Original Issue Discount

Original Issue Discount (OID) refers to the discount at which a debt instrument like a bond is first issued. It indicates the difference between the bond’s face value or redemption price and the bond issuance price, where the bond issuance price is less than the bond’s face value. An original issue discount calculator is used to calculate the gains made out of such purchases.

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.

• 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 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 a bond issued at a discount, it may also indicate the financial crisis in the issuing company.

The original issue discount accounting 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 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.

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 original issue discount calculator and 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.

Let us understand the concept of original issue discount accounting and other related factors with the help of a couple of examples. These examples will help us understand the intricacies of the concept.

Example #1

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 Laurel.

At maturity, the investor will get the face value which is $100.

Example #2

iSun Inc. is a market leader in the field of solar energy and clean mobility infrastructure. They raised a debt of $25 million in November 2022 to settle their financial obligations and to serve general corporate purposes.

The funding of the debt raised was divided into two equal halves for accounting and convenience. An initial funding of $12.5 million was available for the company which would be exclusive of the 6% lesser than the original issue discount and transaction charges.

The additional $12.5 million minus the original issue discount and the transactional charges would be made available for the company at a later date agreed upon between the company and the convener.

Let us understand the advantages of the original issue discount calculator through the explanation below.

• Investors pay lesser on the initial payment towards a bond than in comparison to a bond with par value.
• It is often noticed that OID bonds face lesser fluctuations in interest rates.
• Zero coupon bonds use OID to lure potential investors into parking their money for such bonds.

Despite the various advantages mentioned above, there are a few disadvantages as well. Let us understand them through the discussion below.

• Original issue accounting might lead to investors being liable to annual taxes even before the bond matures.
• Discount on the initial price of the bond might be an indicator of the financial crunch faced by the issuer. This creates a negative image in the market for them and their company, which might not necessarily be the case.
• OID issues might not be able to offset rates that are offered by conventional fixed-rate bonds.

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

• Green Bonds
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