is irrelevant. • Acquisition discount includes both OID and market discount and automatically offsets acquisition premium against remaining OID.
9. Accrual of Interest on a STGO (Cont.) • Accrual of acquisition discount is a straight-line allocation of the total acquisition discount to the number of remaining days to maturity of the obligation, including the maturity date but excluding the date of acquisition. IRC §1283(b)(1). • A holder may elect daily compounding, and, therefore, compute the yield-to-maturity on this basis and make computations analogous to the OID computations for a debt instrument with daily accrual periods. IRC §1283(b)(2).
10. Example • Treasury Bill with face amount = $1,000,000 • Issue price: $900,000 • Term: 1 year, daily accrual • YTM = 10.5375% (compute) • First 6 months straight-line accrual: $50,000 ($100,000 /2) • Compound accrual for first 6 months: $48,683 • Conclusion: because the term is short, differences are small.
11. Short-Term Non-government Obligation (“STNGO”): Definition (IRC §1271(a)(4)(B) • Fixed maturity date not more than 1 year from the issue date. • Not a short-term government obligation.
12. Treatment of STNGOs • Pursuant to Reg. §1.1273-1(c)(5), in the case of a debt instrument with a term not more than 1 year, no payment of interest is considered to be QSI. • Thus, any STNGO, including one calling for semiannual, quarterly, or monthly interest, will be treated as having OID equal to the excess of the total payments on the instrument over its issue price.
13. Accrual of Interest on a STNGO • Unless the holder elects to be subject to the same rules as for STGOs (under IRC §1283(c)(2)), a holder must include OID in income as it accrues, but not “market discount.” IRC §1283(c)(1). • Accrual is made on a straight-line basis, unless the holder elects a daily accrual. • The market discount rules of IRC §§1276-78 do not apply to such an instrument.
14. Deferral of Interest Deductions under IRC §1282 • The purpose of IRC §1282 is to prevent cash- method taxpayers not subject to IRC§ 1281 from artificially deferring taxable income a leveraged purchase of a STO. • IRC §1282 works similarly to IRC §1277: it postpones “net direct interest expense” with respect to a STO.