Are distressed debt investors required to treat their speculative investment gains as ordinary interest income under the market discount rules, while continuing to treat their investment losses as capital losses? Or can they rely on the common law “doubtful collectibility doctrine” to stop accruing market discount as interest income, notwithstanding an IRS memorandum that seems to reject this approach? The recent economic downturn underscores the need for clear, consistent rules that do not artificially deflate investor demand. This article examines the current state of the law, and considers whether House Ways and Means Committee Chairman Dave Camp’s proposal to reform the market discount rules (which parallels one of President Obama’s revenue proposals) would be a step in the right direction.

Introduction

When interest rates rise, secondary market bond prices decline to compensate investors for accepting a below-market stated interest rate. In response to this phenomenon, Congress enacted the market discount rules of the Internal Revenue Code.¹These rules recharacterize principal payments as deferred interest to the extent of a bond’s market discount, so that economic gain on the maturity or sale of a discounted bond is taxed as interest income.

Secondary market bond prices also decline when an issuer’s credit deteriorates, to compensate investors for increased risk of non-repayment. The market discount rules do not differentiate between discount that is attributable to a rise in general interest rates and discount that is attributable to credit risk.

Because principal payments on distressed debt lack the predictability and security that typify interest payments on performing debt, it is inappropriate to require taxpayers to treat market discount as interest income if the discount is attributable to an issuer’s financial deterioration, and not a rise in interest rates. Moreover, it is implausible that Congress intended to tax bond investors (but not other investors) at ordinary income rates on their speculative gains, while still requiring them to treat their losses as capital losses that can offset only up to $3,000 of ordinary income each year.²

Investors in distressed debt therefore have to make a tough decision. They can comply with the letter of the law, and suffer adverse (and probably unintended) tax consequences. Alternatively, they can take the position that the market discount rules do not apply to distressed debt.

The most obvious basis for treating accrued market discount as capital gain rather than as interest income is that the common law “doubtful collectibility doctrine” generally permits a taxpayer to stop accruing interest if it is unlikely that the interest will ever be collected. Some taxpayers have taken the position that an analogous rule applies to permit them to stop accruing a bond’s market discount as interest income if there is no reasonable expectation that the issuer will fully repay the bond’s principal amount.³

Unfortunately, in 1995, the IRS issued a Technical Advice Memorandum (the “1995 TAM”) in which it concluded, based on highly fl awed reasoning, that the doubtful collectibility doctrine does not apply to original issue discount (OID).⁴OID is economically identical to market discount; accordingly, the 1995 TAM’s existence is a problematic detail for distressed debt investors.

The recent financial crisis underscored the need for sensible market discount rules that differentiate between discount that is attributable to a rise in interest rates and discount that is attributable to credit risk. Without such rules, prospective debt investors who are uncomfortable disregarding the 1995 TAM could shy away from buying discounted bonds. A lack of investor appetite could add undesirable momentum to a downward spiral of ratings downgrades, capital calls, and defaults, and unnecessarily prolong an economic downturn.

On February 26, 2014, Representative Dave Camp, Chairman of the House Committee on Ways and Means, released a discussion draft of a bill that would dramatically change the market discount rules.⁵The bill would:

• Require investors to accrue market discount currently under a constant yield method, in the same manner as OID; and
• Limit market discount accruals in a manner intended to approximate the market discount that is attributable to increases in interest rates (and not to the issuer’s financial deterioration).⁶

Under this proposal, every taxpayer who purchases discounted debt on the secondary market would have phantom taxable income each year, and broker-dealers would have to develop complex systems for reporting this income to their customers. Accordingly, the proposal could be highly disruptive for the secondary debt markets.

Moreover, although the proposed cap on market discount inclusions is a step in the right direction, it fails to provide definitive guidance as to whether the doubtful collectibility doctrine can apply to OID and market discount, and therefore may raise more questions than it answers.

This article first discusses the doubtful collectibility doctrine, and then discusses Camp’s market discount proposal.

The Doubtful Collectibility Doctrine

Overview. A taxpayer on the cash method of accounting generally includes interest in income upon receipt.⁷A taxpayer on the accrual method of accounting includes interest in income when all events have occurred that fi x the taxpayer’s right to receive the interest and the amount of the interest can be determined with reasonable accuracy.⁸Accordingly, an accrual method taxpayer generally will accrue “qualified stated interest”—interest that is unconditionally payable at least annually—ratably over the accrual periods to which the interest relates.⁹

However, under longstanding common law precedent, an accrual method taxpayer is not required to accrue qualified stated interest in advance of receipt if the interest “is of doubtful collectability or it is reasonably certain that it will not be collected.”¹⁰

For example, assume that an investor using the accrual method of accounting purchases a 10-year bond at initial issuance, and that the bond has a $100 issue price, a $100 face amount, and provides for annual interest payments of $3.64. Five years later, the issuer suffers a financial setback and, as a result, is unable to continue servicing its debt. Under the doubtful collectibility doctrine, the investor is not required to continue to accrue interest on the bond.

The contours of the doubtful collectibility doctrine are fuzzy.¹¹Some courts have required taxpayers to demonstrate the absence of any reasonable expectation that interest would be received in order to stop accruing the interest.¹²Other courts have required taxpayers to demonstrate only reasonable doubt as to future receipt.¹³However, courts and the IRS agree that at some point in an issuer’s fi nancial decline an investor can stop accruing interest income.

Applicability of Doubtful Collectibility Doctrine to OID. OID is economically identical to interest, and is taxed similarly to interest, so there is no obvious reason for the doubtful collectibility doctrine to apply differently to OID than to interest.

For example, assume that an investor purchases a 10-year zero- coupon bond at initial issuance, and that the bond has a $70 issue price and a $100 face amount. Under Section 1272, the investor is required to include the bond’s $30 of OID in income over the term of the bond, under a constant yield method.¹⁴This requirement arises from Congress’s recognition that OID is economically indistinguishable from interest:¹⁵the $30 of discount from the bond’s issue price reflects an unstated interest rate of 3.64 percent, compounded annually. In fact, the zero-coupon bond has the same yield to maturity, and thus has the same net present value, as the 10-year current-pay bond described in the prior example.

Misguided IRS Guidance. Even though OID is economically identical to interest, the IRS concluded in the 1995 TAM that the doubtful collectibility doctrine does not apply to OID.¹⁶Thus, the investor in the zero-coupon bond described above must continue to accrue OID in income after principal on the bond becomes uncollectible, even though the investor in the current-pay bond described above may stop accruing interest once the interest becomes uncollectible.

The conclusion in the 1995 TAM is premised on a deeply fl awed analysis and has been heavily criticized.¹⁷

Analysis of IRS Rationales. As discussed below, the IRS’s four rationales for requiring current income accruals on a distressed OID bond are unpersuasive.

IRS Rationale #1: OID Is Different From the Accrual Method. According to the IRS, whereas the accrual method of accounting requires income inclusions “in advance of receipt,” and therefore does not require income inclusions when there is no reasonable expectation of receipt, Section 1272 requires income inclusions ” in lieu of receipt,” and therefore requires income inclusions even when there is no reasonable expectation of receipt.

This effort to divorce the OID rules from the accrual method of accounting ignores the legislative history of the OID rules, which provides unequivocally that “the application of the OID rules will require the issuer and the holder of the debt instrument to use the accrual method of accounting for any interest (whether stated or imputed) that is not paid currently.”¹⁸

IRS Rationale #2: Imputed Receipt Through Circular Cash Flow. According to the IRS, the OID provisions impute receipt by treating OID inclusions as a two-step process:

In support of this theory, the IRS cited prefatory language in legislative history published 15 years after the OID rules were enacted. This same legislative history, however, goes on to provide that investors purchasing OID bonds must account for the OID “on an economic accrual basis.”¹⁹Thus, it is more likely that the circular-cash-flow theory was intended merely as an unsophisticated explanation of compound interest.

IRS Rationale #3: Preventing Whipsaw. Under Section 163, an issuer that uses the accrual method of accounting generally may deduct interest whether or not the issuer is able to service its debt. The IRS expressed concern that allowing investors to stop accruing OID under the doubtful collectibility doctrine, without simultaneously requiring issuers to stop accruing OID deductions under Section 163, would be inconsistent with one of the principal purposes of the OID regime expressed in the legislative history—namely, matching investors’ interest inclusions with the issuer’s interest deductions.

The IRS’s reliance on legislative history in support of this justification was disingenuous. The “mismatch” that concerned Congress occurred when accrual-method issuers were permitted to deduct OID on a current basis, while cash-method investors did not include the discount in income until they received it.²⁰Section 163 existed when the OID rules were enacted, and there is no suggestion in the legislative history that Congress was concerned about the different legal standards that apply to determine when an accrual method issuer must stop accruing deductions and when an accrual method investor may stop accruing income. Moreover, if Congress were, indeed, concerned about these different standards, it is improbable that Congress would have addressed this concern only for instruments issued with OID and not for current- pay instruments.

IRS Rationale #4: Preemption. According to the IRS, the Tax Court had already ruled that “general accrual method principles,” such as the doubtful collectibility doctrine, should not trump “more specifi c rules,” such as the OID regime.²¹

However, in both cases cited by the IRS, the Tax Court had been asked to decide which of two statutes applied to the facts before it, and not—as the IRS suggested—whether a statute could overrule a common law doctrine by remaining silent on the doctrine’s applicability. The Supreme Court has addressed the latter question and concluded that “statutes which invade the common law . . . are to be read with a presumption favoring the retention of long established and familiar principles, except when a statutory purpose to the contrary is evident.”²²Under this analysis, Congress’s silence with respect to the doubtful collectibility doctrine should be construed not as preemption, but as acquiescence.

An Unwarranted Obstacle. Though its reasoning is unsound, and it lacks precedential value,²³the 1995 TAM reflects the IRS’s published view on the applicability of the doubtful collectibility doctrine to OID.²⁴Adopting a contrary position could be perilous for a taxpayer.

Market Discount

In General. When market interest rates rise, the prices of outstanding bonds fall. As noted previously, this price reduction compensates purchasers of outstanding bonds for accepting below-market stated interest rates. For example, assume that an investor purchases a fi ve-year zero-coupon bond at initial issuance, and that the bond has a $70 issue price and a $100 face amount. The bond’s yield-to-maturity is 7.39 percent, and the investor must include the bond’s $30 of OID in income under a constant yield method. Assume that, immediately after issuance, market interest rates rise by 2 percent. In an efficient market, the bond’s price would drop to $63.83, so that its yield to-maturity is now increased to 9.39 percent (i.e., the bond’s original yield to maturity, plus 2 percentage points).

Congress enacted the market discount rules because it recognized that market discount arising as a result of interest rate fluctuations—such as the bond devaluation described immediately above—is indistinguishable from OID, and is a substitute for stated interest income.²⁵Under Section 1276, an investor must treat any gain on the sale or retirement of a bond as ordinary income to the extent of accrued market discount.²⁶

The Section 1276 regime differs from the OID regime in two respects:

These distinctions exist only to avoid administrative complexity.²⁷Because OID is calculated by reference to issue price, an issuer can report OID accruals for an entire debt issuance.²⁸By contrast, the amount of a bond’s market discount depends on the bond’s purchase price, and therefore differs from holder to holder. Because the amount of market discount accruals must be made at the investor level, and not the issuer level, Congress apparently preferred to adopt a less complicated accrual calculation method, and to permit holders to avoid having to calculate accruals entirely if they hold their bonds to maturity (because, in that case, the amount of gain that is converted to ordinary income under the market discount rules is simply the discount from the issue price at which the bond was purchased).

Applicability of Market Discount Rules to Distressed Debt. One of the hallmarks of debt is an unconditional right to repayment, and an instrument the repayment of which is speculative when it is issued may not be characterized as debt for tax purposes, even if the parties refer to the instrument as “debt.”²⁹However, an instrument’s debt or equity characterization for tax purposes generally is not retested after issuance.³⁰

As a result, by their terms, the market discount rules apply to distressed instruments that would not be treated as debt for tax purposes if they were issued on their acquisition date. The rules thus subject equity-like, risk-based returns to taxation as if those returns were interest. In so doing, the rules give rise to several inappropriate and unintended consequences.

Disproportionate Effect on Short-Term Bonds. Because discount on distressed debt reflects increased risk, not the time value of money, two bonds with the same level of priority in a financially distressed issuer’s capital structure generally will have the same price, regardless of their maturity dates.³¹Stated differently, when an issuer is in distress, the reduction in the price of its debt on the secondary market reflects the debt’s rank in the issuer’s capital structure—in effect, the investor’s place in line in a hypothetical bankruptcy proceeding—and is not closely correlated to fluctuations in prevailing interest rates. However, because the market discount rules treat market discount as a return that is pegged to the time value of money, they require investors to accrue the discount based on the remaining number of years to the debt’s maturity. The market discount rules thus disproportionately affect secondary market purchasers of shorter-term debt by requiring them to accrue market discount faster than purchasers of longer-term debt.

For example, suppose that an issuer issues two $100 unsecured bonds at par on the same day, and that one bond matures in five years and the other in 10 years. At the beginning of Year 3, when the issuer is in financial distress (and interest rates remain unchanged), two secondary market purchasers buy the bonds for $40 each. The issuer makes a full recovery so that, at the end of Year 5, the purchaser of the five-year bond receives $100 of principal, and the purchaser of the 10-year bond sells the bond for $100. Each purchaser has $60 of economic gain. However, the purchaser of the five-year bond must treat the entire $60 as ordinary income under Section 1276, whereas the purchaser of the 10-year bond must treat $34.29 as ordinary income, and will treat the remaining $25.71 as long-term capital gain.³²The $60 of discount reflects a risk-based price adjustment for both investors, so there is no obvious reason to tax the discount on the two bonds differently.

Mismatch Between Investment Gains and Losses. The market discount rules treat investment gains differently from investment losses: investment gains are characterized as ordinary income, but investment losses are characterized as capital losses.

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