October 4, 2018 IRS confirms that Section 451(b) does not accelerate inclusion of market discount income In Notice 2018-80, the IRS has announced that it intends to issue proposed regulations confirming that taxpayers may continue to defer including market discount income in income for tax purposes until there is a payment or sale at a gain. The proposed regulations will provide that Section 451(b), which generally requires the recognition of income for tax purposes no later than when it must be recognized as revenue for financial accounting purposes, will not apply to market discount income. Accordingly, even though market discount may have to be included in income currently as it accrues for financial accounting purposes, taxpayers may defer the income for tax purposes. Background: taxation of market discount If a taxpayer purchases a bond for less than its face amount (or, for a bond that was issued with original issue discount, for less than its "adjusted issue price"), the difference is called "market discount." Generally, a taxpayer is not required to include accrued market discount in taxable income until the taxpayer receives a principal payment or the bond is sold or redeemed at a gain. Section 1278 offers an elective alternative: taxpayers may elect to include market discount as ordinary income as it accrues currently. Financial accounting does not work this way. Generally, under US GAAP, taxpayers recognize market discount in interest income over the life of the instrument.1 Section 451(b) As amended in 2017 by the Tax Cuts and Jobs Act,2 Section 451(b) generally provides that, for accrual-method taxpayers, the "all events test" is met with respect to any item of income no later than when the item is taken into account as revenue in: (1) the taxpayer's applicable financial statement (as defined in Section 451(b)(3)), or (2) such other financial statement as the Secretary specifies for purposes of the new provision. In other words, taxpayers cannot defer recognition of taxable income for tax purposes past when it is recognized as revenue for financial accounting purposes. New Section 451(b)(2) then states that the general rule does not apply to the extent a specific item of income is subject to a special method of accounting under the Code, other than a rule in the time-value-of-money rules (Section 1271 to 1288).3 Footnote 872 of the Conference Report to Section 451(b) states that the "provision does not revise the rules associated with when an item is realized for Federal income tax purposes and accordingly, does not require the recognition of income [when] the Federal income tax realization event has not yet occurred."4 Accordingly, an item is not income subject to Section 451(b) until it is realized. Planned regulations Responding to requests for guidance on whether market discount must be included in income under Section 451(b) no later than when it was recognized for financial accounting purposes, Notice 2018-80 states that the IRS intends to issue proposed regulations specifying that Section 451(b) does not apply to market discount. Instead, market discount will continue to be governed by Sections 1276 — 1278, notwithstanding how market discount may be treated for financial accounting purposes. The Notice also provides that the anticipated guidance will apply as of January 1, 2018, when Section 451(b) became effective. Implications The drafting of the 2017 tax legislation created much confusion about what effect (if any) Congress intended Section 451(b) to have on market discount. Notice 2018-80 confirms the view of many practitioners, based on the limited legislative history of the new rule, that Congress did not intend to have Section 451(b) override the long-standing market discount rules under Sections 1276–1278. The Notice does not, however, answer a number of other questions about the interaction between Section 451(b) and the Code sections governing various other financial transactions (e.g., whether Section 451(b) overrides the regulatory regime for taxing de minimis original issue discount). ———————————————
——————————————— 1 Financial Accounting Standards Board, ASC 310 — Receivables and ASC 320 — Debt and Equity Securities. 2 P.L. 115-97, Section 13221(a). 3 New Section 451(b)(1)(B)(ii) also provides a specific exception for income related to mortgage servicing rights on debt instruments. 4 H.R. Rep. No. 115-466, at 428 (2017) (Conf. Rep.). | |||||||||||||||||||||
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