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OID accruals on securities with doubtful collectibility.

Letter Ruling (TAM) 9538007 held that taxpayers must continue to accrue original issue discount (OID) on debt instruments even when the issuer's financial condition is such that there is no reasonable expectation that the accrued OID win be collected. The IRS National Office concluded that the doubtful-collectibility exception to the accrual of interest by accrual-method taxpayers does not extend to accruals of OID. This holding relies on the view that the OID provisions are designed to "match" the holders OID income with the issuers OID deduction and that permitting the holder to suspend accruals of OID would result in the very mismatching that the OID provisions were enacted to avoid. Case law and legislative history suggest a well-reasoned argument can be put forth that suspension of OID accruals is appropriate given serious doubtful collectibility of the OID amounts.

OID and Interest

The Supreme Court stated in Midland-Ross Corp., 381 US 54 (1965), that "[e]arned original issue discount serves the same function as stated is simply `compensation for the use or forbearance of money.'" The Court has also recognized the economic function of debt discount as interest incurred in borrowing money, see National Alfalfa Dehydrating & Milling Co., 417 US 134 (1974). Further, Congress, in enacting Sec. 1232 (the predecessor to the current OID provisions), referred to OID as "a form of interest income" (S. Rep. No. 83-1622, 83d Cong., 2d Sess. 112 (1954)). Accordingly, OID may be viewed as the equivalent of "interest," although the means by which the amount of OID accrual is determined and the general timing rules for both cash and accrual-method taxpayers are governed by Secs. 1271-1275.

In enacting the OID rules, Congress assumed that most issuers of discount bonds were deducting a portion of the discount annually, while the holders, many of whom were cash-method individuals, were including the discount in income only on disposition of the bond, if at all. If the discount was taxable only at the time of disposition, the holder was more likely to ignore that the discount was taxable and that it was ordinary income rather than capital gain. Congress believed that by requiring the bondholders to report discount income on an accrual basis, better compliance would be achieved (H. Rep. No. 91-413 (Part I), 91st Cong., 1st Sess. 109, (1969); S. Rep. No. 91-552, 91st Cong., 1st Sess. 146-147). The OID provisions are designed to parallel the manner in which interest would be recognized by cash- and accrual-method taxpayers through borrowing with a nondiscount obligation requiring current payment of interest, see the Staff of the Joint Committee's General Explanation of the Tax Equity and Fiscal Responsibility Act of 1982 (Act Section 231). Accordingly, it is arguable that overriding accrual-method principles continue to apply to accruals of OID.

Suspension of Accrual

For an accrual-method taxpayer, it is the right to receive an item of income and not the actual receipt that determines the inclusion of the amount in gross income. When the right to receive an amount becomes fixed, the right accrues (Regs. Sec. 1.451-1(a)); Spring City Foundry Co., 292 US 182 (1934)). A fixed right to a determinable amount, however, does not require accrual if the income is uncollectible when the right to receive the income item arises. Accordingly, the accrual of income is not required when a fixed right to receive arises if there is no reasonable expectancy that the claim will ever be paid (Jones Lumber Co., 404 F2d 764 (6th Cir. 1968); Rev. Rul. 80-361; Clifton Mfg. Co., 137 F2d 290 (4th Cir. 1943)).

Satisfying the "doubtful collectibility" exception is to be strictly construed. For suspension of accruals of income, uncertainty as to collection must be substantial and not simply technical in nature. One must provide substantial evidence to establish there is no reasonable expectancy of payment (Stephens Marine, Inc., 430 F2d 679 (9th Cir. 1970)). The burden of proof to demonstrate doubtful collectibility rests with the taxpayer (Greer-Robbins Co., 119 F2d 92 (9th Cir. 1941)). This "doubtful collectibility" exception began with Corn Exchange Bank, 37 F2d 34 (2d Cir. 1930), in which the court stated: "[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 collectibility or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation."

TAM 9538007 acknowledged the "doubtful collectibility" exception for accruing interest, however, the Service noted that no exception to OID accruals appeared in the legislative history, and that creating a "doubtful collectibility" exception would cause a mismatching of income and expense. The TAM then stated that the general interest-accrual provisions did not override the more specific OID rules, based on the holdings in Weis, 94 TC 473 (1990), and Williams, 94 TC 464 (1990). On the other hand, it is arguable that accruals of OID remain subject to the overriding income-recognition provisions of accrual accounting, which allow mismatching under certain circumstances, and that if there is no reasonable expectation that accrued OID will be collected, the suspension of OID accruals is appropriate. Weis and Williams may be viewed to hold for the proposition that the manner by which OID is to be accrued in income is governed by the specific OID provisions, but that suspension of accruing OID is appropriate when the amounts are of doubtful collectibility under general accrual accounting principles. As stated in Corn Exchange Bank, it would be an injustice to insist on the taxation of an accrued amount when it is reasonably certain the amount will not be collected.

Although the suspension of OID accruals appears appropriate in "doubtful collectibility" situations, the threshold for nonaccrual status is probably substantial, especially with respect to accruals of OID when the amounts accrued under the instrument are not yet due and payable and there is not a formal default through violation of a debt covenant, etc. In European American Bank & Trust Co., Fed. Cir., 1991, a taxpayer was held to the contract terms of a loan document and was required to accrue interest when the taxpayer did not formally declare the notes to be in default. The taxpayer argued that placing the notes in default would be futile and had no bearing on the debtor's ability to meet the terms of the loan document. The court stated, however, that failure to declare the loan in default precludes the taxpayer from not accruing interest or deviating from the stated term of the contract. Accordingly, the threshold for suspending the accrual of OID is very high and may apply when the debtor is in technical default and possibly when near technical default is imminent on outstanding debt. In addition, the likelihood of the debtors future solvency must be in serious doubt.

This threshold for suspending the accrual of OID may be met, for example, when senior debt instruments of the debtor are currently in default, the debtor's future solvency is in serious doubt and the OID security is subordinated to the debt in default. If the debtor is not in default on existing debt, a showing of the debtors insolvency and the doubtful collectibility of the OID accruals must be carefully and factually supported.

The threshold for not accruing income is more substantial than in those situations in which income is accrued and a comparable bad-debt chargeoff is recorded. See, e.g., Minneapolis, St. Paul & Sault Ste. Marie R.R. Co., 164 Ct. Cl. 226 (1964), in which the court stated that in determining worthlessness, a taxpayer should "strike a middle course between optimism and pessimism ... based upon as complete information as is reasonably obtainable."
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Title Annotation:original issue discount
Author:Siegel, Robert S.
Publication:The Tax Adviser
Date:Nov 1, 1996
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