There is a new provision included in the Tax Cuts and Jobs Act of 2017, that may impact US investment funds (regulated investment companies, RICs) and other US funds (hedge funds, private equity, etc. treated as investment partnerships for US tax purposes) and those who invest in RICs and investment partnerships.
The provision, dubbed “Accounting Methods, Taxable Year of Inclusion” requires that an accrual basis taxpayer recognize income not later than the year in which it is reported in the taxpayer’s financial statements. Due to the way the provision is worded, it has the potential to require that bonds acquired with market discount amortize the discount into income on a current basis.
The investment industry is seeking guidance from Treasury and the Internal Revenue Service (IRS) that would alleviate entirely, or in part, this provision’s impact on US funds that invest in market discount bonds. The following discusses the impact on investors, the provision’s tax controversy, and what US funds should be doing as we await guidance from Treasury and the IRS.
Market discount is amortized into income on a current basis for financial statement (GAAP) purposes. For US tax purposes, market discount often is not recognized until the associated bond is sold or disposed of and, if there is a gain on the sale or disposition, the gain is treated as taxable ordinary income to the extent of market discount that would have accreted while the bond is held.1 When a fund applies the new provision, it will experience an increase in current taxable income without a corresponding cash receipt. In turn, this will increase taxable distributions from funds that are required to make distributions to their investors (RICs) or for those funds that do not have a distribution requirement (investment partnerships), an increase in ordinary income reported on partnership schedules K-1. This will be particularly detrimental to municipal bond fund shareholders and other investors seeking tax-exempt income, because market discount is treated as taxable income even on municipal bonds acquired at a discount. The income thus recognized will increase the bond’s basis and, accordingly, reduce capital gains or increase capital losses that would otherwise be recognized when the bond is sold or disposed. Essentially, the provision converts future capital gains and, potentially, capital losses into current taxable ordinary income making such investments tax inefficient. This effect is particularly dramatic in the hedge fund and private equity space where distressed debt is often purchased at deep discounts with little likelihood of recovering par value.
A RIC or investment partnership may elect to amortize market discount into income on a current basis.2 However, because the election is prospective, funds may still be required to track often large book tax accounting differences on market discount bonds acquired prior to the provision’s effective date or when the election is made.
The provision states that for accrual basis taxpayers, the “all events test” is met not later than when an item of gross income is reflected in the taxpayer’s financial statements. It references items in the Internal Revenue Code, Part V of Subchapter P. This subchapter happens also to include the market discount rules. The industry is concerned that market discount has inadvertently been caught up in these new rules and that the new rules, for the below reasons, should not apply to market discount.
Based on the TCJA Joint Conference Agreement, the provision’s primary focus appears to be advance payments and other items such as credit card fees, late-payment fees, cash-advance fees, or interchange fees that may be treated as original issue discount (OID) for tax purposes, but that are not treated as having OID for financial statement purposes, and bonds issued with OID.3 However, based on a prima facie reading of the statute, the provision may also apply to market discount.
- The TCJA Conference Agreement states that this provision applies to income items recognized under the current law all events test4 for accrual basis tax payers but that the provision does not limit the use of “special accounting methods” applicable to various specific transaction types. Market discount is subject to a special accounting method. It must be recognized upon sale or disposition of the bond or, at the election of the bond holder, amortized over the associated bond’s maturity.5
- Further, the provision does not affect when an item of gross income is “realized” for tax purposes. An income item would not be subject to the provision’s recognition rules if it has not been realized. It can be argued that market discount is not realized until the associated bond is sold.6
- Finally, again arguably, market discount is not subject to the all events test.7 Rather, it is included in income by statute.
It would seem, then, that even though the market discount rules are covered in Part V of Subchapter P, market discount should not be subject to this provision.
In the absence of guidance, clients may want to consider how ongoing investment in market discount bonds will impact the funds they manage. Clients should consult with their tax advisers to determine if they are subject to the new rules and develop an appropriate tax treatment for market discount. Finally, if a fund decides to change its market discount tax treatment, they should consider any system changes that will be necessary to comply with the new rules. Brown Brothers Harriman tax teams will continue to follow the provision and provide information to our clients as they investigate whether and how to modify their operations to apply the new rules.
FOR MORE INFORMATION, PLEASE CONTACT YOUR RELATIONSHIP MANAGER.
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1 Internal Revenue Code §1276(a)(1).
2 Internal Revenue Code §1278(b).
3 TCJA Conference Agreement, p. 274.
4 The all events test, IRC §451, is met when all events have occurred that fix the right to receive income and the income is readily determinable. IRC §451(b) adds the additional requirement that for an accrual basis tax payer, the all events test is met not later than when the income is reflected in the taxpayer’s financial statements.
5 IRC §1276 and §1278 (included in Part V of Subchapter P of the Code).
6 The TCJA Conference Agreement, foot note 872, provides an example, in the case of a security, that a realization event has not occurred until it is sold or disposed of and gain is not recognized until then. The market discount rules do not require recognition until the bond is disposed. Current recognition of market discount amortization is elective. Accordingly, it seems that in the absence of such an election, market discount is not realized until sale of the associated bond. By contrast, Part V of Subchapter P, requires that OID be accreted daily.
7 David Garlock, Federal Income Taxation of Debt Instruments, Wolters Kluwer CCH Publications, ¶1101, INTRODUCTION, makes the very strong argument that Congress did not originally intend that market discount be subject to the “all events” test and current accrual:
In October 1987, the House of Representatives passed a bill that generally would have required the current accrual of market discount. Omnibus Budget Reconciliation Act of 1987, H.R. 3545, 100th Cong., 1st Sess., §10118. The Senate version of this bill did not contain a comparable provision, and the proposal was dropped in conference. See H.R. Rep. No. 100-391, at 1056-57 (1987) and H.R. Rep. No. 100-495, at 932-33 (1987). In its Fiscal Year 2000 and Fiscal Year 2001 budgets, the Clinton Administration proposed requiring holders that use an accrual method of accounting to include market discount in income on a constant-yield basis as it accrues. To address the concern . . ., the holder’s yield for this purpose would have been limited to the greater of (1) the original yield to maturity of the debt instrument plus five percentage points, or (2) the applicable Federal rate at the time the holder acquired the debt instrument plus five percentage points. The proposal was to have been effective for debt instruments acquired on or after the date of enactment. The proposal was never enacted.”
- Despite its perception that market discount and original issue discount are economically indistinguishable from the holder’s perspective, Congress adopted a separate set of rules for market discount bonds to address the perceived abuses. The most significant difference between the OID [Original Issue
- Discount is also included in Part V of Subchapter P] and market discount rules is that a holder is not required to include market discount in income as it accrues, even if it otherwise uses the accrual method of accounting.