Taxing Market Discount on Distressed Debt

Abstract

The statutory rules regarding the timing and character of income and losses on debt instruments overtax distressed debt investors. Investors that make profitable investments in distressed debt are likely to have some or all of their income tainted as market discount and hence ordinary income, whereas investments that turn out badly are highly likely to generate capital losses. Taxable income is also sometimes accelerated relative to economic income. Despite widespread agreement on the nature and extent of the problems, there is lack of consensus on whether the inappropriate outcomes that are generated by the statutory rules are tempered by common law doctrines. There is also disagreement regarding how policymakers should address the problem. I first summarize how the statutory rules generate inappropriate outcomes, then offer a new perspective on how the statutory and common law rules governing distressed debt interrelate, and finally explain and evaluate the options for reform.

Keywords: tax, tax policy, financial instruments, debt

JEL Classification: K34, H24, H25, G32