Corporate Bonds

March 13, 2024

7637 / How is a convertible bond taxed on conversion?

<div class="Section1">Ordinarily, a convertible bond is one that is exchangeable, at the holder’s option, into a specified number of the company’s common shares at a fixed price within a certain time period–usually up to the maturity of the bond. A bond may also be issued in such a form as to grant to the holder a right to convert the bond into another debt instrument of the issuing company.<div class="Section1"> Gain or loss is not recognized when, under the terms of a bond convertible into stock of the issuing corporation, the bond is exchanged for (converted into) that stock. This is true whether or not the fair market value of the stock exceeds the holder’s adjusted basis in the bond and any additional amount paid on exercise of the conversion right. The holder’s basis in the stock is the adjusted basis in the bond plus any amount paid on conversion.<a href="#_ftn1" name="_ftnref1">1</a> It is unclear whether the same tax treatment would apply upon the conversion of a bond convertible into another bond of the issuer. The conversion of a bond (in accordance with its terms) into stock of a different corporation is a taxable event (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7635">7635</a>).<a href="#_ftn2" name="_ftnref2">2</a> For the treatment of original issue discount (OID) in the case of a convertible bond, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7638">7638</a>. For the treatment of the sale of stock acquired on conversion of a market discount bond, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7648">7648</a>. For the treatment of a convertible bond that is part of a conversion transaction (as defined in IRC Section 1258), see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 72-265, 1972-2 CB 222. <a href="#_ftnref2" name="_ftn2">2</a>.   Rev. Rul. 69-135, 1969-1 CB 198. </div></div>

March 13, 2024

7636 / How is the donor of a corporate bond taxed on interest that has accrued prior to the date of the gift?

<div class="Section1">Interest accrued, but not yet due, on corporate bonds (and Treasury bonds and notes) before the date of a gift is includable as ordinary income in the donor’s income for the taxable year during which the bond interest is actually or constructively received by the donee. Therefore, the donor will not necessarily be taxed on such income in the year in which the gift is made. Amounts received from interest accruing after the transfer date are includable in the gross income of the donee.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> For treatment of accrued market discount in a disposition by gift, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7646">7646</a>. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7679">7679</a> regarding gifts of Series E and EE bonds. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 72-312, 1972-1 CB 22. </div></div>

March 13, 2024

7635 / How are proceeds on the sale or retirement of a corporate bond taxed?

<div class="Section1">(1) If the sale occurs between interest due dates, as it generally does, stated interest accrued to the date of sale but not yet due is customarily added to the purchase price. This must be included in the seller’s income as interest.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> (2) Proceeds in excess of item (1), above, are recovered tax-free to the extent of the investor’s adjusted basis in the bond.<a href="#_ftn2" name="_ftnref2">2</a> As a general rule, the investor’s adjusted basis is the cost of acquisition adjusted by (a) adding any original issue discount (OID) included in income as it accrued (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7652">7652</a>) and market discount included in income prior to the sale (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7646">7646</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7647">7647</a>), or (b) subtracting amounts of premium deductible or applied to reduce interest payments if an election was made to amortize bond premium (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7654">7654</a>). (3) Ordinarily, amounts in excess of interest and basis are treated as capital gain (long-term or short-term, depending on the investor’s holding period). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="699">699</a> regarding holding periods and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses. However, if the bond was originally issued at a discount or was purchased on the market at a discount, part or all of the gain must be treated as interest instead of capital gain, if the discount was not included in income as it accrued. (Discount that is less than ¼ of 1 percent (.0025) of face value multiplied by the number of complete years to maturity is considered no discount.) (a) If the bond was issued after July 18, 1984, or if the bond was issued on or before July 18, 1984, and purchased on the market after April 30, 1993, gain to the extent it does not exceed market discount must be treated as interest income, not capital gain (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7643">7643</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7647">7647</a>). If a bond issued on or before July 18, 1984 was acquired after July 18, 1984, but before May 1, 1993, at a market discount using borrowed funds, a part of the gain must be treated as ordinary income if a deferred interest expense deduction is taken (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>). (b) If the bond was originally issued at a discount of ¼ of 1 percent (.0025) or more of the face amount multiplied by the number of full years from issue to maturity and the seller had not purchased the bond at a premium, a part of any gain realized is treated as ordinary income in the following cases: If the bond was issued after May 27, 1969, OID is includable in income annually (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7652">7652</a>) and basis is adjusted for amounts included.<a href="#_ftn3" name="_ftnref3">3</a> However, if at the time of original issue there was an intention to call the bond in for redemption before maturity, gain on sale or redemption is ordinary income up to the entire amount of the OID reduced by the portions of OID previously includable in income by any holder.<a href="#_ftn4" name="_ftnref4">4</a> An intention to call is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7653">7653</a>. The amount of OID allocable to each day, in the case of bonds issued after July 1, 1982, is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>; the amount allocable to each month in the case of bonds issued on or before July 1, 1982, and after May 27, 1969, is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7652">7652</a>. If the bond was issued on or before May 27, 1969, and after December 31, 1954, any gain realized on sale or redemption is taxed as ordinary income to the extent of an amount that bears the same ratio to the total OID as the number of full months the bond was held by the taxpayer bears to the number of full months from issue date to maturity date. Days amounting to less than a full month are not counted. The period the taxpayer held the bond must include any period it was held by another person if the bond has the same basis, in whole or in part, in the taxpayer’s hands as it would have in the hands of the other person.<a href="#_ftn5" name="_ftnref5">5</a> However, if there was an intention at the time of issue to call the bond before maturity, gain up to the entire OID is included as ordinary income.<a href="#_ftn6" name="_ftnref6">6</a> If the obligation was issued before 1955, the Supreme Court has ruled that OID serves the same purpose as interest and should be taxed as ordinary income rather than capital gain.<a href="#_ftn7" name="_ftnref7">7</a> (4) If there was a loss on the sale or redemption, no OID or market discount is recovered. Loss will be treated as a capital loss. However, if “substantially identical” obligations were acquired (or a contract for their acquisition was made) within 30 days before or 30 days after the sale, the loss will be subject to the “wash sale” rule discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7537">7537</a>.If the sale is made to a related party, the loss deduction may be disallowed (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="701">701</a>). (5) Amounts received on retirement are treated as amounts received on sale (but for obligations issued before 1955, only if the obligation was in coupon or registered form on March 1, 1954).<a href="#_ftn8" name="_ftnref8">8</a> The installment method for reporting gain is not available for securities traded on an established securities market. As a result, gain from sale is included in income for the year in which the trade date occurs even if one or more payments are received in the subsequent tax year.<a href="#_ftn9" name="_ftnref9">9</a> If a corporate bond was held as part of a tax straddle, the additional rules and qualifications explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7593">7593</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7614">7614</a> apply. If a bond was held as part of a conversion transaction, the additional rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> will apply. If principal or interest was in default and the bond was bought or sold “flat,” see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7671">7671</a>. Generally, neither gain nor loss is recognized on a transfer between spouses, or between former spouses if incident to divorce (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="789">789</a>).<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Treas. Reg. § 1.61-7(d). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1001(a). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1272(d)(2). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1271(a)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   Treas. Reg. § 1.1232-3(c). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1271(c). <a href="#_ftnref7" name="_ftn7">7</a>.   U.S. v. Midland-Ross Corp., 381 U.S. 54 (1965). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC §§ 1271(a), 1271(c). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 453(k). See Rev. Rul. 93-84, 1993-2 CB 225. <a href="#_ftnref10" name="_ftn10">10</a>.   IRC § 1041. </div></div>

March 13, 2024

7634 / What amounts are included in current income by an investor who holds a taxable corporate bond?

<div class="Section1">(1) Interest that accrues after the date of purchase is included as ordinary income in the year in which it is received or made available.<a href="#_ftn1" name="_ftnref1">1</a> As a general rule, interest is considered received on the date the interest check is received, if the bond is registered, or on the date the coupon matures, in the case of a bearer coupon bond.<a href="#_ftn2" name="_ftnref2">2</a> (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="662">662</a> for an explanation of the doctrine of constructive receipt.) If the investor purchased the bond between interest dates and the investor paid the seller interest accrued but not yet due at that time, he or she receives that amount as a tax-free return of capital out of the first interest payment received. The investor includes in income only the balance of the interest.<a href="#_ftn3" name="_ftnref3">3</a> If principal or interest was in default at the time of purchase and the bond traded without allocation of price between principal and accrued interest, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7671">7671</a>.<div class="Section1"> (2) If the holder purchased the bond at a premium, he or she may elect to amortize a part of the premium each year and reduce basis by the amount deductible (or applied to reduce interest payments) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7654">7654</a>). (3) Unless the bondholder purchased the bond at a premium (i.e., at an amount in excess of the face value of the bond), the holder of a bond originally issued at a discount after May 27, 1969, must include in income a portion of the original issue discount (OID). However, if the discount at issue was less than ¼ of 1 percent (.0025) of the stated redemption price multiplied by the number of full years from the date of original issue to maturity, the bond is treated as if it were not issued at a discount and no part of the discount is included in income as it accrues.<a href="#_ftn4" name="_ftnref4">4</a> OID on bonds issued after May 27, 1969, and on or before July 1, 1982, accrues as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7652">7652</a>.OID on bonds issued after July 1, 1982, accrues as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7650">7650</a>. (4) If the bond was issued after July 18, 1984, or if the bond was issued on or before July 18, 1984, and was purchased after April 30, 1993, and the purchase occurred on the market at a discount of ¼ of 1 percent (.0025) or more of the stated redemption price at maturity multiplied by the number of years until maturity, a cash basis investor must include the market discount in income as it accrues if he or she has made an election to include accrued market discount with respect to that bond or other market discount obligations, as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>.<a href="#_ftn5" name="_ftnref5">5</a> (5) Any partial payment of principal on a market discount bond acquired after October 22, 1986, is treated as a payment of market discount and included in income to the extent that market discount has accrued up to that time.<a href="#_ftn6" name="_ftnref6">6</a> Where principal is to be paid in two or more payments, the amount of accrued market discount will be determined under regulations.<a href="#_ftn7" name="_ftnref7">7</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Treas. Reg. § 1.61-7. <a href="#_ftnref2" name="_ftn2">2</a>.   Treas. Reg. § 1.451-2(b); Lavery v. Comm., 158 F.2d 859 (7th Cir. 1946); Obland v. U.S., 67-2 USTC ¶ 9751 (E.D. Mo. 1967). <a href="#_ftnref3" name="_ftn3">3</a>.   L.A. Thompson Scenic Ry. Co. v. Comm., 9 BTA 1203 (1928); Rev. Rul. 69-263, 1969-1 CB 197. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC §§ 1272(a), 1272(b), 1273(a)(3); see Treas. Reg. § 1.1232-3. <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1278(b). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1276(a)(3). <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 1276(b)(3). </div></div>

March 13, 2024

7638 / How is original issue discount (OID) determined in the case of a convertible bond?

<div class="Section1">No adjustment is made for the value of the conversion feature of a bond convertible into stock or another debt instrument of the issuer or a related party in calculating the bond’s issue price for purposes of determining whether the bond was issued at an original issue discount.<a href="#_ftn1" name="_ftnref1">1</a> Under regulations, the issue price of a bond convertible into stock or another debt instrument of the issuer includes any amount paid for the conversion privilege, even if the privilege may be satisfied for the cash value of the stock or other debt instrument.<a href="#_ftn2" name="_ftnref2">2</a> For debt instruments issued on or after February 5, 2013, this includes the equity interests of entities classified as partnerships as well as those classified as corporations for tax purposes. Although the regulations are effective for bonds issued after April 3, 1994, taxpayers may rely on the regulations for bonds issued after December 21, 1992. (However, under amendments (issued February 28, 1991) to the 1986 proposed regulations, a portion of the bond’s issue price was allocable to the conversion feature if the conversion feature could have been satisfied in cash. This amendment was modified by further proposed regulations (issued December 22, 1992) and is not mentioned in the final regulations (adopted January 27, 1994).)</div> <div class="Section1"> Bonds that are convertible into stock or a debt instrument of a corporation other than the issuer are valued under the noncontingent bond method.<a href="#_ftn3" name="_ftnref3">3</a> This method provides for a projected payment schedule consisting of all noncontingent payments and a projected amount for each contingent payment.<a href="#_ftn4" name="_ftnref4">4</a> Except in the case of a contingent payment that is fixed more than six months before it is due, the projected payment schedule generally remains fixed throughout the term of the debt instrument and any income, deductions, gain, or loss attributable to the debt instrument is based on this schedule.<a href="#_ftn5" name="_ftnref5">5</a> (Proposed regulations formerly provided for valuing the bond and conversion feature separately and allocating the issue price to the separate components.) The Service has ruled that the noncontingent bond method applied to a debt instrument that was convertible into stock of the issuer and that also provided for one or more contingent cash payments.<a href="#_ftn6" name="_ftnref6">6</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. §§ 1.1232-3(b)(2)(i); 1.1273-2(j). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.1273-2(j). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.1275-4(b)(1). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.1275-4(b)(2). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.1275-4(b). <a href="#_ftnref6" name="_ftn6">6</a>. Rev. Rul. 2002-42, 2002-2 CB 76. </div>