Yesterday, the U.S. Internal Revenue Service (IRS) released Notice 2018-80, announcing that it will issue proposed regulations under section 451(b) of the Internal Revenue Code (Code) to provide that accrued market discount is not includible in income under that section.
Accrual basis bond holders and, in particular, mutual funds holding tax-exempt bonds with market discount, have been waiting intently for this clarification (relief) as the new section 451(b) provisions had already come into effect as of January 1, 2018 as part of the 2017 Tax Cuts and Jobs Act (TCJA or more properly P.L. 115-97). Taxpayers had differed on whether the section 451(b) rules applied to accrued market discount on bonds. If they applied, it would change the timing of inclusion of market discount to a book accounting methodology rather than under current tax rules where accrued market discount under section 1276(a), absent a section 1278(b) election, is not taken into income until the tax year in which a disposition or redemption of or a principal payment on the bond occurs.
Tax-exempt bond investors and mutual funds holding tax-exempt bonds were especially concerned since market discount on a tax-exempt bond is taxable. Certain mutual funds were caught in an especially difficult conundrum since applying the rules (and overriding current tax treatment of accrued market discount) had the potential to cause unexpected tax results flowing to their shareholders but not applying them and having to reverse their position subsequently due to contrary IRS guidance would have affected current distribution calculations, qualification testing and tax reporting (likely requiring correction of tax forms).
The Notice clarified that section 451(b) income inclusion rules would not apply to market discount. Consequently, the current tax rules under section 1276(a) still apply. Moreover, the guidance in the notice is applicable retroactive to January 1, 2018.
Some additional background may be helpful in understanding the notice and its relatively short statement.
Less discussed than other provisions of the TCJA, the section 451(b) amendment affects how accrual taxpayers apply the “all events test” for income recognition. Under the “all events test,” accrual basis taxpayers recognize income in the taxable year in which “all the events have occurred which fix the right to receive such income and the amount of such income can be determined with reasonable accuracy.” The TCJA amendment provided (with certain exceptions) that the all events test with respect to an item of gross income cannot be treated as met any later than when such income item is taken into account as revenue in an applicable financial statement (e.g., US GAAP financial statement in a 10K). Tax was, thus, set to conform to book.
Section 451(b) refers specifically to part V of subchapter P of the Code (which includes the market discount provision under section 1276(a)) as within the purview of the section 451(b). Thus, some taxpayers and tax practitioners were concerned that this would change the current tax treatment of market discount on bonds to one where market discount would need to be included currently in income based on book accounting even absent a disposition event or a principal payment.
The uncertainty, at least for market discount, is alleviated with this notice, though practitioners are reminded that new section 451(b) could potentially have wider, sometimes unexpected, impact on other areas of tax law.
Notice 2018-80 is available here: https://www.irs.gov/pub/irs-drop/n-18-80.pdf