Time Value of Money: OID and Imputed Interest (Portfolio 535)

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Tax Management Portfolio, Time Value of Money: OID and Imputed Interest, No. 535, examines the tax treatment of the issuers and holders of debt instruments under Code §1271 et seq. It examines the original issue discount (OID) rules and the Treasury regulations interpreting them as well as the rules governing the tax treatment of market discount and the §7872 rules which impute interest deductions and income to the parties to certain “below market interest” loans. In addition to providing an analysis of the rules, the Portfolio contains numerous computational examples, demonstrating the application of the Code and regulations to specific debt instruments.

Tax Management Portfolios on related topics include:

• 186 T.M., Financial Instruments: Special Rules.

• 187 T.M., Taxation of Non-Equity Derivatives.

• 188 T.M., Taxation of Equity Derivatives.

• 536 T.M., Interest Expense Deductions.

This Portfolio may be cited as McCawley, 535 T.M., Time Value of Money: OID and Imputed Interest.


Harrison B. McCawley

Harrison B. McCawley, Esq; A.B., Princeton University (1948); LL.B., Harvard Law School (1951); Attorney, Tax Division, Department of Justice (1955–60); Staff Attorney, Joint Committee on Taxation (1960–72); Refund Counsel, Joint Committee on Taxation (1972–80).

Table of Contents

Detailed Analysis

I. Scope, Background and Organization

A. Introduction

B. Scope

1. Principal Code Provisions Discussed

2. The Regulations

C. Background

1. Definition of Debt Instrument

a. General

b. “Retirement CDs”

2. Development of the OID Rules

3. Technical

a. Economic Accrual

b. Compounding

c. Future and Present Value Calculations

d. Determining Yield

e. The Accrual Period

f. Counting Conventions

II. Original Issue Discount

A. Introduction

B. Evolution of the Statutory OID Rules

1. Pre–DEFRA Developments

2. DEFRA Provisions

C. The Definition of OID

1. General

2. Determination of SRPM and QSI

a. Definition of SRPM

b. Definition of Qualified Stated Interest (QSI)

(1) General

(2) Unconditionally Payable

(3) Remote and Incidental Contingencies

(4) Treatment of Alternative Payment Schedules

(5) Preamble to T.D. 8674

(6) QSI Where DI Is Subject to Contingencies

(7) Payable at a Single Fixed Rate

3. Variable Rate and Short–term DIs

4. De minimis OID

a. General

b. Rules for Installment Obligations

c. Teaser Rates, Interest Holidays, and Similar Interest Shortfalls

5. Issue Price and Issue Date

a. Introduction

b. DIs Issued for Money

c. Publicly Traded DIs Issued for Property

d. Untraded DIs Issued for Publicly Traded Property

e. “Publicly Traded” Defined

f. Debt–for Debt Exchanges

g. Other DIs

6. Cash Payments Incident to Lending Transactions

a. Introduction

b. Treatment Under the 1986 Proposed Regulations

c. Treatment Under the Final OID Regulations

7. Investment Units

8. Convertible DIs

9. Pre–issuance Accrued Interest

10. Other Rules Related to Issue Price

a. DIs Distributed by a Corporation With Respect to Its Stock

b. The Aggregation Rule

c. Treasury Securities: Special Rules

11. Reopenings

a. Background

b. Treasury Securities

c. Final Reopening Rules: Non-Treasury Securities

(1) Background

(2) Treatment of Holders

(3) Treatment of Issuers

D. How OID Is Taken Into Account by the Holder of a DI: 1272 and the Regulations Thereunder

1. Introduction

2. The Statutory Provisions

a. General

b. Current Inclusion in the Holder's Income

3. The Regulations

a. General

b. The Mechanics of OID Accrual: The Constant Yield Method

(1) Yield to Maturity (YTM)

(2) Determination of Accrual Period

(3) Determining the OID Allocable to Each Accrual Period

(4) The Ordering Rule

(a) In General

(b) Installment Obligations

(5) Other Aspects of OID Accrual

(6) Determining the Daily Portions of OID

4. Exceptions and Modifications

5. Accrual of OID and QSI: Technical Aspects

a. Ratable Accrual

b. Short Periods

6. How De Minimis OID Is Taken into Account

a. General

b. Treatment of De Minimis OID by the Holder

c. Treatment of De Minimis OID by the Issuer

d. DIs with Stepped Interest Issued at Discount

7. Special Rule for Unpaid QSI Allocable to an Accrual Period.

8. DIs Issued in Connection with the Acquisition of Personal Use Property

9. DIs Subject to Certain Contingencies

a. General

b. Options

(1) Introduction

(2) Treatment of Options Under the Final Regulations

c. Subsequent Adjustments

(1) Provisions of 1986 and 1992 Proposed Regulations

(2) Final Regulations

d. Pro Rata Prepayments

10. Payments of Interest “In Kind” (PIK)

11. Principal Payment Uncertain as to Time

12. Basis Adjustment

13. Rules for Determining Whether a DI Is Short–term

14. DIs Denominated in a Currency Other than the U.S. Dollar

15. DIs Acquired at a Premium

16. Treatment of DIs with Principal Subject to Acceleration

E. Section 1271

1. Redemption as Sale or Exchange

2. DIs Issued With an Intention to Call Before Maturity

F. Section 163(e)

1. General

2. Liquid Yield Option Notes (LYONs)

3. High Yield OID Obligations

a. Introduction

b. General Rule and Definition

(1) General Rule

(2) AHYDO Defined

(3) “Significant OID”

(4) Examples

c. Treatment of “Disqualified” OID

d. Miscellaneous Additional Aspects of AHYDOs

4. Debt Incurred to Acquire Personal Use Property

5. Debt Transactions with Related Foreign Persons

G. Disqualified Debt: Section 163(l)

1. Introduction

2. Background of Section 163(l)

a. Rev. Rul. 85–119

b. DECS and MIPS

c. Notices 94–47 and 94–48

3. 1997 TRA and 2004 AJCA Amendments: 163(l)

4. Legislative History

5. Conclusions

H. Stripped Bonds

1. Introduction

2. Purchasers

3. The Stripper

4. Special Rules for Tax–Exempt Obligations

5. Stripped Preferred Stock

I. Application of Stripped Bond Rules to Sales of Mortgage Pools

1. Introduction

2. Type of Transactions to Which Rules Apply: Rev. Rul. 91–46

3. Treatment of the Stripper/Seller of the Mortgages

a. Treatment of the Person Stripping the Mortgages

b. Safe Harbor Rates for Reasonable Servicing Charge

III. Imputation of Interest

A. Introduction: Interest Imputation Before DEFRA

B. Revision of the Interest Imputation Provisions by DEFRA

1. Overview of DEFRA Reforms

2. Transactions Exempted from the Imputation Provisions

3. The “Applicable Federal Rate”

a. General

b. AFRs Appropriate to the Term of the DI

c. The Three–Month Rate

d. Use of Rate Other than the AFR

e. Special Rules

(1) Installment Obligations

(2) Variable Rate DIs

C. Section 1274

1. General

2. Specific Exceptions

a. Sales of Farms for Over $1 Million

b. Sales of Principal Residences

c. Sales Involving Payments of $250,000 or Less

d. Sales to Which Section 483(e) Applies

e. Other

3. Determining the Imputed Principal Amount

4. Treatment of Options

5. Potentially Abusive Situations

a. Introduction

b. The Statutory Provisions

c. The Regulations

d. Consistency Rule

6. Certain Transactions Between Related Parties

7. Qualified and Cash Method DIs: Section 1274A

a. Qualified DIs

b. Cash Method DIs

(1) General

(2) Restrictions and Limitations

(3) Transfers of CMDIs

(4) Inflation Adjustments

(5) Aggregation Rules

(6) Miscellaneous Rules

D. Section 483

1. General

2. Relationship with Section 1274

3. Other Exceptions and Limitations

4. Determination of Unstated Interest

5. How Unstated Interest Is Taken into Account: Regs. Section 1.446–2

a. General

b. Accrual of Interest Other Than QSI

6. Contingent Stock Payouts

7. Sales of Land Between Related Individuals

a. Statutory Provisions

b. Regulations

(1) Bifurcation of a DI for Section 1274 Purposes

(2) Special Rules of Regs. Section 1.483–3(b)(2)

E. Regs. Section 1.1001–1(g) and Section 1.1012–1(g)

F. Assumptions

1. Introduction and Background

2. Meaning and Effect of “Modification”

G. Modifications of Debt Instruments

1. Introduction

a. How the Modification/Deemed Exchange Rule Evolved

b. Ramifications of the Modification/Deemed Exchange Rule

c. The 1992 Proposed OID Regulations

2. Regs. Section 1.1001–3

a. The Cottage Savings Decision

b. The Final Regulations: Preamble and Structure

c. The Final Regulations: General Rule and Scope

3. Modification Defined

a. General

b. Alterations Pursuant to the Terms of the DI

(1) General Rule

(2) Exceptions to the General Rule

c. Failure to Perform

d. Time of Modification

e. Examples

4. Significant Modifications

a. Introduction

b. General Rule

c. Change in Yield

d. Changes in Timing of Payments

(1) Basic Rules

(2) Safe Harbor Period

e. Change in Obligor or Security

(1) In General

(2) Changes in a Transaction to Which 381(a) Applies

(3) Where Substantially All of Issuer's Assets Acquired

(4) Tax–Exempt Bonds

(5) Significant Alteration Defined

(6) Assumptions Pursuant to 1274(c)(4)

(7) Section 338 Election; Bankruptcy; Nonrecourse DIs; Co–Obligors

f. Change in Payment Expectations

g. Change in Security or Credit Enhancement

(1) Recourse DIs

(2) Nonrecourse DIs

h. Changes in the Nature of a DI

(1) From DI to Other Type of Instrument

(2) Change in Recourse Nature

5. Rules of Application

a. Testing for Significance

b. Modifications That Are Not Significant

6. Tax–Exempt Bonds

H. Contingent Payments

1. General

2. DIs Denominated in a Foreign Currency

IV. Variable Rate Debt Instruments

A. Introduction

B. Definition of VRDI

1. General

2. DIs Issued for Nonpublicly Traded Property

3. Qualified Floating Rate Defined

4. Objective Rate Defined

a. General

b. Definition of Objective Rate for DIs Issued on or After April 2, 1994, and Before August 13, 1996

c. Definition of Objective Rate for DIs Issued on or After August 13, 1996

d. Examples

C. Qualified Stated Interest and OID with Respect to VRDIs

1. General

2. VRDIs to Which Section 1274 Applies

3. Three Classes of VRDIs to Which Rules Apply

a. Annual Payments of Interest at a Single Variable Rate

b. All Other VRDIs (Except Those That Provide a Fixed Rate)

(1) Step One

(2) Step Two

(3) Step Three

(4) Step Four

c. VRDIs That Provide for a Fixed Rate

D. Special Rule for Reset Bonds

E. Hedging Rules of Regs. Section 1.1275–6

F. Application of the CDI Rules to DIs That Fail VRDI Status Due to Contingent Principal Payments

V. Debt Instruments That Provide One or More Contingent Payments

A. Introduction

B. The 1986 Proposed CDI Regulations

1. General

2. CDIs Issued for Money or Publicly Traded Property: The E and F Rules

3. The G Rules

4. CDIs Subject to Section 1274: The C and D Rules

C. The Final CDI Regulations

1. Background

a. In General

b. Characteristics of CDIs Issued for Money

c. CDIs Issued for Property

2. DIs Providing Contingent Payments that Are Not CDIs

3. Noncontingent Bond Method

a. Introduction

b. Methodology of 1994 Proposed CDI Regulations

(1) In General

(2) Forward Prices

(a) Forward Contracts

(b) Options

c. Methodology of Final Regulations

(1) Determining the CDI's Comparable Yield

(2) Construction of a Projected Payment Schedule

(3) Projected Payment Schedule Must Be Consistent with Comparable Yield

d. Determining the Daily Portions of Interest

e. Adjustments for Variances Between Actual and Projected Amounts

f. Scheduled and Unscheduled Retirements

g. CDIs Acquired After Original Issue

h. Contingent Payments Fixed More Than Six Months Before Due

i. Character of Gain or Loss on Sale, Exchange or Retirement

j. Miscellaneous Rules

(1) Timing Contingencies

(2) Other Special Provisions

(a) Cross-border Transactions; Investments in U.S. Real Property

(b) Coordination with Subchapter M and Section 1092

4. Tax-Exempt Obligations

a. General Rules for Tax-Exempt Obligations (TEOs)

b. TEOs with Interest and Revenue Based Payments

c. Special Rules for Tax-Exempt Obligations

5. Obligations Issued for Nonpublicly Traded Property

a. Introduction

b. The 1986 Proposed Regulations

(1) In General

(2) The D Rules

(a) Buyer's Initial Basis

(b) Adjustments to Basis

(c) Determining OID Allocable to Each Accrual Period

(i) Method (1)

(ii) Method (2)

(d) OID Calculations Compared

(3) The 1986 C Rules

c. The Final Regulations

(1) Buyers' Obligations That Are Subject to Section 1274 and Section 483

(a) CDIs Subject to Section 1274

(b) Obligations Subject to Section 483

(2) Tax Consequences of Holding, Issuing, and Disposing of CDIs Subject to Regs. Section 1.1275-4(c)

(a) Treatment of the Buyer/Issuer

(b) Treatment of the Seller/Holder

(i) Determining Gain or Loss from the Sale or Exchange of the Property and Interest Income from the CDI

(ii) Basis Different from AIP

(iii) Treatment of Holder on Sale, Exchange or Retirement

D. Section 1.1275-6 Hedges: Integration of Hedges and Qualifying DIs

1. Introduction

2. Definition of Qualifying DI

3. Definition of Section 1.1275-6 Hedge: Integration with the QDI

4. Requirements for Integration

5. Integration by Commissioner

6. Legging Into and Out of an Integrated Transaction

a. Legging Into

b. Legging Out

(1) Definitions; Commissioner-Integrated Transactions; Nonrecognition Transactions

(2) Operating Rules

7. Identification Requirements

8. Taxation of Integrated Transactions

a. General

b. Terms and Attributes of a Synthetic DI

c. Predecessors and Successors

d. Examples Provided in the Regulations

9. Additional Requirements Under the Tax Shelter Reporting Rules

E. Inflation-Indexed Debt Instruments

1. Introduction

2. Applicable Debt Instruments

3. Coupon Bond Method

a. When Applicable

b. Taking QSI Into Account

c. Inflation Adjustments Treated as OID

4. Discount Bond Method

a. The Five Steps for Applying the Discount Bond Method

b. Example

5. Deflation Adjustments

6. Adjustments to Basis

7. Subsequent Holders

8. Reopenings

VI. Market Discount; Bond Premium; Election Under Regs. 1.1272–3; DIs Purchased Between Payment Dates, Short–term Obligations, Etc.

A. Market Discount

1. General and Introductory: Market Discount Defined

2. Determining the Amount of Market Discount

a. Market Discount Defined

b. Extension of the Market Discount Rules to “Pre–enactment” Bonds

c. Determination of a MDB's “Revised Issue Price”

d. DIs Excluded from the MDB Provisions

e. Options

3. DIs Acquired at Original Issue

4. How Market Discount Is Taken into Account

a. General

b. Where Partial Payments of Principal Are Called For

c. Methods Used to Accrue Market Discount

(1) General

(2) Ratable Accrual

(3) Constant Interest Rate Accrual

(4) Special Rules for Installment Obligations

5. Elections Under Sections 1276(b)1278(b) and Regs. Section 1.1272–3

6. Dispositions of Market Discount Bonds

a. General

b. Rules Similar to Those of 1245(b) to Apply

c. Treatment of Nonrecognition Transactions

7. Deferral of Interest Deductions: 1277

B. Bond Premium

1. Introduction

a. In General

b. Final 1997 Bond Premium Regulations

2. Amortization of Premium by the Holder of a DI

a. Statutory Provisions

b. The Regulations

(1) Overview and Exceptions

(2) Determining Total Premium to be Amortized

(a) Basis

(b) Amount Payable on Maturity

(3) Amortization of Premium Under Constant Interest Method

(a) In General

(b) Treatment of “Excess Premium”

(c) Calculating Amortization: Examples

(4) Payments Subject to Various Contingencies

(a) Variable Rate Debt Instruments

(b) Inflation–Indexed DIs

(c) Other Bonds Subject to Contingencies

(i) Payment Schedule Significantly More Likely to Occur Than Alternatives

(ii) DIs Subject to a Sinking Fund

(iii) Options

(iv) Subsequent Adjustments

(5) Election Under Section 171

3. Treatment of the Issuer

a. Introduction

b. Regs. Section 1.61–12(c)

c. Amortization of Issuance Premium: Regs. Section 1.163–13

(1) General

(2) Determining Amount of Premium to be Amortized

(3) Excess Premium

(4) VRDIs and Inflation–Indexed Debt Instruments

(5) Other DIs Subject to Contingencies

d. Effective Date; Accounting Method Changes

C. Election Under Regs. Section 1.1272–3

D. DIs Purchased Between Payment Dates

E. Short–Term Obligations

1. Introduction

2. Sections 1281–83

a. Background

b. STOs to Which Section 1281 Applies

c. How Discount Is Taken into Account

(1) Governmental Obligations

(2) Nongovernmental Obligations

3. Section 1271(a)(3) and (4)

4. Interest Deferral

F. Information that Must Be Supplied by the Issuer of a DI

1. The “Consistency Rules”

2. OID Information Reporting Requirements

a. In General

b. Exceptions

3. Information To Be Provided to the Secretary upon Issuance of a Publicly Offered DI

4. Other Provisions of Regs. Section 1.1275–3

G. Anti–Abuse Rule

1. General

2. Anti–abuse Provisions

3. Examples in the Regulations Regs. Section 1.1275–2(g)(3) provides three examples. The first and third are substantially the same as Examples 1 and 2 of the temporary regulations. T.D. 8674 added current Example 2.

VII. Below Market Loans

A. Background of Section 7872

B. Basic Rules

1. General

2. Definition of “Loan” for 7872 Purposes

3. Demand and Term Loans Distinguished

4. Types of Loans Subject to 7872

a. Introduction

b. The Six Categories of Loans to Which 7872 Applies

(1) Gift Loans

(2) Compensation–Related Loans

(3) Corporation–Shareholder Loans

(4) Tax Avoidance Loans

(5) Loans with “Significant Tax Effect”

(6) Loans to Continuing Care Facilities

5. BMLs Considered Not to Have a Significant Tax Effect

6. Special Cases

a. Employee Relocation Loans

b. Loans to Continuing Care Facilities

c. Loans to Employees Conditioned on Performance of Future Services

d. BMLs Involving Foreign Persons

C. Timing and Amounts of Transfers

1. Introduction

2. Demand Loans

a. The Timing Rules

b. Computing “Forgone Interest”

(1) The (e)(2)(A) Amount

(2) The (e)(2)(B) Amount

(3) Special Rule for Term Loans Treated as Demand Loans

3. Term Loans

a. In General

b. Term Gift Loans

c. Variable Rate Loans

D. De Minimis Rules and Special Rule for Gift Loans

1. The De Minimis Rules

a. Gift Loans

(1) General Rule

(2) Determining the Aggregate Outstanding Loan Balance

b. Compensation–Related and Corporation– Shareholder Loans

2. Special Rule for Gift Loans Aggregating $100,000 or Less


Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Performing OID Calculations with the HP 19B [TM] Business Calculator.

Worksheet 1A Calculation of Yield for Debt Instruments Acquired Between Payment Dates (or with pre–issuance interest).

Worksheet 1B Imputed Interest Worksheet: Applying Section 1274 to a Debt Instrument.

Worksheet 2 OID: Excerpts from the Joint Committee on Taxation “Bluebook,” General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (December 31, 1984).

Worksheet 3 OID: Excerpts from the Joint Committee on Taxation “Bluebook,” Explanation of Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation (May 13, 1987).

Worksheet 4 Below–Market Loans: Excerpts from the Joint Committee on Taxation “Bluebook” General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, December 31, 1984.

Worksheet 5 Election to Treat a Substitution of Debt Instruments as a Realization Event Under Rev. Proc. 2001-21




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