Contingent Payments and the Time Value of Money | The Tax Lawyer
Updated: 5 days ago
This article was originally published in Vol. 40, No. 2 (Winter 1987) edition of The Tax Lawyer. The full pdf is linked below, and you can find it in JSTOR.
In the 1980s, the tax law “discovered” the time value of money. Timing issues had always been important, even in the early days of the income tax, although the stakes more often depended on changing tax rates, when taxpayers sought to avoid reporting income in wartime years in which tax rates spiked. But even when tax rates are stable, there is an economic benefit to deferring payment of tax, which is worth as much as a complete exemption of the return on the tax deferred.
The high inflation of the 1970s and early 1980s, accompanied by high interest rates, magnified this economic benefit, and motivated much planning for tax deferral. Rapid depreciation rules adopted in 1981 added fuel to the fire. This was the golden age of individual tax shelters, brought to an end only by the passage of the passive activity loss restrictions in 1986. This period also saw a refinement in the accrual of income on debt instruments.
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The rules that since 1969 had required straight-line amortization of original discount were modified in 1982 to require amortization on a constant-yield basis. While those rules worked reasonably well for fixed-yield instruments, it was unclear at the time what should be done about debt instruments that provided for contingent payments. At the time this paper was written, an initial set of proposed regulations on contingent payment debt instruments had been issued; later, further revisions were necessary before a set of final regulations could be published.
This paper takes a broad look at the challenge posed by contingent payments as the tax rules sought to prevent unwarranted tax deferral at a time when the benefits of deferral were high. In particular, the paper looks not just to contingent payment debt instruments but also to other forms of contingent payments that arise whenever an item of income is earned before or after it is paid for. In this broad view, any capital asset can be seen as a contingent payment instrument by virtue of the cash flows that it generates. A common theme is the implicit “null hypothesis” that is implicit in each of the tax rules that deal with these payments, which makes a default assumption regarding the amount of an uncertain payment until the uncertainty is resolved.
The final regulations on contingent payment debt instruments, while not without problems, effectively ended the controversy in this area. But broader questions persist. For example, open questions remain about the treatment of deferred contingent payments in notional principal contracts.The paper suggests that a broader solution to the treatment of contingent payments could be found in the use of a “yield-based” method, where the tax rate applicable to a transaction was adjusted to compensate for the effects of deferral. I felt, however, that the implications of the yield-based method had not been fully explored, and years later I returned to the topic for a much more comprehensive treatment in Defeating Deferral: A Proposal for Retrospective Taxation, also reproduced in these volumes. In a sense, this paper can be seen as a prequel to that paper.
When the paper was written, tax rates as high as 70 percent and interest rates as high as 20 percent were within recent memory. The concluding section of the paper points out that the scale of the problems posed by contingent payments can be much reduced with lower tax rates and interest rates. Much progress has been made on both fronts since that time, as the current maximum federal income tax rate is 35 percent, and interest rates are near zero.
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