Camp’s Market Discount Proposal Is A Mixed Bag For Distressed Debt

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...