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Bulletin No. 1996–28

July 8, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

certain agreements for the lease of tangible property. A

public hearing will be held on September 25, 1996.

Rev. Rul. 96–34, page 4.

Federal rates; adjusted federal rates; adjusted federal longterm rate, and the long-term exempt rate. For purposes of

sections 1274, 1288, 382, and other sections of the

Code, tables set forth the rates for July 1996.

TAX CONVENTIONS

Page 36.

The bilateral agreements between the U.S. and Luxembourg, providing for the reciprocal tax exemption of

income from the international operation of ships and/or

aircraft, are set forth.

T.D. 8674, page 7.

Final regulations under section 1275 of the Code relate

to the tax treatment of debt instruments that provide

for one or more contingent payments.

ADMINISTRATIVE

Announcement 96–62, page 53.

Taxpayers can use the current Forms 706, 706–A,

706–NA, 709, 709–A, and their instructions until the

new revisions are available.

IA–292–84, page 38.

Proposed regulations under section 467 of the Code

relate to the treatment of rent and interest under

Finding Lists begin on page 59.

Announcement of Disbarments and Suspensions begins on page 56.

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Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of

view.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining officers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great courtesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

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Introduction

The Internal Revenue Bulletin is the authoritative

instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the

Internal Revenue Service and for publishing Treasury

Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription basis. Bulletin contents of a permanent nature are

consolidated semiannually into Cumulative Bulletins,

which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin

all substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published

rulings apply retroactively unless otherwise indicated.

Procedures relating solely to matters of internal

management are not published; however, statements of

internal practices and procedures that affect the rights

and duties of taxpayers are published.

Revenue rulings represent the conclusions of the

Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on

positions taken in rulings to taxpayers or technical

advice to Service field offices, identifying details and

information of a confidential nature are deleted to

prevent unwarranted invasions of privacy and to comply

with statutory requirements.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be

considered, and Service personnel and others concerned are cautioned against reaching the same

conclusions in other cases unless the facts and

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary

(Enforcement).

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly

and semiannual basis, and are published in the first

Bulletin of the succeeding quarterly and semi-annual

period, respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 42.—Low-Income Housing

Credit

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

Section 468.—Special Rules for

Mining and Solid Waste Reclamation

and Closing Costs

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

Federal rates; adjusted federal

rates; adjusted federal long-term rate,

and the long-term exempt rate. For

purposes of sections 1274, 1288, 382,

and other sections of the Code, tables

set forth the rates for July 1996.

Rev. Rul. 96–34

Section 280G.—Golden Parachute

Payments

Federal short-term, mid-term, and long-term

rates are set forth for the month of July 1996.

See Rev. Rul. 96–34, on this page.

Section 382.—Limitation on Net

Operating Loss Carryforwards and

Certain Built-In Losses Following

Ownership Change

Section 483.—Interest on Certain

Deferred Payments

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

Section 807.—Rules for Certain

Reserves

The adjusted federal long-term rate is set forth

for the month of July 1996. See Rev. Rul. 96–34,

on this page.

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

Section 412.—Minimum Funding

Standards

Section 846.—Discounted Unpaid

Losses Defined

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

Section 467.—Certain Payments for

the Use of Property or Services

Section 1274.—Determination of

Issue Price in the Case of Certain

Debt Instruments Issued for Property

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of July 1996. See Rev. Rul. 96–34, on

this page.

(Also Sections 42, 280G, 382, 412, 467, 468,

482, 483, 807, 846, 1288, 7520, 7872.)

This revenue ruling provides various

prescribed rates for federal income tax

purposes for July 1996 (the current

month.) Table 1 contains the shortterm, mid-term, and long-term applicable federal rates (AFR) for the current

month for purposes of section 1274(d)

of the Internal Revenue Code. Table 2

contains the short-term, mid-term, and

long-term adjusted applicable federal

rates (adjusted AFR) for the current

month for purposes of section 1288(b).

Table 3 sets forth the adjusted federal

long-term rate and the long-term taxexempt rate described in section 382(f).

Table 4 contains the appropriate percentages for determining the lowincome housing credit described in

section 42(b)(2) for buildings placed in

service during the current month. Table

5 contains the federal rate for determining the present value of an annuity, an

interest for life or for a term of years,

or a remainder or a reversionary

interest for purposes of section 7520.

Finally, Table 6 contains the blended

annual rate for purposes of section

7872.

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REV. RUL. 96–34 TABLE 1

Applicable Federal Rates (AFR) for July 1996

Period for Compounding

Annual

Semiannual

Quarterly

Monthly

Short-Term

AFR

110% AFR

120% AFR

130% AFR

Mid-Term

AFR

110% AFR

120% AFR

130% AFR

150% AFR

175% AFR

6.04%

6.66%

7.27%

7.89%

5.95%

6.55%

7.14%

7.74%

5.91%

6.50%

7.08%

7.67%

5.88%

6.46%

7.04%

7.62%

6.74%

7.42%

8.12%

8.81%

10.20%

11.94%

6.63%

7.29%

7.96%

8.62%

9.95%

11.60%

6.58%

7.22%

7.88%

8.53%

9.83%

11.44%

6.54%

7.18%

7.83%

8.47%

9.75%

11.33%

Long-Term

AFR

110% AFR

120% AFR

130% AFR

7.12%

7.85%

8.58%

9.31%

7.00%

7.70%

8.40%

9.10%

6.94%

7.63%

8.31%

9.00%

6.90%

7.58%

8.26%

8.93%

Annual

Period for Compounding

Semiannual

Quarterly

Monthly

3.88%

3.84%

3.82%

3.81%

4.83%

4.77%

4.74%

4.72%

5.78%

5.70%

5.66%

5.63%

REV. RUL. 96–34 TABLE 2

Adjusted AFR for July 1996

Short-term

adjusted AFR

Mid-term

adjusted AFR

Long-term

adjusted AFR

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REV. RUL. 96–34 TABLE 3

Rates Under Section 382 for July 1996

Adjusted federal long-term rate for the current month

5.78%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the

adjusted federal long-term rates for the current month and the prior two months.)

5.78%

REV. RUL. 96–34 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for July 1996

Appropriate percentage for the 70% present value low-income housing credit

8.63%

Appropriate percentage for the 30% present value low-income housing credit

3.70%

REV. RUL. 96–34 TABLE 5

Rate Under Section 7520 for July 1996

Applicable federal rate for determining the present value of an annuity, an interest for life or

a term of years, or a remainder or reversionary interest

8.2%

REV. RUL. 96–34 TABLE 6

Blended Annual Rate for 1996

Section 7872(e)(2) blended annual rate for 1996

5.77%

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Section 1275.—Other Definitions and

Special Rules

26 CFR 1.1275–4: Contingent payment debt

instruments.

T.D. 8674

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Debt Instruments with Original Issue

Discount; Contingent Payments; AntiAbuse Rule

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains

final regulations relating to the tax

treatment of debt instruments that

provide for one or more contingent

payments. This document also contains

final regulations that treat a debt

instrument and a related hedge as an

integrated transaction. In addition, this

document contains amendments to the

original issue discount regulations, and

finalizes the anti-abuse rule relating to

those regulations. The final regulations

in this document provide needed guidance to holders and issuers of contingent payment debt instruments.

DATES: Except as noted below, the

regulations are effective August 13,

1996. The amendments to §1.1275–5

are effective June 14, 1996, except for

paragraphs (a)(6), (b)(2), and (c)(1),

which are effective August 13, 1996.

The removal of §1.483–2T is effective

June 14, 1996. The removal of

§1.1275–2T is effective August 13,

1996.

For dates of applicability of these

regulations, see Effective Dates under

Supplementary Information.

FOR FURTHER INFORMATION

CONTACT: Concerning the regulations

(other than §1.1275–6), William E.

Blanchard, (202) 622-3950, or Jeffrey

W. Maddrey, (202) 622-3940; or concerning §1.1275–6, Michael S. Novey,

(202) 622-3900 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545–1450. Responses

to these collections of information are

required to determine a taxpayer’s

interest income or deductions on a

contingent payment debt instrument.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The estimated annual burden per

respondent/recordkeeper varies from .3

hours to .5 hours, depending on individual circumstances, with an estimated

average of .47 hours.

Comments concerning the accuracy

of this burden estimate and suggestions

for reducing this burden should be sent

to the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the

Office of Management and Budget,

Attn: Desk Officer for the Department

of the Treasury, Office of Information

and Regulatory Affairs, Washington,

DC 20503.

Books or records relating to the

collections of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

also contained proposed amendments to

the regulations under sections 483

(relating to unstated interest), 1001

(relating to the amount realized on a

sale, exchange, or other disposition of

property), 1272 (relating to the accrual

of OID), 1274 (relating to debt instruments issued for nonpublicly traded

property), and 1275(c) (relating to OID

information reporting requirements),

and to §1.1275–5 (relating to variable

rate debt instruments). In addition, the

notice contained proposed regulations

relating to the integration of a contingent payment or variable rate debt

instrument with a related hedge. The

notice withdrew the proposed regulations relating to contingent payment

debt instruments that were previously

published in the Federal Register on

April 8, 1986 (51 FR 12087), and

February 28, 1991 (56 FR 8308).

On March 16, 1995, the IRS held a

public hearing on the proposed regulations. In addition, the IRS received a

number of written comments on the

proposed regulations. The proposed

regulations, with certain changes to

respond to comments, are adopted as

final regulations. In addition, certain

clarifying and conforming amendments

are made to the OID regulations that

were published in the Federal Register

on February 2, 1994. The comments

and significant changes are discussed

below.

Background

Section 1.1275–4 Contingent payment

debt instruments

Section 1275(d) of the Internal Revenue Code (Code) grants the Secretary

the authority to prescribe regulations

under the original issue discount (OID)

provisions of the Code (sections 163(e)

and 1271 through 1275), including

regulations relating to debt instruments

that provide for contingent payments.

On February 2, 1994, the IRS published final OID regulations in the

Federal Register (59 FR 4799 [TD

8517, 1994–1 C.B. 38]). However, the

final OID regulations did not contain

rules for contingent payment debt

instruments.

On December 16, 1994, the IRS

published a notice of proposed

rulemaking in the Federal Register (59

FR 62884 [FI–59–91, 1995–1 C.B.

894]) relating to the tax treatment of

debt instruments that provide for one or

more contingent payments. The notice

Explanation of Provisions

A. Noncontingent bond method

Under the noncontingent bond

method in the proposed regulations, a

taxpayer computes interest accruals on

a contingent payment debt instrument

by setting a payment schedule as of the

issue date and applying the OID rules

to the payment schedule. The payment

schedule consists of all fixed payments

on the debt instrument and a projected

amount for each contingent payment.

For market-based contingencies (i.e.,

contingencies for which price quotes

are readily available), the projected

amount is the forward price of the

contingency. For other contingencies,

the issuer first determines a reasonable

yield for the debt instrument and then

sets projected amounts equal to the

relative expected payments on the

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contingencies so that the payment

schedule produces the reasonable yield.

These rules were designed to produce a

yield similar to the yield the issuer

would obtain on a fixed rate debt

instrument.

Commentators suggested that the

regulations could be simplified if they

used the same basic methodology for

both market-based and non-marketbased contingencies. In addition, commentators suggested that forward price

quotes would be variable or manipulable and that taxpayers will set more

appropriate payment schedules if they

first determine yield and then set the

payment schedule to fit the yield.

The final regulations adopt these

suggestions and generally conform the

treatment of debt instruments that

provide for either market-based or nonmarket-based contingent payments.

Thus, for any contingent payment debt

instrument subject to the noncontingent

bond method, a taxpayer first determines the yield on the instrument and

then sets the payment schedule to fit

the yield. The yield is determined by

the yield at which the issuer would

issue a fixed rate debt instrument with

terms and conditions similar to the

contingent payment debt instrument

(the comparable yield). Relevant terms

and conditions include the level of

subordination, term, timing of payments, and general market conditions.

For example, if a hedge is available

such that the issuer or holder could

integrate the debt instrument and the

hedge into a synthetic fixed-rate debt

instrument under the rules of §1.1275–

6, the comparable yield is the yield that

the synthetic fixed-rate debt instrument

would have. If a §1.1275–6 hedge (or

the substantial equivalent) is not available, but similar fixed rate debt instruments of the issuer trade at a price that

reflects a spread above a benchmark

rate, the comparable yield is the sum of

the value of the benchmark rate on the

issue date and the spread. In all cases,

the yield must be a reasonable yield for

the issuer and may not be less than the

applicable Federal rate (AFR).

Once the comparable yield is determined, the payment schedule is set to

produce the comparable yield. The final

regulations retain the general approach

of the proposed regulations in determining the payment schedule. Thus, for

market-based payments, the projected

payment is the forward price of the

payment. For non-market-based payments, the projected payment is the

expected amount of the payment as of

the issue date.

Commentators were concerned that a

taxpayer could overstate the yield on a

contingent payment debt instrument

and, therefore, claim excess interest

deductions during the term of the instrument. They were particularly concerned about a long-term debt instrument that has non-market-based

payments because the taxpayer’s determination would be hard to verify and

any excess interest deductions would

not be recaptured for a long time.

The final regulations address this

concern by providing that the comparable yield for a debt instrument is

presumed to be the AFR if the

instrument provides for a non-marketbased payment and is part of an issue

that is marketed or sold in substantial

part to tax-exempt investors or other

investors for whom the treatment of the

debt instrument is not expected to have

a substantial effect on their U.S. tax

liability. A taxpayer may overcome this

presumption only with clear and convincing evidence that the comparable

yield for the debt instrument should be

a specific yield that is higher than the

AFR. Appraisals and other valuations

of nonpublicly traded property cannot

be used to overcome the presumption,

nor can references to general market

rates. An issuer may, for example,

overcome the presumption by showing

that recently issued similar debt instruments of the issuer trade at a price that

reflects a specific yield.

One commentator suggested that the

use of the term projected payment

schedule caused securities law problems because the issuer could be seen

as making representations to the holder

about the expected payments. The

comparable yield and projected payment schedule determined under these

regulations are for tax purposes only

and are not assurances by the issuer

with respect to the payments. The final

regulations retain the term projected

payment schedule, but an issuer may

use a different term to describe the

payment schedule (e.g., payment schedule determined under §1.1275–4) if the

language used by the issuer is clear.

Under the proposed regulations, projected payments rather than actual

payments are used to determine the

adjusted issue price of a debt instrument, the holder’s basis in a debt

instrument, and the amount of any

contingent payment treated as made on

the scheduled retirement of a debt

instrument. One commentator questioned the use of projected payments to

make these determinations. The approach in the proposed regulations is

appropriate, however, because a positive or negative adjustment is used to

take into account the difference between the actual amount and the

projected amount of a contingent payment. This difference would be counted

twice if the adjusted issue price, the

holder’s basis, and the amount deemed

paid on retirement were based on the

actual amount rather than the projected

amount of a contingent payment. Thus,

the approach used in the proposed

regulations is retained in the final

regulations.

B. Tax-exempt obligations

In response to comments, the rules

contained in §1.1275–4(d) relating to

tax-exempt contingent payment obligations have been revised. Under the

proposed regulations, tax-exempt obligations are generally subject to the

noncontingent bond method, with the

following modifications: (1) The yield

on which interest accruals are based

may not exceed the greater of the yield

on the obligation, determined without

regard to the non-market-based contingent payments, and the tax-exempt

AFR that applies to the obligation; (2)

Positive adjustments are treated as gain

from the sale or exchange of the

obligation rather than as interest; and

(3) Negative adjustments reduce the

amount of tax-exempt interest, and,

therefore, are generally not taken into

account as deductible losses. These

modifications to the noncontingent

bond method for tax-exempt obligations were added because the IRS and

Treasury believe that when a property

right is embedded in a tax-exempt

obligation it is generally inappropriate

to treat payments on the right as

interest on an obligation of a state or

political subdivision.

Several commentators suggested that

the proposed regulations relating to taxexempt obligations are overly restrictive. These commentators questioned

the reason for limiting the rate of

accrual to the tax-exempt AFR and

characterizing positive adjustments as

taxable gain rather than interest. They

also questioned the fairness of treating

negative adjustments as nondeductible

adjustments to tax-exempt interest

when positive adjustments are treated

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as taxable gain. Some of the commentators suggested that, at a minimum,

the interest limitations should not apply

to contingent obligations that pay interest based on interest rate formulas that

reflect the cost of funds rather than

changes in the value of embedded

property rights. Finally, commentators

noted that programs involving municipal refinancings of real estate projects

(for example, low-income multi-family

housing projects) would be jeopardized

by the proposed regulations because

payments on tax-exempt obligations

issued to finance these projects are in

certain cases contingent in part on the

revenues or appreciation in value of the

project.

The IRS and Treasury continue to

believe that gain from a property right

should not be recharacterized as taxexempt interest merely because the

property right is embedded in a taxexempt obligation. The IRS and Treasury nevertheless recognize that certain

types of traditional tax-exempt financings should not be subject to the

interest limitations of the proposed

regulations (e.g., financings on which

interest is computed in a manner that

relates to the cost of funds). Accordingly, §1.1275–4(d) has been revised to

include a category of tax-exempt obligations that will be subject to the

noncontingent bond method without the

tax-exempt interest limitations contained in the proposed regulations. This

category of tax-exempt obligations includes (1) obligations that would

qualify as variable rate debt instruments (VRDIs) except for the failure to

meet certain of the technical requirements of the VRDI definition (such as

the cap and floor limitations, or the

requirement that interest be paid or

compounded at least annually), and (2)

certain obligations issued to refinance

an obligation, the proceeds of which

were used to finance a project.

For other tax-exempt obligations, the

interest restrictions of the proposed

regulations are adopted in final form.

Section 1.1275–4(d) has been revised,

however, to provide that a negative

adjustment is treated as a taxable loss

from the sale or exchange of the

obligation, rather than as a nondeductible adjustment to tax-exempt interest.

C. Prepaid tuition plans

A number of commentators asked

whether contracts issued under state-

sponsored prepaid tuition plans are

subject to §1.1275–4. Although the

terms of the contracts vary, the contracts generally are issued pursuant to a

plan created by a state to enable the

participants in the plan to save for

post-secondary education for themselves or other designated beneficiaries.

In addition, the plans generally provide

protection against increases in the costs

of higher education or otherwise subsidize these costs, often by providing for

contingent payments that are linked to

the future costs of post-secondary

education.

The commentators argue that

§1.1275–4 does not apply to the

contracts because the contracts are not

debt instruments for federal income tax

purposes. In addition, the commentators

argue that, even if the contracts are

debt instruments, the noncontingent

bond method would be unduly burdensome and inappropriate for contracts of

this type.

The final regulations under §1.1275–

4 do not affect the treatment of

contracts issued pursuant to statesponsored prepaid tuition plans,

whether or not the contracts are debt

instruments. The final regulations, like

the proposed regulations, only apply to

debt instruments. Thus, the final regulations do not apply to contracts

issued pursuant to a plan created by a

state to enable participants to save for

post-secondary education if the contracts are not debt instruments. In

addition, the final regulations provide

an exception for any debt instrument

issued pursuant to a state-sponsored

prepaid tuition plan.

This exception applies to a contract

issued pursuant to a plan or arrangement if: The plan or arrangement is

created by a state statute; the plan or

arrangement has a primary objective of

enabling the participants to pay for the

costs of post-secondary education for

themselves or their designated beneficiaries; and the contingencies under the

contract are related to such purpose.

These characteristics are intended to

describe all existing state-sponsored

prepaid tuition plans. Therefore, the

final regulations do not change the tax

treatment of a contract issued pursuant

to these plans. As a result, if the

contract is a debt instrument, the

contingent payments on the contract are

not taken into account by an individual

until the payments are made.

The exception in the final regulations

is intended to apply only to the existing

state-sponsored prepaid tuition plans

and to any future plans that are substantially similar to the existing plans.

In addition, no inference is intended as

to whether contracts issued by any

state-sponsored prepaid tuition plan are

debt instruments.

D. Debt instruments subject to

section 1274

The proposed regulations provide a

method for contingent payment debt

instruments not subject to the noncontingent bond method (i.e., a nonpublicly traded debt instrument issued

in a sale or exchange of nonpublicly

traded property). Under the method, a

debt instrument’s noncontingent payments are treated as a separate debt

instrument, which is generally taxed

under the rules for noncontingent debt

instruments. The debt instrument’s contingent payments are taken into account

when made. A portion of each contingent payment is treated as principal,

based on the amount determined by

discounting the payment at the AFR

from the payment date to the issue

date, and the remainder is treated as

interest. Special rules are provided if a

contingent payment becomes fixed

more than 6 months before it is due.

The final regulations generally adopt

the method in the proposed regulations.

In addition, the final regulations contain rules for a holder whose basis in a

debt instrument is different from the

instrument’s adjusted issue price (e.g.,

a subsequent holder).

E. Inflation-indexed bonds

The Treasury recently announced

that it was considering issuing bonds

indexed to inflation (61 FR 25164).

Depending on their ultimate structure,

the noncontingent bond method might

be inappropriate for these bonds. If the

Treasury issues these bonds, the Treasury and IRS may issue regulations to

provide a simplified tax treatment for

the bonds. The treatment would require

current accrual of the inflation

component.

Other amendments to the OID

regulations

A. Alternative payment schedules

under §1.1272–1(c)

Section 1.1272–1(c) provides rules to

determine the yield and maturity of

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certain debt instruments that provide

for one or more alternative payment

schedules applicable upon the occurrence of a contingency (or contingencies), provided that the timing and

amounts of the payments that comprise

each payment schedule are known as of

the issue date. Under these rules, the

yield and maturity of a debt instrument

are generally determined by assuming

that the payments will be made under

the payment schedule most likely to

occur (based on all the facts and

circumstances as of the issue date).

Special rules are provided for unconditional options and mandatory sinking

funds.

The general rules in §1.1272–1(c)

produce a reasonable result when a

debt instrument has one stated payment

schedule that is very likely to occur

and one or more alternative payment

schedules that are unlikely to occur. In

this case, adherence to the stated

payment schedule will result in accruals on the debt instrument that

reasonably reflect the expected return

on the instrument. The rules can lead to

unreasonable results, however, if a debt

instrument provides for a stated payment schedule and one or more alternative payment schedules that differ

significantly and that have a comparable likelihood of occurring. In this

case, the accruals based on the payment

schedule identified as most likely to

occur could differ significantly from

the expected return on the debt instrument, which would reflect all the

payment schedules and their relative

probabilities of occurrence.

Because the general rules of

§1.1272–1(c) could produce unreasonable results, these rules have been

modified. Under the final regulations, if

a single payment schedule is significantly more likely than not to occur,

the yield and maturity of the debt

instrument are calculated based on that

payment schedule. As a result, any

other debt instrument that provides for

an alternative payment schedule (other

than because of an unconditional option

or mandatory sinking fund) will generally be subject to the rules in §1.1275–

4 for contingent payment debt instruments. The final regulations generally

retain the rules for mandatory sinking

funds and unconditional options.

B. Remote and incidental

contingencies

The proposed regulations provide

that a payment subject to a remote or

incidental contingency is not considered a contingent payment for purposes

of §1.1275–4. In response to a comment, the rule relating to remote and

incidental contingencies has been

broadened, through the addition of new

§1.1275–2(h), to provide that remote

and incidental contingencies are generally ignored for purposes of sections

163(e) (other than section 163(e)(5))

and 1271 through 1275 and the regulations thereunder. Thus, for example, if

an otherwise fixed payment debt instrument provides for an additional payment that will be made upon the

occurrence of a contingency and there

is a remote likelihood that the contingency will occur, the contingent

payment is ignored for purposes of

computing OID accruals on the instrument. If the contingency occurs, however, then, solely for purposes of

sections 1272 and 1273, the debt

instrument is treated as reissued. Therefore, OID on the debt instrument is

redetermined.

C. Definition of qualified stated

interest

The addition of the rules for remote

or incidental contingencies and the

changes to the rules for alternative

payment schedules allow simplification

of the definition of qualified stated

interest. Under §1.1273–1(c), as published in the Federal Register on

February 2, 1994, qualified stated

interest must be unconditionally payable in cash or property at least

annually at a single fixed rate. Interest

is unconditionally payable only if late

payment (other than a late payment that

occurs within a reasonable grace

period) or nonpayment is expected to

be penalized or reasonable remedies

exist to compel payment.

This definition of unconditionally

payable can be read to conflict with the

alternative payment schedule rules. For

example, if a debt instrument has two

alternative payment schedules, one

schedule can be stated as the required

payment schedule and the other schedule can be stated as a penalty if the

required payments are not made. The

required payments might then be

treated as unconditionally payable and,

therefore, as being qualified stated

interest even if they would not be

qualified stated interest if treated under

the alternative payment schedule rules.

Under this treatment, if a payment is

not made, the reissuance rules of the

alternative payment schedule regime do

not apply. Holders can thus argue that

no OID would accrue with respect to

the debt instrument even though OID

would accrue if the instrument were

treated as having an alternative payment schedule and holders fully expect

any unmade payment to be made in the

future.

The remote or incidental rules in

§1.1275–2(h) provide a better mechanism for determining whether a payment is qualified stated interest and

determining the treatment if no payment is made. Thus, the final regulations modify the definition of unconditionally payable so that interest is

unconditionally payable only if reasonable legal remedies exist to compel

payment or the debt instrument otherwise provides terms and conditions that

make the likelihood of late payment

(other than a late payment that occurs

within a reasonable grace period) or

nonpayment remote. If the payment is

not made (other than because of insolvency, default, or similar circumstances), the final regulations require a

deemed reissuance for OID purposes,

which ensures that OID will accrue.

This approach should simplify the

treatment of many debt instruments and

yet ensure that OID accrues in appropriate circumstances.

D. OID anti-abuse rule

On February 2, 1994, the IRS

published in the Federal Register

temporary and proposed regulations

that contained an anti-abuse rule for

purposes of the OID regulations

(§1.1275–2T (59 FR 4831); §1.1275–

2(g) (59 FR 4878)). Under the antiabuse rule, the Commissioner can apply

or depart from the regulations under

section 163(e) or sections 1271 through

1275 as necessary to achieve a reasonable result if a principal purpose in

structuring a debt instrument or engaging in a transaction is to achieve a

result under the regulations that is

unreasonable in light of the applicable

statutes. This rule is adopted as a final

regulation with some clarifying changes

and the addition of an example to

illustrate its application to certain contingent payment debt instruments.

E. Determination of issue price under

section 1274

Under the proposed regulations, the

issue price of a contingent payment

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debt instrument that is subject to

section 1274 (i.e., a debt instrument

issued in exchange for nonpublicly

traded property) is determined without

taking into account the instrument’s

contingent payments. Thus, the issue

price of the debt instrument (and the

buyer’s initial basis in the property) is

limited to an amount determined by

taking into account only the noncontingent payments. The buyer’s basis in

the property, however, is increased by

the amount of a contingent payment

treated as principal. This approach was

adopted primarily because it is inappropriate to allow a buyer a basis in

property that reflects anticipated contingent payments that are uncertain in

amount. In addition, this approach

limits the ability of the buyer to

overstate interest deductions over the

term of the debt instrument. The

approach of the proposed regulations

has been adopted in the final regulations for taxable debt instruments subject to section 1274. See §1.1274–2(g).

It is not appropriate, however, to

apply this approach to tax-exempt

contingent payment obligations subject

to section 1274. Because the present

value of projected contingent payments

generally is not included in the issue

price of a taxable debt instrument

subject to section 1274, the instrument

is accounted for under §1.1275–4(c).

This regime is not appropriate for taxexempt obligations because it does not

distinguish between tax-exempt interest

and gain attributable to an embedded

property right. Thus, in order to permit

tax-exempt obligations to be subject to

the noncontingent bond method under

§1.1275–4(b), the final regulations

provide special rules to determine the

issue price of a tax-exempt contingent

payment obligation subject to section

1274.

Under these rules, the issue price of

a tax-exempt contingent payment obligation subject to section 1274 is equal

to the fair market value of the obligation on the issue date (or, in the case of

an obligation that provides for interestbased or revenue-based payments, the

greater of the obligation’s fair market

value or stated principal amount). In

addition, the obligation is subject to the

rules of §1.1275–4(d) (the noncontingent bond method for tax-exempt

contingent payment obligations) rather

than §1.1275–4(c). However, to ensure

that the buyer’s basis is the same as if

the buyer had issued a taxable debt

instrument, the final regulations limit

the buyer’s basis to the present value

of the fixed payments.

§1.1275–6 Integration rules

Commentators generally approved of

the integration rules in the proposed

regulations, and those rules are adopted

with only two significant changes.

First, the final regulations allow (but

do not require) the integration of a

hedge with a fixed rate debt instrument.

For example, a taxpayer may integrate

a fixed rate debt instrument and a swap

into a VRDI. Although the hedging

transaction regulations (§1.446–4)

cover many of these transactions, the

integration rules provide more certain

treatment. The final regulations, however, do not allow the Commissioner to

integrate a hedge with either a fixed

rate debt instrument or a VRDI that

provides for interest at a qualified

floating rate. In these cases, treating the

hedge and the debt instrument separately is a longstanding rule that

generally clearly reflects income.

Second, in limited circumstances, the

final regulations allow a hedge to be

entered into prior to the date the

taxpayer issues or acquires the debt

instrument. In these circumstances,

however, the taxpayer must identify the

hedge as part of an integrated transaction on the day the hedge is entered

into by the taxpayer. Under the final

regulations, if the hedging transaction

has not yet had any cash flows (including amounts paid to enter into or

purchase the hedge), the integration

rules work appropriately so that any

built-in gain or loss on the hedge at the

time of integration is included over the

term of the synthetic debt instrument.

Thus, the final regulations put no

restriction on the time the hedging

transaction has to be entered into in

this case. If there have been cash flows

on the hedge, the final regulations

require the hedge to be entered into no

earlier than a date that is substantially

contemporaneous with the date on

which the debt instrument is acquired.

This approach should allow commercially reasonable transactions to be

integrated without the need to create

complex rules to determine the treatment of prior cash flows on the

hedging transaction.

The rules for remote and incidental

contingencies in §1.1275–2(h) apply

for purposes of the integration rules.

Thus, if there is an incidental mismatch

between a §1.1275–6 hedge and a qualifying debt instrument, a taxpayer may

still integrate the hedge and the instrument. The mismatch is dealt with

according to the rules for incidental

contingencies.

The final regulations also clarify the

timing of income, deductions, gains, and

losses from a hedge of a contingent

payment debt instrument not subject to

integration. Under §1.446–4, the income, deductions, gains, and losses must

match the income, deductions, gains,

and losses from the debt instrument.

The final regulations clarify that gain or

loss realized on a transaction that

hedges a contingent payment on a debt

instrument subject to §1.1275–4(c) is

taken into account when the contingent

payment is taken into account under

§1.1275–4(c). This treatment does not

allow the taxpayer to change the timing

of the income, deductions, gains, and

losses from the debt instrument.

Effective Dates

In general, the final regulations apply

to debt instruments issued on or after

August 13, 1996. Section 1.1275–6

applies to a qualifying debt instrument

issued on or after August 13, 1996.

Section 1.1275–6 also applies to a

qualifying debt instrument acquired by

the taxpayer on or after August 13,

1996, if the qualifying debt instrument

is a fixed rate debt instrument or a

VRDI or if the qualifying debt instrument and the §1.1275–6 hedge are

acquired by the taxpayer substantially

contemporaneously. Except as otherwise

provided in the regulations, the changes

to §1.1275–5 apply to debt instruments

issued on or after April 4, 1994.

Debt instruments issued before the

effective date of the final regulations

For a contingent payment debt instrument issued before August 13,

1996, a taxpayer may use any reasonable method to account for the debt

instrument, including a method that

would have been required under the

proposed regulations when the debt

instrument was issued. However, unless

§1.1275–6 applies to the debt instrument, integration is not a reasonable

method to account for the instrument.

Consent to change accounting method

The Commissioner grants consent for

a taxpayer to change its method of

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accounting to follow the final regulations in this document. This consent is

granted, however, only for a change for

the first taxable year in which the

taxpayer must account for a debt

instrument under the final regulations.

The change is made on a cut-off basis

(i.e., the new method only applies to

debt instruments issued on or after

August 13, 1996). Therefore, no items

of income or deduction are omitted or

duplicated, and no adjustment under

section 481 is allowed.

Special Analyses

Section 1.1275–6 also issued under 26

U.S.C. 1275(d). * * *

Par. 2. Section 1.163–7 is amended

by adding a sentence at the end of

paragraph (a) to read as follows:

§1.163–7 Deduction for OID on

certain debt instruments.

(a) * * * To determine the amount

of interest (OID) that is deductible each

year on a debt instrument that provides

for contingent payments, see §1.1275–

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory assessment is not required. It also has been

determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and, therefore, a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these regulations was submitted to the Small Business Administration for comment on its impact on

small business.

Several persons from the Office of

Chief Counsel and the Treasury Department, including Andrew C. Kittler,

formerly of the Office of the Assistant

Chief Counsel (Financial Institutions

and Products), participated in developing these regulations.

Adoption of Amendments to the

Regulations

Par. 3. Section 1.446–4 is amended

by:

1. Redesignating paragraphs (a)(2)(ii) and (a)(2)(iii) as paragraphs (a)(2)(iii) and (a)(2)(iv), respectively.

2. Adding a new paragraph (a)(2)(ii).

3. Adding a sentence at the end of

paragraph (e)(4).

The additions read as follows:

§1.446–4 Hedging transactions.

(a) * * *

(2) * * *

(ii) An integrated transaction subject

to §1.1275–6;

Drafting Information

(e) * * *

(4) * * * Similarly, gain or loss

realized on a transaction that hedges a

contingent payment on a debt instrument subject to §1.1275–4(c) (a contingent payment debt instrument issued

for nonpublicly traded property) is

taken into account when the contingent

payment is taken into account under

§1.1275–4(c).

§1.483–2T [Removed]

Accordingly, 26 CFR parts 1 and

602 are amended as follows:

Part 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by removing the

entry for §1.1275–2T and adding two

entries in numerical order to read as

follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.483–4 also issued under 26

U.S.C. 483(f). * * *

Par. 4. Section 1.483–2T is removed

effective June 14, 1996.

Par. 5. Section 1.483–4 is added to

read as follows:

§1.483–4 Contingent payments.

(a) In general. This section applies

to a contract for the sale or exchange

of property (the overall contract) if the

contract provides for one or more

contingent payments and the contract is

subject to section 483. This section

applies even if the contract provides for

adequate stated interest under §1.483–

2. If this section applies to a contract,

interest under the contract is generally

computed and accounted for using rules

similar to those that would apply if the

contract were a debt instrument subject

to §1.1275–4(c). Consequently, all noncontingent payments under the overall

contract are treated as if made under a

separate contract, and interest accruals

on this separate contract are computed

under rules similar to those contained

in §1.1275–4(c)(3). Each contingent

payment under the overall contract is

characterized as principal and interest

under rules similar to those contained

in §1.1275–4(c)(4). However, any interest, or amount treated as interest, on a

contract subject to this section is taken

into account by a taxpayer under the

taxpayer’s regular method of accounting (e.g., an accrual method or the cash

receipts and disbursements method).

(b) Examples. The following examples illustrate the provisions of paragraph (a) of this section.

Example 1. Deferred payment sale with

contingent interest—(i) Facts. On December 31,

1996, A sells depreciable personal property to B.

As consideration for the sale, B issues to A a

debt instrument with a maturity date of December 31, 2001. The debt instrument provides for a

principal payment of $200,000 on the maturity

date, and a payment of interest on December 31

of each year, beginning in 1997, equal to a

percentage of the total gross income derived

from the property in that year. However, the total

interest payable on the debt instrument over its

entire term is limited to a maximum of $50,000.

Assume that on December 31, 1996, the shortterm applicable Federal rate is 4 percent,

compounded annually, and the mid-term applicable Federal rate is 5 percent, compounded

annually.

(ii) Treatment of noncontingent payment as

separate contract. Each payment of interest is a

contingent payment. Accordingly, under paragraph (a) of this section, for purposes of

applying section 483 to the debt instrument, the

right to the noncontingent payment of $200,000

is treated as a separate contract. The amount of

unstated interest on this separate contract is

equal to $43,295, which is the amount by which

the payment ($200,000) exceeds the present

value of the payment ($156,705), calculated

using the test rate of 5 percent, compounded

annually. The $200,000 payment is thus treated

as consisting of a payment of interest of $43,295

and a payment of principal of $156,705. The

interest is includible in A’s gross income, and

deductible by B, under their respective methods

of accounting.

(iii) Treatment of contingent payments. Assume that the amount of the contingent payment

that is paid on December 31, 1997, is $20,000.

Under paragraph (a) of this section, the $20,000

payment is treated as a payment of principal of

$19,231 (the present value, as of the date of sale,

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of the $20,000 payment, calculated using a test

rate equal to 4 percent, compounded annually)

and a payment of interest of $769. The $769

interest payment is includible in A’s gross

income, and deductible by B, in their respective

taxable years in which the payment occurs. The

amount treated as principal gives B additional

basis in the property on December 31, 1997. The

remaining contingent payments on the debt

instrument are accounted for similarly, using a

test rate of 4 percent, compounded annually, for

the payments made on December 31, 1998, and

December 31, 1999, and a test rate of 5 percent,

compounded annually, for the payments made on

December 31, 2000, and December 31, 2001.

Example 2. Contingent stock payout—(i)

Facts. M Corporation and N Corporation each

owns one-half of the stock of O Corporation. On

December 31, 1996, pursuant to a reorganization

qualifying under section 368(a)(1)(B), M acquires the one-half interest of O held by N in

exchange for 30,000 shares of M voting stock

and a non-assignable right to receive up to

10,000 additional shares of M’s voting stock

during the next 3 years, provided the net profits

of O exceed certain amounts specified in the

contract. No interest is provided for in the

contract. No additional shares are received in

1997 or in 1998. In 1999, the annual earnings of

O exceed the specified amount, and, on December 31, 1999, an additional 3,000 M voting

shares are transferred to N. The fair market value

of the 3,000 shares on December 31, 1999, is

$300,000. Assume that on December 31, 1996,

the short-term applicable Federal rate is 4

percent, compounded annually. M and N are

calendar year taxpayers.

(ii) Allocation of interest. Section 1274 does

not apply to the right to receive the additional

shares because the right is not a debt instrument

for federal income tax purposes. As a result, the

transfer of the 3,000 M voting shares to N is a

deferred payment subject to section 483 and a

portion of the shares is treated as unstated

interest under that section. The amount of

interest allocable to the shares is equal to the

excess of $300,000 (the fair market value of the

shares on December 31, 1999) over $266,699

(the present value of $300,000, determined by

discounting the payment at the test rate of 4

percent, compounded annually, from December

31, 1999, to December 31, 1996). As a result,

the amount of interest allocable to the payment

of the shares is $33,301 ($300,000 – $266,699).

Both M and N take the interest into account in

1999.

on or after August 13, 1996.

Par. 6. Section 1.1001–1 is amended

by revising paragraph (g) to read as

follows:

§1.1001–1 Computation of gain or

loss.

(g) Debt instruments issued in exchange for property—(1) In general. If

a debt instrument is issued in exchange

for property, the amount realized attributable to the debt instrument is the

issue price of the debt instrument as

determined under §1.1273–2 or

§1.1274–2, whichever is applicable. If,

however, the issue price of the debt

instrument is determined under section

1273(b)(4), the amount realized attributable to the debt instrument is its stated

principal amount reduced by any unstated interest (as determined under

section 483).

(2) Certain debt instruments that

provide for contingent payments—(i) In

general. Paragraph (g)(1) of this section does not apply to a debt instrument subject to either §1.483–4 or

§1.1275–4(c) (certain contingent payment debt instruments issued for nonpublicly traded property).

(ii) Special rule to determine amount

realized. If a debt instrument subject to

§1.1275–4(c) is issued in exchange for

property, and the income from the

exchange is not reported under the

installment method of section 453, the

amount realized attributable to the debt

instrument is the issue price of the debt

instrument as determined under

§1.1274–2(g), increased by the fair

market value of the contingent payments payable on the debt instrument.

If a debt instrument subject to §1.483–

4 is issued in exchange for property,

and the income from the exchange is

not reported under the installment

method of section 453, the amount

realized attributable to the debt instrument is its stated principal amount,

reduced by any unstated interest (as

determined under section 483), and

increased by the fair market value of

the contingent payments payable on the

debt instrument. This paragraph

(g)(2)(ii), however, does not apply to a

debt instrument if the fair market value

of the contingent payments is not

reasonably ascertainable. Only in rare

and extraordinary cases will the fair

market value of the contingent payments be treated as not reasonably

ascertainable.

(3) Coordination with section 453. If

a debt instrument is issued in exchange

for property, and the income from the

exchange is not reported under the

installment method of section 453, this

paragraph (g) applies rather than

§15a.453–1(d)(2) to determine the taxpayer’s amount realized attributable to

the debt instrument.

(4) Effective date. This paragraph (g)

applies to sales or exchanges that occur

on or after August 13, 1996.

Par. 7. Section 1.1012–1 is amended

by revising paragraph (g) to read as

follows:

§1.1012–1 Basis of property.

(g) Debt instruments issued in exchange for property—(1) In general.

For purposes of paragraph (a) of this

section, if a debt instrument is issued

in exchange for property, the cost of

the property that is attributable to the

debt instrument is the issue price of the

debt instrument as determined under

§1.1273–2 or §1.1274–2, whichever is

applicable. If, however, the issue price

of the debt instrument is determined

under section 1273(b)(4), the cost of

the property attributable to the debt

instrument is its stated principal

amount reduced by any unstated interest (as determined under section 483).

(2) Certain tax-exempt obligations.

This paragraph (g)(2) applies to a taxexempt obligation (as defined in section 1275(a)(3)) that is issued in

exchange for property and that has an

issue price determined under §1.1274–

2(j) (concerning tax-exempt contingent

payment obligations and certain taxexempt variable rate debt instruments

subject to section 1274). Notwithstanding paragraph (g)(1) of this section, if

this paragraph (g)(2) applies to a taxexempt obligation, for purposes of

paragraph (a) of this section, the cost

of the property that is attributable to

the obligation is the sum of the present

values of the noncontingent payments

(as determined under §1.1274–2(c)).

(3) Effective date. This paragraph (g)

applies to sales or exchanges that occur

on or after August 13, 1996.

Par. 8. Section 1.1271–0(b) is

amended by:

1. Revising the entries for paragraphs (c)(2), (c)(3), (c)(4), and (d) of

§1.1272–1.

2. Adding an entry for paragraph

(c)(7) of §1.1272–1.

3. Revising the entry for paragraph

(g) and adding entries for paragraphs

(i) and (j) of §1.1274–2.

4. Removing the language ‘‘[Reserved]’’ from the entry for paragraph

(g) and adding entries for paragraphs

(g), (h), (i), and (j) of §1.1275–2.

5. Removing the entr ies for

§1.1275–2T.

6. Adding entries for §1.1275–4.

7. Adding entries for paragraphs

(a)(5) and (a)(6) of §1.1275–5.

8. Revising the entries for paragraphs (c)(1) and (c)(5) of §1.1275–5.

9. Adding entries for §1.1275–6.

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The revisions and additions read as

follows:

§1.1271–0 Original issue discount;

effective date; table of contents.

(b) * * *

§1.1272–1 Current inclusion of OID

in income.

(2) Payment schedule that is significantly more likely than

not to occur.

(3) Mandatory sinking fund provision.

(4) Consistency rule. [Reserved]

(7) Effective date.

(d) Certain debt instruments that

provide for a fixed yield.

§1.1274–2 Issue price of debt

instruments to which section 1274

applies.

(g) Treatment of contingent payment

debt instruments.

(i)

(j)

[Reserved]

Special rules for tax-exempt

obligations.

(1) Certain variable rate debt instruments.

(2) Contingent payment debt instruments.

(3) Effective date.

§1.1275–2 Special rules relating to

debt instruments.

(g) Anti-abuse rule.

(1) In general.

(2) Unreasonable result.

(3) Examples.

(4) Effective date.

(h) Remote and incidental contingencies.

(1) In general.

(2) Remote contingencies.

(3) Incidental contingencies.

(4) Aggregation rule.

(5) Consistency rule.

(6) Subsequent adjustments.

(7) Effective date.

(i) [Reserved]

(j) Treatment of certain modifications.

* * * * * *

§1.1275–4 Contingent payment debt

instruments.

(a) Applicability.

(1) In general.

(2) Exceptions.

(3) Insolvency and default.

(4) Convertible debt instruments.

(5) Remote and incidental contingencies.

(b) Noncontingent bond method.

(1) Applicability.

(2) In general.

(3) Description of method.

(4) Comparable yield and projected payment schedule.

(5) Qualified stated interest.

(6) Adjustments.

(7) Adjusted issue price, adjusted

basis, and retirement.

(8) Character on sale, exchange,

or retirement.

(9) Operating rules.

subject to the noncontingent

bond method.

(1) Applicability.

(2) Separation into components.

(3) Treatment of noncontingent

payments.

(4) Treatment of contingent payments.

(5) Basis different from adjusted

issue price.

(6) Treatment of a holder on

sale, exchange, or retirement.

(7) Examples.

(d) Rules for tax-exempt obligations.

(1) In general.

(2) Certain tax-exempt obligations with interest-based or

revenue-based payments

(3) All other tax-exempt obligations.

(4) Basis different from adjusted

issue price.

(e) Amounts treated as interest under

this section.

(f) Effective date.

§1.1275–5 Variable rate debt

instruments.

(a) * * *

(5) No contingent principal payments.

(6) Special rule for debt instruments issued for nonpublicly

traded property.

* * * * * *

(1) Definition.

* * * * * *

(5) Tax-exempt obligations.

* * * * * *

§1.1275–6 Integration of qualifying

debt instruments.

(a) In general.

(b) Definitions.

(1) Qualifying debt instrument.

(2) Section 1.1275–6 hedge.

(3) Financial instrument.

(4) Synthetic debt instrument.

(1) Integration by taxpayer.

(2) Integration by Commissioner.

(d) Special rules for legging into

and legging out of an integrated

transaction.

(1) Legging into.

(2) Legging out.

(e) Identification requirements.

(f) Taxation of integrated transactions.

(1) General rule.

(2) Issue date.

(3) Term.

(4) Issue price.

(5) Adjusted issue price.

(6) Qualified stated interest.

(7) Stated redemption price at

maturity.

(8) Source of interest income and

allocation of expense.

(9) Effectively connected income.

(10) Not a short-term obligation.

(11) Special rules in the event of

integration by the Commissioner.

(12) Retention of separate transaction rules for certain purposes.

(13) Coordination with consolidated return rules.

(g) Predecessors and successors.

(h) Examples.

(i) [Reserved]

(j) Effective date.

Par. 9. Section 1.1272–1 is amended

by:

1. Revising paragraphs (b)(2)(ii), (c),

and (d).

2. Adding a sentence at the end of

paragraph (f)(2).

3. Removing the language ‘‘determining yield and maturity’’ from the

first sentence of paragraph (j) Example

5 (iii) and adding the language ‘‘sections 1272 and 1273’’ in its place.

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4. Removing the language ‘‘determining yield and maturity’’ from the

second sentence of paragraph (j) Example 7 (v) and adding the language

‘‘sections 1272 and 1273’’ in its place.

The revisions and addition read as

follows:

§1.1272–1 Current inclusion of OID

in income.

(b) * * *

(2) * * *

(ii) A debt instrument that provides

for contingent payments, other than a

debt instrument described in paragraph

provided in §1.1275–4; or

debt instruments subject to contingencies—(1) Applicability. This

paragraph (c) provides rules to determine the yield and maturity of certain

debt instruments that provide for an

alternative payment schedule (or schedules) applicable upon the occurrence of

a contingency (or contingencies). This

paragraph (c) applies, however, only if

the timing and amounts of the payments that comprise each payment

schedule are known as of the issue date

and the debt instrument is subject to

paragraph (c)(2), (3), or (5) of this

section. A debt instrument does not

provide for an alternative payment

schedule merely because there is a

possibility of impairment of a payment

(or payments) by insolvency, default,

or similar circumstances. See §1.1275–

4 for the treatment of a debt instrument

that provides for a contingency that is

not described in this paragraph (c). See

§1.1273–1(c) to determine whether

stated interest on a debt instrument

subject to this paragraph (c) is qualified

stated interest.

(2) Payment schedule that is significantly more likely than not to occur. If,

based on all the facts and circumstances as of the issue date, a single

payment schedule for a debt instrument, including the stated payment

schedule, is significantly more likely

than not to occur, the yield and

maturity of the debt instrument are

computed based on this payment

schedule.

(3) Mandatory sinking fund provision. Notwithstanding paragraph (c)(2)

of this section, if a debt instrument is

subject to a mandatory sinking fund

provision, the provision is ignored for

purposes of computing the yield and

maturity of the debt instrument if the

use and terms of the provision meet

reasonable commercial standards. For

purposes of the preceding sentence, a

mandatory sinking fund provision is a

provision that meets the following

requirements:

(i) The provision requires the issuer

to redeem a certain amount of debt

instruments in an issue prior to

maturity.

(ii) The debt instruments actually

redeemed are chosen by lot or purchased by the issuer either in the open

market or pursuant to an offer made to

all holders (with any proration determined by lot).

(iii) On the issue date, the specific

debt instruments that will be redeemed

on any date prior to maturity cannot be

identified.

(4) Consistency rule. [Reserved]

(5) Treatment of certain options.

Notwithstanding paragraphs (c)(2) and

(3) of this section, the rules of this

paragraph (c)(5) determine the yield

and maturity of a debt instrument that

provides the holder or issuer with an

unconditional option or options, exercisable on one or more dates during

the term of the debt instrument, that, if

exercised, require payments to be made

on the debt instrument under an alternative payment schedule or schedules

(e.g., an option to extend or an option

to call a debt instrument at a fixed

premium). Under this paragraph (c)(5),

an issuer is deemed to exercise or not

exercise an option or combination of

options in a manner that minimizes the

yield on the debt instrument, and a

holder is deemed to exercise or not

exercise an option or combination of

options in a manner that maximizes the

yield on the debt instrument. If both

the issuer and the holder have options,

the rules of this paragraph (c)(5) are

applied to the options in the order that

they may be exercised. See paragraph

(j) Example 5 through Example 8 of

this section.

(6) Subsequent adjustments. If a

contingency described in this paragraph

described in paragraph (c)(5) of this

section) actually occurs or does not

occur, contrary to the assumption made

pursuant to this paragraph (c) (a change

in circumstances), then, solely for

purposes of sections 1272 and 1273,

the debt instrument is treated as retired

and then reissued on the date of the

change in circumstances for an amount

equal to its adjusted issue price on that

date. See paragraph (j) Example 5 and

Example 7 of this section. If, however,

the change in circumstances results in a

substantially contemporaneous pro-rata

prepayment as defined in §1.1275–

2(f)(2), the pro-rata prepayment is

treated as a payment in retirement of a

portion of the debt instrument, which

may result in gain or loss to the holder.

See paragraph (j) Example 6 and

Example 8 of this section.

(7) Effective date. This paragraph (c)

applies to debt instruments issued on or

after August 13, 1996.

(d) Certain debt instruments that

provide for a fixed yield. If a debt

instrument provides for one or more

contingent payments but all possible

payment schedules under the terms of

the instrument result in the same fixed

yield, the yield of the debt instrument

is the fixed yield. For example, the

yield of a debt instrument with principal payments that are fixed in total

amount but that are uncertain as to

time (such as a demand loan) is the

stated interest rate if the issue price of

the instrument is equal to the stated

principal amount and interest is paid or

compounded at a fixed rate over the

entire term of the instrument. This

paragraph (d) applies to debt instruments issued on or after August 13,

1996.

(f) * * *

(2) * * * For purposes of the

preceding sentence, the last possible

date that the debt instrument could be

outstanding is determined without regard to §1.1275–2(h) (relating to payments subject to remote or incidental

contingencies).

Par. 10. Section 1.1273–1 is

amended by:

1. Removing the language ‘‘principal payments uncertain as to time’’ in

the fourth sentence of paragraph (a)

and adding the language ‘‘a fixed

yield’’ in its place.

2. Revising paragraph (c)(1)(ii).

3. Revising paragraph (f) Example 4.

The revisions read as follows:

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§1.1273–1 Definition of OID.

* * * * * *

(ii) Unconditionally payable. Interest

is unconditionally payable only if reasonable legal remedies exist to compel

timely payment or the debt instrument

otherwise provides terms and conditions that make the likelihood of late

payment (other than a late payment that

occurs within a reasonable grace

period) or nonpayment a remote contingency (within the meaning of

§1.1275–2(h)). For purposes of the

preceding sentence, remedies or other

terms and conditions are not taken into

account if the lending transaction does

not reflect arm’s length dealing and the

holder does not intend to enforce the

remedies or other terms and conditions.

For purposes of determining whether

interest is unconditionally payable, the

possibility of nonpayment due to default, insolvency, or similar circumstances, or due to the exercise of a

conversion option described in

§1.1272–1(e) is ignored. This paragraph (c)(1)(ii) applies to debt instruments issued on or after August 13,

1996.

* *

(f) * * *

Example 4. Qualified stated interest on a debt

instrument that is subject to an option—(i)

Facts. On January 1, 1997, A issues, for

$100,000, a 10-year debt instrument that

provides for a $100,000 principal payment at

maturity and for annual interest payments of

$10,000. Under the terms of the debt instrument,

A has the option, exercisable on January 1, 2002,

to lower the annual interest payments to $8,000.

In addition, the debt instrument gives the holder

an unconditional right to put the debt instrument

back to A, exercisable on January 1, 2002, in

return for $100,000.

(ii) Amount of qualified stated interest. Under

paragraph (c)(2) of this section, the debt

instrument provides for qualified stated interest

to the extent of the lowest fixed rate at which

qualified stated interest would be payable under

any payment schedule. If the payment schedule

determined by assuming that the issuer’s option

will be exercised and the put option will not be

exercised were treated as the debt instrument’s

sole payment schedule, only $8,000 of each

annual interest payment would be qualified stated

interest. Under any other payment schedule, the

debt instrument would provide for annual

qualified stated interest payments of $10,000.

Accordingly, only $8,000 of each annual interest

payment is qualified stated interest. Any excess

of each annual interest payment over $8,000 is

included in the debt instrument’s stated redemption price at maturity.

* * * * * *

Par. 11. Section 1.1274–2

amended by:

1. Removing the language

‘‘§1.1272–1(c)(3)(ii)’’ from paragraph

(e) and adding the language ‘‘§1.1272–

1(c)(3)’’ in its place.

2. Revising paragraph (g).

3. Adding and reserving paragraph

(i) and adding paragraph (j).

The revisions and additions read as

follows:

§1.1274–2 Issue price of debt

instruments to which section 1274

applies.

(g) Treatment of contingent payment

debt instruments. Notwithstanding paragraph (b) of this section, if a debt

instrument subject to section 1274

provides for one or more contingent

payments, the issue price of the debt

instrument is the lesser of the instrument’s noncontingent principal payments and the sum of the present

values of the noncontingent payments

(as determined under paragraph (c) of

this section). However, if the debt

instrument is issued in a potentially

abusive situation, the issue price of the

debt instrument is the fair market value

of the noncontingent payments. For

additional rules relating to a debt

instrument that provides for one or

more contingent payments, see

§1.1275–4. This paragraph (g) applies

to debt instruments issued on or after

August 13, 1996.

(i) [Reserved]

(j) Special rules for tax-exempt

obligations—(1) Certain variable rate

debt instruments. Notwithstanding paragraph (b) of this section, if a taxexempt obligation (as defined in section 1275(a)(3)) is a variable rate debt

instrument (within the meaning of

§1.1275–5) that pays interest at an

objective rate and is subject to section

1274, the issue price of the obligation

is the greater of the obligation’s fair

market value and its stated principal

amount.

(2) Contingent payment debt instruments. Notwithstanding paragraphs (b)

and (g) of this section, if a tax-exempt

obligation (as defined in section

1275(a)(3)) is subject to section 1274

and §1.1275–4, the issue price of the

obligation is the fair market value of

the obligation. However, in the case of

a tax-exempt obligation that is subject

to §1.1275–4(d)(2) (an obligation that

provides for interest-based or revenuebased payments), the issue price of the

obligation is the greater of the obligation’s fair market value and its stated

principal amount.

(3) Effective date. This paragraph (j)

applies to debt instruments issued on or

after August 13, 1996.

Par. 12. Section 1.1275–2 is

amended by adding the text of paragraph (g), adding paragraph (h), adding

and reserving paragraph (i), and adding

paragraph (j) to read as follows:

§1.1275–2 Special rules relating to

debt instruments.

(g) Anti-abuse rule—(1) In general.

If a principal purpose in structuring a

debt instrument or engaging in a transaction is to achieve a result that is

unreasonable in light of the purposes of

section 163(e), sections 1271 through

1275, or any related section of the

Code, the Commissioner can apply or

depart from the regulations under the

applicable sections as necessary or

appropriate to achieve a reasonable

result. For example, if this paragraph

(g) applies to a debt instrument that

provides for a contingent payment, the

Commissioner can treat the contingency as if it were a separate

position.

(2) Unreasonable result. Whether a

result is unreasonable is determined

based on all the facts and circumstances. In making this determination, a

significant fact is whether the treatment

of the debt instrument is expected to

have a substantial effect on the issuer’s

or a holder’s U.S. tax liability. In the

case of a contingent payment debt

instrument, another significant fact is

whether the result is obtainable without

the application of §1.1275–4 and any

related provisions (e.g., if the debt

instrument and the contingency were

entered into separately). A result will

not be considered unreasonable, however, in the absence of an expected

substantial effect on the present value

of a taxpayer’s tax liability.

(3) Examples. The following examples illustrate the provisions of this

paragraph (g).

Example 1. A issues a current-pay, increasingrate note that provides for an early call option.

Although the option is deemed exercised on the

call date under §1.1272–1(c)(5), the option is not

expected to be exercised by A. In addition, a

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principal purpose of including the option in the

terms of the note is to limit the amount of

interest income includible by the holder in the

period prior to the call date by virtue of the

option rules in §1.1272–1(c)(5). Moreover, the

application of the option rules is expected to

substantially reduce the present value of the

holder’s tax liability. Based on these facts, the

application of §1.1272–1(c)(5) produces an unreasonable result. Therefore, under this paragraph

(g), the Commissioner can apply the regulations

(in whole or in part) to the note without regard

to §1.1272–1(c)(5).

Example 2. C, a foreign corporation not

subject to U.S. taxation, issues to a U.S. holder a

debt instrument that provides for a contingent

payment. The debt instrument is issued for cash

and is subject to the noncontingent bond method

in §1.1275–4(b). Six months after issuance, C

and the holder modify the debt instrument so that

there is a deemed reissuance of the instrument

under section 1001. The new debt instrument is

subject to the rules of §1.1275–4(c) rather than

§1.1275–4(b). The application of §1.1275–4(c) is

expected to substantially reduce the present value

of the holder’s tax liability as compared to the

application of §1.1275–4(b). In addition, a

principal purpose of the modification is to

substantially reduce the present value of the

holder’s tax liability through the application of

§1.1275–4(c). Based on these facts, the application of §1.1275–4(c) produces an unreasonable

result. Therefore, under this paragraph (g), the

Commissioner can apply the noncontingent bond

method to the modified debt instrument.

Example 3. D issues a convertible debt

instrument rather than an economically

equivalent investment unit consisting of a debt

instrument and a warrant. The convertible debt

instrument is issued at par and provides for

annual payments of interest. D issues the

convertible debt instrument rather than the

investment unit so that the debt instrument would

not have OID. See §1.1273–2(j). In general, this

is a reasonable result in light of the purposes of

the applicable statutes. Therefore, the Commissioner generally will not use the authority under

this paragraph (g) to depart from the application

of §1.1273-2(j) in this case.

(4) Effective date. This paragraph (g)

applies to debt instruments issued on or

after August 13, 1996.

(h) Remote and incidental contingencies—(1) In general. This paragraph (h) applies to a debt instrument

if one or more payments on the

instrument are subject to either a

remote or incidental contingency.

Whether a contingency is remote or

incidental is determined as of the issue

date of the debt instrument, including

any date there is a deemed reissuance

of the debt instrument under paragraph

(h)(6)(ii) or (j) of this section or

§1.1272–1(c)(6). Except as otherwise

provided, the treatment of the contingency under this paragraph (h) applies for all purposes of sections 163(e)

(other than section 163(e)(5)) and 1271

through 1275 and the regulations thereunder. For purposes of this paragraph

(h), the possibility of impairment of a

payment by insolvency, default, or

similar circumstances is not a

contingency.

(2) Remote contingencies. A contingency is remote if there is a remote

likelihood either that the contingency

will occur or that the contingency will

not occur. If there is a remote likelihood that the contingency will occur, it

is assumed that the contingency will

not occur. If there is a remote likelihood that the contingency will not

occur, it is assumed that the contingency will occur.

(3) Incidental contingencies—(i)

Contingency relating to amount. A

contingency relating to the amount of a

payment is incidental if, under all

reasonably expected market conditions,

the potential amount of the payment is

insignificant relative to the total expected amount of the remaining payments on the debt instrument. If a

payment on a debt instrument is subject

to an incidental contingency described

in this paragraph (h)(3)(i), the payment

is ignored until the payment is made.

However, see paragraph (h)(6)(i)(B) of

this section for the treatment of the

debt instrument if a change in circumstances occurs prior to the date the

payment is made.

(ii) Contingency relating to time. A

contingency relating to the timing of a

payment is incidental if, under all

reasonably expected market conditions,

the potential difference in the timing of

the payment (from the earliest date to

the latest date) is insignificant. If a

payment on a debt instrument is subject

to an incidental contingency described

in this paragraph (h)(3)(ii), the payment

is treated as made on the earliest date

that the payment could be made pursuant to the contingency. If the payment is not made on this date, a

taxpayer makes appropriate adjustments

to take into account the delay in

payment. However, see paragraph

(h)(6)(i)(C) of this section for the

treatment of the debt instrument if the

delay is not insignificant.

(4) Aggregation rule. For purposes

of paragraph (h)(2) of this section, if a

debt instrument provides for multiple

contingencies each of which has a

remote likelihood of occurring but,

when all of the contingencies are considered together, there is a greater than

remote likelihood that at least one of

the contingencies will occur, none of

the contingencies is treated as a remote

contingency. For purposes of paragraph

(h)(3)(i) of this section, if a debt

instrument provides for multiple contingencies each of which is incidental

but the potential total amount of all of

the payments subject to the contingencies is not, under reasonably expected

market conditions, insignificant relative

to the total expected amount of the

remaining payments on the debt instrument, none of the contingencies is

treated as incidental.

(5) Consistency rule. For purposes

of paragraphs (h)(2) and (3) of this section, the issuer’s determination that a

contingency is either remote or incidental is binding on all holders. However, the issuer’s determination is not

binding on a holder that explicitly

discloses that its determination is different from the issuer’s determination.

Unless otherwise prescribed by the

Commissioner, the disclosure must be

made on a statement attached to the

holder’s timely filed federal income tax

return for the taxable year that includes

the acquisition date of the debt instrument. See §1.1275–2(e) for rules relating to the issuer’s obligation to disclose

certain information to holders.

(6) Subsequent adjustments—(i) Applicability. This paragraph (h)(6) applies to a debt instrument when there is

a change in circumstances. For purposes of the preceding sentence, there

is a change in circumstances if—

(A) A remote contingency actually

occurs or does not occur, contrary to

the assumption made in paragraph

(h)(2) of this section;

(B) A payment subject to an incidental contingency described in paragraph (h)(3)(i) of this section becomes

fixed in an amount that is not insignificant relative to the total expected

amount of the remaining payments on

the debt instrument; or

fixed such that the difference between

the assumed payment date and the due

date of the payment is not insignificant.

(ii) In general. If a change in

circumstances occurs, solely for purposes of sections 1272 and 1273, the

debt instrument is treated as retired and

then reissued on the date of the change

in circumstances for an amount equal

to the instrument’s adjusted issue price

on that date.

(iii) Contingent payment debt instruments. Notwithstanding paragraph

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(h)(6)(ii) of this section, in the case of

a contingent payment debt instrument

subject to §1.1275–4, if a change in

circumstances occurs, no retirement or

reissuance is treated as occurring, but

any payment that is fixed as a result of

the change in circumstances is governed by the rules in §1.1275–4 that

apply when the amount of a contingent

payment becomes fixed.

(7) Effective date. This paragraph (h)

applies to debt instruments issued on or

after August 13, 1996.

(i) [Reserved]

(j) Treatment of certain modifications. If the terms of a debt instrument

are modified to defer one or more

payments, and the modification does

not cause an exchange under section

1001, then, solely for purposes of

sections 1272 and 1273, the debt instrument is treated as retired and then

reissued on the date of the modification

for an amount equal to the instrument’s

adjusted issue price on that date. This

paragraph (j) applies to debt instruments issued on or after August 13,

1996.

§1.1275–2T [Removed]

Par. 13. Section 1.1275–2T is removed effective August 13, 1996.

Par. 14. In §1.1275–3, paragraph

(b)(1)(i) is revised to read as follows:

§1.1275–3 OID information reporting

requirements.

(b) * * * (1) * * *

(i) Set forth on the face of the debt

instrument the issue price, the amount

of OID, the issue date, the yield to

maturity, and, in the case of a debt

instrument subject to the rules of

§1.1275–4(b), the comparable yield and

projected payment schedule; or

Par. 15. Section 1.1275–4 is added to

read as follows:

§1.1275–4 Contingent payment debt

instruments.

(a) Applicability—(1) In general.

Except as provided in paragraph (a)(2)

of this section, this section applies to

any debt instrument that provides for

one or more contingent payments. In

general, paragraph (b) of this section

applies to a contingent payment debt

instrument that is issued for money or

publicly traded property and paragraph

issued for nonpublicly traded property.

Paragraph (d) of this section provides

special rules for tax-exempt obligations. See §1.1275–6 for a taxpayer’s

treatment of a contingent payment debt

instrument and a hedge.

(2) Exceptions. This section does not

apply to—

(i) A debt instrument that has an

issue price determined under section

1273(b)(4) (e.g., a debt instrument

subject to section 483);

(ii) A variable rate debt instrument

(as defined in §1.1275–5);

(iii) A debt instrument subject to

§1.1272–1(c) (a debt instrument that

provides for certain contingencies) or

§1.1272–1(d) (a debt instrument that

provides for a fixed yield);

(iv) A debt instrument subject to

section 988 (except as provided in

section 988 and the regulations

thereunder);

(v) A debt instrument to which

section 1272(a)(6) applies (certain interests in or mortgages held by a

REMIC, and certain other debt instruments with payments subject to

acceleration);

(vi) A debt instrument (other than a

tax-exempt obligation) described in

section 1272(a)(2) (e.g., U.S. savings

bonds, certain loans between natural

persons, and short-term taxable obligations); or

(vii) A debt instrument issued pursuant to a plan or arrangement if—

(A) The plan or arrangement is

created by a state statute;

(B) A primary objective of the plan

or arrangement is to enable the participants to pay for the costs of postsecondary education for themselves or

their designated beneficiaries; and

instrument are related to such

objective.

(3) Insolvency and default. A payment is not contingent merely because

of the possibility of impairment by

insolvency, default, or similar circumstances.

(4) Convertible debt instruments. A

debt instrument does not provide for

contingent payments merely because it

provides for an option to convert the

debt instrument into the stock of the

issuer, into the stock or debt of a

related party (within the meaning of

section 267(b) or 707(b)(1)), or into

cash or other property in an amount

equal to the approximate value of such

stock or debt.

(5) Remote and incidental contingencies. A payment is not a contingent

payment merely because of a contingency that, as of the issue date, is

either remote or incidental. See

§1.1275–2(h) for the treatment of remote and incidental contingencies.

(b) Noncontingent bond method—(1)

Applicability. The noncontingent bond

method described in this paragraph (b)

applies to a contingent payment debt

instrument that has an issue price

determined under §1.1273–2 (e.g., a

contingent payment debt instrument

that is issued for money or publicly

traded property).

(2) In general. Under the noncontingent bond method, interest on a debt

instrument must be taken into account

whether or not the amount of any payment is fixed or determinable in the

taxable year. The amount of interest

that is taken into account for each

accrual period is determined by constructing a projected payment schedule

for the debt instrument and applying

rules similar to those for accruing OID

on a noncontingent debt instrument. If

the actual amount of a contingent payment is not equal to the projected

amount, appropriate adjustments are

made to reflect the difference.

(3) Description of method. The following steps describe how to compute

the amount of income, deductions,

gain, and loss under the noncontingent

bond method:

(i) Step one: Determine the comparable yield. Determine the comparable

yield for the debt instrument under the

rules of paragraph (b)(4) of this section. The comparable yield is determined as of the debt instrument’s issue

date.

(ii) Step two: Determine the projected payment schedule. Determine the

projected payment schedule for the

debt instrument under the rules of

paragraph (b)(4) of this section. The

projected payment schedule is determined as of the issue date and remains

fixed throughout the term of the debt

instrument (except under paragraph

(b)(9)(ii) of this section, which applies

to a payment that is fixed more than 6

months before it is due).

(iii) Step three: Determine the daily

portions of interest. Determine the

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daily portions of interest on the debt

instrument for a taxable year as follows. The amount of interest that

accrues in each accrual period is the

product of the comparable yield of the

debt instrument (properly adjusted for

the length of the accrual period) and

the debt instrument’s adjusted issue

price at the beginning of the accrual

period. See paragraph (b)(7)(ii) of this

section to determine the adjusted issue

price of the debt instrument. The daily

portions of interest are determined by

allocating to each day in the accrual

period the ratable portion of the interest

that accrues in the accrual period.

Except as modified by paragraph

(b)(3)(iv) of this section, the daily

portions of interest are includible in

income by a holder for each day in the

holder’s taxable year on which the

holder held the debt instrument and are

deductible by the issuer for each day

during the issuer’s taxable year on

which the issuer was primarily liable

on the debt instrument.

(iv) Step four: Adjust the amount of

income or deductions for differences

between projected and actual contingent payments. Make appropriate

adjustments to the amount of income or

deductions attributable to the debt

instrument in a taxable year for any

differences between projected and actual contingent payments. See paragraph (b)(6) of this section to determine the amount of an adjustment and

the treatment of the adjustment.

(4) Comparable yield and projected

payment schedule. This paragraph (b)(4) provides rules for determining the

comparable yield and projected payment schedule for a debt instrument.

The comparable yield and projected

payment schedule must be supported by

contemporaneous documentation showing that both are reasonable, are based

on reliable, complete, and accurate

data, and are made in good faith.

(i) Comparable yield—(A) In general. Except as provided in paragraph

(b)(4)(i)(B) of this section, the comparable yield for a debt instrument is the

yield at which the issuer would issue a

fixed rate debt instrument with terms

and conditions similar to those of the

contingent payment debt instrument

(the comparable fixed rate debt instrument), including the level of subordination, term, timing of payments, and

general market conditions. For example, if a §1.1275–6 hedge (or the

substantial equivalent) is available, the

comparable yield is the yield on the

synthetic fixed rate debt instrument that

would result if the issuer entered into

the §1.1275–6 hedge. If a §1.1275–6

hedge (or the substantial equivalent) is

not available, but similar fixed rate

debt instruments of the issuer trade at a

price that reflects a spread above a

benchmark rate, the comparable yield is

the sum of the value of the benchmark

rate on the issue date and the spread. In

determining the comparable yield, no

adjustments are made for the riskiness

of the contingencies or the liquidity of

the debt instrument. The comparable

yield must be a reasonable yield for the

issuer and must not be less than the

applicable Federal rate (based on the

overall maturity of the debt instrument).

(B) Presumption for certain debt

instruments. This paragraph (b)(4)(i)(B)

applies to a debt instrument if the

instrument provides for one or more

contingent payments not based on

market information and the instrument

is part of an issue that is marketed or

sold in substantial part to persons for

whom the inclusion of interest under

this paragraph (b) is not expected to

have a substantial effect on their U.S.

tax liability. If this paragraph

(b)(4)(i)(B) applies to a debt instrument, the instrument’s comparable

yield is presumed to be the applicable

Federal rate (based on the overall

maturity of the debt instrument). A

taxpayer may overcome this presumption only with clear and convincing

evidence that the comparable yield for

the debt instrument should be a specific

yield (determined using the principles

in paragraph (b)(4)(i)(A) of this section) that is higher than the applicable

Federal rate. The presumption may not

be overcome with appraisals or other

valuations of nonpublicly traded property. Evidence used to overcome the

presumption must be specific to the

issuer and must not be based on

comparable issuers or general market

conditions.

(ii) Projected payment schedule. The

projected payment schedule for a debt

instrument includes each noncontingent

payment and an amount for each

contingent payment determined as

follows:

(A) Market-based payments. If a

contingent payment is based on market

information (a market-based payment),

the amount of the projected payment is

the forward price of the contingent

payment. The forward price of a

contingent payment is the amount one

party would agree, as of the issue date,

to pay an unrelated party for the right

to the contingent payment on the

settlement date (e.g., the date the

contingent payment is made). For example, if the right to a contingent

payment is substantially similar to an

exchange-traded option, the forward

price is the spot price of the option (the

option premium) compounded at the

applicable Federal rate from the issue

date to the date the contingent payment

is due.

(B) Other payments. If a contingent

payment is not based on market information (a non-market-based payment),

the amount of the projected payment is

the expected value of the contingent

payment as of the issue date.

payment schedule. The projected payment schedule must produce the comparable yield. If the projected payment

schedule does not produce the comparable yield, the schedule must be adjusted consistent with the principles of

this paragraph (b)(4) to produce the

comparable yield. For example, the

adjusted amounts of non-market-based

payments must reasonably reflect the

relative expected values of the payments and must not be set to accelerate

or defer income or deductions. If the

debt instrument contains both marketbased and non-market-based payments,

adjustments are generally made first to

the non-market-based payments because more objective information is

available for the market-based

payments.

(iii) Market information. For purposes of this paragraph (b), market

information is any information on

which an objective rate can be based

under §1.1275–5(c)(1) or (2).

(iv) Issuer/holder consistency. The

issuer’s projected payment schedule is

used to determine the holder’s interest

accruals and adjustments. The issuer

must provide the projected payment

schedule to the holder in a manner

consistent with the issuer disclosure

rules of §1.1275–2(e). If the issuer

does not create a projected payment

schedule for a debt instrument or the

issuer’s projected payment schedule is

unreasonable, the holder of the debt

instrument must determine the comparable yield and projected payment

schedule for the debt instrument under

the rules of this paragraph (b)(4). A

holder that determines its own projected payment schedule must explicitly

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disclose this fact and the reason why

the holder set its own schedule (e.g.,

why the issuer’s projected payment

schedule is unreasonable). Unless otherwise prescribed by the Commissioner,

the disclosure must be made on a

statement attached to the holder’s

timely filed federal income tax return

for the taxable year that includes the

acquisition date of the debt instrument.

(v) Issuer’s determination respected—(A) In general. If the issuer

maintains the contemporaneous documentation required by this paragraph

(b)(4), the issuer’s determination of the

comparable yield and projected payment schedule will be respected unless

either is unreasonable.

(B) Unreasonable determination. For

purposes of paragraph (b)(4)(v)(A) of

this section, a comparable yield or

projected payment schedule generally

will be considered unreasonable if it is

set with a purpose to overstate, understate, accelerate, or defer interest accruals on the debt instrument. In a

determination of whether a comparable

yield or projected payment schedule is

unreasonable, consideration will be

given to whether the treatment of the

debt instrument under this section is

expected to have a substantial effect on

the issuer’s or holder’s U.S. tax liability. For example, if a taxable issuer

markets a debt instrument to a holder

not subject to U.S. taxation, the comparable yield will be given close

scrutiny and will not be respected

unless contemporaneous documentation

shows that the yield is not too high.

debt instrument subject to paragraph

(b)(4)(i)(B) of this section (concerning

a yield presumption for certain debt

instruments that provide for nonmarket-based payments).

(vi) Examples. The following examples illustrate the provisions of this

paragraph (b)(4). In each example,

assume that the instrument described is

a debt instrument for federal income

tax purposes. No inference is intended,

however, as to whether the instrument

is a debt instrument for federal income

tax purposes.

Example 1. Market-based payment—(i) Facts.

On December 31, 1996, X corporation issues for

$1,000,000 a debt instrument that matures on

December 31, 2006. The debt instrument provides for annual payments of interest, beginning

in 1997, at the rate of 6 percent and for a

payment at maturity equal to $1,000,000 plus the

excess, if any, of the price of 10,000 shares of

publicly traded stock in an unrelated corporation

on the maturity date over $350,000, or less the

excess, if any, of $350,000 over the price of

10,000 shares of the stock on the maturity date.

On the issue date, the forward price to purchase

10,000 shares of the stock on December 31,

2006, is $350,000.

(ii) Comparable yield. Under paragraph

(b)(4)(i) of this section, the debt instrument’s

comparable yield is the yield on the synthetic

debt instrument that would result if X corporation entered into a §1.1275–6 hedge. A §1.1275–

6 hedge in this case is a forward contract to

purchase 10,000 shares of the stock on December

31, 2006. If X corporation entered into this

hedge, the resulting synthetic debt instrument

would yield 6 percent, compounded annually.

Thus, the comparable yield on the debt instrument is 6 percent, compounded annually.

(iii) Projected payment schedule. Under paragraph (b)(4)(ii) of this section, the projected

payment schedule for the debt instrument consists of 10 annual payments of $60,000 and a

projected amount for the contingent payment at

maturity. Because the right to the contingent

payment is based on market information, the

projected amount of the contingent payment is

the forward price of the payment. The right to

the contingent payment is substantially similar to

a right to a payment of $1,000,000 combined

with a cash-settled forward contract for the

purchase of 10,000 shares of the stock for

$350,000 on December 31, 2006. Because the

forward price to purchase 10,000 shares of the

stock on December 31, 2006, is $350,000, the

amount to be received or paid under the forward

contract is projected to be zero. As a result, the

projected amount of the contingent payment at

maturity is $1,000,000, consisting of the

$1,000,000 base amount and no additional

amount to be received or paid under the forward

contract.

(A) Assume, alternatively, that on the issue

date the forward price to purchase 10,000 shares

of the stock on December 31, 2006, is $370,000.

If X corporation entered into a §1.1275–6 hedge

(a forward contract to purchase the shares for

$370,000), the resulting synthetic debt instrument

would yield 6.15 percent, compounded annually.

Thus, the comparable yield on the debt instrument is 6.15 percent, compounded annually. The

projected payment schedule for the debt instrument consists of 10 annual payments of $60,000

and a projected amount for the contingent

payment at maturity. The projected amount of

the contingent payment is $1,020,000, consisting

of the $1,000,000 base amount plus the excess

$20,000 of the forward price of the stock over

the purchase price of the stock under the forward

contract.

(B) Assume, alternatively, that on the issue

date the forward price to purchase 10,000 shares

of the stock on December 31, 2006, is $330,000.

If X corporation entered into a §1.1275–6 hedge,

the resulting synthetic debt instrument would

yield 5.85 percent, compounded annually. Thus,

the comparable yield on the debt instrument is

5.85 percent, compounded annually. The projected payment schedule for the debt instrument

consists of 10 annual payments of $60,000 and a

projected amount for the contingent payment at

maturity. The projected amount of the contingent

payment is $980,000, consisting of the

$1,000,000 base amount minus the excess

$20,000 of the purchase price of the stock under

the forward contract over the forward price of

the stock.

Example 2. Non-market-based payments—(i)

Facts. On December 31, 1996, Y issues to Z for

$1,000,000 a debt instrument that matures on

December 31, 2000. The debt instrument has a

stated principal amount of $1,000,000, payable at

maturity, and provides for payments on December 31 of each year, beginning in 1997, of

$20,000 plus 1 percent of Y’s gross receipts, if

any, for the year. On the issue date, Y has

outstanding fixed rate debt instruments with

maturities of 2 to 10 years that trade at a price

that reflects an average of 100 basis points over

Treasury bonds. These debt instruments have

terms and conditions similar to those of the debt

instrument. Assume that on December 31, 1996,

4-year Treasury bonds have a yield of 6.5

percent, compounded annually, and that no

§1.1275–6 hedge is available for the debt

instrument. In addition, assume that the interest

inclusions attributable to the debt instrument are

expected to have a substantial effect on Z’s U.S.

tax liability.

(ii) Comparable yield. The comparable yield

for the debt instrument is equal to the value of

the benchmark rate (i.e., the yield on 4-year

Treasury bonds) on the issue date plus the

spread. Thus, the debt instrument’s comparable

yield is 7.5 percent, compounded annually.

(iii) Projected payment schedule. Y anticipates

that it will have no gross receipts in 1997, but

that it will have gross receipts in later years, and

those gross receipts will grow each year for the

next three years. Based on its business projections, Y believes that it is not unreasonable to

expect that its gross receipts in 1999 and each

year thereafter will grow by between 6 percent

and 13 percent over the prior year. Thus, Y must

take these expectations into account in establishing a projected payment schedule for the debt

instrument that results in a yield of 7.5 percent,

compounded annually. Accordingly, Y could

reasonably set the following projected payment

schedule for the debt instrument:

Date

12/31/1997

12/31/1998

12/31/1999

12/31/2000

Noncontingent

payment

Contingent

payment

$ 20,000

20,000

1,020,000

$ 0

70,000

75,600

83,850

(5) Qualified stated interest. No

amounts payable on a debt instrument

to which this paragraph (b) applies are

qualified stated interest within the

meaning of §1.1273–1(c).

(6) Adjustments. This paragraph

(b)(6) provides rules for the treatment

of positive and negative adjustments

under the noncontingent bond method.

A taxpayer takes into account only

those adjustments that occur during a

taxable year while the debt instrument

is held by the taxpayer or while the

taxpayer is primarily liable on the debt

instrument.

(i) Determination of positive and

negative adjustments. If the amount of

a contingent payment is more than the

projected amount of the contingent

payment, the difference is a positive

adjustment on the date of the payment.

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If the amount of a contingent payment

is less than the projected amount of the

contingent payment, the difference is a

negative adjustment on the date of the

payment (or on the scheduled date of

the payment if the amount of the

payment is zero).

(ii) Treatment of net positive adjustments. The amount, if any, by which

total positive adjustments on a debt

instrument in a taxable year exceed the

total negative adjustments on the debt

instrument in the taxable year is a net

positive adjustment. A net positive

adjustment is treated as additional

interest for the taxable year.

(iii) Treatment of net negative adjustments. The amount, if any, by

which total negative adjustments on a

debt instrument in a taxable year

exceed the total positive adjustments on

the debt instrument in the taxable year

is a net negative adjustment. A taxpayer’s net negative adjustment on a

debt instrument for a taxable year is

treated as follows:

(A) Reduction of interest accruals.

A net negative adjustment first reduces

interest for the taxable year that the

taxpayer would otherwise account for

on the debt instrument under paragraph

(b)(3)(iii) of this section.

(B) Ordinary income or loss. If the

net negative adjustment exceeds the

interest for the taxable year that the

taxpayer would otherwise account for

on the debt instrument under paragraph

(b)(3)(iii) of this section, the excess is

treated as ordinary loss by a holder and

ordinary income by an issuer. However, the amount treated as ordinary

loss by a holder is limited to the

amount by which the holder’s total

interest inclusions on the debt instrument exceed the total amount of the

holder’s net negative adjustments

treated as ordinary loss on the debt

instrument in prior taxable years. The

amount treated as ordinary income by

an issuer is limited to the amount by

which the issuer’s total interest deductions on the debt instrument exceed the

total amount of the issuer’s net negative adjustments treated as ordinary

income on the debt instrument in prior

taxable years.

amounts treated by the taxpayer as a

reduction of interest and as ordinary

income or loss (as the case may be) on

the debt instrument for the taxable

year, the excess is a negative adjust-

ment carryforward for the taxable year.

In general, a taxpayer treats a negative

adjustment carryforward for a taxable

year as a negative adjustment on the

debt instrument on the first day of the

succeeding taxable year. However, if a

holder of a debt instrument has a

negative adjustment carryforward on

the debt instrument in a taxable year in

which the debt instrument is sold,

exchanged, or retired, the negative

adjustment carryforward reduces the

holder’s amount realized on the sale,

exchange, or retirement. If an issuer of

a debt instrument has a negative

adjustment carryforward on the debt

instrument for a taxable year in which

the debt instrument is retired, the issuer

takes the negative adjustment carryforward into account as ordinary income.

(D) Treatment under section 67. A

net negative adjustment is not subject

to section 67 (the 2-percent floor on

miscellaneous itemized deductions).

(iv) Cross-references. If a holder has

a basis in a debt instrument that is

different from the debt instrument’s

adjusted issue price, the holder may

have additional positive or negative

adjustments under paragraph (b)(9)(i)

of this section. If the amount of a

contingent payment is fixed more than

6 months before the date it is due, the

amount and timing of the adjustment

are determined under paragraph

(b)(9)(ii) of this section.

(7) Adjusted issue price, adjusted

basis, and retirement—(i) In general. If

a debt instrument is subject to the

noncontingent bond method, this paragraph (b)(7) provides rules to determine the adjusted issue price of the

debt instrument, the holder’s basis in

the debt instrument, and the treatment

of any scheduled or unscheduled retirements. In general, because any difference between the actual amount of a

contingent payment and the projected

amount of the payment is taken into

account as an adjustment to income or

deduction, the projected payments are

treated as the actual payments for

purposes of making adjustments to

issue price and basis and determining

the amount of any contingent payment

made on a scheduled retirement.

(ii) Definition of adjusted issue

price. The adjusted issue price of a

debt instrument is equal to the debt

instrument’s issue price, increased by

the interest previously accrued on the

debt instrument under paragraph

(b)(3)(iii) of this section (determined

without regard to any adjustments

taken into account under paragraph

(b)(3)(iv) of this section), and decreased by the amount of any noncontingent payment and the projected

amount of any contingent payment

previously made on the debt instrument. See paragraph (b)(9)(ii) of this

section for special rules that apply

when a contingent payment is fixed

more than 6 months before it is due.

(iii) Adjustments to basis. A holder’s

basis in a debt instrument is increased

by the interest previously accrued by

the holder on the debt instrument under

paragraph (b)(3)(iii) of this section

(determined without regard to any

adjustments taken into account under

paragraph (b)(3)(iv) of this section),

and decreased by the amount of any

noncontingent payment and the projected amount of any contingent payment previously made on the debt

instrument to the holder. See paragraph

(b)(9)(i) of this section for special rules

that apply when basis is different from

adjusted issue price and paragraph

(b)(9)(ii) of this section for special

rules that apply when a contingent

payment is fixed more than 6 months

before it is due.

(iv) Scheduled retirements. For purposes of determining the amount realized by a holder and the repurchase

price paid by the issuer on the scheduled retirement of a debt instrument, a

holder is treated as receiving, and the

issuer is treated as paying, the projected amount of any contingent payment due at maturity. If the amount

paid or received is different from the

projected amount, see paragraph (b)(6)

of this section for the treatment of the

difference by the taxpayer. Under paragraph (b)(6)(iii)(C) of this section, the

amount realized by a holder on the

retirement of a debt instrument is

reduced by any negative adjustment

carryforward determined in the taxable

year of the retirement.

(v) Unscheduled retirements. An unscheduled retirement of a debt instrument (or the receipt of a pro-rata

prepayment that is treated as a retirement of a portion of a debt instrument

under §1.1275-2(f)) is treated as a

repurchase of the debt instrument (or a

pro-rata portion of the debt instrument)

by the issuer from the holder for the

amount paid by the issuer to the holder.

(vi) Examples. The following examples illustrate the provisions of paragraphs (b)(6) and (7) of this section. In

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each example, assume that the instrument described is a debt instrument for

federal income tax purposes. No inference is intended, however, as to

whether the instrument is a debt

instrument for federal income tax

purposes.

Example 1. Treatment of positive and negative

adjustments—(i) Facts. On December 31, 1996,

Z, a calendar year taxpayer, purchases a debt

instrument subject to this paragraph (b) at

original issue for $1,000. The debt instrument’s

comparable yield is 10 percent, compounded

annually, and the projected payment schedule

provides for payments of $500 on December 31,

1997 (consisting of a noncontingent payment of

$375 and a projected amount of $125) and $660

on December 31, 1998 (consisting of a noncontingent payment of $600 and a projected amount

of $60). The debt instrument is a capital asset in

the hands of Z.

(ii) Adjustment in 1997. Based on the projected payment schedule, Z’s total daily portions

of interest on the debt instrument are $100 for

1997 (issue price of $1,000 x 10 percent).

Assume that the payment actually made on

December 31, 1997, is $375, rather than the

projected $500. Under paragraph (b)(6)(i) of this

section, Z has a negative adjustment of $125 on

December 31, 1997, attributable to the difference

between the amount of the actual payment and

the amount of the projected payment. Because Z

has no positive adjustments for 1997, Z has a net

negative adjustment of $125 on the debt

instrument for 1997. This net negative adjustment reduces to zero the $100 total daily

portions of interest Z would otherwise include in

income in 1997. Accordingly, Z has no interest

income on the debt instrument for 1997. Because

Z had no interest inclusions on the debt

instrument for prior taxable years, the remaining

$25 of the net negative adjustment is a negative

adjustment carryforward for 1997 that results in

a negative adjustment of $25 on January 1, 1998.

(iii) Adjustment to issue price and basis. Z’s

total daily portions of interest on the debt

instrument are $100 for 1997. The adjusted issue

price of the debt instrument and Z’s adjusted

basis in the debt instrument are increased by this

amount, despite the fact that Z does not include

this amount in income because of the net

negative adjustment for 1997. In addition, the

adjusted issue price of the debt instrument and

Z’s adjusted basis in the debt instrument are

decreased on December 31, 1997, by the

projected amount of the payment on that date

($500). Thus, on January 1, 1998, Z’s adjusted

basis in the debt instrument and the adjusted

issue price of the debt instrument are $600.

(iv) Adjustments in 1998. Based on the projected payment schedule, Z’s total daily portions

of interest are $60 for 1998 (adjusted issue price

of $600 3 10 percent). Assume that the payment

actually made on December 31, 1998, is $700,

rather than the projected $660. Under paragraph

(b)(6)(i) of this section, Z has a positive

adjustment of $40 on December 31, 1998,

attributable to the difference between the amount

of the actual payment and the amount of the

projected payment. Because Z also has a

negative adjustment of $25 on January 1, 1998,

Z has a net positive adjustment of $15 on the

debt instrument for 1998 (the excess of the $40

positive adjustment over the $25 negative adjustment). As a result, Z has $75 of interest income

on the debt instrument for 1998 (the $15 net

positive adjustment plus the $60 total daily

portions of interest that are taken into account by

Z in that year).

(v) Retirement. Based on the projected payment schedule, Z’s adjusted basis in the debt

instrument immediately before the payment at

maturity is $660 ($600 plus $60 total daily

portions of interest for 1998). Even though Z

receives $700 at maturity, for purposes of

determining the amount realized by Z on

retirement of the debt instrument, Z is treated as

receiving the projected amount of the contingent

payment on December 31, 1998. Therefore, Z is

treated as receiving $660 on December 31, 1998.

Because Z’s adjusted basis in the debt instrument

immediately before its retirement is $660, Z

recognizes no gain or loss on the retirement.

Example 2. Negative adjustment carryforward

for year of sale—(i) Facts. Assume the same

facts as in Example 1 of this paragraph

(b)(7)(vi), except that Z sells the debt instrument

on January 1, 1998, for $630.

(ii) Gain on sale. On the date the debt

instrument is sold, Z’s adjusted basis in the debt

instrument is $600. Because Z has a negative

adjustment of $25 on the debt instrument on

January 1, 1998, and has no positive adjustments

on the debt instrument in 1998, Z has a net

negative adjustment for 1998 of $25. Because Z

has not included in income any interest on the

debt instrument, the entire $25 net negative

adjustment is a negative adjustment carryforward

for the taxable year of the sale. Under paragraph

(b)(6)(iii)(C) of this section, the $25 negative

adjustment carryforward reduces the amount

realized by Z on the sale of the debt instrument

from $630 to $605. Thus, Z has a gain on the

sale of $5 ($605 – $600). Under paragraph

(b)(8)(i) of this section, the gain is treated as

interest income.

Example 3. Negative adjustment carryforward

for year of retirement—(i) Facts. Assume the

same facts as in Example 1 of this paragraph

(b)(7)(vi), except that the payment actually made

on December 31, 1998, is $615, rather than the

projected $660.

(ii) Adjustments in 1998. Under paragraph

(b)(6)(i) of this section, Z has a negative

adjustment of $45 on December 31, 1998,

attributable to the difference between the amount

of the actual payment and the amount of the

projected payment. In addition, Z has a negative

adjustment of $25 on January 1, 1998. See

Example 1 (ii) of this paragraph (b)(7)(vi).

Because Z has no positive adjustments in 1998,

Z has a net negative adjustment of $70 for 1998.

This net negative adjustment reduces to zero the

$60 total daily portions of interest Z would

otherwise include in income for 1998. Therefore,

Z has no interest income on the debt instrument

for 1998. Because Z had no interest inclusions

on the debt instrument for 1997, the remaining

$10 of the net negative adjustment is a negative

adjustment carryforward for 1998 that reduces

the amount realized by Z on retirement of the

debt instrument.

(iii) Loss on retirement. Immediately before

the payment at maturity, Z’s adjusted basis in the

debt instrument is $660. Under paragraph

(b)(7)(iv) of this section, Z is treated as receiving

the projected amount of the contingent payment,

or $660, as the payment at maturity. Under

paragraph (b)(6)(iii)(C) of this section, however,

this amount is reduced by any negative adjustment carryforward determined for the taxable

year of retirement to calculate the amount Z

realizes on retirement of the debt instrument.

Thus, Z has a loss of $10 on the retirement of

the debt instrument, equal to the amount by

which Z’s adjusted basis in the debt instrument

($660) exceeds the amount Z realizes on the

retirement of the debt instrument ($660 minus

the $10 negative adjustment carryforward). Under paragraph (b)(8)(ii) of this section, the loss is

a capital loss.

(8) Character on sale, exchange, or

retirement—(i) Gain. Any gain recognized by a holder on the sale, exchange, or retirement of a debt

instrument subject to this paragraph (b)

is interest income.

(ii) Loss. Any loss recognized by a

holder on the sale, exchange, or retirement of a debt instrument subject to

this paragraph (b) is ordinary loss to

the extent that the holder’s total interest

inclusions on the debt instrument exceed the total net negative adjustments

on the debt instrument the holder took

into account as ordinary loss. Any

additional loss is treated as loss from

the sale, exchange, or retirement of the

debt instrument. However, any loss that

would otherwise be ordinary under this

paragraph (b)(8)(ii) and that is attributable to the holder’s basis that could

not be amortized under section

171(b)(4) is loss from the sale, exchange, or retirement of the debt

instrument.

(iii) Special rule if there are no

remaining contingent payments on the

debt instrument—(A) In general. Notwithstanding paragraphs (b)(8)(i) and

(ii) of this section, if, at the time of the

sale, exchange, or retirement of the

debt instrument, there are no remaining

contingent payments due on the debt

instrument under the projected payment

schedule, any gain or loss recognized

by the holder is gain or loss from the

sale, exchange, or retirement of the

debt instrument. See paragraph (b)(9)(ii) of this section to determine

whether there are no remaining contingent payments on a debt instrument

that provides for fixed but deferred

contingent payments.

(B) Exception for certain positive

adjustments. Notwithstanding paragraph

(b)(8)(iii)(A) of this section, if a

positive adjustment on a debt instrument is spread under paragraph (b)(9)(ii)(F) or (G) of this section, any gain

recognized by the holder on the sale,

exchange, or retirement of the instrument is treated as interest income to

the extent of the positive adjustment

that has not yet been accrued and

included in income by the holder.

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(iv) Examples. The following examples illustrate the provisions of this

paragraph (b)(8). In each example,

assume that the instrument described is

a debt instrument for federal income

tax purposes. No inference is intended,

however, as to whether the instrument

is a debt instrument for federal income

tax purposes.

Example 1. Gain on sale—(i) Facts. On

January 1, 1998, D, a calendar year taxpayer,

sells a debt instrument that is subject to

paragraph (b) of this section for $1,350. The

projected payment schedule for the debt instrument provides for contingent payments after

January 1, 1998. On January 1, 1998, D has an

adjusted basis in the debt instrument of $1,200.

In addition, D has a negative adjustment carryforward of $50 for 1997 that, under paragraph

(b)(6)(iii)(C) of this section, results in a negative

adjustment of $50 on January 1, 1998. D has no

positive adjustments on the debt instrument on

January 1, 1998.

(ii) Character of gain. Under paragraph (b)(6)

of this section, the $50 negative adjustment on

January 1, 1998, results in a negative adjustment

carryforward for 1998, the taxable year of the

sale of the debt instrument. Under paragraph

(b)(6)(iii)(C) of this section, the negative adjustment carryforward reduces the amount realized

by D on the sale of the debt instrument from

$1,350 to $1,300. As a result, D realizes a $100

gain on the sale of the debt instrument, equal to

the $1,300 amount realized minus D’s $1,200

adjusted basis in the debt instrument. Under

paragraph (b)(8)(i) of this section, the gain is

interest income to D.

Example 2. Loss on sale—(i) Facts. On

December 31, 1996, E, a calendar year taxpayer,

purchases a debt instrument at original issue for

$1,000. The debt instrument is a capital asset in

the hands of E. The debt instrument provides for

a single payment on December 31, 1998 (the

maturity date of the instrument), of $1,000 plus

an amount based on the increase, if any, in the

price of a specified commodity over the term of

the instrument. The comparable yield for the debt

instrument is 9.54 percent, compounded annually, and the projected payment schedule

provides for a payment of $1,200 on December

31, 1998. Based on the projected payment

schedule, the total daily portions of interest are

$95 for 1997 and $105 for 1998.

(ii) Ordinary loss. Assume that E sells the

debt instrument for $1,050 on December 31,

1997. On that date, E has an adjusted basis in the

debt instrument of $1,095 ($1,000 original basis,

plus total daily portions of $95 for 1997).

Therefore, E realizes a $45 loss on the sale of

the debt instrument ($1,050 – $1,095). The loss

is ordinary to the extent E’s total interest

inclusions on the debt instrument ($95) exceed

the total net negative adjustments on the

instrument that E took into account as an

ordinary loss. Because E has not had any net

negative adjustments on the debt instrument, the

$45 loss is an ordinary loss.

(iii) Capital loss. Alternatively, assume that E

sells the debt instrument for $990 on December

31, 1997. E realizes a $105 loss on the sale of

the debt instrument ($990 – $1,095). The loss is

ordinary to the extent E’s total interest inclusions

on the debt instrument ($95) exceed the total net

negative adjustments on the instrument that E

took into account as an ordinary loss. Because E

has not had any net negative adjustments on the

debt instrument, $95 of the $105 loss is an

ordinary loss. The remaining $10 of the $105

loss is a capital loss.

(9) Operating rules. The rules of

this paragraph (b)(9) apply to a debt

instrument subject to the noncontingent

bond method notwithstanding any other

rule of this paragraph (b).

(i) Basis different from adjusted issue price. This paragraph (b)(9)(i)

provides rules for a holder whose basis

in a debt instrument is different from

the adjusted issue price of the debt

instrument (e.g., a subsequent holder

that purchases the debt instrument for

more or less than the instrument’s

adjusted issue price).

(A) General rule. The holder accrues interest under paragraph (b)(3)(iii) of this section and makes

adjustments under paragraph (b)(3)(iv)

of this section based on the projected

payment schedule determined as of the

issue date of the debt instrument.

However, upon acquiring the debt

instrument, the holder must reasonably

allocate any difference between the

adjusted issue price and the basis to

daily portions of interest or projected

payments over the remaining term of

the debt instrument. Allocations are

taken into account under paragraphs

(b)(9)(i)(B) and (C) of this section.

(B) Basis greater than adjusted issue

price. If the holder’s basis in the debt

instrument exceeds the debt instrument’s adjusted issue price, the amount

of the difference allocated to a daily

portion of interest or to a projected

payment is treated as a negative

adjustment on the date the daily portion

accrues or the payment is made. On the

date of the adjustment, the holder’s

adjusted basis in the debt instrument is

reduced by the amount the holder treats

as a negative adjustment under this

paragraph (b)(9)(i)(B). See paragraph

(b)(9)(ii)(E) of this section for a special

rule that applies when a contingent

payment is fixed more than 6 months

before it is due.

price. If the holder’s basis in the debt

instrument is less than the debt instrument’s adjusted issue price, the amount

of the difference allocated to a daily

portion of interest or to a projected

payment is treated as a positive adjustment on the date the daily portion

accrues or the payment is made. On the

date of the adjustment, the holder’s

adjusted basis in the debt instrument is

increased by the amount the holder

treats as a positive adjustment under

this paragraph (b)(9)(i)(C). See paragraph (b)(9)(ii)(E) of this section for a

special rule that applies when a contingent payment is fixed more than 6

months before it is due.

(D) Premium and discount rules do

not apply. The rules for accruing

premium and discount in sections 171,

1272(a)(7), 1276, and 1281 do not

apply. Other rules of those sections,

such as section 171(b)(4), continue to

apply to the extent relevant.

(E) Safe harbor for exchange listed

debt instruments. If the debt instrument

is exchange listed property (within the

meaning of §1.1273–2(f)(2)), it is

reasonable for the holder to allocate

any difference between the holder’s

basis and the adjusted issue price of the

debt instrument pro-rata to daily portions of interest (as determined under

paragraph (b)(3)(iii) of this section)

over the remaining term of the debt

instrument. A pro-rata allocation is not

reasonable, however, to the extent the

holder’s yield on the debt instrument,

determined after taking into account the

amounts allocated under this paragraph

(b)(9)(i)(E), is less than the applicable

Federal rate for the instrument. For

purposes of the preceding sentence, the

applicable Federal rate for the debt

instrument is determined as if the

purchase date were the issue date and

the remaining term of the instrument

were the term of the instrument.

(F) Examples. The following examples illustrate the provisions of this

paragraph (b)(9)(i). In each example,

assume that the instrument described is

a debt instrument for federal income

tax purposes. No inference is intended,

however, as to whether the instrument

is a debt instrument for federal income

tax purposes. In addition, assume that

each instrument is not exchange listed

property.

Example 1. Basis greater than adjusted issue

price—(i) Facts. On July 1, 1998, Z purchases

for $1,405 a debt instrument that matures on

December 31, 1999, and promises to pay on the

maturity date $1,000 plus the increase, if any, in

the price of a specified amount of a commodity

from the issue date to the maturity date. The debt

instrument was originally issued on December

31, 1996, for an issue price of $1,000. The

comparable yield for the debt instrument is 10.25

percent, compounded semiannually, and the

projected payment schedule for the debt instrument (determined as of the issue date) provides

for a single payment at maturity of $1,350. At

the time of the purchase, the debt instrument has

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an adjusted issue price of $1,162, assuming

semiannual accrual periods ending on December

31 and June 30 of each year. The increase in the

value of the debt instrument over its adjusted

issue price is due to an increase in the expected

amount of the contingent payment and not to a

decrease in market interest rates. The debt

instrument is a capital asset in the hands of Z. Z

is a calendar year taxpayer.

(ii) Allocation of the difference between basis

and adjusted issue price. Z’s basis in the debt

instrument on July 1, 1998, is $1,405. Under

paragraph (b)(9)(i)(A) of this section, Z allocates

the $243 difference between basis ($1,405) and

adjusted issue price ($1,162) to the contingent

payment at maturity. Z’s allocation of the

difference between basis and adjusted issue price

is reasonable because the increase in the value of

the debt instrument over its adjusted issue price

is due to an increase in the expected amount of

the contingent payment.

(iii) Treatment of debt instrument for 1998.

Based on the projected payment schedule, $60 of

interest accrues on the debt instrument from July

1, 1998 to December 31, 1998 (the product of

the debt instrument’s adjusted issue price on July

1, 1998 ($1,162) and the comparable yield

properly adjusted for the length of the accrual

period (10.25 percent/2)). Z has no net negative

or positive adjustments for 1998. Thus, Z

includes in income $60 of total daily portions of

interest for 1998. On December 31, 1998, Z’s

adjusted basis in the debt instrument is $1,465

($1,405 original basis, plus total daily portions of

$60 for 1998).

(iv) Effect of allocation to contingent payment

at maturity. Assume that the payment actually

made on December 31, 1999, is $1,400, rather

than the projected $1,350. Thus, under paragraph

(b)(6)(i) of this section, Z has a positive

adjustment of $50 on December 31, 1999. In

addition, under paragraph (b)(9)(i)(B) of this

section, Z has a negative adjustment of $243 on

December 31, 1999, which is attributable to the

difference between Z’s basis in the debt instrument on July 1, 1998, and the instrument’s

adjusted issue price on that date. As a result, Z

has a net negative adjustment of $193 for 1999.

This net negative adjustment reduces to zero the

$128 total daily portions of interest Z would

otherwise include in income in 1999. Accordingly, Z has no interest income on the debt

instrument for 1999. Because Z had $60 of

interest inclusions for 1998, $60 of the remaining

$65 net negative adjustment is treated by Z as an

ordinary loss for 1999. The remaining $5 of the

net negative adjustment is a negative adjustment

carryforward for 1999 that reduces the amount

realized by Z on the retirement of the debt

instrument from $1,350 to $1,345.

(v) Loss at maturity. On December 31, 1999,

Z’s basis in the debt instrument is $1,350

($1,405 original basis, plus total daily portions of

$60 for 1998 and $128 for 1999, minus the

negative adjustment of $243). As a result, Z

realizes a loss of $5 on the retirement of the debt

instrument (the difference between the amount

realized on the retirement ($1,345) and Z’s

adjusted basis in the debt instrument ($1,350)).

Under paragraph (b)(8)(ii) of this section, the $5

loss is treated as loss from the retirement of the

debt instrument. Consequently, Z realizes a total

loss of $65 on the debt instrument for 1999 (a

$60 ordinary loss and a $5 capital loss).

Example 2. Basis less than adjusted issue

price—(i) Facts. On January 1, 1999, Y purchases for $910 a debt instrument that pays 7

percent interest semiannually on June 30 and

December 31 of each year, and that promises to

pay on December 31, 2001, $1,000 plus or minus

$10 times the positive or negative difference, if

any, between a specified amount and the value of

an index on December 31, 2001. However, the

payment on December 31, 2001, may not be less

than $650. The debt instrument was originally

issued on December 31, 1996, for an issue price

of $1,000. The comparable yield for the debt

instrument is 9.80 percent, compounded semiannually, and the projected payment schedule for

the debt instrument (determined as of the issue

date) provides for semiannual payments of $35

and a contingent payment at maturity of $1,175.

On January 1, 1999, the debt instrument has an

adjusted issue price of $1,060, assuming semiannual accrual periods ending on December 31 and

June 30 of each year. Y is a calendar year

taxpayer.

(ii) Allocation of the difference between basis

and adjusted issue price. Y’s basis in the debt

instrument on January 1, 1999, is $910. Under

paragraph (b)(9)(i)(A) of this section, Y must

allocate the $150 difference between basis ($910)

and adjusted issue price ($1,060) to daily

portions of interest or to projected payments.

These amounts will be positive adjustments taken

into account at the time the daily portions accrue

or the payments are made.

(A) Assume that, because of a decrease in the

relevant index, the expected value of the

payment at maturity has declined by about 9

percent. Based on forward prices on January 1,

1999, Y determines that approximately $105 of

the difference between basis and adjusted issue

price is allocable to the contingent payment. Y

allocates the remaining $45 to daily portions of

interest on a pro-rata basis (i.e., the amount

allocated to an accrual period equals the product

of $45 and a fraction, the numerator of which is

the total daily portions for the accrual period and

the denominator of which is the total daily

portions remaining on the debt instrument on

January 1, 1999). This allocation is reasonable.

(B) Assume alternatively that, based on yields

of comparable debt instruments and its purchase

price for the debt instrument, Y determines that

an appropriate yield for the debt instrument is 13

percent, compounded semiannually. Based on

this determination, Y allocates $55.75 of the

difference between basis and adjusted issue price

to daily portions of interest as follows: $15.19 to

the daily portions of interest for the taxable year

ending December 31, 1999; $18.40 to the daily

portions of interest for the taxable year ending

December 31, 2000; and $22.16 to the daily

portions of interest for the taxable year ending

December 31, 2001. Y allocates the remaining

$94.25 to the contingent payment at maturity.

This allocation is reasonable.

(ii) Fixed but deferred contingent

payments. This paragraph (b)(9)(ii)

provides rules that apply when the

amount of a contingent payment becomes fixed before the payment is due.

For purposes of paragraph (b) of this

section, if a contingent payment becomes fixed within the 6-month period

ending on the due date of the payment,

the payment is treated as a contingent

payment even after the payment is

fixed. If a contingent payment becomes

fixed more than 6 months before the

payment is due, the following rules

apply to the debt instrument.

(A) Determining adjustments. The

amount of the adjustment attributable

to the contingent payment is equal to

the difference between the present

value of the amount that is fixed and

the present value of the projected

amount of the contingent payment. The

present value of each amount is determined by discounting the amount from

the date the payment is due to the date

the payment becomes fixed, using a

discount rate equal to the comparable

yield on the debt instrument. The

adjustment is treated as a positive or

negative adjustment, as appropriate, on

the date the contingent payment becomes fixed. See paragraph (b)(9)(ii)(G) of this section to determine the

timing of the adjustment if all remaining contingent payments on the debt

instrument become fixed substantially

contemporaneously.

(B) Payment schedule. The contingent payment is no longer treated as

a contingent payment after the date the

amount of the payment becomes fixed.

On the date the contingent payment

becomes fixed, the projected payment

schedule for the debt instrument is

modified prospectively to reflect the

fixed amount of the payment. Therefore, no adjustment is made under

paragraph (b)(3)(iv) of this section

when the contingent payment is actually made.

the determination under §1.1272–1(b)(1)(ii) of accrual periods for the debt

instrument, an accrual period ends on

the day the contingent payment becomes fixed, and a new accrual period

begins on the day after the day the

contingent payment becomes fixed.

(D) Adjustments to basis and adjusted issue price. The amount of any

positive adjustment on a debt instrument determined under paragraph (b)(9)(ii)(A) of this section increases the

adjusted issue price of the instrument

and the holder’s adjusted basis in the

instrument. Similarly, the amount of

any negative adjustment on a debt

instrument determined under paragraph

(b)(9)(ii)(A) of this section decreases

the adjusted issue price of the instrument and the holder’s adjusted basis in

the instrument.

(E) Basis different from adjusted

issue price. If a holder’s basis in a debt

instrument exceeds the debt instrument’s adjusted issue price, the amount

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allocated to a projected payment under

paragraph (b)(9)(i) of this section is

treated as a negative adjustment on the

date the payment becomes fixed. If a

holder’s basis in a debt instrument is

less than the debt instrument’s adjusted

issue price, the amount allocated to a

projected payment under paragraph

(b)(9)(i) of this section is treated as a

positive adjustment on the date the

payment becomes fixed.

(F) Special rule for certain contingent interest payments. Notwithstanding paragraph (b)(9)(ii)(A) of this

section, this paragraph (b)(9)(ii)(F) applies to contingent stated interest payments that are adjusted to compensate

for contingencies regarding the reasonableness of the debt instrument’s stated

rate of interest. For example, this

paragraph (b)(9)(ii)(F) applies to a debt

instrument that provides for an increase

in the stated rate of interest if the credit

quality of the issuer or liquidity of the

debt instrument deteriorates. Contingent

stated interest payments of this type are

recognized over the period to which

they relate in a reasonable manner.

(G) Special rule when all contingent

payments become fixed. Notwithstanding paragraph (b)(9)(ii)(A) of this

section, if all the remaining contingent

payments on a debt instrument become

fixed substantially contemporaneously,

any positive or negative adjustments on

the instrument are taken into account in

a reasonable manner over the period to

which they relate. For purposes of the

preceding sentence, a payment is

treated as a fixed payment if all

remaining contingencies with respect to

the payment are remote or incidental

(within the meaning of §1.1275–2(h)).

(H) Example. The following example illustrates the provisions of this

paragraph (b)(9)(ii). In this example,

assume that the instrument described is

a debt instrument for federal income

tax purposes. No inference is intended,

however, as to whether the instrument

is a debt instrument for federal income

tax purposes.

Example. Fixed but deferred payments—(i)

Facts. On December 31, 1996, B, a calendar year

taxpayer, purchases a debt instrument at original

issue for $1,000. The debt instrument matures on

December 31, 2002, and provides for a payment

of $1,000 at maturity. In addition, on December

31, 1999, and December 31, 2002, the debt

instrument provides for payments equal to the

excess of the average daily value of an index for

the 6-month period ending on September 30 of

the preceding year over a specified amount. The

debt instrument’s comparable yield is 10 percent,

compounded annually, and the instrument’s

projected payment schedule consists of a payment of $250 on December 31, 1999, and a

payment of $1,439 on December 31, 2002. B

uses annual accrual periods.

(ii) Interest accrual for 1997. Based on the

projected payment schedule, B includes a total of

$100 of daily portions of interest in income in

1997. B’s adjusted basis in the debt instrument

and the debt instrument’s adjusted issue price on

December 31, 1997, is $1,100.

(iii) Interest accrual for 1998—(A) Adjustment. Based on the projected payment schedule,

B would include $110 of total daily portions of

interest in income in 1998. However, assume that

on September 30, 1998, the payment due on

December 31, 1999, fixes at $300, rather than

the projected $250. Thus, on September 30,

1998, B has an adjustment equal to the

difference between the present value of the $300

fixed amount and the present value of the $250

projected amount of the contingent payment. The

present values of the two payments are determined by discounting each payment from the

date the payment is due (December 31, 1999) to

the date the payment becomes fixed (September

30, 1998), using a discount rate equal to 10

percent, compounded annually. The present value

of the fixed payment is $266.30 and the present

value of the projected amount of the contingent

payment is $221.91. Thus, on September 30,

1998, B has a positive adjustment of $44.39

($266.30 – $221.91).

(B) Effect of adjustment. Under paragraph

(b)(9)(ii)(C) of this section, B’s accrual period

ends on September 30, 1998. The daily portions

of interest on the debt instrument for the period

from January 1, 1998 to September 30, 1998

total $81.51. The adjusted issue price of the debt

instrument and B’s adjusted basis in the debt

instrument are thus increased over this period by

$125.90 (the sum of the daily portions of interest

of $81.51 and the positive adjustment of $44.39

made at the end of the period) to $1,225.90. For

purposes of all future accrual periods, including

the new accrual period from October 1, 1998, to

December 31, 1998, the debt instrument’s

projected payment schedule is modified to reflect

a fixed payment of $300 on December 31, 1999.

Based on the new adjusted issue price of the debt

instrument and the new projected payment

schedule, the yield on the debt instrument does

not change.

modified projected payment schedule, $29.56 of

interest accrues during the accrual period that

ends on December 31, 1998. Because B has no

other adjustments during 1998, the $44.39

positive adjustment on September 30, 1998,

results in a net positive adjustment for 1998,

which is additional interest for that year. Thus, B

includes $155.46 ($81.51 + $29.56 + $44.39) of

interest in income in 1998. B’s adjusted basis in

the debt instrument and the debt instrument’s

adjusted issue price on December 31, 1998, is

$1,255.46 ($1,225.90 from the end of the prior

accrual period plus $29.56 total daily portions

for the current accrual period).

(iii) Timing contingencies. This paragraph (b)(9)(iii) provides rules for debt

instruments that have payments that are

contingent as to time.

(A) Treatment of certain options. If

a taxpayer has an unconditional option

to put or call the debt instrument, to

exchange the debt instrument for other

property, or to extend the maturity date

of the debt instrument, the projected

payment schedule is determined by

using the principles of §1.1272–1(c)(5).

(B) Other timing contingencies.

[Reserved]

(iv) Cross-border transactions—(A)

Allocation of deductions. For purposes

of §1.861–8, the holder of a debt

instrument shall treat any deduction or

loss treated as an ordinary loss under

paragraph (b)(6)(iii)(B) or (b)(8)(ii) of

this section as a deduction that is

definitely related to the class of gross

income to which income from such

debt instrument belongs. Accordingly,

if a U.S. person holds a debt instrument issued by a related controlled

foreign corporation and, pursuant to

section 904(d)(3) and the regulations

thereunder, any interest accrued by

such U.S. person with respect to such

debt instrument would be treated as

foreign source general limitation income, any deductions relating to a net

negative adjustment will reduce the

U.S. person’s foreign source general

limitation income. The holder shall

apply the general rules relating to

allocation and apportionment of deductions to any other deduction or loss

realized by the holder with respect to

the debt instrument.

(B) Investments in United States real

property. Notwithstanding paragraph

(b)(8)(i) of this section, gain on the

sale, exchange, or retirement of a debt

instrument that is a United States real

property interest is treated as gain for

purposes of sections 897, 1445, and

6039C.

(v) Coordination with subchapter M

and related provisions. For purposes of

sections 852(c)(2) and 4982 and

§1.852–11, any positive adjustment,

negative adjustment, income, or loss on

a debt instrument that occurs after

October 31 of a taxable year is treated

in the same manner as foreign currency

gain or loss that is attributable to a

section 988 transaction.

(vi) Coordination with section 1092.

A holder treats a negative adjustment

and an issuer treats a positive adjustment as a loss with respect to a

position in a straddle if the debt

instrument is a position in a straddle

and the contingency (or any portion of

the contingency) to which the adjustment relates would be part of the

straddle if entered into as a separate

position.

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subject to the noncontingent bond

method—(1) Applicability. This paragraph (c) applies to a contingent

payment debt instrument (other than a

tax-exempt obligation) that has an issue

price determined under §1.1274–2. For

example, this paragraph (c) generally

applies to a contingent payment debt

instrument that is issued for nonpublicly traded property.

(2) Separation into components. If

paragraph (c) of this section applies to

a debt instrument (the overall debt

instrument), the noncontingent payments are subject to the rules in

paragraph (c)(3) of this section, and the

contingent payments are accounted for

separately under the rules in paragraph

(c)(4) of this section.

(3) Treatment of noncontingent payments. The noncontingent payments are

treated as a separate debt instrument.

The issue price of the separate debt

instrument is the issue price of the

overall debt instrument, determined

under §1.1274–2(g). No interest payments on the separate debt instrument

are qualified stated interest payments

(within the meaning of §1.1273–1(c))

and the de minimis rules of section

1273(a)(3) and §1.1273–1(d) do not

apply to the separate debt instrument.

(4) Treatment of contingent payments—(i) In general. Except as

provided in paragraph (c)(4)(iii) of this

section, the portion of a contingent

payment treated as interest under paragraph (c)(4)(ii) of this section is

includible in gross income by the

holder and deductible from gross income by the issuer in their respective

taxable years in which the payment is

made.

(ii) Characterization of contingent

payments as principal and interest—

(A) General rule. A contingent payment is treated as a payment of

principal in an amount equal to the

present value of the payment, determined by discounting the payment at

the test rate from the date the payment

is made to the issue date. The amount

of the payment in excess of the amount

treated as principal under the preceding

sentence is treated as a payment of

interest.

(B) Test rate. The test rate used for

purposes of paragraph (c)(4)(ii)(A) of

this section is the rate that would be

the test rate for the overall debt

instrument under §1.1274–4 if the term

of the overall debt instrument began on

the issue date of the overall debt

instrument and ended on the date the

contingent payment is made. However,

in the case of a contingent payment

that consists of a payment of stated

principal accompanied by a payment of

stated interest at a rate that exceeds the

test rate determined under the preceding sentence, the test rate is the stated

interest rate.

(iii) Certain delayed contingent

payments—(A) General rule. Notwithstanding paragraph (c)(4)(ii) of this

section, if a contingent payment becomes fixed more than 6 months before

the payment is due, the issuer and

holder are treated as if the issuer had

issued a separate debt instrument on

the date the payment becomes fixed,

maturing on the date the payment is

due. This separate debt instrument is

treated as a debt instrument to which

section 1274 applies. The stated principal amount of this separate debt

instrument is the amount of the payment that becomes fixed. An amount

equal to the issue price of this debt

instrument is characterized as interest

or principal under the rules of paragraph (c)(4)(ii) of this section and

accounted for as if this amount had

been paid by the issuer to the holder on

the date that the amount of the payment

becomes fixed. To determine the issue

price of the separate debt instrument,

the payment is discounted at the test

rate from the maturity date of the

separate debt instrument to the date

that the amount of the payment becomes fixed.

(B) Test rate. The test rate used for

purposes of paragraph (c)(4)(iii)(A) of

this section is determined in the same

manner as the test rate under paragraph

(c)(4)(ii)(B) of this section is determined except that the date the contingent payment is due is used rather

than the date the contingent payment is

made.

(5) Basis different from adjusted

issue price. This paragraph (c)(5)

provides rules for a holder whose basis

in a debt instrument is different from

the instrument’s adjusted issue price

(e.g., a subsequent holder). This paragraph (c)(5), however, does not apply

if the holder is reporting income under

the installment method of section 453.

(i) Allocation of basis. The holder

must allocate basis to the noncontingent component (i.e., the right to the

noncontingent payments) and to any

separate debt instruments described in

paragraph (c)(4)(iii) of this section in

an amount up to the total of the

adjusted issue price of the noncontingent component and the adjusted

issue prices of the separate debt instruments. The holder must allocate the

remaining basis, if any, to the contingent component (i.e., the right to the

contingent payments).

(ii) Noncontingent component. Any

difference between the holder’s basis in

the noncontingent component and the

adjusted issue price of the noncontingent component, and any difference

between the holder’s basis in a separate

debt instrument and the adjusted issue

price of the separate debt instrument, is

taken into account under the rules for

market discount, premium, and acquisition premium that apply to a noncontingent debt instrument.

(iii) Contingent component. Amounts

received by the holder that are treated

as principal payments under paragraph

(c)(4)(ii) of this section reduce the

holder’s basis in the contingent component. If the holder’s basis in the

contingent component is reduced to

zero, any additional principal payments

on the contingent component are

treated as gain from the sale or

exchange of the debt instrument. Any

basis remaining on the contingent

component on the date the final contingent payment is made increases the

holder’s adjusted basis in the noncontingent component (or, if there are no

remaining noncontingent payments, is

treated as loss from the sale or

exchange of the debt instrument).

(6) Treatment of a holder on sale,

exchange, or retirement. This paragraph (c)(6) provides rules for the

treatment of a holder on the sale,

exchange, or retirement of a debt

instrument subject to paragraph (c) of

this section. Under this paragraph

(c)(6), the holder must allocate the

amount received from the sale, exchange, or retirement of a debt instrument first to the noncontingent

component and to any separate debt

instruments described in paragraph

(c)(4)(iii) of this section in an amount

up to the total of the adjusted issue

price of the noncontingent component

and the adjusted issue prices of the

separate debt instruments. The holder

must allocate the remaining amount

received, if any, to the contingent

component.

(i) Amount allocated to the noncontingent component. The amount allo-

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cated to the noncontingent component

and any separate debt instruments is

treated as an amount realized from the

sale, exchange, or retirement of the

noncontingent component or separate

debt instrument.

(ii) Amount allocated to the contingent component. The amount allocated to the contingent component is

treated as a contingent payment that is

made on the date of the sale, exchange,

or retirement and is characterized as

interest and principal under the rules of

paragraph (c)(4)(ii) of this section.

(7) Examples. The following examples illustrate the provisions of this

paragraph (c). In each example, assume

that the instrument described is a debt

instrument for federal income tax purposes. No inference is intended, however, as to whether the instrument is a

debt instrument for federal income tax

purposes.

Example 1. Contingent interest payments—(i)

Facts. A owns Blackacre, unencumbered depreciable real estate. On January 1, 1997, A sells

Blackacre to B. As consideration for the sale, B

makes a downpayment of $1,000,000 and issues

to A a debt instrument that matures on December

31, 2001. The debt instrument provides for a

payment of principal at maturity of $5,000,000

and a contingent payment of interest on December 31 of each year equal to a fixed percentage

of the gross rents B receives from Blackacre in

that year. Assume that the debt instrument is not

issued in a potentially abusive situation. Assume

also that on January 1, 1997, the short-term

applicable Federal rate is 5 percent, compounded

annually, and the mid-term applicable Federal

rate is 6 percent, compounded annually.

(ii) Determination of issue price. Under

§1.1274–2(g), the issue price of the debt

instrument is $3,736,291, which is the present

value, as of the issue date, of the $5,000,000

noncontingent payment due at maturity, calculated using a discount rate equal to the mid-term

applicable Federal rate. Under §1.1012–1(g)(1),

B’s basis in Blackacre on January 1, 1997, is

$4,736,291 ($1,000,000 down payment plus the

$3,736,291 issue price of the debt instrument).

(iii) Noncontingent payment treated as separate debt instrument. Under paragraph (c)(3) of

this section, the right to the noncontingent

payment of principal at maturity is treated as a

separate debt instrument. The issue price of this

separate debt instrument is $3,736,291 (the issue

price of the overall debt in

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