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Accrual of OID income required on "troubled" debt instrument

Under the tax law, original issue discount (OID) arises when a debtor issues a debt instrument, such as a bond or note, for an "issue price" less than the face amount of the debt instrument. OID is, in a sense, a subclass of interest. However the definition of OID for tax purposes is extremely broad. Under the current OID regime, not only may significant portions of the principal amount of a debt instrument be treated as OID, but all or some of he stated interest may, except in the most "plain vanilla" cases, be governed by the special OID rules, rather than the general interest rules.

The debtor (or "issuer") of a debt instrument issued with OID has long been allowed to amortize the amount of the OID as a deductible expense over the life of the instrument; in effect, a portion of the instrument's stated principal amount has been recharacterized, from the issuer's perspective, as interest expense and thus accrued over the term of the instrument. Prior to 1969, however, the holder of a debt instrument issued with OID was not required to include any portion of the OID in income until the holder disposed of the instrument; at that time, all or a portion of the holder's gain was characterized as ordinary income, rather than capital gain, reflecting the OID that had accrued while the holder held the debt instrument.

The Tax Reform Act of changed this rule. Congress was troubled by the nonparallel treatment of issuers and holders and wanted both parties to a debt instrument to be treated consistently. Moreover, it seemed that many holders of debt instruments issued at a discount were "forgetting" to report any portion of their gain as ordinary income. Accordingly, the 1969 Act required holders for the first time to accrue OID income in the same manner that issuers are permitted to accrue OID deductions. (In order to avoid an excessive inclusion of income, special relief rules were provided for holders whose purchase price was greater than the issue price plus OID accrued to the date of purchase.) Under the 1969 Act, as under pre-1969 law, OID was deemed to accrue on a "straight-line," rather than an "economic accrual," basis. The effect of this rule was generally to accelerate deductions. and inclusions on a debt instrument issued with OID relative to when interest deductions and interest income inclusions would be taken into account on a comparable non-OID debt instrument that provided for payments in identical dollar amounts and at identical times but with a greater amount of stated interest and a lesser stated principal amount.

At the time of the enactment of the Tax Equity and Fiscal Responsibility Act of 1982, Congress expressed its concern that the use of straight-line accrual for OID purposes resulted in distortions relating to the front-loading of interest that could not be justified by the relative simplicity of the straight-line method. The magnitude of those distortions was increased by the fact that interest rates in 1982 were materially higher than those in 1969. Therefore, in the case of debt instruments issued after July 1, 1982, Congress required that OID be computed on the "economic accrual" method. (It has been suggested, only partly in jest, that the development of the hand-held financial calculator in the early 1980s also contributed to Congress's willingness to change the law, since the arcane calculations needed to compute a debt instrument's yield to maturity, an essential step in "economic accrual" calculations, could now be performed by a broader range of individuals without advanced financial or mathematical training.) The Congressional Committee Reports accompanying the 1982 Act, as well as those accompanying the Tax Reform Act of 1984, which further expanded the scope of the OID provisions, expressed the view that an important purpose of the OID provisions is to place the holders of OID instruments, regardless of the method of accounting they generally employ, on a par with accrual-method holders of debt instruments that pay interest currently.

In the case of current-pay debt instruments, there is a well-recognized rule under which a taxpayer on the accrual method of accounting need not accrue interest in income, if, at the time the interest would otherwise be earned, it reasonably appears that the interest will be uncollectible because of the issuer's insolvency. There has long been an unresolved question regarding whether this rule applies to the accrual of OID by the holders of debt instruments. Several factors have combined to give this question some urgency -- the expansion of the OID regime to instruments that do not, at first glance, appear to be issued at a discount; high interest rates (which increase the amount of OID accruals); and a market flooded with "troubled" debt instruments, on which the likelihood of recovering even the holder's investment, much less any interest or OID income, is small. Recently, the Internal Revenue Service, in Technical Advice Memorandum 9538007 (June 13, 1995), expressed its view. Much to the disappointment of many taxpayers (and the* advisers), the Service held that OID accrual may not be suspended by reason of the issuer's financial condition, even if there is "no reasonable expectation that the debt instrument will be redeemed according to its terms."

The Technical Advice Memorandum involved a rather extreme set of facts. The taxpayer was the holder of subordinated debentures issued with OID by a corporation. During the three years in question, the issuer had defaulted on its senior debt and the debentures held by the taxpayer were traded at less than 10% of their face value. During the first year, the issuer expressed doubts about its ability to continue as a going concern and, by the close of the third year, it had filed for bankruptcy. Nevertheless, the Service required the taxpayer to include the OID, which it had considered to be "uncollectible," in its income. (It is not clear whether the Service continued to require accrual of the OID after the issuer's bankruptcy.)

In justifying this holding, the Service explained that the accrual method requires the current inclusion of interest income which will ultimately be collected; in other words, the accrual method is a rule relating to the timing of inclusion of collectible income. The "doubtful collectibility" exception, in the Service's view, is therefore grounded in the inappropriateness of accelerating the inclusion of income which will never be collected. "OID, by contrast," according to the Service, "is not included in income in advance of receipt; it is included in lieu of receipt," as though the issuer had paid cash to the holder and the holder had then re turned that cash to the issuer as a new loan.

The Service was unimpressed by arguments drawn from the 1982 and 1984 Committee Reports, to the effect that the OID rules were intended to create parity between OID instruments and current-pay instruments held by accrual-method taxpayers. Rather, the Service was more concerned with maintaining a different sort of parity, which it felt, based on the 1969 Committee Reports, underlies the entire OID regime -- parity between issuers (who will continue to deduct OID, notwithstanding any financial difficulties, at least short of bankruptcy, in which they find themselves), and holders (who should therefore continue to include OID under those same circumstances). Thus, the Technical Advice Memorandum takes the position that accrual of OID income should not be discontinued on the grounds of the issuer's poor financial condition.

A Technical Advice Memorandum has no formal precedential status and it is possible that this taxpayer or another will successfully challenge the Service's view in court (or even persuade the Service to change its own position). Nevertheless, as the first guidance on this issue either from the Service or the courts, this particular Technical Advice Memorandum is likely to have a significant impact on the planning and reporting of transactions. Moreover, a Technical Advice Memorandum may be taken into account as "authority" in determining whether a taxpayer will be penalized for an understatement of tax (even though it is not supposed to be taken into account in determining whether or not such an understatement exists). Any taxpayer or adviser faced with the question whether or not to report OID income accruing on a debt instrument issued by a troubled debtor will have to rethink the answer that may have been given only a few months ago.

Ronald A. Morris and Elliot Pisem, members of the New York bar, are partners in the law firm of Roberts & Holland LLP, New York City and Washington, D.C.

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