Editor: Greg A. Fairbanks, J.D., LL.M.
Due to the recent turmoil in the credit markets, creditors and borrowers alike are evaluating the tax treatment of interest accruals related to troubled loans. Generally under Regs. Sec. 1.446-2(a), interest is taken into account by a taxpayer according to the taxpayer's regular method of accounting. Beyond the specific rules for accrual-method taxpayers, there are established rules for determining:
- Whether interest related to troubled loans is a deductible expense to the borrower (the issuer of a note) as it accrues; and
- Whether interest related to troubled loans is income to the lender (the holder of a note) as it accrues.
Whether Interest Is Deductible to the Borrower as It AccruesTaxpayers may generally deduct interest paid or accrued within a tax year under Sec. 163(a). Accrual-method taxpayers deduct interest under Regs. Sec. 1.461-1(a)(2) when:
- All events have occurred that establish the interest as a liability;
- The amount of the interest can be determined with reasonable accuracy; and
- Economic performance has occurred with respect to the interest.
If the borrower experiences financial hardship, can the borrower deduct interest that it may not be able to pay? Case law provides that the lack of ability to pay is not sufficient to prevent an issuer's accrual and deduction. In Zimmerman Steel Co., 130 F.2d 1011 (8th Cir. 1942), the Eighth Circuit allowed a taxpayer's deduction of interest despite the fact that the taxpayer's liabilities exceeded its assets for the period that such interest accrued. (See also Cohen, 21 T.C. 855 (1954).)
Even though the lack of ability to pay is not enough to prevent an issuer's deduction, issues may arise when a taxpayer is under bankruptcy proceedings. The IRS ruled in Rev. Rul. 70-367 that a taxpayer in bankruptcy could deduct interest as it accrues despite there being no reasonable expectancy that it would pay such interest in full. The ruling states, "The doubt as to the payment of such interest is not a contingency of a kind that postpones the accrual of the liability until the contingency is resolved."
Subsequently, courts have held that taxpayers could not deduct interest related to pre-bankruptcy debt that accrues after the issuer enters bankruptcy (postpetition interest) when the taxpayer did not have sufficient assets to pay the interest (In re Continental Vending Machine Corp., No. 63-B-663 (E.D.N.Y. 11/22/76), and Kellogg, 54 F.3d 1194 (5th Cir. 1995)). The courts distinguished both Continental Vending and Kellogg from Rev. Rul. 70- 367 because the bankruptcy proceedings in each were under a different bankruptcy law than the taxpayer in Rev. Rul. 70-367. (See Henderson and Goldring, Tax Planning for Troubled Corporations, §302 at 19 (CCH 2006).) However, in In re Dow Corning Corp., 270 B.R. 393 (Bankr. E.D. Mich. 2001), the court allowed a taxpayer to deduct postpetition interest as it accrued when the creditors had a contractual right to receive postpetition interest.
The IRS recently affirmed its agreement with the holding in Dow Corning through the issuance of Chief Counsel Advice (CCA) 200801039 (1/4/08). The CCA provides that a corporation may deduct postpetition interest in its consolidated tax return on behalf of the contractual borrowings of a subsidiary member. The CCA primarily addresses whether the postpetition interest is fixed rather than the reasonable accuracy and economic performance requirements. The CCA concluded that the corporation may deduct such postpetition interest until the confirmation of the reorganization plan in the bankruptcy proceeding. The Service provides that "while Subsidiary's filing of a bankruptcy petition created doubt as to the likelihood of the payment of interest on the Subsidiary's contractual borrowings, the bankruptcy petition did not change Subsidiary's obligation to pay the interest." It should be noted that the CCA also provides that the taxpayer must recognize interest income under the tax benefit rule when the deduction in an earlier tax year is determined not to be owed and payable in a later tax year.
Based on the above cases and IRS guidance, a borrower may deduct interest as it accrues despite uncertainty that it will actually pay such interest. In this case, the borrower still incurs a liability that enables the borrower to deduct the interest under the accrual method.
Whether Interest Is Income to the Lender as It AccruesRegs. Sec. 1.451-1(a) provides that an accrual-method taxpayer must recognize income when (1) all events have occurred to fix the right to receive such income and (2) the amount can be determined with reasonable accuracy. Thus, an accrualmethod holder generally recognizes interest income as it is earned over the term of a loan.
As the certainty for payment from the borrower diminishes, must the holder continue to recognize interest income as it accrues? In Corn Exchange Bank, 37 F.2d 34 (2d Cir. 1930), the court did not force an accrual-method taxpayer to recognize interest income arising after the borrower went into receivership. The court noted that income is taxed on a reasonable expectancy that it will be received and the taxpayer did not have income if there is no such reasonable expectancy. Because the borrower was in receivership, the taxpayer could not collect the interest in due course. The court stated:
A taxpayer, even though keeping his books upon an accrual basis, should not be required to pay a tax on an accrued income unless it is good and collectable, and, where it is of doubtful collectability or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation. [37 F.2d at 34.]
In Jones Lumber Co., 404 F.2d 764 (6th Cir. 1968), the court required an accrual-method taxpayer to recognize interest income because the taxpayer failed to provide evidence demonstrating "reasonable doubt as to the collectibility of the notes" due to the financial condition or insolvency of the debtor (doubtful collectibility). Even though the loans had no ascertainable fair market value, the taxpayer was required to accrue interest because there must be "a definite showing that the insolvency of the debtor makes receipt improbable." (See also Georgia School-Book Depository, Inc., 1 T.C. 463 (1943)).
Such a "definite showing" must provide that doubt relates to a permanent uncollectibility, according to the U.S. Court of Claims in Koehring Co., 421 F.2d 715 (Ct. Cl. 1970). The court held that a taxpayer must accrue income despite the payor's financial problems that resulted in nonpayment when payments were due. The taxpayer regarded the obligor's financial problems as temporary, and such financial problems did not affect the taxpayer's expectation that it would eventually receive payment. (See also European Amer. Bank and Trust Co., 20 Cl. Ct. 594 (1990), aff'd per curiam, 940 F.2d 677 (Fed. Cir. 1991): "For accrual of income to be prevented, uncertainty as to collection must be substantial, and not simply technical in nature.")
Establishing its position on the subject, the IRS issued Rev. Rul. 80-361, confirming that a taxpayer need not recognize interest in circumstances for which there is doubtful collectibility of such interest (the doubtful collectibility exception). In the ruling, a taxpayer may stop recognizing interest as it accrues when a borrower becomes insolvent. Most notable in the ruling, the Service differentiated between interest related to the period before the borrower became insolvent and interest related to the period after the borrower became insolvent. The IRS ruled that the lender must recognize interest prior to the borrower's insolvency as it accrues, and such interest could be subject to Sec. 166 as a bad debt deduction in the event of uncollectibility. The IRS also ruled that the lender need not accrue interest related to the day of the borrower's insolvency and thereafter.
Based on Rev. Rul. 80-361, is the IRS's position for nonaccrual based solely on the insolvency of the borrower? More recently, the Service ruled in Rev. Rul. 2007-32 that an accrual-method lender must recognize as it accrues interest that relates to a loan in which the borrower has technically defaulted from late payments. Similar to Koehring Co., the ruling provides that "late payment of interest by itself is not sufficient" to demonstrate no reasonable expectancy of payment. However, the Service also stated in Rev. Rul. 2007-32: "If there is some doubt regarding receipt of payment but a reasonable person would have an expectancy of payment, then an accrual method taxpayer is required to recognize the income," which may suggest that the IRS's position extends beyond the mere insolvency of the borrower.
While there is guidance for the nonrecognition of interest as it accrues due to the doubtful collectibility exception, there is uncertainty whether the doubtful collectibility exception applies to the accrual of original issue discount (OID). In Technical Advice Memorandum (TAM) 9538007, the IRS concluded that a cash-basis lender was required to include OID that was doubtful to be collected due to the borrower's financial condition. The Service's position primarily relies on the argument that OID is separately accounted for under the tax law despite being treated similar to the accrual method. The IRS also notes in the TAM that the legislative history of Sec. 1232 (the predecessor of Sec. 1272) states that Congress provided for interest inclusion by the holder to eliminate a mismatch between the lender's income and the borrower's deduction. It is the IRS's position that applying the doubtful collectibility exception for OID could potentially create such a mismatch. The IRS relaxed its position on borrowers in bankruptcy proceedings in IRS Litigation Guideline Memorandum TL-103 (5/6/96) by providing that the holder "may not include interest, including original issue discount, in income after the issuer has filed a petition for bankruptcy."
Recent events in the credit markets have reopened debate as to whether TAM 9538007 is correct in distinguishing OID from interest. If the doubtful collectibility exception is available for the recognition of interest as it accrues, why should such an exception be restricted to non-OID interest? The New York City Bar Committee on Taxation of Business Entities recently published a report arguing that the doubtful collectibility exception should be available for holders with respect to OID (New York City Bar, Committee on Taxation of Business Entities, "Report Regarding Proposals for Accounting Treatment of Interest on Non-Performing Loans," 2008 TNT 145-59 (July 28, 2008)). It argues that the legislative history to Secs. 1271–1275 (which provide for the recognition of OID as it accrues) indicates that Congress was concerned with the mismatch between cash-method lenders and accrual-method borrowers rather than a mismatch due to nonrecognition of interest income by a lender via the doubtful collectibility exception. Accordingly, there is an inconsistency in allowing the doubtful collectibility exception to apply for interest accrual but not OID.
As in Corn Exchange, "it would be an injustice" to require a taxpayer to recognize income that it will never receive. Such an injustice occurs regardless of whether or not such uncollectible interest constitutes OID.
Greg A. Fairbanks, J.D., LL.M., is a tax manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.