Original Issue Discount Definition

It is usually observed with the issuance of debt instruments like bonds, debentures, notes, and certificates. The investor receives the interest income based on the coupon payment, and when the OID matures, the face value is paid to the investor. The difference between the face value and the price paid is treated as the gain to the investor.

Key Takeaways

  • Original Issue Discount (OID) occurs when an entity issues a debt instrument at a discount, and OID is the difference between the face value and issuance price of the debt instrument.It is an option when the coupon rate is lower than the market interest rate or when investors doubt the creditworthiness of the issuing company because a reduced issuance price can attract more investors.It is a return on investment and treated as interest.There are two types of OID – bonds with a coupon and bonds that do not have a coupon rate.

Original Issue Discount Explained

Original issue discount happens when the issuer issues a debt instrument at a discounted price. Issuing a debt instrument at a discount to the par value is common when the instrument’s coupon rate or interest rate is below the market rates, and the issuer reduces the purchase price to attract investors. It is also an option when investors negatively perceive the company’s credit quality, trustworthiness, and capacity to pay back the bond principal when it matures. Since OID is the bond issued at a discount, it may also indicate the financial crisis in the issuing company.

The OID can be classified into two types, one with a coupon rate and the other without a coupon rate. The OID bonds with a coupon rate offer regular interest payments to the investors and a price below the bond’s face value. On the other hand, if the OID does not have a coupon rate and the OID is large, it is known as a zero coupon bond. And in these types of bonds, the discount or the significant difference between the face value and issuance price attracts the investors even if it does not provide interest income.

One important factor is that the discount negatively correlates to the coupon rate. If the coupon rate is higher, it is less likely to sell at a discount. If the discount is high, then the coupon rate will be low. These bonds benefit the investment holder because of their high profits and less capital for the investment required. People also reinvest their discount payments at a high-interest rate to boost their returns. As a result, it is typical for investors planning their retirement to invest in original issue discount instruments.

Tax Treatment

If the bond issuance date points to a time after 1984, the OID is considered as interest for income tax purposes, accrues over the bond term, and attracts taxes. It also increases the basis of the bond. Hence it reduces the capital gain or increases the losses at the selling time.

If the bond is issued before May 28, 1969, the basis is not increased in line with the OID. If the bond was issued after  May 27, 1969, and before 1985, OID associated with the bond held for investment purposes is added to the basis as it accrues each year. The Form 1099-OID to the investor will be delivered by the bond issuer. The amount of OID to include in the income is specified on this form.

Knowledge about the “original issue discount” tax treatment is important. Brokers and other intermediaries can depend on the OID tables to identify whether a debt instrument was issued at a discount and the OID that needs to be disclosed on information returns.   In general, issuers of publicly offered OID debt instruments must submit Form 8281 within 30 days after the issuance and, if registered with the SEC, within 30 days after registration.

Example

To understand it better, let’s take a simple original issue discount example:

Laurel purchases a bond for $90 from an issuer. The bond’s face value is $100. Here the OID is $5. The issuer accepts a lower price, as the bond’s stated interest rate is lower than the market interest rate; by doing so, the issuer raises the effective interest rate for the Laurel. At maturity, the investor will get the face value that is $100.

This has been a Guide to What is Original Issue Discount (OID). We explain its examples, tax treatment, provisions and reporting, OID bonds, etc. You may learn more from the following articles –

Original issue discount occurs when debt securities, mostly bonds, are issued at a price below their face value to attract buyers so that the issuer can raise capital for their business. Hence it is the difference between a bond’s face value and the issuance price.

Yes, the buyer of OID bonds pays tax on the difference between the original face value of the bond and the discounted price paid by the investor. Several tax consequences associated with OIDs are one of the significant drawbacks of buying them.

There is an IRS form called Form 1099-OID in which any individual can mention the amount of OID as a part of their taxable income. The original issue discount bonds or securities are subject to tax over the entire obligation period.

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