On September 27, 2018, the US Internal Revenue Service (the "IRS") released Notice 2018-80 (the "Notice"),1 announcing that the Treasury Department and the IRS intend to issue proposed regulations providing that market discount is not subject to accelerated income inclusion under Section 451(b) of the Code.2 This Legal Update puts the impact of that guidance into perspective.
The Tax Cuts and Jobs Act of 2017 ("TCJA")3 added new Section 451(b) to the Code. Code § 451(b) generally requires accrual method taxpayers who prepare certain financial statements4 to include items of income in their gross income at the earlier of (a) the time that the income accrues for tax purposes and (b) the time that the income is taken into account for financial statement purposes. These rules override the timing rules for original issue discount ("OID") and interest. Certain types of income, including (a) gross income in connection with mortgage servicing contracts and (b) items of income recognized based on specialized methods of accounting (such as the long-term contracts method), are exempt. This provision generally applies beginning on January 1, 2018 (January 1, 2019, for debt instruments with OID).
Until the Notice, it was unclear whether new Code § 451(b) would apply to accrued market discount. Generally, a debt instrument is acquired with market discount when the debt instrument is purchased in the secondary market (i.e., after initial issuance) for an amount that is less than its stated redemption price at maturity. A taxpayer that acquires a debt instrument with market discount can either (a) accrue such discount ratably on a daily basis following the date of purchase through the date of maturity or (b) elect to accrue such discount under principles similar to the OID rules. If a debt instrument with accrued market discount is subsequently disposed of or matures at a gain, the market discount rules recharacterize gain that would otherwise be capital gain as ordinary income to the extent of the accrued market discount.
It was unclear from the legislative history of the TCJA whether new Code § 451(b) would require accrued market discount on market discount bonds to be included in income before such discount would otherwise be recognized as ordinary income for tax purposes (if required to be recognized at all). The ambiguity caused some taxpayers to include disclosure in debt offering documents explaining the risk that market discount may have to be taken into income for tax purposes prior to a disposition or maturity. Unlike many of the recent voluminous pieces of guidance related to the TCJA, the Notice simply states, in a single sentence, that the Treasury Department and the IRS intend to issue proposed regulations providing that accrued market discount is not includible in income under the new income acceleration provisions of Code § 451(b). This makes sense, because, absent an affirmative election otherwise, market discount only serves to change the character of payments and is not itself an income recognition provision. The Notice does not provide a timeline for the forthcoming regulations, but it does state that the guidance in the Notice will be applicable as of January 1, 2018. In similar situations in the recent past, the IRS has been in no rush to issue regulations following up a Notice with such clear guidance.
1 Notice 2018-72 is available at https://www.irs.gov/pub/irs-drop/n-18-80.pdf.
2 All section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the Treasury regulations promulgated thereunder.
3 For an overview of the TCJA and related IRS guidance implementing the same, see the Mayer Brown Tax Reform Roadmap, available at https://www.mayerbrown.com/experience/us-tax-reform-roadmap/.
4 Code § 451(b)(3) lists the types of financial statements that will trigger the rule, which include (a) a 10-K or other annual report required to be filed by the taxpayer; (b) an audited financial statement used for credit purposes, reporting to shareholders, partners, or other proprietors or to beneficiaries, or any other substantial nontax purpose; (c) an audited financial statement filed with any other federal agency; (d) any non-U.S. financial statements filed by a taxpayer with an agency of a foreign government equivalent to the Securities Exchange Commission; and (e) any other financial statement filed by a taxpayer with any other regulatory or governmental body specified by the Treasury secretary.
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