Included in the Tax Cuts and Jobs Act of 2017 is Section 13221 entitled “Certain Special Rules for Taxable Year of Inclusion,” relating to Section 451 of the Internal Revenue Code (the “New 451 Rules”). The scope and applicability of the proposed 451 rules remains uncertain with respect to market discount and original issue discount (“OID”), and we believe the uncertainty creates a risk that the rules could cause acceleration of OID and market discount to match financial statement recognition.
Unless further guidance is forthcoming, we believe the provision may have an impact on investors in certain debt instruments acquired at a discount because it could cause them to recognize income and pay taxes before they receive cash. This shift in timing could impact investors from a taxable income, liquidity, and operational perspective. If further guidance does not provide relief, the New 451 Rules could require additional operational and governance considerations, such as process enhancements, data needs, and system capabilities. For example, because the rules do not appear to provide GAAP/Tax conformity, parallel GAAP and tax calculations—along with ongoing adjustments—will be required to determine the higher amount under GAAP or current tax rules.
The following analysis is intended to illustrate how the Proposed 451 Rules could impact tax accounting for debt instruments under one of many interpretations of the provision and summarizes very generally GAAP and tax accounting considerations. This analysis should be viewed as being for illustrative purposes only and not as guidance for current or future accounting or tax policy.
|Item of income||Tax timing||
|Proposed 451 rules|
|Stated Interest Payments (coupon)||Generally recognized currently on a cash or accrual basis.||Generally recognized currently.||As currently drafted, the rules do not appear to apply to stated interest payments.|
|Original Issue Discount (OID)1||Generally recognized as it economically accrues over the life of the instrument. Special rules for asset-backed securities and certain other debt.||Depending upon the instrument type and credit quality, it may be recognized over the expected or contractual life of the instrument. GAAP and tax can have material differences depending on the terms of the instrument and variables used to project cash flows.||If enacted, it appears as though taxpayers may need to calculate tax accruals alongside GAAP accruals for each instrument and subsequently report the income using whichever method provides for earliest recognition, which can change over the life of certain debt instruments. This could potentially create ongoing computational and tracking challenges to comply with the differences between GAAP
|Market Discount2||Generally economically accrued over the life of debt instrument, but only recognized when principal payments are received or when a debt instrument is sold unless a holder elects to recognize currently.||See OID analysis above.||It appears as though taxpayers could be required to pay tax on market discount income even though no corresponding cash is received. Note that, in addition, computational and tracking issues similar to OID could exist for market discount (see OID above).|
|Premium||Taxpayers may elect to amortize and deduct premium economically over the life of the debt instrument.||See OID analysis above.||As currently drafted it appears as though the Proposed 451 Rules do not apply to premiums; provision only applies to “item[s] of gross income.”|
 OID is discount generally created at the time the debt instrument is issued.
 Market discount is discount generally created from secondary market purchases.
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