United States

IRS resolves dispute over cost recovery method for distressed debt

Taxpayer, PRA Group, Inc. (Nasdaq: PRAA), announces settlement

TAX ALERT  | 

Taxpayers have long argued, based on decided cases, that market discount on distressed debt instruments can properly be accounted for on a cost recovery method. Such a method allows the taxpayer’s cost basis to be fully recovered before including any gain from the receipt of principal payments on a debt instrument purchased at a discount. As explained by the Tax Court in Liftin v. Commissioner, 36 TC 909 (1961):

After a consideration of the cited cases and also of the general statutory provisions (see May D. Hatch, supra at 242-243), we conclude that a rule of law applicable to the instant case may be stated as follows: Where a taxpayer acquires at a discount contractual obligations calling for periodic payments of parts of the face amount of principal due, where the taxpayer's cost of such obligations is definitely ascertainable, and where there is no "doubt whether the contract[s] [will] be completely carried out" (Hatch v. Commissioner, supra at 257), it is proper to allocate such payments, part to be considered as a return of cost and part to be considered as the receipt of discount income; but, conversely, where it is shown that the amount of realizable discount gain is uncertain or that there is "doubt whether the contract [will] be completely carried out," the payments should be considered as a return of cost until the full amount thereof has been recovered, and no allocation should be made as between such cost and discount income.

In the instant case the petitioner, who of course has the burden of proof, has shown to our satisfaction that the amount of realizable discount income to be derived from the contractual obligations here in question was uncertain. That the notes were highly speculative is evidenced by the substantial discounts (up to 45 percent) at which they were purchased, and the quality of the security which was junior to a first deed of trust (up to 60 to 80 percent of the selling price of the property). The evidence is that makers of the notes had but small equities in the properties covered by the deeds of trust because of their small cash payments to the sellers. When purchasing notes petitioner gave consideration to the length of time the loan was to run, to the holder's equity in the property, sometimes to his credit standing, and generally to the location and condition of the property covered by the trust deed after what he called "an outside inspection." During the few years in question about 19 of the 84 notes were disposed of, about half of them were disposed of by payment in full while the other half were disposed of by foreclosure, the acceptance by the petitioner of a deed, or the acceptance by the petitioner of less than face for an early payoff. It was petitioner's experience that the latter half of the notes so disposed of resulted in his receiving less than the face value of the notes. (pg. 912)

Despite this and other longstanding court decisions favoring taxpayers, the IRS has indicated some disagreement with that position.

The issue was headed for litigation between a prominent purchaser and collector of distressed debt and the IRS. On May 15, 2017, the taxpayer, PRA Group, Inc. (Nasdaq: PRAA) issued a press release indicating that a settlement had been reached allowing all open years to remain unchanged, but requiring a new method to be applied going forward. The press release did not indicate the details of the new method.

RSM US will be following this development closely, because it may indicate an important change in the IRS litigating position on this and similar issues affecting a wide variety of financial institutions, lenders and debt investors.

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