Recently, some banks have been offering a hybrid investment known as a “market-linked CD” (MLCD). While these investments may be very attractive due to the potential for a high return and ability to diversify with virtually no risk as to principal, there are also some disadvantages such as severe early withdrawal penalties and a reduced investment return due to participation rates or interest rate caps. The main disadvantage and the focus of this article is the adverse tax consequences of investing in an MLCD.
The terms of most MLCDs generally provide for the guaranteed return of the initial investment plus the potential for at least one additional payment representing the investment’s earnings. The contingent nature of these investments subjects investors to a complex set of federal income tax rules, known as the Original Issue Discount (OID) rules, whereby income must be reported despite the fact that it may never actually be received. Under these rules, the issuer is required to provide investors with information that is necessary to comply with them
Investors are required to accrue OID into income over the term of the MLCD, based on a comparable yield which is determined by the issuer solely for purposes of computing federal taxable income and is neither a guarantee nor a prediction of the actual yield. Community Associations will treat the OID as interest income which will be subject to tax as either non-exempt function income or non-membership income depending upon whether the Association is taxed under IRC §528 or §277.
The amount of interest to be accrued is determined by multiplying the comparable yield for the accrual period by the “adjusted issue price” of the MLCD at the beginning of the accrual period. The adjusted issue price is equal to the original issue price plus the OID required to be recognized by the investor for each accrual period. Further, the OID to be recognized is based on the actual number of days the security is held by the investor in each period. Fiscal year and calendar year taxpayers will recognize the same amount of income on the same investment, only the recognition periods will differ.
The issuer is also required to determine a projected payment schedule which reflects projected payments throughout the term, if any, and also at maturity. If any actual payment received, whether during the term or at maturity, is more than the projected payment, the difference represents additional OID income that must be recognized. If, however, an actual payment received is less than the projected payment, the difference is a negative adjustment first applied to reduce the amount of OID that must be recognized for the year. At maturity, to the extent
the negative adjustment exceeds the OID, the remainder can be deducted as an ordinary loss to the extent of all previously recognized OID income.
In order to properly track the adjusted issue price or basis, it will be necessary to record the OID, as well as any actual payments received, on the books of the investor. The OID required to be recognized should be reflected as an increase in the investment while any actual payments received will be reflected as reductions.
While there is generally no secondary market for the MLCD’s, if you enter into a sale, exchange, or other disposition transaction gain, will be recognized if the amount realized exceeds your adjusted basis in the MLCD. This gain will be taxed as ordinary income similar to the OID. To the extent there is a loss on the transaction, such loss will be treated as an ordinary loss to the extent of previously recognized OID income inclusions and any excess will be treated as a capital loss.
As you can see, investing in a Market Linked Certificate of Deposit requires some detailed analysis. On the face, it is very easy to be drawn to the guaranteed return of your initial investment as well as the potential to capture the upside of a market (stocks, commodities, etc.) without the risk. However, further investigation into the terms and provisions of such investments highlights the disadvantages of investing in one of these instruments.
As indicated above, one of the major disadvantages is paying taxes on income that you have not yet received. As with any investment decision, you should consult with your trusted advisors prior to committing your funds for a potentially long period of time to ensure that you have a full understanding of all of the implications of making such an investment.