Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011

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Taxation of Financial Products and Transactions Practicing Law Institute -- Tax Policy Lessons From the Crash. Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011. Disclaimer. - PowerPoint PPT Presentation

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  • Taxation of Financial Products and Transactions

    Practicing Law Institute -- Tax Policy Lessons From the Crash

    Andrew NeedhamMatthew StevensMichael NoveyViva Hammer

    January 26, 2011

  • Disclaimer

    ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

  • *Accrual of OID on Distressed Debt

    X, an accrual method taxpayer, buys a $1000 distressed bond for $200. On the date of original issue, the bond had an issue price of $1000 and a 10% coupon. At the time of purchase, X did not expect to collect more than $1000 on the bondMust X continue to include the 10% interest as it accrues?No: an accrual method taxpayer has no obligation to report stated interest of doubtful collectibilityBut what if the bond paid interest at the same rate, but either in-kind or at maturity?In TAM 9538007, the IRS concluded that the doubtful collectibility doctrine does not apply to OIDWas it right?What about the $800 of market discount?

  • *Accrual of Market Discount on Distressed DebtMarket discount is defined as the excess of the face amount of a debt instrument over the taxpayers basis in the debtUnder the statute, therefore, X acquired the bond at a market discount of $800Assume that X ultimately collects $400 on the bond, realizing a $200 gainX must therefore report the $200 gain as ordinary income, but only to the extent of the accrued market discountSo what portion of the $200 gain represents accrued market discount?Is any of it market discount?

  • *Do the Market Discount Rules Even Apply to Distressed Debt?

    No guidance from the IRS or Treasury. Must X continue to include the 10% interest as it accrues?The 2010-2011 Priority Guidance Plan released in December by Treasury and the IRS includes guidance relating to accruals of interest (including discount) on distressed debtUntil then, we are left with Common Law Doubtful collectibility doctrineTAM 9538007Legislative HistoryWhat about common sense?

  • *The Economics of Debt Prices: Interest RatesBond prices are sensitive to interest rates:This is because the bond now pays interest at a below market rate, causing the price of the bond to fall.SimilarlyWhen interest rates go downBond prices go up%%$$This is because the bond now pays interest at an above market rate, causing the price of the bond to rise

  • *The Economics of Debt Prices: Financial Distress

    But suppose that the discount arises not from an increase in interest rates, but from a (severe) decline in credit quality?What happens to the price of a bond under these conditions?Does it depend upon the bonds maturity date?Does it depend upon the bonds seniority within the capital structure?Lets look at some empirical data

  • *The Lehman Brothers Debacle in 2008

    Lehman Brothers bonds of every maturity converged to the same price, culminating in the largest bankruptcy in U.S. history

    Chart3

    98.31892.75192.133

    97.83888.46488.983

    97.00286.80779.624

    97.36887.57380.528

    96.09886.54177.808

    96.12985.94976.642

    96.16586.17777.146

    96.2284.26577.643

    96.1286.13678.632

    95.81484.81176.874

    94.60177.82976.559

    80.96768.15869.402

    78.08867.64762.526

    343434

    Bonds of Different Maturities:

    2010 Bond

    2017 Bond

    2038 Bond

    Period Preceding Bankruptcy Filing

    Price($)

    Lehman Brothers Bond Prices Leading Up to September 15, 2008 Bankruptcy

    Sheet1

    DateJan 2010 4.25% BondNov 2017 5.875% BondJan 2038 7.0% BondDec 2037 7.0% Bond

    2/01/200899.23198.55694.91394.472

    2/04/200899.28498.2797.36893.915

    2/05/200899.50898.70597.82794.355

    2/06/200899.47598.48997.55794.074

    2/07/200899.28997.20395.83492.308

    2/08/200899.34697.48896.09792.557

    2/11/200899.30797.56296.1492.589

    2/12/200899.23697.06695.53791.993

    2/13/200899.42397.21195.47991.921

    2/14/200899.40796.29794.08890.516

    2/15/200899.33996.36994.35690.796

    2/19/200899.12195.74493.71590.18

    2/20/200898.96295.47193.71390.212

    2/21/200899.296.37794.73991.213

    2/22/200899.20996.30994.41290.868

    2/25/200898.98795.33993.5890.062

    2/26/200899.12995.61793.6590.109

    2/27/200899.19995.69193.82690.289

    2/28/200899.43396.59994.84991.289

    2/29/200899.25895.69596.313100.624

    3/03/200899.21695.28395.796100.137

    3/04/200899.20295.07995.34399.71

    3/05/200898.92590.23294.09898.519

    3/06/200899.10288.14494.36198.804

    3/07/200898.93787.77393.52798.07

    3/10/200898.6987.15992.58397.162

    3/11/200898.20385.82291.69396.202

    3/12/200898.38786.49892.94997.462

    3/13/200897.91384.40389.81494.402

    3/14/200895.72181.97277.60981.805

    3/17/200894.33481.46778.10982.349

    3/18/200893.53985.49577.85382.059

    3/19/200895.72287.38178.51282.775

    3/20/200894.45887.5779.09183.395

    3/24/200895.69392.69277.92782.13

    3/25/200895.72192.89377.92982.135

    3/26/200896.38292.89984.57685.483

    3/27/200896.39991.64984.12485.027

    3/28/200896.4291.91384.23185.135

    3/31/200896.46992.11384.59685.506

    4/01/200896.9693.84388.23189.149

    4/02/200896.8493.84888.46989.386

    4/03/200896.80594.59288.45689.373

    4/04/200897.18396.30790.52291.439

    4/07/200897.07796.03490.28291.194

    4/08/200897.18696.03690.10991.025

    4/09/200897.39595.69590.90891.829

    4/10/200897.28493.66490.57791.493

    4/11/200897.39294.06990.99391.914

    4/14/200897.39192.80690.61491.536

    4/15/200897.29493.33989.9490.866

    4/16/200897.38993.81190.39491.303

    4/17/200897.16293.01590.34891.252

    4/18/200897.06193.88390.4191.314

    4/21/200898.06494.0290.77591.68

    4/22/200898.00294.02290.84791.75

    4/23/200898.01293.96190.66691.568

    4/24/200897.76293.29790.04690.936

    4/25/200897.70193.03492.29292.306

    4/28/200897.78592.90692.50292.52

    4/29/200898.1292.97492.60392.62

    4/30/200898.35493.77693.2593.266

    5/01/200898.23693.97893.29993.313

    5/02/200898.20793.84793.20193.215

    5/05/200898.28393.85193.05893.072

    5/06/200898.34393.05792.5392.545

    5/07/200898.38193.12992.56892.585

    5/08/200898.40993.19792.64192.66

    5/09/200898.44393.26692.76292.779

    5/12/200898.36993.20492.7592.764

    5/13/200898.05992.28791.72791.742

    5/14/200898.16392.09791.51191.529Date2010 Bond2017 Bond2038 Bond

    5/15/200898.31892.75192.13392.1515-May-0898.31892.75192.133

    5/16/200898.31192.68892.12392.14330-May-0897.83888.46488.98389.005

    5/19/200898.37792.88892.22592.24516-Jun-0897.00286.80779.62479.657

    5/20/200898.41592.69391.86391.88230-Jun-0897.36887.57380.52880.497

    5/21/200898.19892.11391.27291.29415-Jul-0896.09886.54177.80877.783

    5/22/200897.89591.0289.86889.8931-Jul-0896.12985.94976.642

    5/23/200898.06989.81890.5590.57115-Aug-0896.16586.17777.146

    5/27/200897.86388.94889.19289.21229-Aug-0896.2284.26577.643

    5/28/200897.85588.82989.27789.3028-Sep-0896.1286.13678.632

    5/29/200897.79788.27688.46288.4849-Sep-0895.81484.81176.874

    5/30/200897.83888.46488.98389.00510-Sep-0894.60177.82976.559

    6/02/200897.9888.96289.32989.35211-Sep-0880.96768.15869.402

    6/03/200898.12189.40190.00290.02412-Sep-0878.08867.64762.526

    6/04/200898.04988.97289.12189.14815-Sep-08343434

    6/05/200897.97289.03688.61688.643

    6/06/200898.04589.41289.11889.145

    6/09/200897.5888.98189.09689.123

    6/10/200897.2888888.31388.342

    6/11/200897.45987.88587.92487.952

    6/12/200896.97787.179.79579.827

    6/13/200896.90586.74379.53879.57

    6/16/200897.00286.80779.62479.657

    6/17/200897.11887.77679.55779.59

    6/18/200897.25987.90680.06580.097

    6/19/200897.1387.60579.88779.92

    6/20/200897.18987.66879.90779.939

    6/23/200897.10987.49179.81779.849

    6/24/200897.17887.67679.91879.95

    6/25/200897.26987.62379.99979.961

    6/26/200897.40387.56580.43380.398

    6/27/200897.40987.87180.9480.904

    6/30/200897.36887.57380.52880.497

    7/01/200897.26187.04180.36280.332

    7/02/200897.35387.28580.78580.754

    7/03/200897.44488.07480.53780.507

    7/07/200897.51188.44580.80380.774

    7/08/200897.5388.69381.2381.202

    7/09/200897.54788.76181.1681.133

    7/10/200897.42488.45880.58380.558

    7/11/200895.91186.17877.7177.684

    7/14/200896.10586.83678.52478.496

    7/15/200896.09886.54177.80877.783

    7/16/200896.11786.01876.85276.829

    7/17/200895.91885.55276.4576.427

    7/18/200895.86985.32276.29276.268

    7/21/200895.83785.38576.37276.343

    7/22/200895.81685.21476.21476.186

    7/23/200895.75784.93375.9875.952

    7/24/200896.00985.69376.69376.666

    7/25/200895.90885.17275.98775.962

    7/28/200896.06685.70176.61676.587

    7/29/200896.04785.52776.54876.585

    7/30/200895.99585.53676.39776.434

    7/31/200896.12985.94976.64276.679

    8/01/200896.16986.12876.96276.997

    8/04/200896.11886.01676.80176.837

    8/05/200896.0986.25476.48576.522

    8/06/200896.0885.9776.02176.057

    8/07/200896.20686.73976.97177.008

    8/08/200896.1686.68377.12877.164

    8/11/200896.07486.27576.65176.686

    8/12/200896.19386.7577.13277.169

    8/13/200896.07286.22976.42976.464

    8/14/200896.13285.93976.82776.861

    8/15/200896.16586.17777.14677.182

    8/18/200896.19686.35877.46577.502

    8/19/200896.23484.90777.22777.263

    8/20/200896.30584.00377.47677.511

    8/21/200896.25883.49877.31577.349

    8/22/200896.16284.69577.3177.344

    8/25/200896.21684.75777.79877.832

    8/26/200896.18184.361