ISSUER'S POOR FINANCIAL CONDITION HAS NO EFFECT ON OID ACCRUAL.

UIL Number(s) 1272.00-00, 1272.03-00, 0354.00-00

                                             Date: June 13, 1995

This Technical Advice Memorandum responds to your request of June 21, 1994.

ISSUES

1. Must the holder of a debt instrument having original issue discount (OID) continue to accrue OID when the financial condition of the issuer is such that there is no reasonable expectation the debt instrument will be redeemed according to its terms?

2. May the holder of a debt instrument having OID recognize a loss upon the exchange of that debt instrument for new common stock of the issuer in a section 368 reorganization?

FACTS

Taxpayers are individuals on the cash receipts and disbursements method of accounting. At the beginning of Year 1, Taxpayers owned Junior Subordinated Debentures (the Debentures) issued by Corporation. The Debentures provided for interest of a percent to be paid semiannually. Corporation had the right to pay "interest" on the Debentures by issuing payment-in-kind debentures ("PIK bonds") in lieu of cash. Generally, PIK bonds nominally provide for current interest payments but give the issuer the unilateral right to pay interest in the form of additional bonds, rather than cash. Because the Corporation was not obligated to make current cash interest payments, the Debentures had OID.

For all three years at issue, Corporation issued Taxpayers additional Debentures in lieu of cash interest payments. Corporation also issued Taxpayers Forms 1099-OID indicating the amount of OID that had accrued on their Debentures. For all three years, Taxpayers considered the OID to be "uncollectible" and excluded most of it from income. The specific amounts and totals are indicated in the chart below:

 Year      Form 1099 OID       OID Excluded        OID Included

The financial situation did not improve in Years 2 and 3. In Year 2, Corporation missed both cash interest payments on its senior debt. Finally, in Year 3 the Corporation underwent a bankruptCY reorganization. Pursuant to the bankruptcy plan, Taxpayers exchanged their Debentures with a principal amount of $X for new common stock with a fair market value of $Y.

LAW & RATIONALE

1. OID ACCRUAL

Sections 163(e) and 1271 through 1275 of the Code provide rules for the treatment of debt instruments that have OID, Section 1272 generally requires holders, regardless of accounting method, to currently include in income OID on debt instruments having OID. Specifically, section 1272(a)(1) provides:

General Rule. -- For purposes of this title, there shall be included in the gross income of the holder of any debt instrument having original issue discount issued after July 1, 1982, an amount equal to the sum of the daily portions of the original issue discount for each day during the taxable year on which such holder held such debt instrument.

(Emphasis added) Sections 1271 through 1275 provide a number of specific and limited exceptions from current OID accrual. These sections do not provide an exception from current OID accrual in "doubtful collectibility" situations.

By contrast, there is a "doubtful collectibility" exception to the accrual of non-OID interest by holders on the accrual method of accounting. Generally, section 1.451-1(a) of the Income Tax Regulations provides that under the accrual method of accounting income is includible in gross income when all events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. Thus, an accrual method holder of a debt instrument must accrue interest in income as it is economically earned over the instrument's term, regardless of when it is actually paid. See sections 1.451-1(a), 1.446-2, and Rev. Rul. 83-84, 1983-1 C.B. 97.

Interest accrual is not required, however, if the interest is "uncollectible" when the right to receive the interest arises. Jones Lumber Co. v. Commissioner, 404 F.2d 764 (6th Cir. 1968) Stated another way, a taxpayer on the accrual method of accounting need not accrue interest in income if, at the time the interest would otherwise be earned, it reasonably appears that the interest will be uncollectible because of the issuer's insolvency. Rev. Rul. 80-361, 1980-2 C.B. 164. The "doubtful collectibility" exception of Rev. Rul. 80-361 grew out of a line of cases beginning with Corn Exchange Bank v. United States, 37 F.2d 34 (2d Cir. 1930). In that case, the court explained:

When a tax is lawfully imposed on income not actually received, it is upon the basis of a reasonable expectancy of its "receipt. . . . 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 collectible, 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 (citations omitted) . The concern in Corn Exchange Bank was one of fairness: It would be an "injustice,, to require a holder to accrue interest when the issuer's financial condition is such that the holder's right to receive interest is largely illusory.

Taxpayers argue that the holding of Rev. Rul. 80-361 should be extended to allow holders of debt instruments having OID to cease accruing OID in "doubtful collectibility" situations. They posit that the OID provisions of the Code are, in essence, an accrual method of accounting similar to the accrual method of accounting described in section 1.446-1(c). Taxpayers conclude that the similarities between the accrual method of accounting of section 1.446-1(c) and the OID provisions warrant extending the rationale of Rev. Rul. 80-361 to holders of debt instruments with OID.

It is true that, in general, the OID provisions can be viewed as an accrual method of accounting designed to place holders of debt instruments having OID on par with holders of debt instruments that pay interest currently ("current-pay" debt instruments). For example, the House Report on the Tax Reform Act of 1984 explained:

The purpose of the OID rules is to ensure that an OID obligation is treated for tax purposes in a manner similar to a nondiscount obligation requiring current payment of interest.

H.R. Rep. No. 432, Part 2, 98th Cong., 2d Sess. 1241, Footnote 2 (1984). See also S. Rep. 494, 97th Cong., 2d Sess. 212 (1982).

It does not follow, however, that the "doubtful collectibility" exception to section 1.451-1(a) accrual should apply to OID accrual as well. The accrual method of accounting requires holders of "current-pay" debt instruments to include interest in income when economically earned, even if actual payment occurs in the holder's following tax year. The "doubtful collectibility" exception to this rule simply recognizes that it is inappropriate to include interest in anticipation of receipt when there is no reasonable expectation of receipt. See, for example, Jones Lumber v. Commissioner, 404 F.2d 764 (6th Cir. 1968); Chicago North Western Railway Company v. Commissioner, 29 T.C. 989, 996 (1958); Corn Exchange Bank v. Commissioner, 37 F.2d 34, 35 (2d Cir. 193(5).

OID, by contrast, is not included in income in advance of receipt; it is included in lieu of receipt. The OID provisions treat the OID transaction as occurring in two steps: First, interest is deemed paid to the holder. Section 1272(a)(1). Second, the holder is deemed to relend the same amount to the issuer. This additional investment in the debt causes the holder's basis in the debt instrument to increase by an equivalent amount. Section 1272(d)(2). As OID is accrued, the holder is, in effect, receiving current interest and extending additional credit. H.R. Rep. No. 432, Part 2, 98th Cong., 2d Sess. 1034 (1984).

Moreover, creating a "doubtful collectibility" exception to OID accrual without simultaneously denying issuers an OID deduction would cause a significant mismatching of income and expense. The legislative history of section 1232 of the Internal Revenue Code of 1954 (the predecessor of current section 1272) indicates that Congress provided for current inclusion of OID by holders in order to synchronize or "match" the holder's OID income with the issuer's OID deduction:

The present treatment of original issue discount results in a nonparallel treatment of the corporation issuing the bond and the person acquiring the bond. The corporation is allowed a deduction each year with respect to the discount. On the other hand, the holder is not required to report any income . . . until [disposition] of the bond. . . . Your committee does not believe that there is a sound basis for treating the corporation issuing the bonds and the owners of the bonds in a different manner with respect to the original issue discount on the bond. . . . [Y]our committee's bill provides that the bondholder and the corporation issuing the bond are to be treated in a consistent manner with respect to the original issue discount on the bond.

H.R. Rep. No. 413, 91st Cong., 1st Sess. 109 (1969). See also S. Rep. No. 552, 91st Cong., 1st Sess. 146 (1969). Allowing holders of debt instruments with OID to cease accruing OID would create the very mismatching the OID provisions of the Code were enacted to avoid.

Finally, the argument that general interest accrual rules should trump more specific rules has been considered and rejected by the Tax Court in Weis v. Commissioner, 94 T.C. 473 (1990) and Williams v. Commissioner, 94 T.C. 464 (1990). In Weis and Williams, the Tax Court held that the general provisions of sections 446 and 461 do not override the specific imputed interest rules of section 483. In Weis, the court stated:

Section 461 is a broad general rule concerning the timing of deductions. Section 483, on the other hand, provides a specific rule intended to apply to definite and limited circumstances. Congress clearly intended the specific enunciation of section 483 to control over the general rule of section 461. See Bulova Watch Co. v. United States, 3Z5 U.S. 753 (1961). Accordingly, with respect to the payments to which section 483 applies, the imputing of interest under that section is done without regard to section 461 or the method of accounting generally used by a taxpayer.

Weis, 94 T.C. at 478. Similarly, the specific OID accrual rules of section 1272 are intended to apply in definite and limited circumstances. General accrual method principles, including the non- statutory "doubtful collectibility" exception to the interest accrual rules, do not apply to OID transactions.

In short, there is no "doubtful collectibility" exception to OID accrual under section 1272. The "doubtful collectibility" exception of Rev. Rul. 80-361 applies only to the accrual of non-OID interest by taxpayers on the accrual method. Extending the holding in that revenue ruling to allow holders of debt instruments to cease accruing OID in doubtful collectibility situations would contravene the Congressional intent underpinning the OID rules by: (1) failing to respect the principle that OID is "deemed" paid as accrued; (2) creating a mismatch of issuer deductions and holder inclusions; and (3) elevating general accrual principles over specific statutory provisions.

We therefore hold that Taxpayers must continue accruing OID for so long as they held the debt instruments, regardless of the financial condition of the issuer. Thus, Taxpayers are required to include in income the full amount of OID attributable to their Debentures in Years 1, 2, and 3.

2. LOSS RECOGNITION UNDER SECTION 354

Section 368(a)(1)(G) of the Code defines the term "reorganization" to include the transfer by a corporation in bankruptcy of all or part of its assets to a new corporation provided that stock or securities of the new corporation are distributed in a transaction to which sections 354, 355, or 356 apply.

Section 354(a)(1) of the Code states the general rule that no gain or loss shall be recognized if stock or securities in a corporation a party to the reorganization are exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

Section 354(a)(2)(B) provides that the general non- recognition rule of section 354(a)(1) does not apply to the extent stock, securities, or other property received is attributable to interest that has accrued on the exchanged securities.

Prior to the enactment of section 354(a)(2)(B), it was understood that a corporate issuer of "current-pay" debt securities could exchange these securities for stock or other securities in a section 368 reorganization just before a scheduled interest payment. A cash method holder would receive new securities in a nonrecognition transaction under section 354(a). In effect, the economically accrued interest (which would have resulted in current ordinary income) could be converted into unrealized appreciation in the new securities. This appreciation would be taxed (as capital gain) only when the securities received were ultimately sold or exchanged. This result springs from the holding in C.I.R. v. Carman, 189 F.2d 363 (2d Cir. 1951), that accrued but unpaid interest is an integral part of the debt security exchanged and, as such, is entitled to non-recognition treatment.

The legislative history of section 354(a)(2)(B) indicates that it was enacted to repeal the so-called Carman rule. S. Rep. No. 1035, 96th Cong., 2d Sess. 33, 38 (1980). Section 354(a)(2)(B),provides that to the extent property received in a reorganization is allocable to economically accrued but unpaid interest, it is not entitled to tax-free treatment. In other words, cash method holders of debt securities can no longer escape ordinary income by exchanging their securities (together with their claim for accrued but unpaid interest) for new securities just before the scheduled interest payment date.

By its terms, section 354(a)(2)(B) provides an exception to section 354(a) nonrecognition treatment only "to the extent that" property received in a reorganization is attributable to accrued interest. It does not expressly provide for loss recognition. However, the Senate Report states:

Under [section 354(a)(2)(B)], a security holder which had previously accrued the interest (including original issue discount) as income recognizes a loss to the extent the interest is not paid in the exchange.

S. Rep. No.1035, 96th Cong., 2d Sess. at 38 (1980). Apparently, the Senate Report reads section 354(a)(2)(B) as severing the claim for accrued but unpaid interest from the debt security for both gain and loss recognition purposes. Only the "security" is entitled to section 354(a) nonrecognition treatment.

Assuming the Senate Report's reading of section 354(a)(1)(B) is correct (that is, that section 354(a)(2)(B) allows an accrual method holder to recognize a loss to the extent accrued but unpaid interest is not paid in the exchange), it does not follow that the holder of a debt instrument with OID should be allowed to recognize similar losses. The theory underpinning the Senate Report's reading of section 354(a)(2)(B) is that the claim for accrued interest is severable from the claim for principal and that only the claim for principal is a "security" entitled to nonrecognition treatment. While this justification may hold true for "current-pay" debt instruments, it does not to the extent a debt instrument has OID. The holder of a debt instrument having OID never has a claim for accrued OID separate from the debt instrument itself. As OID is accrued, it is deemed paid. Section 1272(a)(1) requires the holder to accrue the OID in income as if it had actually been paid. To offset this "deemed" inclusion, section 1272(d)(2) allows the holder to increase (step-up) the basis in the debt instrument by the amount of OID included in income. In a very real sense, the claim for accrued OID is folded into, and becomes indistinguishable from, the debt instrument itself.

Thus, even if section 354(a)(2)(8) does operate to sever the claim for accrued but unpaid interest from the claim for principal, section 354(a)(2)(B) does not apply to the extent a debt instrument has OID.

CONCLUSION

Holders of debt instruments having OID must accrue OID so long as they hold the debt instruments regardless of the financial condition of the issuer. There is no "doubtful collectibility" exception from OID accrual. Thus, Taxpayers are required to include in income the full amount of OID attributable to their Debentures in Years 1, 2, and 3.

The section 354(a)(2)(B) exception from section 354(a)(1) nonrecognition treatment does not apply to accrued OID. Thus, Taxpayers are not entitled to recognize a loss on the exchange of their Debentures for common stock in a section 368(a)(1)(G) reorganization.

Due to the speculative nature of the Debentures (including the Debentures paid-in-kind) issued by Corporation, the Debentures may be treated as equity rather than debt. We express no opinion in this Technical Advice Memorandum about the debt/equity treatment of the Debentures and have assumed their treatment as debt solely for purposes of responding to this request for Technical Advice. In the event the Debentures are determined to be equity; Taxpayers must treat the receipt of PIK bonds with respect to the Debentures as a distribution to the , Taxpayers of stock with respect to preferred stock. See ' section 305(b)(4). If the PIK bonds are characterized as equity and their stated redemption amount exceeds their fair market value at issuance by more than the amount of a reasonable redemption premium, the excess will accrue as a series of constructive distributions to Taxpayer. See section 1.305-5(b) and (d) Example L5A and Example (7). The distributions described in this paragraph will be dividends to Taxpayers to the extent of the earnings and profits of Corporation. Also, if the distributions are treated as equity, under section 354, no loss will be allowable on their exchange for Corporation-stock in the reorganization.

A copy of this memorandum is to be given to the Taxpayers. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.