The Treasury Department is seeking legislation to change the method of calculating the amount of interest income to be declared each year on corporate zero-coupon bonds.
When I first wrote about zero-coupons Washington Business, Aug. 2 , I said that you report, and pay tax on, a pro rata share each year of the eventual total payoff.
This method spreads the total amount of interest evenly over the years from purchase to maturity. The corporate issuer of the bond would take a corresponding annual deduction for interest expense.
Now the Treasury has realized that this linear pro ration is not an economically accurate method because it ignores the effect of compounding.
Let's look at a modified version of the example Treasury cites. Say you buy a $10,000, 30-year zero-coupon bond from ABC Corporation at a discounted cost of $121.
Using the present method, you would subtract the cost ($121) from the maturity value ($10,000) to arrive at a total interest of $9,879. An equal proration over 30 years would give you annual interest income of $329.30. The ABC Corporation would claim an interest expense deduction of the same amount.
What happens if we consider compounding? I won't bother you with the calculations -- but based on annual compounding, the yield to maturity works out to 15.83 percent.
The Treasury Department proposes that the income (and expense) to be reported the first year, then, be determined by applying that 15.83 percent yield to $121, the value of the obligation on the date of issue. That's only $19.15 instead of the $329.30 reached by the linear proration method.
To get the second year interest figure you would add $19.15 (the first year's interest) to $121 (the original cost), then take 15.83 percent of that $140.15 total, for interest income or expense of $22.19. There would be a corresponding increase in each succeeding year.
Seems as if interest income and interest expense pretty well cancel each other; whatever amount the issuer gets to deduct as an expense, the investor must add as income. So what's in it for the Treasury Department?
Well, don't sell short the importance of a principle -- it's nice to have these off-beat techniques resting on a mathematically sound basis.
And there may be dollars involved as well. Consider what happens, for instance, if a chunk of these bonds are bought for the portfolio of a tax-exempt charitable foundation or an educational endowment fund.
Now the issuer gets to deduct the calculated interest expense -- but there is no compensating income reported by the buyer.
Although the total deduction eventually claimed will be the same in either case, a linear projection provides an unjustifiably large deduction in the early years compared to the more soundly based compounding method.
For the individual taxpayer buying these bonds the proposed method would mean much lower interest income to report in the beginning. Of course there would be correspondingly larger income figures later on -- but the tax on a substantial number of dollars would be deferred for quite a few years.
Question: As the husband of a librarian, I was shocked by your column in this morning's Post (Aug. 16). In the last answer you write: "You should be able to find a copy (of a magazine) at your local library; check out page 63." If people start tearing out individual pages of magazines and attempting to check them out of the library, can the Encyclopedia be safe for long? Your financial advice seems sound to me; I am not so sure of your bibliographic practices.
Answer: Whoa! As a lover of libraries I plead not guilty to any intent to encourage the dismemberment of magazines at local libraries.
However, I must plead guilty to a poor choice of words. When I wrote "check out page 63" I simply meant "take a look" at it. At the time -- and in fact until your letter arrived -- I didn't connect the phrase with its use and meaning at public libraries.