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Stimulus conference OID relief comes up short
February 13, 2009
The conference version of the stimulus monstrosity provides a narrow break for corporations that issue "applicable high-yield debt obligations." The tax law normally haircuts interest deductions for corporations on certain debts that carry an interest rate six or more percentage points higher than the applicable federal rate. The bill provides limited relief (Section 1232) for some obligations issued from September 1, 2008 through December 31, 2009.
The bill (Sec. 1231) also gives taxpayers with debt forgiveness income the option of taking the income into account over a five-year period. If the debt forgiveness creates an original issue discount obligation, the OID deduction would also be deferred.
This bill fails to address the obscure tax issue that makes it difficult for banks to liquify by selling off bad loans: the "Cottage Grove" income recognition rules of Regs. Sec. 1.1001-3. These rules cause phantom income to anybody who buys a bad loan and restructures it. It works like this:
- I buy a bad loan from Sadder and Wiser Bank. The loan has a face value of $100,000, and I buy it for $50,000, which is what the bank thinks it is worth.
- I then sit down with the debtor, and we figure out a way for him to pay off $70,000 of the $100,000 balance. We rewrite the debt to reflect a $70,000 balance, and he agrees to resume making payments on the $70,000 balance, at the old interest rate.
Under this deal, the debtor has $30,000 debt-forgiveness income (which the conference bill would allow him to defer over five years), but I have a $20,000 gain on a "deemed" sale for $70,000 of the bad loan I bought for $50,000. That gain, of course, comes before I see a dime from the debtor. The conference bill does nothing to fix this foolish Treasury policy, a policy that makes it harder for banks to liquify their troubled loan portfolio.
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