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Treatment of OID on debt retirement - foreign holders.

A borrower in financial distress may be unable to fully repay a loan and a lender may have to settle for less than the principal amount. With original issue discount (OLD) obligations, foreign lenders and U.S. borrowers face a troublesome U.S. tax issue when the amount recovered is less than the amount advanced.

OlD is defined in Sec. 1273 as the excess of a debt instrument's stated redemption price at maturity (SRPM) over its issue price; qualified periodic interest payments (QPIPs) are not OID. Sec. 1272 provides for the current inclusion of OID in income as it accrues regardless of a holder's method of accounting. The issue price and the holder's basis are adjusted to reflect accrued OlD. Because U.S. taxpayers are on an accrual method with respect to OID, they may be taxed on income that is never received if an OlD obligation is retired for an amount less than its adjusted issue price. In this situation, taxpayers may also have a capital loss in an amount equal to the accrued OlD, since Sec. 1271 treats debt retirement as a sale or exchange.

Unlike U.S. taxpayers, nonresident aliens and foreign corporations that hold OlD obligations not effectively connected with a U.S. trade or business are basically on a cash method of accounting with respect to OlD. Such taxpayers determine income inclusion with respect to such obligations pursuant to special rules contained in 'Sec. 871(a)(1)(C)or 8811a)(3), which in effect provide for the inclusion of OlD in income only when interest payments are received on the obligation or on its sale or exchange (including its retirement). Nevertheless, the rules of Sec. 1272 are referenced to determine the portion of the OlD that accrues during any holding period for purposes of OlD taxation when it is treated as received under Sec. 871 or 881 (Sec. 871(g)(2)).

When an OlD obligation is retired, under Sec. 871(a)(1)(C)(i) or 881(a)(3)(A), tax is imposed on the amount of OlD accruing while such obligation was held by the foreign investor who receives the retirement proceeds.

Prior to the enactment of the Tax Reform Act of 1986 (TRA), the amount of OlD that could be taxed to a foreign investor was limited to the investor's gain on the sale or exchange of the obligation. As a result of a technical amendment made by the TRA, a foreign investor is now taxed on the full amount of previously untaxed OlD that accrued while the instrument was held by the investor "whether or not that amount exceeds the foreign investor's gain on the sale, exchange, or retirement."

Example: X, a foreign corporation not engaged in U.S. business, acquires at original issue a zero coupon bond of Y, a U.S. corporation, with an issue price of $90 and an SRPM of $100. At maturity, X receives only $96 due to Y's financial condition. The portfolio interest exemption does not apply and interest is not exempt under a treaty. Because Sec. 881(a)(31 applies, the $10 of accrued OID is subject to tax under Sec. 881(a). If the obligation is a capital asset, X will have a capital loss of $4, which appears to be of no use to X because it is not subject to U.S. tax on capital gains.

This result appears to be consistent with prior case law. For example, proceeds from the sale of a bond purchased and sold "flat" ii.e., without an allocation between principal and accrued interest) by a cash-basis taxpayer were required to be allocated between principal and accrued interest even though the resulting amount of taxable interest exceeded economic gain (see Langston, 308 F2d 729 (Sth Cir. 1962)).

On the other hand, the consequences of a literal application of Sees. 871(a)(l)(C)(i)and 881(a)(3)(A) under particular circumstances could be viewed as inconsistent with general tax principles on recovery of principal. In the example, if X had received only $80 and $10 is taxable OlD, X would effectively be taxed on a partial recovery of principal. Rev. Rul. 73-328 held that no portion of the amount realized on sale or exchange of a debt instrument was considered to be interest if the amount realized was less than basis; because interest represented compensation for the use of principal, no interest was received when the amount realized was less than principal. (See also John Hancock Mutual Life Insurance Co., 10 BTA 736 (19281, acq., which involved a real estate foreclosure.) Of course, the continued validity of these early precedents, issued prior to the present OID regime, is questionable.

In the example, if Y's OlD obligation had also provided for QPIPs that were accrued but unpaid, such interest would not have been taxed to foreign investors. Interest (other than OlD) is taxed only when received under Sees. 871(a)(1)(A) and 881(a)(1). Even though OlD is taxed separately for Sec. 881 purposes, such OID is still treated as interest for many other purposes; for example, under Regs. Sec. 1.871-12(b)(1)(iii), OlD taxed under Secs. 871(a)(1)(C) and 881(a)(3) is considered to be interest for treaty purposes.

Given the unfairness of a foreign investor being taxed on OlD that will never be received, with no offsetting capital loss being allowable, foreign investors may also wish to consider whether it is possible not to accrue OlD due to doubtful collectibility. (See the Tax Clinic item, "OlD and Junk Bonds of Distressed Companies: Must Income Be Recognized?" TTA, July 1990, at 421.) Possible treaty protection should also be considered in appropriate cases.

The withholding obligation for OlD on obligations held by foreign investors is also in disarray. Although Sec. 1441(c)(8)authorizes the Treasury to provide regulations for withholding with regard to OlD, none have been promulgated and proposed regulations issued in 1976 were never finalized.

From Stephen R. Orme, Esq., New York, N.Y.
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Title Annotation:original issue discount
Author:Orme, Stephen R.
Publication:The Tax Adviser
Date:Jul 1, 1992
Words:1006
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