Original Issue Discount Accruals for Debt When Collectability is Doubtful

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1 WALL STREET CONCEPTS [Title] WSC BRIEFING Original Issue Discount Accruals for Debt When Collectability is Doubtful IRS Guidance in Technical Advice Memorandum and Litigation Guideline Memorandum TL-103 Offer Somewhat Inconsistent Guidance OID Interest is Distinguishable from Stated Interest in Distressed Situations TAM Secured Debt Interest is Distinguishable from Unsecured Debt Interest in Bankruptcy Situations but not OID and Stated Interest LGM TL-103 August 2, 2013

2 Original Issue Discount Accruals for Debt When Collectability is Doubtful Issue The continued reporting of Original Issue Discount on Form 1099-OID from an issuer that is financially unstable creates potential tax issues for the taxpayer and service issues for the broker. This briefing reviews IRS guidance on the treatment of stated interest and OID interest relative to a distressed issuer. It further examines the need for a taxpayer to accrue OID on debt instruments when it appears there is no reasonable expectation of collecting the OID interest from a distressed issuer. It also analyzes IRS distinctions between secured and unsecured debt under such circumstances. Summary IRS Technical Advice Memorandum ( TAM ) 1 requires continued accrual of OID on debt in distressed situations by investor as long as investor holds the debt IRS Litigation Guideline Memorandum TL-103 ( LGM TL-103 ) 2 does not require continued accrual of prepetition debt OID under certain circumstances in postpetition bankruptcy situations 1 2 Technical Advice Memorandum: A technical advice memorandum, or TAM, is guidance furnished by the Office of Chief Counsel upon the request of an IRS director or an area director, appeals, in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally stems from an examination of a taxpayer's return, a consideration of a taxpayer's claim for a refund or credit, or any other matter involving a specific taxpayer under the jurisdiction of the territory manager or the area director, appeals. Technical Advice Memoranda are issued only on closed transactions and provide the interpretation of proper application of tax laws, tax treaties, regulations, revenue rulings or other precedents. The advice rendered represents a final determination of the position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued. Technical Advice Memoranda are generally made public after all information has been removed that could identify the taxpayer whose circumstances triggered a specific memorandum. (Understanding IRS Guidance - A Brief Primer, Internal Revenue Service A TAM may be considered a revenue ruling. The IRS states that taxpayers generally may rely on published revenue rulings in determining the tax treatment of their own transaction that arise out of similar facts and circumstances. Treas. Reg. Sec (d)(v)(d) Litigation Guideline Memoranda: This is internal memoranda prepared by the Office of Chief Counsel with information and instructions on matters of litigation. The memoranda often addresses matters of interest and under litigation by IRS attorneys. General Counsel Memoranda may also contain the reasons behind the adoption of revenue rulings, private letter rulings, and technical advice memoranda and have important precedential value in determining future tax questions. Taxation With Representation Fund v. IRS, 485 F.Supp. 263 at 266 (D.D.C. 1980). SunGard Wall Street Concepts CONFIDENTIAL January 18,

3 IRS makes a distinction in TAM between Stated Interest and OID relative to doubtful collectability while LGM TL-103 does not discuss doubtful collectability IRS distinction in LGM TL-103 between Secured and Unsecured Debt treatment in postpetition bankruptcy is not consistent with TAM approach to OID There is no specific IRS guidance available to paying agents as to fulfilling their OID reporting obligations in distressed and bankruptcy situations. Client Impact Brokers find themselves in a difficult situation: When should they stop issuing Forms 1099-OID, if at all, when an issuer is experience solvency difficulties and is not capable of servicing its debt. Background A recurring question that is raised by investors and paying agents concerns the treatment of Original Issue Discount when the issuing company is in distress and ultimate payment of the debt instrument is in doubt. There is both uncertainty and confusion as they try to understand what they should do in light of regulations that do not adequately address this topic and amid somewhat conflicting guidance from the IRS. The problem for investors is one of timing and character of income/loss. They pay taxes on the current accrual of OID at ordinary tax rates. However, as the OID is rolled up into the underlying debt instrument they will most likely have to wait until some time in the future to take a long-term capital loss at a much lower tax rate. Thus the current OID interest income will become a long-term capital loss, and possibly a deferred capital loss due to IRS loss limitations. The problem for the paying agent is, when should it stop issuing Forms 1099-OID, if at all, and will its decision, if wrong, adversely impact its customer or itself upon an IRS examination. In TAM , issued in June of 1995, the IRS sought to answer the following question: Must the holder of a debt instrument having OID continue to accrue OID when the financial condition of the issuer is such that there is no reasonable expectation the debt instrument will be redeemed according to its terms? The facts of the case involved a corporation that had issued Forms 1099-OID to holders of certain debentures it had issued for three years in lieu of interest payments but the investors were not including this OID in income as they reasonably believed that the financial condition of the corporation was such that the debentures (some being originally purchased and others received as OID, payments-in-kind) would never be redeemed according to their terms. Prior to entering bankruptcy reorganization in the third year the corporation had defaulted on senior debt, its annual report expressed doubt as to its ability to continue as a going concern and the debentures involved were trading at less than ten percent of their face value. SunGard Wall Street Concepts CONFIDENTIAL August 2,

4 Discussion In considering whether OID should continue to accrue on the debentures the IRS referred to the requirement in Code Section 1272 that generally requires taxpayers, including cash basis ones, to include OID in income currently. The IRS noted that Sections 1271 through 1275 provide some limited exceptions to this, but "doubtful collectability" was not one. They contrasted this to the "doubtful collectability" exception to the accrual of stated interest for accrual basis taxpayers. After establishing that Section provides that an accrual method holder of a debt instrument is required to accrue interest as it is earned over an bond's term, regardless of when it is actually paid, they proceeded to note that it is established case law that an interest accrual is not required if the interest is "uncollectible" when the right to receive the interest arises. The IRS quoted the court in Corn Exchange Bank: When a tax is lawfully imposed on income not actually received, it is upon the basis of a reasonable expectancy of its receipt.... A taxpayer, even though keeping his books upon an accrual basis, should not be required to pay a tax on an accrued income unless it is good and collectable, and, where it is of doubtful collectability or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation. Although citing doubtful collectability implies that recognition of OID will cease, the IRS further distinguished OID from periodic cash interest payments. They claimed that OID is included in income in lieu of receipt. They noted that OID rules treat OID transactions as a two stepped process. Step one is the payment of interest (Section 1272(a)(1)) and step 2 is that the holder is deemed to have lent the same amount to the issuer which is the amount that increases the holder s basis in the instrument (Section 1272(d)(2)). 3 In TAM the IRS states, As OID is accrued, the holder is, in effect, receiving current interest and extending additional credit to the issuer. Essentially, the whole notion of doubtful collectability is not at issue since each day the accrued interest is earned, received and then lent to the issuer. The IRS also referred to the legislative history of the OID rules and noted that congress intended on matching the ability of a corporation to deduct OID currently with the taxpayer s ability to recognize the income. They opined that creating a "doubtful collectability" exception to OID for taxpayer accruals without simultaneously prohibiting an OID deduction for the corporation would not be in keeping with this matching concept. Thus the IRS arrived at the conclusion that taxpayers should continue to accrue OID on instruments even when collectability is doubtful. In May of 1996, the IRS Office of Chief Counsel issued LGM TL-103 that addressed the proper tax treatment of postpetition interest in bankruptcy, including original issue discount. It addressed those debt instruments where the issuer had filed a bankruptcy petition under Title 11 and the issuer's bankruptcy case precluded accrual of postpetition interest expense. LGM TL-103 noted that IRS regulations do not address whether OID should continue to accrue on unsecured debt where the issuer has filed a petition for bankruptcy. It did not specifically discuss TAM While this two step process addresses a classis OID situation, the IRS fails to discuss the treatment of various other situations including coupon bearing OID bonds, short-term OID bonds, and the many possible variations of Non- Qualified Stated Interest OID. SunGard Wall Street Concepts CONFIDENTIAL August 2,

5 which was issued in the prior year, however, in LGM TL-103 the IRS took the position that if a bankruptcy proceeding prevents the accrual of interest expense for the filing company on unsecured debt, then there should be no further accrual of interest income by the holders of that debt until a final order or confirmed bankruptcy plan indicates otherwise. This seems to address the matching concept concern expressed in TAM In supporting its approach in LGM TL-103 the IRS noted that in Section 502 of the Bankruptcy Code claims for postpetition interest generally are not allowed on prepetition debts. They pointed out that interest claims on prepetition debt are disallowed under the bankruptcy code as unmatured interest and the courts have found that unamortized original issue discount is unmatured interest. Therefore the IRS concluded that because the Bankruptcy Code does not allow a claim for post petition interest on unsecured debt as a matter of law, OID is not deductible to the issuer or accruable for the investor in the postpetition phase of a bankruptcy. However, the IRS then noted in LGM TL-103 that no inference should be drawn from LGM TL-103 related to secured debt instruments in a postpetition setting. Conclusion The present state of affairs regarding the taxability of OID when the collectability of interest is doubtful is confusing. According to TAM taxpayers should continue to accrue OID for as long as they hold the debt instruments regardless of the issuer s financial condition. While the TAM did not specifically address what to do in bankruptcy, it did rule out the doubtful collectability exception for OID accruals. To extend it to holders of OID instruments would, among other things, ignore the principle that OID is deemed paid as accrued as well as create a mismatch of issuer deductions with investor revenue recognition. The IRS did not distinguish secured from unsecured debt with regard to the TAM s application. According to LGM TL-103 accruing of OID on unsecured instruments should continue until the time of filing a bankruptcy petition. At that time accruing should cease while the issuer remains in bankruptcy until a final order is issued. In its analysis the IRS relied heavily upon the treatment of debt in bankruptcy. Rather than addressing the issue of doubtful collectability, the IRS cited section 502(b)(2) of the Bankruptcy Code to match a disallowance of an issuer s interest deduction on postpetition OID with a non-recognition of postpetition OID income accrual by the investor. Secured instruments were not addressed in LGM TL-103 but rather portions of the Bankruptcy Code were cited for the reader s reference to determine their treatment. Since the Internal Revenue Code does not specifically address whether an issuer may deduct or an investor must accrue OID on distressed debt instruments and since TAM and LGM 103 are not completely harmonious on this issue as well, a broker must balance what may be a perceived legal obligation to report with the very real potential adverse consequences such reporting can have upon its customers. The boundaries drawn by the IRS compare debt with stated interest and debt with OID on one hand, and debt that is secured and unsecured on the other hand, but the guidance does not reconcile those pairings with each other. TAM permits the discontinuance of stated interest accrual when the collectability of such interest becomes doubtful. However, no absolutes are established as to when a firm s financial instability SunGard Wall Street Concepts CONFIDENTIAL August 2,

6 has turned into insolvency and the accruals should cease. But what is clear is that the TAM excludes OID from such consideration. It would seem the most client favorable approach a broker or investor could take would be to begin with the premise of LGM TL-103 that OID accruing by both the issuer and investor on unsecured debt should cease at the moment a bankruptcy petition is filed. If the customer seeks to then expand the timeframe for discontinuing an OID accrual to before the bankruptcy petition filing, they could rely upon the failure to distinguish OID from stated interest in LGM TL-103 as being persuasive and that as a result, there should be no distinction for purposes of doubtful collectability as well. Perhaps the best place to begin a challenge to the IRS reasoning in the TAM is with the New York City Bar Committee on Taxation of Business Entities 2008 letter to the House Ways and Means Committee for the treatment of interest and OID in situations where issuers were unlikely to perform on their obligations. They refute Tam and offer well-reasoned rejections of that document s conclusions as well as practical alternative approaches in presenting their position that the rules for OID be conformed with the rules for stated interest. They factually dispute the IRS s conclusions about congressional intent and the matching issue. They also dismiss the argument that doubtful collectability should only apply to stated interest and not OID as being weak since neither is provided this exception in the regulations. Since it is a legal construct, it could be applied to both forms of interest. As always, it is advisable for a broker to consult their legal and tax advisors in matters such as this. The choice the broker faces is a balancing act between an IRS mandate that requires continued 1099-OID reporting of interest income that will never be received and its fiduciary duties of loyalty and care to protect the assets of its customers. In addressing these responsibilities brokers may consider preparing correspondence to their account holders presenting the issues, their implications and risks, and the alternatives available to the taxpayer. Additional Information References and Citations 11 USC Sec. 502(b)(2) IRC Sec through 1275 Treas. Reg. Sec Treas. Reg. Sec (d)(v)(d) Corn Exchange Bank v. United States, 37 F.2d 34 (2d Cir. 1930) IRS Technical Advice Memorandum IRS Litigation Guideline Memorandum TL-103 SunGard Wall Street Concepts CONFIDENTIAL August 2,

7 Further Information Service Announcements OID Tutorial FAQS WSC Modules Impacted Long Term OID OID Calculator Key Words and Definitions Doubtful Collectability Original Issue Discount Bankruptcy TAM LGM TL-103 SunGard Wall Street Concepts CONFIDENTIAL August 2,

8 THIS IS A CONFIDENTIAL DOCUMENT In consideration of making this document available to you and your firm, you agree to keep confidential the contents of this document and shall not, without the prior written approval of SunGard, disclose to any person outside of your firm, the whole or any part of the information contained in or associated with this document. No part of this publication may be reproduced or utilized, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of SunGard. DISCLAIMER The information contained in this document is provided for informational purposes only and does not purport to be legal, tax or professional advice. This document is provided on the understanding that its content is based on information available as of the date of publication and is solely intended to promote discussion and inquiry by you and your firm on its subject matter. The individual circumstances of a firm should always dictate the actions, if any, a firm takes with regard to the subject matter contained herein and SunGard will not be held responsible for the results of any actions you or your firm may take in reliance upon or as a result of reading the information in this document. Applicability of this information to specific situations at your firm and determinations as to the appropriate approach your firm should take must always be made in consultation with your legal and/or tax advisors SunGard. Trademark Information: SunGard and the SunGard logo are trademarks or registered trademarks of SunGard Data Systems Inc. or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders. SunGard Wall Street Concepts CONFIDENTIAL January 18,