Interest and OID Accruals on Troubled Debt

Many taxpayers currently hold debt instruments issued by borrowers experiencing financial difficulties. It is unclear in such cases whether the borrower will be able to pay the remaining principal balance of the loan—much less any accrued interest.

If a borrower is experiencing financial difficulties, the holder of the debt instrument is likely to stop reporting any additional interest that continues to accrue. Accrual basis holders often refer to this as putting the debt on "non-accrual" status.

In Revenue Ruling 80-361, the IRS acknowledges the existence of this exception to the basic principles of accrual basis accounting.

IRS: Holders of Troubled Debt Instruments Must Include Accrued OID

In many respects, original issue discount (OID) is nothing more than accrued interest paid at maturity of a debt instrument.

The classic example of an OID instrument is a zero coupon bond. The bond will have a purchase price that is substantially below the amount payable at maturity. The difference between the amount payable at maturity and the issue price is a substitute for the accrued and compounded interest with respect to the instrument over its life. If a debt instrument has OID, both accrual basis and cash basis holders are generally required to accrue the OID on a constant yield to maturity basis over the life of the debt instrument.

Surprisingly, the IRS takes a different position on OID that accrues with respect to a troubled debt instrument. In a technical advice memorandum issued in 1995 (TAM 9538007), the IRS took the position that the general exception for interest accruals attributable to a troubled debtor was not applicable to OID accruals in similar circumstances. The consequence is that a holder of a debt instrument would need to continue to include the accrued OID in income, notwithstanding the financial difficulties of the debtor. This creates an obvious tension between interest accruals and OID accruals.

Ordinary Income Reported in Exchange for Capital Loss

This issue raises both timing and character concerns for the holder.

OID accruals by the holder will be taxable as additional ordinary income. This unpaid amount will be included in the holder's basis for the debt instrument and increase the loss when the debtor does default on its repayment obligation. From this perspective, the issue is solely timing.

However, the loss on disposition will most likely be a capital loss that will be of less utility to the holder. The upshot is that if the holder is required to continue accruing the OID, the holder will report ordinary income currently in exchange for an increased capital loss in the future.

This timing and character result illustrates why holders will want to stop accruing the OID on debt issued by a troubled debtor, notwithstanding the official IRS position to the contrary.

Rationale for Disparate Treatment of Interest and OID Not Clear

IRS analysis supporting disparate treatment of interest and OID is not particularly convincing. In fact, some practitioners argue that IRS analysis in the TAM is simply wrong.

Support for non-accrual of interest in the case of troubled borrowers stems from a series of court cases dating back to the 1930s. Analysis in these cases is not especially sophisticated. They conclude that when it is doubtful the debtor will be able to pay the full amount owed, it is unrealistic to require an accrual basis holder to continue to accrue the interest since the interest will most likely never be paid. This analysis would seem equally applicable to accruals of either interest or OID.

Since the OID analysis is contained only in a TAM (rather than in the code or regulations), many taxpayers are likely ignoring the IRS position and not accruing OID income after the borrower starts experiencing financial difficulties.

While it is not clear how aggressively the IRS is pursuing its position, there do not appear to be court cases addressing this issue. This is a bit surprising given that the TAM is almost 15 years old.

Avoiding OID Issues Presents Challenge

Once a debt instrument has been issued and the debtor has encountered financial difficulty, holders have limited options. Since the existence of OID is determined at the time of "original issue," holders can only weigh potential risk of an IRS audit when deciding whether to suspend further OID accruals.

This issue can be addressed earlier in the issuing process, however.

When new debt is being issued—either for new consideration or in a restructuring—the parties sometimes acknowledge that the debtor could encounter financial difficulties.

If the potential holder of the debt instrument is concerned about the IRS position on OID accruals, it may make sense to structure the instrument to stay outside the OID arena. Unfortunately, this often means changing the economics since the typical way to avoid OID is by providing that all interest on the debt instrument is "qualified stated interest," i.e., interest that is payable at intervals of one year or less throughout the life of the debt instrument.

Will the IRS Pursue Its Position?

Given the number of debtors experiencing financial difficulties, proper reporting of interest and OID accruals by creditors will likely receive greater scrutiny. It remains to be seen whether the IRS actively pursues its official position that the accrual rules apply differently to interest and OID in this setting.