Treatment of OID on debt retirement - foreign holders.

• Author: Orme, Stephen R.
• Position: Original issue discount

A borrower in financial distress may be unable to fully repay a loan and a lender may have to settle for less than the principal amount. With original issue discount (OLD) obligations, foreign lenders and U.S. borrowers face a troublesome U.S. tax issue when the amount recovered is less than the amount advanced.

OlD is defined in Sec. 1273 as the excess of a debt instrument's stated redemption price at maturity (SRPM) over its issue price; qualified periodic interest payments (QPIPs) are not OID. Sec. 1272 provides for the current inclusion of OID in income as it accrues regardless of a holder's method of accounting. The issue price and the holder's basis are adjusted to reflect accrued OlD. Because U.S. taxpayers are on an accrual method with respect to OID, they may be taxed on income that is never received if an OlD obligation is retired for an amount less than its adjusted issue price. In this situation, taxpayers may also have a capital loss in an amount equal to the accrued OlD, since Sec. 1271 treats debt retirement as a sale or exchange.

Unlike U.S. taxpayers, nonresident aliens and foreign corporations that hold OlD obligations not effectively connected with a U.S. trade or business are basically on a cash method of accounting with respect to OlD. Such taxpayers determine income inclusion with respect to such obligations pursuant to special rules contained in 'Sec. 871(a)(1)(C)or 8811a)(3), which in effect provide for the inclusion of OlD in income only when interest payments are received on the obligation or on its sale or exchange (including its retirement). Nevertheless, the rules of Sec. 1272 are referenced to determine the portion of the OlD that accrues during any holding period for purposes of OlD taxation when it is treated as received under Sec. 871 or 881 (Sec. 871(g)(2)).

When an OlD obligation is retired, under Sec. 871(a)(1)(C)(i) or 881(a)(3)(A), tax is imposed on the amount of OlD accruing while such obligation was held by the foreign investor who receives the retirement proceeds.

Prior to the enactment of the Tax Reform Act of 1986 (TRA), the amount of OlD that could be taxed to a foreign investor was limited to the investor's gain on the sale or exchange of the obligation. As a result of a technical amendment made by the TRA, a foreign investor is now taxed on the full amount of previously untaxed OlD that accrued while the instrument was held by the investor "whether or not that amount exceeds the foreign...