Building A Case for Year End: Tax Planning for Interest Income from Distressed Debt Investments
As annus horribilis heads into its fourth quarter, taxpayers[1] should be looking for tax planning opportunities within their investment portfolio. Distressed debt investments - whether unwittingly held or opportunistically acquired - present such opportunities.
For starters, debt investments are typically tax inefficient because:
● interest income is taxed at ordinary rates,
● U.S. tax accounting rules broadly require an accrual of interest income before cash is received[2],
● payments made under a debt instrument are presumed to represent unpaid interest first[3],
● realized discount income from secondary market transactions result in ordinary income characterization rather than capital gain (even if held as a long-term capital asset)[4], and
● bad debt investments generally result in capital losses, which carry their own limitations on tax deductibility.[5]
An automatic application of these U.S. tax accounting rules to distressed debt investments may produce surprising and costly tax results for investors.
So what should taxpayers consider when it appears that borrowers may no longer pay the amounts promised under a debt instrument?
This post summarizes the general issues surrounding interest income recognition with respect to distressed debt instruments.[6]
Types of Interest Income and Methods of Tax Accounting
Taxpayers should first understand the interest income characteristics of the particular debt investment owned and their method of tax accounting with respect to its interest income.
Interest income can be classified as: (i) qualified stated interest (“QSI”) or (ii) original issue discount (“OID”). QSI is commonly called “coupon interest”, i.e., interest payable at least annually at a fixed or floating rate. OID exists when the amount borrowed is less than the aggregate payments to be made under a debt instrument, excluding QSI payments.[7]
Taxpayers determine the timing of the income based on their method of accounting (i.e., cash vs accrual method) under Internal Revenue Code (“IRC”) Section 446.
Cash-method taxpayers recognize income when it is received, unless required to use a different accounting method for specific types of income and deductions. OID is one such example of income having a required accounting method for all taxpayers.[8]
Accrual-method taxpayers recognize income when all the events have occurred that “fix the right” to receive such income and the amount is determined with reasonable accuracy (the “All-Events Test”).[9] Interest income is “earned” under the All-Events Test by the passage of time, and accrues when earned unless prepaid.[10]
As a result, cash-method taxpayers recognize QSI upon cash receipt and OID as it is earned. Accrual-method taxpayers recognize both QSI and OID equally into income as time goes by.
When interest income is properly accrued and subsequently becomes uncollectible, the taxpayer’s remedy is by way of a deduction rather than through “elimination” of the accrual.[11]
Tax Accounting for Distressed Debt
Unfortunately, these rules - which work reasonably well for non-distressed debt - break down when it is no longer certain the borrower can pay amounts that are owed.
Consider a non-dealer investor who purchased a debt instrument with a principal amount of $100,000 and a 7% annual PIK interest component for $100,000. Assume the borrower faced financial hardships such that there are serious doubts as to whether the debt will ever be repaid. Finally, assume after two years of delay, the holder ultimately collects $100,000 upon settlement of the debt instrument.
Over the two-year period, the investor would have recognized $14,000 of ordinary income and a $14,000 capital loss upon settlement.[12]
Due to accruals of ordinary income without cash receipt and potential limitations on the deductibility of the capital loss, the taxpayer above has a negative after-tax return on a break-even investment.
The Doubtful Collectability Doctrine[13]
It is well established that taxpayers may turn off interest accruals if and when that income is not reasonably certain to be collected under the “doubtful collectability” doctrine enumerated through U.S. case law.[14] The IRS confirmed this doubtful collectability doctrine in Rev. Rul. 80-361 by stating that a debt investor is “not required” to accrue interest income when the claim for interest is “uncollectible” as it economically accretes due to the borrower’s insolvency.
Interestingly, applying the doubtful collectability doctrine to OID remains uncertain. In TAM 9538007, the IRS asserted that case law rulings and Rev. Rul. 80-361 do not apply to OID. TAM 9538007 has been widely criticized by many well-respected and experienced tax advisors.[15] Perhaps the IRS realized a mistake had been made because in a subsequently-released Tax Litigation Memo, the IRS softened its OID position by stating that debt investors could cease OID accruals when the debt issuer filed for bankruptcy.[16]
The foundation of the doubtful collectability doctrine rests on the following premises: (i) taxing unrealizable “income” contradicts the U.S. federal tax system and (ii) accruing an amount of income that is not fixed or determinable belies the All-Events Test.
Despite the benefits and wide applicability of the doubtful collectability doctrine, taxpayers are left with no objective standards as to when and how this rule may apply.
Regardless, investors should know that invoking the doubtful collectability doctrine affects the timing of interest income recognition, but not the character of that income. Subject to a few exceptions, the doubtful collectability doctrine simply allows taxpayers (regardless of their required method of accounting) to temporarily account for interest income (regardless of a QSI or OID distinction) on the cash method of accounting. Thus, QSI and OID accruals do need to be tracked in the event payments are made in the future.
The doubtful collectability doctrine also does not require that the debt as a whole is uncollectible; only the interest must be uncollectible.[17]
Application of the Doubtful Collectability Doctrine
Ultimately the facts and circumstances of the debt investment at hand determine the validity of the doubtful collectability doctrine with respect to its interest income.
What have we learned from a thorough read of the case law on the doubtful collectability doctrine?
● The doubtful collectability doctrine should be applied narrowly and that temporary financial difficulties of the issuer are not sufficient to invoke the rule.[18]
● Courts have often looked for an “insolvent” borrower in order to support the doubtful collectability doctrine.[19] Because those cases have hinged on the borrower’s ability to pay (i.e., cash-flow insolvency), it’s not clear that a low trading value compared to par (i.e., fair value insolvency) alone can suffice to invoke the doubtful collectability doctrine.[20]
● Insolvency is not a mandatory requirement and the rule is applied on a loan-by-loan basis.[21]
● Taxpayers may consider the portion of the debt ultimately expected to be paid and the extent of accrued but unpaid interest with respect to invoking the doubtful collectability doctrine.[22]
● Courts have also considered whether the interest payment was ultimately paid.[23]
What have other tax practitioners written about the doubtful collectability doctrine?
● A bankruptcy filing by the borrower should be sufficient to cease all forms of interest accruals, except in special circumstances where the debt instrument is a debtor-in-possession loan or the bankruptcy filing is “pre-packaged” and there is reasonable certainty surrounding the timing and amounts of future debt payments.[24]
● Invoking the doubtful collectability doctrine on QSI accruals appears to be self-evident: has the borrower paid the QSI or not? If not, then the taxpayer may have its answer on whether to accrue that QSI.[25]
● As mentioned above, some tax advisors believe that OID accruals are not required in certain distressed situations, despite the language and reasoning of TAM 9538007. Instruments with OID components are inherently more difficult to invoke the doubtful collectability doctrine due to the nature of an OID payment schedule. Unlike QSI instruments, payments on pure OID instruments are generally deferred until maturity. Thus, the pertinent question with OID instruments is not whether interest will be paid, but whether stated principal will be paid. Some sort of quantifiable measurement on whether the holder expects to receive more cash than invested has been suggested as the proper way to determine the applicability of the doubtful collectability doctrine to OID instruments.[26]
● In a 50-page report issued in 2011, the New York State Bar Association (NYSBA) summarized their view with respect to QSI and OID accruals on distressed debt: “Do not accrue income you do not expect to receive.” The NYSBA believes a 40% chance of not receiving interest would presumably satisfy a “reasonable doubt” standard. Surprisingly - and somewhat aggressively - they suggest that this standard should apply to all remaining interest payments taken as a whole. In other words, if there’s a 40% chance of not collecting all remaining interest, the NYSBA believes the next interest payment should not be accrued even if it’s reasonably expected to be paid on time. As described above, if this payment is made, it should still be considered interest income when received.[27]
● If the borrower invokes a contractually bargained right to pay interest in kind instead of in cash with respect to “PIK Toggle” instruments, it does not follow that the borrower is in such dire financial straits that interest income need no longer be accrued by the investor.[28]
● Holders of nonrecourse loans (i.e. those secured by specific assets and without personal liability of the borrower) may consider ceasing interest income accruals at the time it can be demonstrated that the property securing the debt is substantially lower than the principal amount of the loan.[29]
It is my belief that the opinion of the investment professional assigned to the financial analysis of the issuer should also be considered heavily in making a doubtful collectibility determination.
For example, if the “Street” is currently valuing the debt instrument on liquidation value, reorganization value, and/or nuisance value, the case for doubtful collectability of the interest income in question is likely strengthened.
Valuation methods that depart from discounting of expected cash flows indicate the instrument is unlikely to perform as traditional debt. This information cannot be gathered solely from quantitative data of trading prices on an investment holdings report.
Has the issuer hired legal counsel to renegotiate its obligations? Has a financial advisor been engaged to calculate what fixed costs the issuer can support in the future?
Again, answers to these questions (which are helpful in building a case for uncollectibility) will not come from an accounting number, no matter how long you look at it.
Finally, if we accept the adage “you are the company you keep”, then taxpayers should also examine the major holder list of a particular debt instrument for other investors known to specialize in distressed debt. Much like the birds, these “vulture” investors focus on non-performing (i.e., dead) debt instruments that conservative debt investors cannot and do not want to own (i.e., eat). Debt that has attracted the distressed investment community may suggest the contracted-for cash flows are in question and support the ceasing of interest income accruals.
Final Considerations
Scrutinizing interest income accruals on a debt portfolio is analogous to “stopping the bleeding” - it is the first step towards effective tax planning for distressed debt instruments. Given the lack of clear guidance from the IRS, the proper application of this tax tourniquet requires a careful examination of the situation. As with any facts and circumstance determination, a well-reasoned and documented position as to why the interest is uncollectible is helpful in the event a tax return position is challenged.
Any views or opinions in this post are personal and belong solely to me and do not represent those of people, institutions or organizations that I may be associated with in a professional or personal capacity. Any mistakes are mine and mine alone. I want to thank Charles Vallone for his feedback.
[1] For purposes of this post, “taxpayer” is assumed to be a U.S. individual, corporate or trust taxpayer who is subject to U.S. income tax on worldwide income.
[2] To the extent an investor purchases a debt instrument at a premium or discount, the tax rules permit taxpayer elections to ensure the premium or discount is recovered over time as an adjustment to income accrual amounts.
[3] Under Treasury Regulation Section 1.446-(e)(2) each payment made under a debt instrument must first be allocated to accrued but unpaid interest (the “payment ordering rule”). Notes that It’s not clear whether the payment ordering rule applies where debt may not be repaid in full.
[4] IRC Section 1278. This rule is commonly referred to as the “market discount” rule.
[5] For noncorporate taxpayers, capital losses are only deductible to the extent of capital gains, plus $3,000 of ordinary income under IRC Section 1211(b). U.S. corporate taxpayers may use capital losses to offset only capital gains and not ordinary income under IRC Section 1211(a).
[6] Scrutinizing interest income accruals is but the first step of tax planning for distressed debt investors. A full detailed explanation of tax planning opportunities will be covered in future posts.
[7] The rules for determining QSI or OID are not as straightforward as one may presume. Two examples of unexpected OID characterization are (i) yield on “PIK Toggle” debt instruments that unilaterally allow borrowers to pay interest in cash or in kind and (ii) debt instruments with “stepped” interest rates. Both debt instruments have an OID component, even if all interest under the terms of the debt instrument is paid in cash.
[8] IRC 1272(a).
[9] Section 1.451-1(a)
[10] Rev. Rul. 74-607
[11] Rev. Rul. 80-361
[12] The $14,000 of accrued but unpaid interest increases the investor’s tax basis in the debt instrument to $114,000. Upon settlement, the amount realized of $100,000 creates a $14,000 capital loss.
[13] This assumes that the “payment ordering rules” described in note 3 do not apply to settlements of distressed debt instruments and TAM 9538007 is incorrect, both assumptions considered to be reasonable under current law.
[14] Corn Exch. Bank v. United States, 37 F.2d 34 (2d Cir. 1930)
[15] John Kaufmann, The Treatment of Payments on Distressed Debt Instruments, 26 J. Tax’n Inv. 13 (2008); Martin D. Pollack et al., Uncollectible OID: To Accrue or Not to Accrue? 84 J. Tax’n 157 (1996); David H. Schnabel, Great Expectations: The Basic Tax Problem with Distressed Debt, Taxes - The Tax Magazine, Vol. 89, No.3 (2011).
[16] Neither a TAM or a Tax Litigation Memo are considered formal guidance from the IRS.
[17]David C. Garlock et al., Federal Income Taxation of Debt Instruments (2020 edition) at para. 1602.01; Andrew W. Needham, Do the Market Discount Rules Apply to Distressed Debt? Probably Not, 8 J. Fin. Prod. 19 (2010).
[18] Koehring Co. v. United States, 421 F.2d 715. (Ct. Cl. 1970)
[19] Corn Exch. supra note 13; Jones Lumber Co. v. Commissioner, 404 F.2d 764 (6th Cir. 1968); European Am. Bank & Trust Co. v. United States, 20 Cl. Ct. (1990)
[20] Under IRC Section 108(a)(3), cancellation of indebtedness income (“CODI”) is excluded from gross income if the taxpayer is “insolvent”. Insolvency in the CODI context generally means that the taxpayer’s liabilities exceed the gross fair market value of its assets, i.e. fair value insolvency.
[21] Rev. Rul. 2007-32. “To treat an item as non-accruable because of doubtful collectibility, the cases generally have required substantial evidence as to the financial instability or insolvency of the debtor. See Jones Lumber Co., 404 F.2d at 766. This substantiation requirement has been applied on a loan by loan basis.”
[22] Clifton Manufacturing Co. v. United States, 293 U.S. 186 (1934).
[23] Corn Exch. Bank supra note 14.
[24] New York City Bar Association, Report Regarding Proposals for Accounting Treatment on Non-Performing Loans (July 23, 2008). In general, payment on claims of a bankrupt debtor may not be made, and if made, may be reduced substantially.
[25] Jeff Maddrey, Esq, “Time Value of Money - Holders of Debt Instruments” 181 Tax Mgmt. (BNA) U.S. Income (“QSI, by definition, has to be paid at least once a year. By the time the tax return is filed, the holder will usually know whether the QSI was paid or not. If the interest was in fact not paid, the earlier judgment to cease accrual appears reinforced.” Further: “In the QSI situation, the precise contours of “doubtful collectability” are unnecessary. A holder can test/verify its uncollectibility assertion with hindsight prior to filing the tax return: Did the coupon get paid or not? If it did not, the judgment not to accrue seems straightforward.”; Schnabel, supra note 15. (“The fact that the stated interest was not paid when due informs the determination whether the interest will ever in fact be paid, including upon settlement of the debt instrument.”)
[26] David C. Garlock, How to Account for Distressed Debt, 2010 Tax Notes 999 (May 31, 2010). Garlock argues that a tax basis standard to which expected payments are compared can be justified on the ground that taxpayers should only have taxable income on accretions to wealth, which are relative to each particular holder. But see Schnabel supra note 12. “...[an] appropriate question would seem to be whether, on any given date, it is sufficiently doubtful that the actual payments in respect of the [OID] debt instrument will exceed the adjusted issue price as of that date, increased by any accrued but unpaid QSI (other than any such QSI excluded by the holder under the doubtful collectability doctrine), less any OID that has been excluded from income under the doubtful collectability doctrine.”
[27] Report on the Tax Section of the New York State Bar Association on the Taxation of Distressed Debt (2011). They also suggest a threshold measurement of “distress” when there is no reasonable expectation that the holder will recover the debt instrument’s principal amount (or, in the case of a debt instrument with OID, its adjusted issue price), in each case plus any unpaid interest that accrued before the instrument become distressed. In this particular argument, they side with the Schnabel “tax principal” standard in note 25.
[28] Maddrey, supra note 25.
[29] David C. Garlock, Unresolved Creditor Issues in Debt Workouts, 1 J. Fin. Prod. 37 (2000). This statement implies that the original loan to value ratio was reasonable. (i.e., 60%). An unreasonably high loan to value ratio on a nonrecourse debt instrument may put the instrument’s tax classification as debt in doubt.