Firm Cites Concerns With Form to Report Contingent Payment Debt

Ms. Pamela Lew

On February 18, 2016 the IRS promulgated updated final cost basis regulations (T.D. 9750). We greatly appreciate and thank you for the guidance provided therein. We are currently very focused in providing systems addressing broker compliance for various types of complex debt that constitute covered debt.

In preparation for the imminent due date for information returns including cost basis reporting for complex debt instruments (February 15, 2017, for such debt acquired on or after January 1, 2016), including contingent payment debt instruments ("CPDI"), we wanted to describe our concerns that certain existing Form 1099-B and 1099-OID information returns (and the rules for broker transfer reporting under Treas. Reg. 1.6045A-1) do not adequately capture important elements of taxable income, expense, gain or loss relating to CPDI. We recognize that the current substantive tax accounting rules for CPDI set forth in Treas. Reg. 1.1275-4 (the "CPDI Regs") were essentially promulgated in 1996 (T.D. 8674, before subsequent amendments). Thus, the rules are not new and are generally understood. However, we are concerned that important information concerning CPDI tax adjustments is not clearly communicated on existing IRS Forms 1099-B and 1099-OID in a manner that facilitates consistent broker and taxpayer reporting and consumption of important information by the Service. We frame much of our discussion in the context of reporting forms, but we acknowledge that many of our recommendations could necessarily also affect regulatory guidance for cost basis reporting. We will attempt to highlight specific concerns with current reporting below.

Our comments address two primary topics: 1) the reporting of actual contingent payments versus projected contingent payments; and 2) the tax accounting and reporting of the consequences of holding a CPDI that is purchased (either at issue or in the secondary market) at a purchase price that differs from the debt instrument's adjusted issue price ("AIP"). In addition, we would like to describe related transfer reporting concerns for CPDI and offer some specific recommendations regarding our concerns. Two additional notes: 1) we are limiting our focus herein to CPDI that are subject to the noncontingent bond method described in Treas. Reg. 1.1275-4(b) and not addressing additional complexities when delayed contingencies are present as provided in Treas. Reg. 1.1275-4(b)(9)(ii); and 2) we have previously commented that we have tax policy concerns regarding the ready availability of such CPDI of comparable yield and projected payment information for brokers obligated to provide cost basis reporting information. We simply reiterate our concerns that the lack of available information is problematic for broker compliance and creates tax policy risks relating to inconsistent reporting.¹

For the technical reasons discussed below, we believe that significant information reporting and transfer reporting difficulties could stem from the mechanical provisions of the CPDI Regulations that result in original issue discount (OID), additional interest income, ordinary loss recognized before disposition, ordinary interest and ordinary loss recognized at maturity and special character rules that apply to sales of CPDI that can result in gain characterized as ordinary (rather than capital) and losses that are bifurcated into part capital and part ordinary. In many cases, these difficulties become clear if you simply focus on addressing how the amounts computed in examples set forth in the CPDI Regulations would (or would not) be reported on information returns. As background, it is worth noting that because stated interest on a CPDI can never qualify as qualified stated interest (QSI) under the OID rules, the only "interest" on such instruments other than OID results from the special rules discussed below. Moreover, although IRS Pub. 1212 provides a general discussion of the adjustment rules, it also suggests that existing information reporting practices do not appear to address many of these cases, even though brokers are already required to report basis for CPDIs acquired on or after January 1, 2016.²

Positive and negative adjustments are netted each tax year and net positive adjustments for a tax year are treated as additional interest⁴ that should be added to the amount of OID accrued for such year; it would seem that the sum should be reportable for such year on Form 1099-OID. Because there is no specific itemization of net positive adjustments required by Form 1099-OID, reconciliation of OID calculations for such year could be troublesome for either the taxpayer or the IRS because it would be unclear whether such adjustments had been included (without further investigation).⁵

Net negative adjustments, however, are subject to limitations under the CPDI Regs. First, a net negative adjustment determined for a tax year may offset the amount of OID accrued for such year by a holder.⁶ The payor would presumably simply report OID of such net amount (but not below zero) for such tax year on Form 1099-OID. Second, any net negative adjustment determined for a tax year that exceeds the amount of OID accrued for such tax year can be taken by the holder as taxable ordinary loss but only to the extent of the sum of such holder's prior total interest and OID inclusions.⁷ There is no current guidance or box on Form 1099-OID for reporting any such additional taxable ordinary loss.⁸

The CPDI Regs further provide that any excess is carried forward to future tax years and can only be released and treated as a recognized loss after reapplying the tests as described above for each future year.⁹ If the debt instrument matures, is retired, or is sold, any unused excess negative adjustment as of the date of sale reduces the holder's amount realized in the debt instrument. By reducing amount realized, the unused excess negative adjustment carryforward is essentially converted to a capital loss (rather than ordinary loss) at such time.

Here are the information reporting concerns that we believe are raised by the operation of these rules:

Although this rule ordinarily applies when a CPDI is acquired in the secondary market upon purchase from a prior holder, this rule can also apply to a holder who purchases a CPDI in the initial offering but at a price different from the instrument's issue price. The cost basis reporting regulations¹⁵ and OID information reporting regulations¹⁶ do not provide any relief from these special rules for brokers obligated to provide cost basis or information reporting relating to CPDI subject to these special rules.

The special rules include a general rule that a holder of a CPDI subject thereto ". . . must reasonably allocate any difference between the adjusted issue price and the basis to daily portions of interest or projected payments . . ."¹⁷ In other words, the holder is required under the CPDI Regs to make a factual determination as to whether the difference in price was due to different expectations regarding projected payments (compared to those used to determine OID accruals under Reg. Sec. 1.1275-4(b)(3)) or different expectations regarding market interest rates at the time of purchase.

Cost basis reporting essentially shifts this factual determination burden from the holder to the broker obligated to compute and report the CPDI's basis, proceeds and OID. We are concerned that these special rules could apply repeatedly to CPDIs for which a broker has cost basis reporting obligations (either due to secondary market purchases or initial purchases at prices other than the issue price). As discussed in prior correspondence (see, e.g., our most recent letter dated August 20, 2015), we are concerned that such determinations are an inappropriate burden on brokers. For example, a custodian can be treated as a broker under Sec. 6045 or a full service broker could be facilitating a trade that was recommended by a third party financial advisor and thus may not have ready access to data necessary to make the factual determination that these special rules impose on holders of such CPDI. This issue is made even more difficult if a CPDI provides for multiple payments where fact-based analysis could conclude that non-linear allocations of any payment related difference should be applied (rather than pro rata adjustments to all future payments). We understand that the broad Congressional mandate of the cost basis reporting rules could be considered as necessitating broker basis determinations even under such special rules. If so, we believe that the cost basis reporting rules should permit a simpler, less fact-determined method for addressing basis and information reporting by brokers for such instruments. We discuss our recommendation below.

In addition, we believe it is important to emphasize that under the special rules, a difference in basis and adjusted issue price at time of purchase has additional tax consequences that could generally affect the timing of income recognition by a holder and create additional complexities in computing the consequences of the receipt of actual payments on a CPDI that are generally discussed in Section I hereof. Others have previously written about these differences.¹⁸ However, we believe it is important to consider these issues in the context of appropriate information reporting burdens and the tax policy goals of information reporting. Therefore, our concerns are described more fully immediately hereafter.

Net Positive and Negative Adjustments and Payment at Maturity: As discussed in the prior section, any allocation of a difference in basis for such CPDI is taken into account as either a negative or positive adjustment at the time an actual payment is received. Example 1³² regarding the special rules describes how this works. As described therein, the "basis difference" related to negative or positive adjustments are essentially simply taken into account as additional adjustments in applying the rules described in Section I above. In the example, a $243 basis difference is allocated as attributable to a contingent payment at maturity. The projected payment at maturity in the example was $1,350. Although not explicitly stated, the holder must have believed at the time the CPDI was purchased that the contingent payment at maturity would be $1,593 ($1,350 plus $243). In the example, the actual amount of the contingent payment received at maturity was $1,400. Under the basic adjustment rules relating to actual payments discussed in Section I, there is a positive adjustment of $50 equal to the amount by which the actual payment of $1,400 exceeded the projected payment of $1,350. The holder further takes into account the negative adjustment due to the basis difference in the example of $243. Thus, there is a net negative adjustment of $193. This net negative adjustment fully offsets the OID accrued for the year of $128, so no interest/OID income is reportable by the holder for such year. There is a remaining amount of the net negative adjustment equal to $65 ($193 minus $128). The holder is entitled to an ordinary loss relating to this remaining amount in an amount not to exceed prior OID available under the CPDI Regs.³³ The amount of the ordinary loss available under this rule in the example is $60.

We are concerned if (or where) this amount should be reported to the taxpayer, but we do not believe it is currently reported on Form 1099-B (although we note that the revision to Reg. Sec. 1.6045-1 providing that Form 1099-B now clearly applies when partial principal payments are received on a debt instrument might be relevant).³⁴ However, the adjustment does not seem to be arising from the disposition and in fact could arise due to actual payments received prior to maturity. Finally, the $5 remainder reduces the holder's amount realized from sale or disposition from $1,350 (the amount of the projected rather than the actual payment) to $1,345 pursuant to Reg. Sec. 1.1275-4(b)(6)(iii)(C).

Because the difference between basis and AIP at purchase was entirely attributable to expected future contingent payments (rather than market interest rates), the $243 was separately tracked and accounted for as a negative adjustment. While holding the CPDI, the holder's basis was increased by a daily amount equal to that determined based on Baseline OID for an original holder that had purchased at AIP. Thus, basis reportable on Form 1099-B at disposition should equal the original acquisition price, $1,405, plus the sum of all OID accruals determined based upon Baseline OID from the acquisition date forward, and reduced by the $243 allocable to expected contingent payments at the time received, resulting in a reportable basis to the holder of $1,350. This could be confusing to the holder because it does not obviously reconcile to the $1,405 originally paid plus the OID accrued while held. As noted in the example, a $5 capital loss is recognized ($1,345 amount realized less the final adjusted basis of $1,350).

Example 2³⁵ illustrates a case where it is factually determined that a portion of the difference between basis and AIP on the date of acquisition is due to market interest rates and a portion relates to expected future payments in amounts that differ from the projected payment schedule. Our analysis of appropriate reporting schema consistent with these special rules causes us to believe that consistent information reporting of adjustments to basis, interest/OID, potential ordinary loss, etc. in cases of such partial allocations are potentially considerably more difficult and confusing to brokers, holders and the IRS.

Gain or Loss on Disposition Prior to Maturity: The CPDI Regs include general rules regarding the character of gain or loss on sale, exchange or retirement.

Gain is treated as interest income.³⁶ Presumably, if a CPDI subject to cost basis reporting is sold and the amount of basis reported by the broker is less than the proceeds reported from such sale, such broker should check the new ordinary box added to the 2016 Form 1099-B. Because other types of ordinary income could arise on the disposition of a covered security (such as Sec. 988 foreign currency gain or loss), the ordinary box may not adequately capture such nuances.

Loss is treated as ordinary loss ". . . to the extent that the holder's total interest inclusions on the debt instrument exceed the total net negative adjustments on the debt instrument the holder took into account as ordinary loss."³⁷ Presumably the new ordinary box added to the 2016 Form 1099-B should be checked if the broker has calculated and tracked net negative adjustments and has determined that the holder is entitled to all or portion of a loss on disposition being treated as ordinary under this rule (although this could be confusing if only a portion of the loss can be treated as ordinary). Because only a portion may be treated as ordinary, how does a holder or the IRS determine if the ordinary loss limitation of the CPDI Regs was applied and if so, how much loss is permitted to be recognized as ordinary? If a broker's computations indicate that a holder's basis exceeds the amount realized by an amount greater than the amount permitted as being treated as ordinary under the CPDI Regs, should the broker also check the long-term or short-term holding period related boxes?

A special rule generally applies providing no ordinary interest or ordinary loss treatment if there are no remaining contingent payments on the CPDI at time of disposition.³⁸

Disposition of a CPDI with a net negative carryforward results in a reduction of the amount realized at disposition as previously described.³⁹ As previously discussed, if the reduction is not reflected in proceeds reported on Form 1099-B, a holder in many cases may not be aware that they are entitled to a capital loss. Conversely, if the definition of proceeds is revised and proceeds reported on Form 1099-B are reduced, how will a holder readily reconcile the amount reported with the actual proceeds received?

What are the consequences if all or portion of any difference between a holder's basis in a CPDI on the date of acquisition and its AIP is allocated to expected future contingent payments and they have not yet been taken into account under the net adjustment rules because the related actual payments have not yet occurred? The loss rule described above references net negative adjustments that the holder "took," implying that such loss rule only applies if actual payments have occurred and net negative adjustments have arisen. It does not appear relevant regarding the consequences of "suspended" negative adjustments arising under the special rules of the CPDI Regs.⁴⁰ The holder's basis continues to include such related amounts unless and until the adjustments are applied.⁴¹ The suspended adjustments simply increase the amount of loss recognized. Ordinary loss treatment should apply to such amounts to the extent of prior ordinary income.⁴² If the suspended adjustments are positive, the holder's basis remains low, resulting in gain on disposition that the general gain rule would treat as ordinary and the ordinary box on the 2016 Form 1099-B would be checked.⁴³ We don't see a difficulty with this rule, although we are concerned that some retail investors may be confused by this result.

1. Information Reporting for CPDI: For the reasons discussed above, because CPDI income and basis adjustments for particular tax lots are determined under the net positive and negative adjustment rules rather than as bond premium, acquisition premium or market discount, the existing information reporting rules do not provide adequate detail to permit the IRS or taxpayer to easily reconcile these adjustments for any CPDI with actual payments that differ from projected payments or if lots are acquired at a price (either on issue or in the secondary market) different than the adjusted issue price. Accordingly, we recommend that either the IRS treat all CPDI as noncovered for cost basis reporting purposes or revise Form 1099-OID and 1099-B reporting to explicitly address these issues and adequately report the adjustments described above. Specific items that require guidance are:

3. There is no systematic method of tracking how much of any net negative adjustment is available to be applied in future years, which creates both risks of confusion and double-counting. Because these amounts are determined during a calendar year when net negative adjustments exceed the amount of OID accrued, we recommend a separate box be added to Form 1099-OID for reporting this information.

4. When there is an unused net negative adjustment carryforward or a net negative adjustment at disposition or at maturity, such amount reduces the amount realized upon disposition as described above, thereby generating a likely capital loss (where basis exceeds the amount realized). However, the definition of proceeds reported on Form 1099-B does not reflect this adjustment and therefore a taxpayer and the IRS do not readily know such a loss is available. We recommend that either such amount be separately reported on Form 1099-B or that the definition of gross proceeds be revised to require adjustment for such carryforwards or adjustments.

5. When both ordinary loss and capital loss arise in connection with the disposition or maturity of a CPDI, it is unclear whether both the ordinary and long-term capital boxes should be checked. We believe that the check-box marked on Form 1099-B should be set to long-term rather than ordinary (because the ordinary loss is separately determined and not part of the computation of loss as basis in excess of amount realized). We recommend clarifying guidance might be helpful so that the taxpayer reports the loss correctly.

6. We believe that it is inappropriate to require brokers to perform computations for CPDI when a CPDI is acquired at basis different than its adjusted issue price under the CPDI Regs in their present form because this places an undue burden on brokers to determine the extent to which the amounts of differences between basis and AIP are reasonably allocated to market interest rates or future contingent payments. We recommend that the cost basis regulations provide a special safe harbor rule as described below for determining the allocation of such differences that would minimize the burden of allocation. We considered recommending that CPDI acquired at a basis different from the AIP be treated as noncovered securities. However, we concluded that the complexities of AIP calculations and basis comparisons create a substantial burden on brokers under the existing CPDI Regs as discussed above in simply determining whether a holder's basis is different from AIP. Thus, if our recommendation for a special safe harbor is not adopted, we reiterate our prior recommendation of treating all CPDI as noncovered securities.

Recommended Broker Safe Harbor

We recommend a special safe harbor rule for broker cost basis reporting purposes only (and to avoid additional broker compliance complexities, we recommend that these rules be mandatory)⁴⁴ that broadens the safe harbor for exchange listed debt instruments in the CPDI Regs⁴⁵ by eliminating (for broker cost basis reporting purposes only) the limitations of availability of the safe harbor to exchange listed instruments and to a yield not lower than applicable Federal rate. Brokers are required to provide cost basis for non-exchange listed debt and therefore we believe that not expanding the safe harbor as currently set forth in the CPDI Regs would force brokers to stand ready to perform burdensome allocation calculations for such non-exchange listed debt. Moreover, it may be more difficult for brokers to obtain data to make any required allocation for such non-listed debt. We believe that the applicable Federal rate limit could be a problem for debt issued since 2008 because of low market interest rates. We are already seeing signs of zero or minimal yield acquisitions of debt and this restriction also forces brokers to make burdensome allocations if it were to apply. Instead, allocations of a difference between basis and AIP to market interest rates only works if it does not result in a negative yield. Thus, we recommend that in those cases where the expanded safe harbor method results in a yield below zero, that the method is not available. Instead, we recommend that in those cases, the broker safe harbor method would further provide that brokers would allocate the entire difference to expected actual versus projected payments. If there were more than one future projected payment, any such difference would be allocated proportionately. We believe an actual determination of allocation of any difference to expected future payments will be problematic and unduly burdensome for brokers in the case of two or more expected actual payments left to maturity. Thus, our recommendation to proportionately allocate any difference to remaining projected payments facilitates straightforward implementation and will provide simple and consistent distribution of such amounts.

7. To the extent our recommendations to exclude CPDI from treatment as covered securities for cost basis reporting purposes are not accepted, we are concerned that due to reasonable allocations of such basis differences to market interest rates, a holder's interest/OID for a calendar year will be different from the amount determined based upon Baseline OID. As previously mentioned, the forms and instructions are not explicit in stating that a payor is obligated to report the correct amounts for such holder even though it differs from the amount based upon Baseline OID because of the broad definition of interest under the Code. However, unless the correct amount for such holders are reported, OID reported on Form 1099-OID may not reconcile with a broker's adjustments to basis required under the cost basis reporting regulations. Such a result seems inconsistent with both tax policy and the addition of bond premium and acquisition premium reporting on Forms 1099-INT and OID. We recommend that these adjustments be separately stated on Form 1099-OID in a manner similar to net positive and negative adjustments as discussed above.

8. The acquisition of a CPDI at a basis different from its AIP creates the same series of issues about the reporting of amounts on Form 1099-OID and 1099-B as described above. We recommend that the boxes and instructions to the forms be revised to address adjustments resulting from the allocation of differences to market interest or basis as described in the CPDI Regs and as illustrated by Example 1 therein.

9. Transfer reporting for CPDIs. We recommend that in order for a receiving broker to be able to consistently compute and report OID and the other adjustments described above, that the IRS clarify that the projected payment schedule, comparable yield, any carryforward losses, actual prior payment history and the allocation of any basis difference should be provided for all CPDI as part of transfer reporting.

We would be pleased to discuss our concerns further at your convenience. Please call or contact me with any questions.

² It is often stated that CPDIs are rarely traded in the secondary market. However, because a number of CPDIs have been publicly issued, it is not clear how often initial purchasers might be purchasing such securities at a price different than issue price (which creates the same problem). The wide public issuance of CPDIs along with debt-like derivatives, particularly given the low market interest rate environment that began after 2008, has created a greater likelihood that secondary market trading occurs. Available reference data indicates that there are generally approximately 4,000 to 6,000 publicly traded CPDIs outstanding at any time. This number does not include CPDI that is classified for operations purposes as "convertible securities." Available reference data also indicates that there are generally approximately 1,600 publicly traded convertible securities outstanding at any time. Our analysis indicates that some of the securities that are classified for operations purposes as convertible securities are in fact CPDI while others are non-debt investment units such as exchange-traded notes. IRS Pub. 1212's guidance on tax return reporting for CPDI suggests that many of the burdens of adjustment calculations are placed on the taxpayer rather than a payor as part of Form 1099-OID reporting, which is inconsistent with a broker's cost basis reporting burdens for CPDI acquired on or after January 1, 2016. Moreover, we question whether this approach is outdated and are not certain that simply leaving such burdens on taxpayers for covered CPDI is consistent with the recent revisions to Form 1099-INT and -OID reporting relating to bond premium and acquisition premium.

³ Reg. Sec. 1.1275-4(b)(6)(i)

⁴ Reg. Sec. 1.1275-4(b)(6)(ii)

⁵ The adjustment is characterized as interest and interest is generally reportable under IRC Sec. 6049.

⁶ Reg. Sec. 1.1275-4(b)(6)(iii)(A)

⁷ Reg. Sec. 1.1275-4(b)(6)(iii)(B)

⁸ Although described as an ordinary loss, the adjustment clearly serves as a reduction to interest which we believe supports reporting under IRC Sec. 6049, similar to bond premium and acquisition discount.

⁹ Reg. Sec. 1.1275-4(b)(6)(iii)(C)

¹⁰ See Reg. 1.1275-4(b)(7)(iii) and IRS Pub. 1212 (December 2015), page 11. Only actual noncontingent payments received and the projected payment amounts (rather than actual amounts) based on the related scheduled payment date reduce basis. However, this is only a general rule and there are exceptions where additional basis adjustments are necessary. See explicit reference therein to Reg. Secs. 1.1275-4(b)(9)(i) and (ii).

¹¹ IRC Sec. 1272(d)(2)

¹² Reg. Sec. 1.6045-1(d)(5), Draft 2016 Form 1099-B instructions, page 8.

¹³ The 2016 Draft Form 1099-B instructions, dated August 25, 2015, provide, "You are permitted to check up to 2 boxes if a portion of the gain or loss is ordinary and the remaining portion is short-term or long-term."

¹⁴ Reg. Sec. 1.1275-4(b)(9)

¹⁵ Reg. Sec. 1.6045-1

¹⁶ Reg. Sec. 1.6049-4

¹⁷ Reg. Sec. 1.1275-4(b)(9)(i)(A)

¹⁸ See Garlock, Federal Income Taxation of Debt Instruments § 904.05[A]; Harrison B. McCawley, "Noncontingent Bond Method," 535-1st Tax Mgmt. (BNA) U.S. Income, sec. V at C.3.g.

¹⁹ Reg. Sec. 1.1275-4(b)(9)(i)(B)

²⁰ Reg. Sec. 1.6049-9

²¹ Reg. Sec. 1.6045-1(n)(6)(ii)

²² See Reg. Sec. 1.1275-4(b)(9)(D)

²³ Reg. Sec. 1.1275-4(b)(9)(i)(B)

²⁴ Reg. Sec. 1.1275-4(b)(9)(i)(C)

²⁵Id.

²⁶ Reg. Sec. 1.1275-4(b)(9)(i)(B)&(C)

²⁷ Reg. Sec. 1.1275-4(b)(7)(iii)

²⁸ Thus, positive and negative adjustments relating to actual versus projected payments do not affect a holder's adjusted basis while those relating to a difference between the holder's basis on the date of acquisition and the CPDI's AIP must subsequently be taken into account in determining adjusted basis ---a little confusing, n'est-ce pas?

²⁹ Reg. Sec. 1.1275-4(b)(9)(i)

³⁰ Reg. Sec. 1.6049-9. See 2016 Form 1099-INT, box 11 and 2016 Form 1099-OID, boxes 6 and 10.

³¹ See the Preamble to T.D. 9750.

³² Reg. Sec. 1.1275-4(b)(9)(i)(F)

³³ Reg. Sec. 1.1275-4(b)(6)(iii)(B)

³⁴ Reg. Sec. 1.6045-1(a)(9)

³⁵ Reg. Sec. 1.1275-4(b)(9)(i)(F)

³⁶ Reg. Sec. 1.1275-4(b)(8)(i)

³⁷ Reg. Sec. 1.1275-4(b)(8)(ii)

³⁸ Reg. Sec. 1.1275-4(b)(8)(iii)

³⁹ Reg. Sec. 1.1275-4(b)(6)(iii)(C)

⁴⁰ Reg. Sec. 1.1275-4(b)(9)(i)(A)

⁴¹ See Reg. 1.1275-4(b)(9)(i)(B)

⁴² See Reg. 1.1275-4(b)(8)(ii)

⁴³ See Reg. 1.1275-4(b)(8)(i)

⁴⁴ Similar to the modification of the cost basis reporting regulations permitting brokers to ignore the "all OID election" under Reg. Sec. 1.6045-1(n)(11)(i)(A)

⁴⁵ Reg. Sec. 1.1275-4(b)(9)(i)(E))