IRS confirms that Sec. 451(b) does not accelerate inclusion of market discount income

Editor: Michael Dell, CPA

In Notice 2018-80, the IRS 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 Sec. 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.

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. Sec. 1278(b) offers an elective alternative: Taxpayers may elect to include market discount as ordinary income as it accrues currently.

Different rules apply in financial accounting. Generally, under U.S. GAAP, taxpayers recognize market discount in interest income over the life of the instrument (FASB ASC Topic 310, Receivables, and ASC Topic 320, Debt and Equity Securities).

Sec. 451(b)

As amended in 2017 by the law known as the Tax Cuts and Jobs Act, P.L. 115-97 (§13221(a)), Sec. 451(b) generally provides that, for accrual-method taxpayers, the all-events test is met for 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 Sec. 451(b)(3)), or (2) such other financial statement as the Treasury 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 Sec. 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 (Secs. 1271-1288). (New Sec. 451(b)(1)(B)(ii) also provides a specific exception for income related to mortgage servicing rights on debt instruments.) Footnote 872 of the Conference Report to Sec. 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” (H.R. Conf. Rep’t No. 115-466, 115th Cong., 1st Sess. 428 (Dec. 15, 2017)). Accordingly, an item is not income subject to Sec. 451(b) until it is realized.

Planned regulations

Responding to requests for guidance on whether market discount must be included in income under Sec. 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 Sec. 451(b) does not apply to market discount. Instead, market discount will continue to be governed by Secs. 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 Jan. 1, 2018, when Sec. 451(b) became effective.

Implications

The drafting of the 2017 tax legislation created much confusion about what effect (if any) Congress intended Sec. 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 Sec. 451(b) override the long-standing market discount rules under Secs. 1276-1278. The notice does not, however, answer a number of other questions about the interaction between Sec. 451(b) and the Code sections governing various other financial transactions (e.g., whether Sec. 451(b) overrides the regulatory regime for taxing de minimis original issue discount).

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP. Ernst & Young previously published versions of these items as Tax Alerts.