Treasury and IRS announce regulation project
Many Taxpayers holding debt purchased with market discount have questioned whether section 451(b), added to the Tax Code in 2017, would require them to include the market discount in income even if they receive no debt repayment. Notice 2018-80 answers “no” to that question.
Treasury and the IRS intend to issue proposed regulations providing that accrued market discount is not includible in income under section 451(b), effective as of Jan. 1, 2018.
Before 2017 tax reform, accrual method taxpayers determined the appropriate timing of income recognition under a two part “all events” test: items of income are properly includible in gross income in the period where (1) all events have occurred that fix the right to receive the item, and (2) the amount of the item can be determined with reasonable accuracy.
After 2017 tax reform, section 451(b) added what is essentially a third component to that test. The all events test is satisfied no later than when the taxpayer takes the income item in question into account in revenues for financial accounting purposes in an, “applicable financial statement” (as defined in section 451(b)(3)).
Market discount arises when a taxpayer purchases a debt instrument after its initial issuance for a price that is less than the debt instrument’s adjusted issue price. The market discount is the excess of the adjusted issue price over the purchase price.
The market discount accrues over the debt’s term to maturity, but generally is not included in the debt holder’s income until payment is received on the debt or the debt instrument is sold. (Note that this rule differs from the rule applicable to original issue discount (OID) on a debt instrument. OID generally is required to be included in the debt holder’s income as it accrues regardless of whether the debt holder receives any payment.) For further discussion of the market discount rules, please refer to RSM’s Guide to Bond Premium and Market Discount.
Market discount and section 451(b)
For applicable financial statements reported in accordance with Generally Accepted Accounting Principles (GAAP), accrued market discount often is included in revenue prior to receiving payment on the associated debt instrument. After Congress signed section 451(b) into law, many taxpayers expressed concerns that this provision would accelerate the recognition of income associated with market discount for tax purposes. In the absence of additional guidance, section 451(b) could be interpreted as requiring taxpayers to recognize accrued market discount as taxable income to the extent it is recognized in revenues for financial reporting purposes.
Notice 2018-80 provides welcome, but brief, clarification on this issue. While the notice clearly states that accrued market discount is not includible in income under section 451(b), it says little else. Given the number of uncertainties that surround both section 451(b) and the market discount rules independently, taxpayers should consult their tax advisers on how section 451(b) and the market discount rules may affect their particular tax situations.