If you have ever invested in a bond, you will know that the terms of the bond are spelled out in excruciating detail: excruciating detail: the principal amount of the issue, the interest rate that will be paid, the first date that the bond begins to earn interest, the dates that interest will be paid, the date that the principal will be repaid, the collateral that secures the debt, etc. All of these terms defined in advance of the issue and disclosed to investors before any money changes hands. Have you ever wondered what happens if someone wants to change one of those terms?
It does not happen often. But in these days of historically low interest rates, it is happening occasionally. The most common reason is early redemption. Most bonds issued today have call features that allow the issuer to redeem the principal earlier than the scheduled maturity date. But that has not always been true. So a corporate issuer that issued a bond in 2006 at 5 1/4 % for 20 years may have thought that they were getting good terms and didn’t need to include any early redemption features. However when interest dipped to 2%, you can bet the CFO is looking for ways to reduce that interest cost.
The bad news for the CFO is that unlike your mortgage, most corporate and municipal debt cannot simply be paid off early if the issue has the funds available. The issuer is liable for interest payments through maturity.
A consent payment is a payment made by the issuer of a debt instrument to holders as compensation for the holders’ agreement to a change in the terms of the bond issue. A simple example of a change in terms is when the bond holder agrees to an early redemption of a bond that is not callable or otherwise redeemable before maturity. Another example might be allowing the issuer to substitute for some of the collateral assets that are securing the debt.
The question that faces brokers when a consent payment is made is, “how is the payment classified from a tax perspective?” Is it some form of income, like interest, discount, or miscellaneous income? Is it an adjustment to basis? If not, what is it?
Unfortunately, the Internal Revenue code is not particularly clear on this point, as is often the case. The treatment can vary depending on the terms of the payment and its effect on the debt instrument. For example, does the payment effectively change the yield of the debt instrument? Tax treatment can vary. The best we can say is that to date, the IRS has not found that the consent payment is reportable by brokers on any form 1099. And, in all the cases I have seen so far, the payment is not an adjustment to the holder’s basis. Generally, the treatment of consent payments for the bond holder has been that the payment is taxable as ordinary income. The legal opinions usually describe the payment as a “fee” paid by the debtor to its creditors.
From a broker’s perspective, this payment is then a credit to the bond holder, but it is not reportable on any 1099 and it is not an adjustment to basis. It may be taxable as ordinary income to the recipient, but that determination must be made on a case by case basis by the taxpayer.
So brokers should classify this payment in a way that does not include it in any of the categories that are rolled up to the various 1099s that the broker produces. It would be useful to provide the details of the payment to clients as supplemental information on a year-end tax statement. Although the broker cannot provide a definitive instructions for the client for how or where to claim this payment, they can at least provide the client a reminder of an issue that needs to be addressed with a tax advisor.
Blog contributed by Bob Linville, Director Tax and Cost Basis Product Management at Scivantage. Bob is former co-chair of the FIF Back Office Committee and is currently Chairman of FIF’s Cost Basis Working Group and DTCC’s CBRS Steering Committee.