When a taxpayer purchases a debt instrument in the secondary market at a discount to its face amount, the discount generally is subject to tax under special "market discount" rules. Under those rules, unless a taxpayer elects to accrue market discount on a current basis as interest income, the market discount rules treat any gain on the disposition of the bond as ordinary interest income up to the amount of "accrued market discount" determined under either a ratable accrual method or a constant yield method. Absent the market discount rules, the entire gain on disposition of a debt instrument would be treated as capital gain, which enjoys a more favorable tax rate.

One justification for treating market discount as ordinary interest income is that the yield on a secondary market bond generally should equal the yield on a newly issued equivalent debt instrument of the same issuer and, in the latter case, the entire yield generally is treated as interest. Accordingly, under this theory, market discount should be considered economically equivalent to interest income and should be treated as such for tax purposes.

When a bond is trading at a substantial discount due to a deterioration in the credit quality of the issuer, however, some commentators and practitioners argue that the market discount rules should not apply, on the theory that the market discount on a distressed bond is not attributable to fluctuations in interest rates or reasonable commercial declines in credit quality of the issuer. Instead it is attributable to a substantial decline in credit quality of the issuer precipitated by an exceptional crisis. Investors discount the price of such an instrument based on an expectation of default by the issuer. Accordingly, in these circumstances, arguments can be made that market discount should be considered akin to an "equity" return rather than interest.

All of this said, the market discount rules are broad and can be read literally to apply to any discount on distressed debt. In addition, it is not entirely clear how to draw the line beyond which a debt instrument should be viewed as sufficiently distressed such that the nature of any gain is not essentially equivalent to interest income. That is, how deep does the discount have to be to be considered equity in nature? The answer, if there is one, is not readily apparent.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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