IRS ANNOUNCES PROCEDURES FOR USING PRINCIPAL-REDUCTION METHOD OF ACCOUNTING FOR DE MINIMIS OID.

Rev. Proc. 94-29

CONTENTS

SECTION 1. PURPOSE

This revenue procedure allows a taxpayer to use the principal- reduction method of accounting -- an aggregate method of accounting for de minimis original issue discount on certain loans originated by the taxpayer. The principal-reduction method is based on the rule that, if a taxpayer holds a debt instrument with de minimis original issue discount, the taxpayer must include that discount in income as stated principal payments are made. See section 1.1273-1(d)(5) of the Income Tax Regulations. The revenue procedure also describes how eligible taxpayers may change to the principal-reduction method for loans acquired on or after a "cut-off date." In addition, the revenue procedure obsoletes several revenue rulings, including the revenue rulings that allowed the composite method and the loan liquidation method of accounting for discount. Thus, a taxpayer may no longer rely on these rulings for any loan required to be accounted for in accordance with the final regulations dealing with original issue discount and other related matters (T.D. 8517, 1994-9 I.R.B. 4).

SEC. 2. BACKGROUND

.01 A debt instrument (loan) is issued with original issue discount (OID) if the loan's issue price is less than its stated redemption price at maturity. See section 1273(a)(1) of the Internal Revenue Code. In some cases, although a loan is issued with OID, the amount of OID is treated as zero. See section 1273(a)(3) and section 1.1273-1(d) (concerning de minimis OID).

.02 Points treated as paid when a loan is originated generally reduce the issue price of the loan. See section 1.1273-2(g) (concerning the effect of certain cash payments on the issue price of a loan). Thus, all points charged on a loan create or increase OID on the loan. As used in this revenue procedure, the term "points" refers only to amounts charged for the use or forbearance of money.

.03 Section 1.1272-3 allows a holder of a debt instrument to elect to use a constant yield method to account for all interest that accrues on the instrument. For purposes of this election, interest includes stated interest, acquisition discount, OID, de minimis OID, market discount, de minimis market discount, and unstated interest, as adjusted by any amortizable bond premium or acquisition premium. A holder may make the election only for a debt instrument acquired on or after April 4, 1994. Section 1.1272-3(d) provides rules for the time and manner of making the election under section 1.1272-3.

.04 Section 446(e) and section 1.446-1(e) state that, except as otherwise provided, a taxpayer must obtain the consent of the Commissioner to change a method of accounting for federal income tax purposes.

.05 Section 1.446-1(e)(3)(i) requires that, in order to obtain the Commissioner's consent to change a method of accounting, a Form 3115, Application for Change in Accounting Method, generally must be filed within 180 days after the beginning of the taxable year in which the proposed change is to be made.

.06 Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to change its method of accounting in accordance with section 446(e).

.07 When taxable income for a taxable year is computed under a method of accounting that is different from the method used to compute taxable income for the preceding taxable year, section 481(a) requires the taxpayer to take into account those adjustments necessary to prevent amounts from being duplicated or omitted.

.08 The Commissioner may determine that certain changes in methods of accounting are to be effected on a "cut-off" basis. If a change is made on a cut-off basis, only the items arising on or after the beginning of the year of change (or other operative date) are accounted for under the new method of accounting. Any items arising prior to that date continue to be accounted for under the former method of accounting. When a change is made on a cut-off basis, no items of income or deduction are duplicated or omitted, and therefore no section 481(a) adjustment is necessary. Section 2.05(3) of Rev. Proc. 92-20, 1992-1 C.B. 685, 689.

.09 Section 6001 and the regulations thereunder require taxpayers to keep permanent books of account or records to establish the amount of gross income for a taxable year.

.10 Rev. Proc. 94-28, page __, this Bulletin, provides procedures for taxpayers to effect timely changes in their methods of accounting to comply with the final regulations dealing with OID and other related matters.

SEC. 3. SCOPE OF THE PRINCIPAL-REDUCTION METHOD AND OTHER DEFINITIONS

.01 Loans.

The principal-reduction method (described in section 5 below) applies only to loans that --

(1) Are acquired by the taxpayer at origination,

(2) Do not have OID or, because the OID is de minimis under section 1.1273-1(d), are treated as not having OID,

(3) Are not issued at a premium,

(4) Are not subject to the election under section 1.1272-3, and

(5) Produce ordinary gain or loss when sold or exchanged by the taxpayer.

.02 Terms defined in the general method change revenue procedure.

Except to the extent explicitly provided in this revenue procedure, the following terms have the meaning given to them by Rev. Proc. 92-20 (or its then-current successor):

o Taxpayer (See section 3.01 of Rev. Proc. 92-20),

o Under examination (See section 3.02 of Rev. Proc. 92-20),

o Year of change (See section 3.03 of Rev. Proc. 92-20), and

o Filed (See section 3.04 of Rev. Proc. 92-20).

SEC. 4. APPLICATION

.01 Use of the principal-reduction method.

The principal-reduction method of accounting, which is described in section 5 of this revenue procedure, is a permissible method for use by taxpayers to account for de minimis OID (discount) on one or more categories of loans described in section 4.02 or section 4.03. If the principal-reduction method is used to account for any loans in a category of loans, the method must be used for the entire category of loans. As is more fully described in section 5, if the method is used for more than one category, separate data for each category must be kept, and the computations must be made separately for each category.

If a taxpayer desires to change its method of accounting to the principal-reduction method, the taxpayer must follow the instructions in sections 8 and 9 of this revenue procedure.

If a taxpayer does not already have a method of accounting for discount on one or more categories of loans, the taxpayer may adopt the principal-reduction method for discount on any or all of those categories of loans by using it on a federal income tax return. The taxpayer must attach to this return a statement identifying the categories of loans to which the new method will apply and describing any "additional categories" permitted under section 4.03 of this revenue procedure.

.02 Standard categories of loans.

The standard categories are:

Category (1) Loans that are secured by 1- to 4-family residential real property and are not home equity lines of credit or construction loans.

Category (2) Loans that are construction loans with original terms not greater than three years.

Category (3) Loans that are secured by real property, are not contained in Category (1) or Category (2), and are not home equity lines of credit.

Category (4) Loans that are consumer loans with original terms not greater than seven years, are not secured by real property, and are not revolving credit loans.

.03 Additional categories of loans.

The principal-reduction method also may be used for discount on loans that are described in section 3.01 but are not in one of the standard categories described in section 4.02. This use is permissible, however, only if the taxpayer defines one or more additional categories of loans that are sufficiently homogeneous so that use of the principal-reduction method for those additional categories clearly reflects the taxpayer's income. In particular, each additional category must consist solely of loans of comparable duration. For this purpose, duration means the weighted average time to expected payments of principal (including expected prepayments of principal). The weighted average is computed using the present value at issue of the expected payments and prepayments.

SEC. 5. PRINCIPAL-REDUCTION METHOD OF ACCOUNTING

Under the principal-reduction method of accounting for discount --

.01 As of the date each loan in a category is acquired, the taxpayer's basis in the loan is deemed to be the loan's stated principal amount. All of the gain represented by the discount on the loan is recognized solely under the principal-reduction method described in this revenue procedure.

.02 The required computations must be made monthly. Thus, the computation period referred to below is the month (or that portion of a month that falls within a short taxable year).

.03 At the start of each computation period, the taxpayer must record and retain the following information for each category of loans for which the taxpayer is using the principal-reduction method:

(1) Unpaid stated principal as of the end of the prior period of all loans in the category that were held at the end of the prior period (Starting Principal).

(2) Unrecognized discount as of the end of the prior period (Starting Discount).

For the initial computation period, Starting Principal and Starting Discount are zero.

.04 During each computation period, the taxpayer must record and retain the following information for each category of loans for which the taxpayer is using the principal-reduction method:

(1) The stated principal amount at the time of acquisition of all loans in the category that were acquired at origination by the taxpayer at any time during the period, whether or not they are still held by the taxpayer at the end of the period (Current Principal). This amount includes loans in the category that are acquired as refinancings of, or in exchange for, loans previously held by the taxpayer. Thus, if a loan (whether or not in the category) is modified and the modification results under section 1001 in a deemed sale or exchange of the old loan for a new one that is in the category, the stated principal amount of the new loan is included in Current Principal.

(2) The aggregate discount (including discount attributable to points) at the time of acquisition on all loans described in section 5.04(1) of this revenue procedure (Current Discount).

(3) The unpaid stated principal amount of all loans in the category that are still held by the taxpayer at the end of the period (Ending Principal). Thus, Ending Principal does not include the stated principal amount of loans disposed of in refinancings or exchanges during the period. Ending Principal does not include rights (such as mortgage servicing rights) that are retained on the sale of a loan, except to the extent that those rights represent a participation interest in the stated principal amount of the original loan. Ending Principal does not include the stated principal amount of any loan to the extent charged off by the taxpayer during the period. Except as provided in the following sentence, if the taxpayer has foreclosed on the property securing a loan, neither the unpaid stated principal on the loan nor any remaining deficiency on the loan is counted as part of Ending Principal. If property securing a loan is acquired in a transaction governed by section 595 and the property has not been disposed of before the end of the period, Ending Principal includes the unpaid stated principal of the loan immediately before the transaction in which the property was acquired.

.05 The discount taken into account as gain (Recognized Discount) during each computation period is the portion of total discount that corresponds to the portion of principal recovered during the period. For this purpose, Recognized Discount is the product of the sum of Starting Discount plus Current Discount times a fraction the denominator of which is the sum of Starting Principal plus Current Principal and the numerator of which is the excess of the denominator over Ending Principal.

This section 5.05 can be restated as:

R = (DStart + DCurrent) x ([PStart + PCurrent - PEnd] / [PStart +

This section 5.06 can be restated as:

     DEnd = DStart + DCurrent - R.

.08 The discount recognized as gain during a taxable year is the sum of the Recognized Discount for all computation periods comprising the year.

.09 For each period, the amounts referred to above must be recorded and separately retained as part of the taxpayer's tax books and records. See section 6001 and the regulations thereunder. These records must be maintained as separate tax records and not merely as a set of adjustments to book figures. These records must affirmatively demonstrate the period-to-period consistency required by subsections .06 and .07 above.

SEC. 6. EXAMPLE

.01 T properly adopts the method described in section 5 for all of the loans that it acquires that are described in Category (1) in section 4.02.

.02 For T's first month in operation, it acquired at origination loans in Category (1) with an aggregate stated principal amount of $10,000,000 at the time of acquisition. The sum of the discount with which these loans were acquired is $400,000. At the end of the month, $9,000,000 was the outstanding stated principal amount on the Category (1) loans still held by T. Thus, the discount recognized during the month is $40,000. That figure is derived as follows:

R = (DStart + DCurrent) x ( [PStart + PCurrent - PEnd] / [PStart +

     DEnd = DStart + DCurrent - R

R = (DStart + DCurrent) x ( [PStart + PCurrent - PEnd] / [PStart +

     DEnd = DStart + DCurrent - R

.01 Waiver. For method changes requested under this revenue procedure, under the authority in section 1.446-1(e)(3)(ii), the Commissioner waives the provision in section 1.446-1(e)(3)(i) that otherwise would have required the taxpayer to file an application within 180 days after the beginning of the taxable year for which the change is to be made. See section 9 below for the time by which this application must be filed.

.02 Consent. Under section 1.446-1(e)(2)(i), the Commissioner grants consent for a taxpayer to change to the principal-reduction method described in section 5 for one or more categories of loans described in section 4.02 or 4.03 of this revenue procedure, using the cut-off procedure described in section 8. This consent is granted for the taxable year (year of change) for which the taxpayer makes a request in the manner described in section 9. The taxpayer also must comply with the provisions of this revenue procedure in all other respects. See subsection .04 below. Consent is not granted, however, if the taxpayer, at the time for filing the Form 3115 required under section 9 of this revenue procedure, is the subject of a criminal investigation or proceeding concerning (1) directly or indirectly, any issue relating to the taxpayer's federal tax liability for any taxable year, or (2) the possibility of false or fraudulent statements made by the taxpayer with respect to any issue relating to its federal tax liability for any taxable year.

.03 Exclusive procedure. This revenue procedure is the exclusive way for taxpayers to obtain the Commissioner's consent to change to the principal-reduction method.

.04 Compliance with conditions. If a taxpayer to which this revenue procedure applies changes to the principal-reduction method without authorization or without complying with all the provisions of this revenue procedure, the taxpayer has initiated a change in method of accounting without obtaining the consent of the Commissioner required by section 446(e).

SEC. 8. CUT-OFF PROCEDURE FOR CHANGE

.01 General provisions.

If a taxpayer is changing to the principal-reduction method for one or more categories of loans, the taxpayer must employ the "cut- off" procedure described in this section 8. A taxpayer may request as the year of change any taxable year ending on or after December 22, 1992, for which the taxpayer has the information that sections 5, 8, and 9 require it to record and retain.

(1) Except as provided in section 8.03, the cut-off date is the first day of the year of change.

(2) The principal-reduction method applies only to loans that were acquired on or after the cut-off date. This revenue procedure does not grant consent to a taxpayer to change its prior method of accounting for discount on loans that were acquired before the cut-off date. The taxpayer must maintain books and records sufficient to satisfy the District Director that old and new loans have been adequately segregated. See Rev. Proc. 94-30, page __, this Bulletin for procedures to be followed by taxpayers that want to change their method of accounting for points on the old loans.

.02 No audit protection.

A taxpayer that receives consent to change one or more methods of accounting under this revenue procedure does not thereby obtain audit protection with respect to its method of accounting for discount on loans acquired prior to the cut-off date.

.03 Special provisions if the year of change contains December 22, 1992, or April 4, 1994.

Notwithstanding section 8.01(1) of this revenue procedure --

(1) If the year of change contains December 22, 1992, the taxpayer must choose December 22, 1992, as the cut-off date.

(2) If the year of change contains April 4, 1994, the taxpayer may choose April 4, 1994, as the cut-off date.

SEC. 9. HOW TO REQUEST A CHANGE TO THE PRINCIPAL-REDUCTION METHOD

.01 Filing of the Form 3115. A taxpayer requesting to change to the principal-reduction method described in section 5 must complete and file in duplicate a current Form 3115. Except as provided in section 9.03 below, the original of the Form 3115 must be attached to the taxpayer's timely filed (including extensions) federal income tax return for the year of change. A copy of the Form 3115 must be filed with the National Office of the Internal Revenue Service, addressed to the Commissioner of Internal Revenue, CC:DOM:IT&A, P.O. Box 7604, Benjamin Franklin Station, Washington, D.C. 20224. This copy must be filed no later than the date the Form 3115 is filed with the federal income tax return. No user fee is required for a filing under this section 9.01. A Form 3115 filed pursuant to this revenue procedure will not be acknowledged.

.02 Additional information, representations, and conditions.

(1) Written statement. On a signed written statement attached to the Form 3115, the taxpayer must (a) identify the cut-off date, (b) identify the categories of loans to which the new method will apply, (c) describe any "additional categories" permitted under section 4.03 of this revenue procedure, and (d) state that it agrees to all the conditions of this revenue procedure.

(2) Labeling the Form 3115. In order to assist in the processing of the change in method of accounting and to ensure proper handling, reference to this revenue procedure must be made a part of the Form 3115 by either typing or legibly printing the following statement at the top of page 1 of Form 3115: "AUTOMATIC CHANGE FILED UNDER REV. PROC. 94-29."

(3) Signature for the Form 3115. The Form 3115 must be signed by or on behalf of the taxpayer requesting the change by an individual with the authority to bind the taxpayer in such matters. For example, an officer must sign on behalf of a corporation. See the signature requirements in the General Instructions for Form 3115. If the taxpayer is a member of a consolidated group, a Form 3115 submitted on behalf of the taxpayer must be signed by a duly authorized officer of the common parent. See section 1.1502-77.

(4) Authorized taxpayer representative. If an agent is authorized to represent the taxpayer before the Service, to receive the original or a copy of correspondence concerning the request, or to perform any other act(s) regarding the Form 3115 on behalf of the taxpayer, a power of attorney reflecting that authorization should be attached to the Form 3115. A taxpayer's representative without a power of attorney to represent the taxpayer will not be given any information regarding the Form 3115.

.03 Amended return.

If the federal income tax return for the year of change is filed before June 17, 1994, the taxpayer must file an amended return for the year of change no later than December 31, 1994. The taxpayer must attach the Form 3115 to the amended return for the year of change. The principal-reduction method must be appropriately reflected on the amended return for the year of change and on returns (or amended returns filed by December 31, 1994) for taxable years after the year of change.

SEC. 10. EFFECT ON OTHER DOCUMENTS

The following revenue rulings are obsolete:

o Rev. Rul. 216, 1953-2 C.B. 38 (concerning the "composite" method of accounting for mortgage acquisition costs);

o Rev. Rul. 54-367, 1954-2 C.B. 109 (concerning the "composite" method of accounting for discount);

o Rev. Rul. 64-278, 1964-2 C.B. 120 (concerning the "liquidation" method of accounting for discount);

o Rev. Rul. 70-540, 1970-2 C.B. 101 (concerning the treatment of points, commitment fees, and service fees by the lender) to the extent of any discussion concerning the treatment of points by the lender; and

o Rev. Rul. 74-607, 1974-2 C.B. 149 (concerning the treatment of points by a lender that uses the accrual method of accounting).

SEC. 11. EFFECTIVE DATE

This revenue procedure is effective on April 4, 1994.

DRAFTING INFORMATION

This revenue procedure was drafted in the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information, contact Albert J. Kiss on (202) 622-3940 (not a toll-free number).