Debt Instruments With Original Issue Discount; Imputed Interest on Deferred Payment Sales or Exchanges of Property

DEPARTMENT OF THE TREASURY

26 CFR Parts 1 and 602

[TD 8517]

RIN 1545-AH46

Debt Instruments With Original Issue Discount; Imputed Interest

on Deferred Payment Sales or Exchanges of Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations relating to the tax

treatment of debt instruments with original issue discount and the

imputation of interest on deferred payments under certain contracts for

the sale or exchange of property. The final regulations provide needed

guidance to holders and issuers of debt instruments with original issue

discount and to buyers and sellers of property.

DATES: The removal of Secs. 1.163-11T, 1.1275-3T, 1.1275-6T and

1.6050H-2 is effective February 2, 1994. The remaining regulations are

effective April 4, 1994.

For dates of applicability of these regulations, see Effective

Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: William E. Blanchard, 202-622-3950

(not a toll-free number), or Andrew C. Kittler, 202-622-3940 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this final regulation

have been reviewed and approved by the Office of Management and Budget

in accordance with the requirements of the Paperwork Reduction Act (44

U.S.C. 3504(h)) under control number 1545-1353. The estimated annual

burden per respondent varies from .3 hours to .5 hours, depending on

individual circumstances, with an estimated average of .4 hours.

These estimates are an approximation of the average time expected

to be necessary for a collection of information. They are based on such

information as is available to the IRS. Individual respondents may

require more or less time, depending on their particular circumstances.

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, PC: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.

Background

On December 22, 1992, the IRS published a notice of proposed

rulemaking in the Federal Register (57 FR 60750) relating to original

issue discount (OID) under section 163(e) and sections 1271 through

1275 of the Internal Revenue Code (Code). The notice also contained

proposed amendments to the regulations under sections 446 (relating to

the accrual of interest), 483 (relating to unstated interest), 1001

(relating to amount realized), and 1012 (relating to basis). The notice

withdrew most of the proposed regulations that were previously

published in the Federal Register on April 8, 1986 (51 FR 12022), as

amended on May 7, 1991 (56 FR 21112), and July 12, 1991 (56 FR 31887).

On February 16, 1993, 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; to

permit further comment, Sec. 1.446-2(e)(3) remains outstanding in

proposed form. The changes, as well as several comments and suggestions

that were not adopted in the final regulations, are discussed below.

Explanation of Provisions

Section 1.163-7 Deduction for OID on Certain Debt Instruments

The final regulations retain the rule of the proposed regulations

that allows the issuer of a debt instrument to deduct de minimis OID

using a straight line method. As requested by a commentator, the final

regulations also allow the issuer the choice of deducting de minimis

OID at maturity or in proportion to stated interest payments.

Because the proposed regulations permit flexible accrual periods, a

commentator requested guidance on what accrual period controls to

determine whether a debt instrument is an applicable high yield debt

obligation under section 163(i). The final regulations provide that the

issuer's choice of accrual periods governs for purposes of section

163(i).

A commentator requested that an immediate deduction be allowed for

a repurchase premium in a debt-for-debt exchange even if the issue

price of the debt instrument received in the exchange is determined

under section 1274. The IRS and Treasury, however, believe that

taxpayers could inappropriately accelerate deductions in these

situations because of the flexibility inherent in section 1274 for

determining the issue price of a debt instrument. Thus, the final

regulations retain the rule in the proposed regulations.

Section 1.446-2 Method of Accounting for Interest

The proposed regulations provide a special payment allocation rule

for certain small transactions. Because of the rule's limited scope and

uncertainty regarding its application, the IRS and Treasury believe

that the rule should not be finalized. However, to allow further

comment on the need for this rule, Sec. 1.446-2(e)(3) is reserved in

the final regulations and remains in proposed form.

Section 1.483-1 Through 1.483-3 Unstated Interest

The proposed regulations provide that stated or unstated interest

under a contract subject to section 483 is taken into account under a

taxpayer's regular method of accounting. One commentator suggested that

an accrual method taxpayer should account for unstated interest in the

year a payment is due, which was the rule in previous final regulations

under section 483. The IRS and Treasury, however, believe that it is

appropriate to treat stated and unstated interest consistently. Thus,

the final regulations retain the rule in the proposed regulations.

Sections 1.1001-1(g) and 1.1012-1(g) Amount Realized and Basis

If a debt instrument is issued in exchange for property, the

proposed regulations provide that the issue price of the debt

instrument is used to determine the seller's amount realized and the

buyer's basis. The final regulations adopt the rules of the proposed

regulations, but clarify the treatment of a debt instrument with an

issue price determined under section 1273(b)(4).

Section 1.1271-1 Special Rules Applicable to Amounts Received on

Retirement, Sale, or Exchange of Debt Instruments

As requested by a commentator, the final regulations provide that

the intention to call rules do not apply to debt instruments sold

pursuant to a private placement memorandum that is distributed to more

than ten offerees and that is subject to certain sanctions of the

Securities Act of 1933 or the Securities Exchange Act of 1934.

Section 1.1272-1 Current Inclusion of OID in Income

The proposed regulations provide that accrual periods may be of any

length and may vary in length over the term of the debt instrument,

provided that each accrual period is not longer than one year and that

all payments are made at the end of an accrual period. In response to

one comment, the final regulations provide that payments also may be

made on the first day of an accrual period.

The rule permitting accrual periods to vary in length was provided

in response to commentators who criticized the prior proposed

regulations as too mechanical and inflexible. While commentators

commended the flexibility of the rule, they noted that the rule raised

several technical issues: (1) the accrual periods used to determine

whether an instrument is an applicable high yield debt obligation under

section 163(i); (2) the accrual periods used by a subsequent holder to

determine adjusted issue price for purposes of OID accruals, market

discount, and acquisition premium; and (3) the accrual periods used for

Form 1099 reporting. As noted above, Sec. 1.163-7 of the final

regulations provides that the issuer's determination of accrual periods

controls for purposes of determining whether a debt instrument is an

applicable high yield debt obligation. In addition, Sec. 1.1275-1(b)(2)

of the final regulations provides that a subsequent holder determines

adjusted issue price for purposes of OID accruals, market discount, and

acquisition premium in any manner consistent with these final

regulations. Rules on Form 1099 reporting will be addressed in a

separate project. Until guidance regarding Form 1099 reporting is

issued, however, an issuer should use the same accrual periods for Form

1099 purposes as it uses for computing OID deductions.

The proposed regulations provide rules to determine the yield and

maturity of a debt instrument with a stated contingency that could

result in the acceleration or deferral of payments if the timing and

amounts payable upon occurrence of the contingency are fixed. The

contingency is ignored unless, based on all the facts and

circumstances, the contingency is more likely than not to occur. The

final regulations clarify that this rule applies when the contingency,

if triggered, would result in an alternative payment schedule as long

as the timing and amounts of the payments comprising the alternative

payment schedule are known as of the issue date. The final regulations

also clarify that these rules apply if the debt instrument is subject

to multiple contingencies that result in alternative payment schedules.

The final regulations retain the rule in the proposed regulations for

determining the yield and the maturity of a debt instrument in the case

of a put or call option.

The final regulations modify the proposed rules regarding

subsequent adjustments that are required when a contingency occurs (or

does not occur) contrary to the assumption initially made. This

modification treats both the acceleration and deferral of payments as a

deemed reissuance for purposes of OID accruals. In addition, the

subsequent adjustment rules are coordinated with the new pro rata

prepayment rule described below in connection with the description of

Sec. 1.1275-2.

Finally, in response to a comment, an example describing the

consequences of a pay-in-kind debt instrument issued at par has been

included in the final regulations.

Section 1.1272-2 Treatment of Debt Instruments Purchased at a Premium

The final regulations retain the rules in the proposed regulations

for debt instruments purchased at a premium. Thus, the holder's basis

in a debt instrument that is acquired in exchange for property and that

otherwise would take a substituted basis generally will not exceed the

fair market value of the property immediately after the exchange. This

rule corresponds to a similar rule in section 171(b)(4) of the Code.

The final regulations clarify the application of the rule to a

situation in which a debt instrument is received in a distribution from

a partnership.

Section 1.1272-3 Election by a Holder to Treat all Interest on a Debt

Instrument as OID

The proposed regulations permit accrual method holders to treat all

interest on a debt instrument as OID. In response to comments, the

final regulations extend this election to holders that use the cash

receipts and disbursements method of accounting.

Section 1.1273-1 Definition of OID

The final regulations retain the definition of qualified stated

interest, but clarify that a conversion feature is ignored for purposes

of determining whether stated interest is unconditionally payable. In

response to a comment, the final regulations provide that if a debt

instrument has payment intervals that are equal in length throughout

the term of the instrument, except for the first or final payment

interval (or both intervals), the interest payment for that interval

(or intervals) is considered to be made at a fixed rate if the value of

the rate on which the payment is based is adjusted in any reasonable

manner to take into account the length of the interval. The final

regulations also clarify the determination of qualified stated interest

for a debt instrument that provides for an alternative payment schedule

(or schedules) upon the occurrence of one or more contingencies. In the

case of these debt instruments, each alternative payment schedule

(including the stated payment schedule) is treated as if it were the

debt instrument's sole payment schedule. Based on this analysis, 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.

The final regulations also provide rules for a subsequent holder's

treatment of a debt instrument issued with de minimis OID. Under these

rules, if a subsequent holder purchases the debt instrument at a

premium, the subsequent holder does not include any de minimis OID in

income. Because the debt instrument is treated as having zero OID under

section 1273(a)(3), if a subsequent holder purchases the debt

instrument at a discount, the subsequent holder reports the discount

under the market discount rules of sections 1276 through 1278 of the

Code, rather than under the rules for de minimis OID.

Finally, the final regulations retain the rule of the proposed

regulations that de minimis OID is includible in the income of the

holder as principal payments are made. Commentators objected to the

fact that this rule is written as applying on a loan-by-loan basis

because it could preclude a financial institution from using the loan

liquidation method. Although the rule is stated in terms of a single

loan, the IRS and Treasury recognize that it may be appropriate to

permit financial institutions to account for de minimis OID on an

aggregate basis. The IRS is reviewing its published position with

respect to the loan liquidation method and plans to issue updated

guidance that permits financial institutions to use some form of

aggregate accounting.

Section 1.1273-2 Determination of Issue Price and Issue Date

If an issue of debt instruments sold for money is publicly offered,

the proposed regulations provide that the issue price of each debt

instrument in the issue is the first price at which a substantial

amount of the debt instruments in the issue is sold to the public.

However, if the issue is not publicly offered, the issue price of each

debt instrument in the issue is the price paid by the first buyer of a

debt instrument that is part of the issue. Commentators suggested that

the issue price rules should be the same for publicly offered and non-

publicly offered issues. In addition, commentators suggested that all

debt instruments in an issue should be fungible with other debt

instruments in the issue.

In response to these comments, the definition of issue price has

been modified. Under the final regulations, if a substantial amount of

debt instruments in an issue is sold for money, the issue price of each

instrument in the issue is the first price at which a substantial

amount is sold for money. If an issue is not subject to this rule, but

a substantial amount of the instruments in the issue is publicly

traded, the issue price of each instrument in the issue is the fair

market value of the instrument as of the issue date. If an issue is not

subject to either of these rules, but a substantial amount of

instruments in the issue is issued in exchange for publicly traded

property, the issue price of each instrument in the issue is the fair

market value of the property as of the issue date. Finally, if an issue

of debt instruments is not described in any of the above rules, the

issue price of each debt instrument in the issue is determined as if

the instrument were a separate issue.

The proposed regulations define publicly traded property generally

to include exchange listed property, property traded on a board of

trade or an interbank market, property appearing on a quotation medium,

and debt instruments for which price quotations are readily available.

In response to a comment, the final regulations clarify that, for

purposes of determining whether an instrument is publicly traded, a

quotation medium is limited to a medium that provides a reasonable

basis to determine fair market value. One commentator suggested that

the rule regarding readily available price quotations should be

eliminated. The IRS and Treasury, however, believe that one principal

way in which debt instruments are traded is through brokers and dealers

from whom price quotations are readily available, that this market is

liquid, and that instruments so traded are susceptible to ready

valuation. In such a case, it is consistent with the purposes of the

rules applicable to publicly traded property that the instruments be

considered publicly traded.

The final regulations clarify the determination of issue price for

a debt instrument that is part of an investment unit. In general, the

issue price of an investment unit is determined as if the investment

unit were a debt instrument. The issue price of the investment unit is

then allocated between the debt instrument and the property right that

comprise the investment unit based on their relative fair market

values. If, however, the issue price of the investment unit is not

determined under the rules of paragraph (a)(1), (b)(1), or (c)(1) of

Sec. 1.1273-2 (e.g., because the investment unit is not issued for

money or publicly traded property), the issue price of the debt

instrument included in the investment unit is determined under section

1273(b)(4) or 1274, whichever is applicable.

To coordinate the definition of issue date with the revised

definition of issue price discussed above, the definition of issue date

has been moved from Sec. 1.1275-1 of the proposed regulations to

Sec. 1.1273-2 of the final regulations.

Sections 1.1274-1 Through 1.1274-5 Determination of Issue Price in the

Case of Certain Debt Instruments Issued for Property

The final regulations modify the rule to determine the test rate

for purposes of sections 483 and 1274. Under the modified rule, the

test rate is generally the lowest of the applicable Federal rates

(based on the appropriate compounding period) in effect during either

(i) the 3-month period ending with the first month in which there is a

binding written contract that substantially sets forth the terms under

which the sale or exchange is ultimately consummated, or (ii) the 3-

month period ending with the month in which the sale or exchange

occurs.

The proposed regulations generally provide that the imputed

principal amount of a contingent payment debt instrument is the sum of

the present values of the noncontingent payments and the fair market

value of the contingent payments. Several comments and questions were

received on this rule, including the comment that the rule should be

reserved pending the resolution of the contingent payment rules in

regulations under section 1275. To allow further study of this issue

and coordination with the contingent payment regulations under section

1275, the final regulations do not adopt the rule in the proposed

regulations. Thus, for example, consistent with existing authorities,

the value of contingent payments is not taken into account for purposes

of determining the basis of property under section 1012. With the

publication of the final regulations in the Federal Register,

Sec. 1.1274-2(e) of the proposed regulations no longer remains as a

proposed regulation. Pending resolution of the issue and publication of

new proposed regulations, paragraphs (c) and (d) of Sec. 1.1275-4 of

the proposed regulations, as proposed in 1986, remain authority under

section 6662 of the Code for a nonpublicly traded debt instrument

issued in exchange for nonpublicly traded property.

Section 1.1274A-1 Special Rules for Certain Transactions Where Stated

Principal Amount Does Not Exceed $2,800,000

No comments were received on these regulations and no material

changes were made to this section.

Section 1.1275-1 Definitions

In response to a comment, the definition of issue has been

expanded. As a result, debt instruments issued in different markets or

for different consideration can be part of the same issue.

Section 1.1275-2 Special Rules Relating to Debt Instruments

The proposed regulations provide that all payments (other than

qualified stated interest payments) consist first of accrued but unpaid

OID, then of principal. Several commentators suggested that unscheduled

prepayments should be treated as partial retirements of the debt

instrument. In response to these comments, the final regulations add

new rules for the treatment of pro rata prepayments. In general, a pro

rata prepayment is an unscheduled payment made on a debt instrument

prior to maturity that results in a substantially pro rata reduction of

each payment of principal and interest remaining on the instrument. If

a prepayment on a debt instrument is a pro rata prepayment, the

prepayment is treated as a payment in retirement of a portion of the

instrument, which may result in gain or loss to the holder. The gain or

loss is calculated by assuming that the debt instrument consists of two

instruments, one that is retired and one that remains outstanding, and

by allocating the adjusted issue price, the holder's adjusted basis,

and the accrued but unpaid qualified stated interest between the two

instruments based on the portion of the instrument that is treated as

retired by the pro rata prepayment. In the case of a pro rata

prepayment, the issuer may realize discharge of indebtedness income (as

determined under Sec. 1.61-12) or repurchase premium (as determined

under Sec. 1.163-7).

Partial retirement treatment is restricted to pro rata prepayments

because the IRS and Treasury believe that this type of prepayment is

common. The extension of the rule to non-pro rata prepayments would add

undue complexity to the regulations. In addition, extension of the rule

to non-pro rata prepayments may cause inappropriate recognition of gain

or loss if, in addition to a prepayment, the interest rate or the

payment schedule is altered. Furthermore, as noted by one commentator,

a rule for non-pro rata prepayments may not be necessary because an

unscheduled prepayment may, depending on the circumstances, result in a

deemed exchange under section 1001.

The proposed regulations contain a number of rules that generally

require a holder to follow the issuer's treatment of an item, such as

whether a debt instrument is issued in a potentially abusive situation.

In response to comments, the final regulations provide that the issuer

must make information relating to its treatment of the item available

to the holder in a reasonable manner.

Section 1.1275-2T, which is published elsewhere in this issue of

the Federal Register, provides for an anti-abuse rule. Under the rule,

the Commissioner of Internal Revenue, in certain circumstances, can

apply or depart from the final regulations in a manner that ensures a

reasonable result in light of the purposes of the statutes governing

OID.

Section 1.1275-3 OID Information Reporting Requirements

The legending requirements in the final regulations for debt

instruments with OID are generally the same as the requirements in the

proposed regulations.

Section 1.1275-5 Variable Rate Debt Instruments

In response to comments that the definition of a variable rate debt

instrument contained in the proposed regulations is overly restrictive,

the final regulations liberalize the rules in several respects. First,

the regulations allow the issue price of a variable rate debt

instrument to exceed the total noncontingent principal payments on the

instrument, provided that the excess is not greater than a specified

amount. Second, the regulations allow a variable rate debt instrument

to provide for stated interest at more than two qualified floating

rates, at a single fixed rate and one or more qualified floating rates,

and at a single fixed rate and an objective rate that is a qualified

inverse floating rate. Third, the regulations provide that interest

that is stated at an initial fixed rate for a period of not more than

one year, followed by a qualified floating rate or an objective rate,

is treated as stated at a single qualified floating rate or an

objective rate in certain circumstances. This rule applies, for

example, if interest for the initial accrual period is set a short time

prior to the issue date at a fixed rate chosen to approximate the

expected value of the qualified floating rate or objective rate on the

issue date. Fourth, the regulations allow certain multiples of a

qualified floating rate to be treated as qualified floating rates.

Fifth, the regulations expand the definition of an objective rate to

include a rate based on the yield of actively traded property, a rate

that would be a qualified floating rate if the debt instrument were

denominated in a foreign currency, and any combination of objective

rates. In addition, the final regulations provide that other rates may

be treated as objective rates if designated by revenue ruling or

revenue procedure.

In response to a comment, the definition of an objective rate has

been narrowed in two respects. While the proposed regulations permit a

rate based on the price of actively traded personal property, the final

regulations permit only a rate based on the change in the price of

actively traded personal property to be an objective rate. In addition,

the final regulations provide a more general rule relating to the

frontloading or backloading of interest such that a variable rate is

not an objective rate if it results in significant frontloading or

backloading of interest.

The rules in the proposed regulations relating to permissible

objective rates on tax-exempt debt instruments have been changed in the

final regulations. Under the revised rules, a variable rate on a tax-

exempt debt instrument is an objective rate only if it is a qualified

inverse floating rate. In general, an objective rate is a qualified

inverse floating rate if the rate is equal to a fixed rate minus a

qualified floating rate and the rate varies in a manner that inversely

reflects contemporaneous variations in the cost of newly borrowed

funds.

The rules in the proposed regulations for determining the accrual

of OID and the amount of qualified stated interest on a variable rate

debt instrument have been revised and simplified in the final

regulations. Under the revised rules, a debt instrument providing for

qualified floating rates is converted to an equivalent fixed rate debt

instrument by assuming that each qualified floating rate will remain at

its value as of the issue date. A debt instrument providing for an

objective rate is converted to an equivalent fixed rate debt instrument

by assuming that the objective rate will equal a fixed rate that

reflects the yield that is reasonably expected for the instrument. The

rules applicable to fixed rate debt instruments are then applied to

determine the OID accruals and the qualified stated interest payments

on the equivalent fixed rate debt instrument. Appropriate adjustments

to these amounts are made in each accrual period if the interest

actually accrued or paid during the accrual period is greater than or

less than the interest assumed to be accrued or paid under the

equivalent fixed rate debt instrument.

In response to a comment, the final regulations provide a special

rule for certain variable rate debt instruments (such as auction rate

or adjustable rate debt instruments) that provide for a fixed rate of

interest for an initial period, followed by a period during which the

interest is reset to a rate that will enable the instrument to trade at

a fixed amount when the reset becomes effective. Under this special

rule, the debt instrument is treated as maturing on the date the reset

rate becomes effective and reissued on that date for the fixed amount.

As a result of this rule, for example, if a debt instrument is issued

at a discount (i.e., the issue price of the debt instrument is less

than its par value) and is reset to par after an initial period, the

discount on the instrument will be accrued entirely in the initial

period rather than over the full term of the instrument.

Effective Dates

These regulations apply to debt instruments issued on or after

April 4, 1994, and to lending transactions, sales, and exchanges that

occur on or after April 4, 1994. However, Sec. 1.1272-3 applies to debt

instruments acquired on or after April 4, 1994, and Sec. 1.1275-2(d)(2)

applies to qualified reopenings that occur on or after March 25, 1992.

Reliance on Final Regulations

Except for Sec. 1.1272-3, taxpayers may rely on the final

regulations for debt instruments issued after December 21, 1992, and

for lending transactions, sales, and exchanges that occur after

December 21, 1992.

Authority Under Section 6662

Although the final regulations dispose of the underlying proposed

regulations (other than Sec. 1.446-2(e)(3)), the IRS will allow

taxpayers to treat the proposed regulations as authority under section

6662 of the Code for debt instruments issued after December 21, 1992,

and prior to April 4, 1994, and for lending transactions, sales, and

exchanges that occurred after December 21, 1992, and prior to April 4,

1994. The IRS also will allow taxpayers to treat the OID regulations

that were proposed in 1986 and 1991 as authority under section 6662 for

debt instruments issued prior to December 22, 1992, and for lending

transactions, sales, and exchanges that occurred prior to December 22,

1992.

Special Analyses

It has been determined that these regulations are not major rules

as defined in Executive Order 12291. Therefore, a Regulatory Impact

Analysis 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 Code, the notice of

proposed rulemaking was submitted to the Small Business Administration

for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are William E. Blanchard

and Andrew C. Kittler of the Office of Assistant Chief Counsel

(Financial Institutions and Products), IRS. However, other personnel

from the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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 ``Section 1.1275-3'' and adding the following

citations in numerical order to read as follows:

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

Secs. 1.483-1 through 1.483-3 also issued under 26 U.S.C.

483(f). * * *

Secs. 1.1271-1 through 1.1274-5 also issued under 26 U.S.C.

1275(d).

Sec. 1.1274A-1 also issued under 26 U.S.C. 1274A(e) and 26

U.S.C. 1275(d).

Secs. 1.1275-1 through 1.1275-5 also issued under 26 U.S.C.

1275(d). * * *

Par. 2. Section 1.163-7 is added to read as follows:

Sec. 1.163-7 Deduction for OID on certain debt instruments.

(a) General rule. Except as otherwise provided in paragraph (b) of

this section, an issuer (including a transferee) determines the amount

of OID that is deductible each year under section 163(e)(1) by using

the constant yield method described in Sec. 1.1272-1(b). This

determination, however, is made without regard to section 1272(a)(7)

(relating to acquisition premium) and Sec. 1.1273-1(d) (relating to de

minimis OID). An issuer is permitted a deduction under section

163(e)(1) only to the extent the issuer is primarily liable on the debt

instrument. For certain limitations on the deductibility of OID, see

sections 163(e) and 1275(b)(2).

(b) Special rules for de minimis OID--(1) Stated interest. If a

debt instrument has a de minimis amount of OID (within the meaning of

Sec. 1.1273-1(d)), the issuer treats all stated interest on the debt

instrument as qualified stated interest. See Secs. 1.446-2(b) and

1.461-1 for the treatment of qualified stated interest.

(2) Deduction of de minimis OID on other than a constant yield

basis. In lieu of deducting de minimis OID under the general rule of

paragraph (a) of this section, an issuer of a debt instrument with a de

minimis amount of OID (other than a de minimis amount treated as

qualified stated interest under paragraph (b)(1) of this section) may

choose to deduct the OID at maturity, on a straight-line basis over the

term of the debt instrument, or in proportion to stated interest

payments. The issuer makes this choice by reporting the de minimis OID

in a manner consistent with the method chosen on the issuer's timely

filed Federal income tax return for the taxable year in which the debt

instrument is issued.

(c) Deduction upon repurchase. Except to the extent disallowed by

any other section of the Internal Revenue Code (e.g., section 249) or

this paragraph (c), if a debt instrument is repurchased by the issuer

for a price in excess of its adjusted issue price (as defined in

Sec. 1.1275-1(b)), the excess (repurchase premium) is deductible as

interest for the taxable year in which the repurchase occurs. If the

issuer repurchases a debt instrument in a debt-for-debt exchange, the

repurchase price is the issue price of the newly issued debt instrument

(reduced by any unstated interest within the meaning of section 483).

However, if the issue price of the newly issued debt instrument is

determined under either section 1273(b)(4) or section 1274, any

repurchase premium is not deductible in the year of the repurchase, but

is amortized over the term of the newly issued debt instrument in the

same manner as if it were OID.

(d) Choice of accrual periods to determine whether a debt

instrument is an applicable high yield discount obligation (AHYDO).

Section 163(e)(5) affects an issuer's OID deductions for certain high

yield debt instruments that have significant OID. For purposes of

section 163(i)(2), which defines significant OID, the issuer's choice

of accrual periods to determine OID accruals is used to determine

whether a debt instrument has significant OID. See Sec. 1.1275-2(e) for

rules relating to the issuer's obligation to disclose certain

information to holders.

(e) Effective date. This section applies to debt instruments issued

on or after April 4, 1994. Taxpayers, however, may rely on this section

for debt instruments issued after December 21, 1992, and before April

4, 1994.

Sec. 1.163-11T [Removed]

Par. 3. Section 1.163-11T is removed as of February 2, 1994.

Par. 4. Section 1.446-2 is added to read as follows:

Sec. 1.446-2 Method of accounting for interest.

(a) Applicability--(1) In general. This section provides rules for

determining the amount of interest that accrues during an accrual

period (other than interest described in paragraph (a)(2) of this

section) and for determining the portion of a payment that consists of

accrued interest. For purposes of this section, interest includes

original issue discount and amounts treated as interest (whether stated

or unstated) in any lending or deferred payment transaction. Accrued

interest determined under 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).

Application of an exception described in paragraph (a)(2) of this

section to one party to a transaction does not affect the application

of this section to any other party to the transaction.

(2) Exceptions--(i) Interest included or deducted under certain

other provisions. This section does not apply to interest that is taken

into account under--

(A) Sections 1272(a), 1275, and 163(e) (income and deductions

relating to original issue discount);

(B) Section 467(a)(2) (certain payments for the use of property or

services);

(C) Sections 1276 through 1278 (market discount);

(D) Sections 1281 through 1283 (discount on certain short-term

obligations);

(E) Section 7872(a) (certain loans with below-market interest

rates); or

(F) Section 1.1272-3 (an election by a holder to treat all interest

on a debt instrument as original issue discount).

(ii) De minimis original issue discount. This section does not

apply to de minimis original issue discount (other than de minimis

original issue discount treated as qualified stated interest) as

determined under Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment

of de minimis original issue discount by the issuer and Secs. 1.1273-

1(d) and 1.1272-3 for the treatment of de minimis original issue

discount by the holder.

(b) Accrual of qualified stated interest. Qualified stated interest

(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual

period (or periods) to which it is attributable and accrues at the

stated rate for the period (or periods).

(c) Accrual of interest other than qualified stated interest.

Subject to the modifications in paragraph (d) of this section, the

amount of interest (other than qualified stated interest) that accrues

for any accrual period is determined under rules similar to those in

the regulations under sections 1272 and 1275 for the accrual of

original issue discount. The preceding sentence applies regardless of

any contrary formula agreed to by the parties.

(d) Modifications--(1) Issue price. The issue price of the loan or

contract is equal to--

(i) In the case of a contract for the sale or exchange of property

to which section 483 applies, the amount described in Sec. 1.483-

2(a)(1)(i) or (ii), whichever is applicable;

(ii) In the case of a contract for the sale or exchange of property

to which section 483 does not apply, the stated principal amount; or

(iii) In any other case, the amount loaned.

(2) Principal payments that are not deferred payments. In the case

of a contract to which section 483 applies, principal payments that are

not deferred payments are ignored for purposes of determining yield and

adjusted issue price.

(e) Allocation of interest to payments--(1) In general. Except as

provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each

payment under a loan (other than payments of additional interest or

similar charges provided with respect to amounts that are not paid when

due) is treated as a payment of interest to the extent of the accrued

and unpaid interest determined under paragraphs (b) and (c) of this

section as of the date the payment becomes due.

(2) Special rule for points deductible under section 461(g)(2). If

a payment of points is deductible by the borrower under section

461(g)(2), the payment is treated by the borrower as a payment of

interest.

(3) Allocation respected in certain small transactions. [Reserved]

(4) Pro rata prepayments. Accrued but unpaid interest is allocated

to a pro rata prepayment under rules similar to those for allocating

accrued but unpaid original issue discount to a pro rata prepayment

under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro

rata prepayment is a payment that is made prior to maturity that--

(i) Is not made pursuant to the contract's payment schedule; and

(ii) Results in a substantially pro rata reduction of each payment

remaining to be paid on the contract.

(f) Aggregation rule. For purposes of this section, all contracts

calling for deferred payments arising from the same transaction (or a

series of related transactions) are treated as a single contract. This

rule, however, generally only applies to contracts involving a single

borrower and a single lender.

(g) Debt instruments denominated in a currency other than the U.S.

dollar. This section applies to a debt instrument that provides for all

payments denominated in, or determined by reference to, the functional

currency of the taxpayer or qualified business unit of the taxpayer

(even if that currency is other than the U.S. dollar). See Sec. 1.988-

2(b) to determine interest income or expense for debt instruments that

provide for payments denominated in, or determined by reference to, a

nonfunctional currency.

(h) Example. The following example illustrates the rules of this

section.

Example. Allocation of unstated interest to deferred payments--

(i) Facts. On July 1, 1996, A sells his personal residence to B for

a stated purchase price of $1,297,143.66. The property is not

personal use property (within the meaning of section 1275(b)(3)) in

the hands of B. Under the loan agreement, B is required to make two

installment payments of $648,571.83 each, the first due on June 30,

1998, and the second due on June 30, 2000. Both A and B use the cash

receipts and disbursements method of accounting and use a calendar

year for their taxable year.

(ii) Amount of unstated interest. Under section 483, the

agreement does not provide for adequate stated interest. Thus, the

loan's yield is the test rate of interest determined under

Sec. 1.483-3. Assume that both A and B use annual accrual periods

and that the test rate of interest is 9.2 percent, compounded

annually. Under Sec. 1.483-2, the present value of the deferred

payments is $1,000,000. Thus, the agreement has unstated interest of

$297,143.66.

(iii) First two accrual periods. Under paragraph (d)(1) of this

section, the issue price at the beginning of the first accrual

period is $1,000,000 (the amount described in Sec. 1.483-

2(a)(1)(i)). Under paragraph (c) of this section, the amount of

interest that accrues for the first accrual period is $92,000

($1,000,000 x .092) and the amount of interest that accrues for the

second accrual period is $100,464 ($1,092,000 x .092). Thus,

$192,464 of interest has accrued as of the end of the second accrual

period. Under paragraph (e)(1) of this section, the $648,571.83

payment made on June 30, 1998, is treated first as a payment of

interest to the extent of $192,464. The remainder of the payment

($456,107.83) is treated as a payment of principal. Both A and B

take the payment of interest ($192,464) into account in 1998.

(iv) Second two accrual periods. The adjusted issue price at the

beginning of the third accrual period is $543,892.17

($1,092,000+$100,464-$648,571.83). The amount of interest that

accrues for the third accrual period is $50,038.08

($543,892.17 x .092) and the amount of interest that accrues for the

final accrual period is $54,641.58, the excess of the amount payable

at maturity ($648,571.83), over the adjusted issue price at the

beginning of the accrual period ($593,930.25). As of the date the

second payment becomes due, $104,679.66 of interest has accrued.

Thus, of the $648,571.83 payment made on June 30, 2000, $104,679.66

is treated as interest and $543,892.17 is treated as principal. Both

A and B take the payment of interest ($104,679.66) into account in

2000.

(i) [Reserved]

(j) Effective date. This section applies to debt instruments issued

on or after April 4, 1994, and to lending transactions, sales, and

exchanges that occur on or after April 4, 1994. Taxpayers, however, may

rely on this section for debt instruments issued after December 21,

1992, and before April 4, 1994, and for lending transactions, sales,

and exchanges that occur after December 21, 1992, and before April 4,

1994.

Par. 5. Sections 1.483-1 and 1.483-2 are revised to read as

follows:

Sec. 1.483-1 Interest on certain deferred payments.

(a) Amount constituting interest in certain deferred payment

transactions--(1) In general. Except as provided in paragraph (c) of

this section, section 483 applies to a contract for the sale or

exchange of property if the contract provides for one or more payments

due more than 1 year after the date of the sale or exchange, and the

contract does not provide for adequate stated interest. In general, a

contract has adequate stated interest if the contract provides for a

stated rate of interest that is at least equal to the test rate

(determined under Sec. 1.483-3) and the interest is paid or compounded

at least annually. Section 483 may apply to a contract whether the

contract is express (written or oral) or implied. For purposes of

section 483, a sale or exchange is any transaction treated as a sale or

exchange for tax purposes. In addition, for purposes of section 483,

property includes debt instruments and investment units, but does not

include money, services, or the right to use property. For the

treatment of certain obligations given in exchange for services or the

use of property, see sections 404 and 467. For purposes of this

paragraph (a), money includes functional currency and, in certain

circumstances, nonfunctional currency. See Sec. 1.988-2(b)(2) for

circumstances when nonfunctional currency is treated as money rather

than as property.

(2) Treatment of contracts to which section 483 applies--(i)

Treatment of unstated interest. If section 483 applies to a contract,

unstated interest under the contract is treated as interest for tax

purposes. Thus, for example, unstated interest is not treated as part

of the amount realized from the sale or exchange of property (in the

case of the seller), and is not included in the purchaser's basis in

the property acquired in the sale or exchange.

(ii) Method of accounting for interest on contracts subject to

section 483. Any stated or unstated interest on a contract subject to

section 483 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). See Secs. 1.446-1, 1.451-1, and

1.461-1. For purposes of the preceding sentence, the amount of interest

(including unstated interest) allocable to a payment under a contract

to which section 483 applies is determined under Sec. 1.446-2(e).

(b) Definitions--(1) Deferred payments. For purposes of the

regulations under section 483, a deferred payment means any payment

that constitutes all or a part of the sales price (as defined in

paragraph (b)(2) of this section), and that is due more than 6 months

after the date of the sale or exchange. Except as provided in section

483(c)(2) (relating to the treatment of a debt instrument of the

purchaser), a payment may be made in the form of cash, stock or

securities, or other property.

(2) Sales price. For purposes of section 483, the sales price for

any sale or exchange is the sum of the amount due under the contract

(other than stated interest) and the amount of any liability included

in the amount realized from the sale or exchange. See Sec. 1.1001-2.

Thus, the sales price for any sale or exchange includes any amount of

unstated interest under the contract.

(c) Exceptions to and limitations on the application of section

483--(1) In general. Sections 483(d), 1274(c)(4), and 1275(b) contain

exceptions to and limitations on the application of section 483.

(2) Sales price of $3,000 or less. Section 483(d)(2) applies only

if it can be determined at the time of the sale or exchange that the

sales price cannot exceed $3,000, regardless of whether the sales price

eventually paid for the property is less than $3,000.

(3) Other exceptions and limitations--(i) Certain transfers subject

to section 1041. Section 483 does not apply to any transfer of property

subject to section 1041 (relating to transfers of property between

spouses or incident to divorce).

(ii) Treatment of certain obligees. Section 483 does not apply to

an obligee under a contract for the sale or exchange of personal use

property (within the meaning of section 1275(b)(3)) in the hands of the

obligor and that evidences a below-market loan described in section

7872(c)(1).

(iii) Transactions involving certain demand loans. Section 483 does

not apply to any payment under a contract that evidences a demand loan

that is a below-market loan described in section 7872(c)(1).

(iv) Transactions involving certain annuity contracts. Section 483

does not apply to any payment under an annuity contract described in

section 1275(a)(1)(B) (relating to annuity contracts excluded from the

definition of debt instrument).

(v) Options. Section 483 does not apply to any payment under an

option to buy or sell property.

(d) Assumptions. If a debt instrument is assumed, or property is

taken subject to a debt instrument, in connection with a sale or

exchange of property, the debt instrument is treated for purposes of

section 483 in a manner consistent with the rules of Sec. 1.1274-5.

(e) Aggregation rule. For purposes of section 483, all sales or

exchanges that are part of the same transaction (or a series of related

transactions) are treated as a single sale or exchange, and all

contracts calling for deferred payments arising from the same

transaction (or a series of related transactions) are treated as a

single contract. This rule, however, generally only applies to

contracts and to sales or exchanges involving a single buyer and a

single seller.

(f) Effective date. This section applies to sales and exchanges

that occur on or after April 4, 1994. Taxpayers, however, may rely on

this section for sales and exchanges that occur after December 21,

1992, and before April 4, 1994.

Sec. 1.483-2 Unstated interest.

(a) In general--(1) Adequate stated interest. For purposes of

section 483, a contract has unstated interest if the contract does not

provide for adequate stated interest. A contract does not provide for

adequate stated interest if the sum of the deferred payments exceeds--

(i) The sum of the present values of the deferred payments and the

present values of any stated interest payments due under the contract;

or

(ii) In the case of a cash method debt instrument (within the

meaning of section 1274A(c)(2)) received in exchange for property in a

potentially abusive situation (as defined in Sec. 1.1274-3), the fair

market value of the property reduced by the fair market value of any

consideration other than the debt instrument, and reduced by the sum of

all principal payments that are not deferred payments.

(2) Amount of unstated interest. For purposes of section 483,

unstated interest means an amount equal to the excess of the sum of the

deferred payments over the amount described in paragraph (a)(1)(i) or

(a)(1)(ii) of this section, whichever is applicable.

(b) Operational rules--(1) In general. For purposes of paragraph

(a) of this section, rules similar to those in Sec. 1.1274-2 apply to

determine whether a contract has adequate stated interest and the

amount of unstated interest, if any, on the contract.

(2) Present value. For purposes of paragraph (a) of this section,

the present value of any deferred payment or interest payment is

determined by discounting the payment from the date it becomes due to

the date of the sale or exchange at the test rate of interest

applicable to the contract in accordance with Sec. 1.483-3.

(c) Examples. The following examples illustrate the rules of this

section.

Example 1. Contract that does not have adequate stated interest.

On January 1, 1995, A sells B nonpublicly traded property under a

contract that calls for a $100,000 payment of principal on January

1, 2005, and 10 annual interest payments of $9,000 on January 1 of

each year, beginning on January 1, 1996. Assume that the test rate

of interest is 9.2 percent, compounded annually. The contract does

not provide for adequate stated interest because it does not provide

for interest equal to 9.2 percent, compounded annually. The present

value of the deferred payments is $98,727.69. As a result, the

contract has unstated interest of $1,272.31 ($100,000 - $98,727.69).

Example 2. Contract that does not have adequate stated interest;

no interest for initial short period. On May 1, 1996, A sells B

nonpublicly traded property under a contract that calls for B to

make a principal payment of $200,000 on December 31, 1998, and

semiannual interest payments of $9,000, payable on June 30 and

December 31 of each year, beginning on December 31, 1996. Assume

that the test rate of interest is 9 percent, compounded

semiannually. Even though the contract calls for a stated rate of

interest no lower than the test rate of interest, the contract does

not provide for adequate stated interest because the stated rate of

interest does not apply for the short period from May 1, 1996,

through June 30, 1996.

Example 3. Potentially abusive situation--(i) Facts. In a

potentially abusive situation, a contract for the sale of

nonpublicly traded personal property calls for the issuance of a

cash method debt instrument (as defined in section 1274A(c)(2)) with

a stated principal amount of $700,000, payable in 5 years. No other

consideration is given. The debt instrument calls for annual

payments of interest over its entire term at a rate of 9.2 percent,

compounded annually (the test rate of interest applicable to the

debt instrument). Thus, the present value of the deferred payment

and the interest payments is $700,000. Assume that the fair market

value of the property is $500,000.

(ii) Amount of unstated interest. A cash method debt instrument

received in exchange for property in a potentially abusive situation

provides for adequate stated interest only if the sum of the

deferred payments under the instrument does not exceed the fair

market value of the property. Because the deferred payment

($700,000) exceeds the fair market value of the property ($500,000),

the debt instrument does not provide for adequate stated interest.

Therefore, the debt instrument has unstated interest of $200,000.

Example 4. Variable rate debt instrument with adequate stated

interest; variable rate as of the issue date greater than the test

rate--(i) Facts. A contract for the sale of nonpublicly traded

property calls for the issuance of a debt instrument in the

principal amount of $75,000 due in 10 years. The debt instrument

calls for interest payable semiannually at a rate of 3 percentage

points above the yield on 6-month Treasury bills at the mid-point of

the semiannual period immediately preceding each interest payment

date. Assume that the interest rate is a qualified floating rate and

that the debt instrument is a variable rate debt instrument within

the meaning of Sec. 1.1275-5.

(ii) Adequate stated interest. Under paragraph (b)(1) of this

section, rules similar to those in Sec. 1.1274-2(f) apply to

determine whether the debt instrument has adequate stated interest.

Assume that the test rate of interest applicable to the debt

instrument is 9 percent, compounded semiannually. Assume also that

the yield on 6-month Treasury bills on the date of the sale is 8.89

percent, which is greater than the yield on 6-month Treasury bills

on the first date on which there is a binding written contract that

substantially sets forth the terms under which the sale is

consummated. Under Sec. 1.1274-2(f), the debt instrument is tested

for adequate stated interest as if it provided for a stated rate of

interest of 11.89 percent (3 percent plus 8.89 percent), compounded

semiannually, payable over its entire term. Because the test rate of

interest is 9 percent, compounded semiannually, and the debt

instrument is treated as providing for stated interest of 11.89

percent, compounded semiannually, the debt instrument provides for

adequate stated interest.

(d) Effective date. This section applies to sales and exchanges

that occur on or after April 4, 1994. Taxpayers, however, may rely on

this section for sales and exchanges that occur after December 21,

1992, and before April 4, 1994.

Par. 6. Section 1.483-3 is added to read as follows:

Sec. 1.483-3 Test rate of interest applicable to a contract.

(a) General rule. For purposes of section 483, the test rate of

interest for a contract is the same as the test rate that would apply

under Sec. 1.1274-4 if the contract were a debt instrument. Paragraph

(b) of this section, however, provides for a lower test rate in the

case of certain sales or exchanges of land between related individuals.

(b) Lower rate for certain sales or exchanges of land between

related individuals--(1) Test rate. In the case of a qualified sale or

exchange of land between related individuals (described in section

483(e)), the test rate is not greater than 6 percent, compounded

semiannually, or an equivalent rate based on an appropriate compounding

period.

(2) Special rules. The following rules and definitions apply in

determining whether a sale or exchange is a qualified sale under

section 483(e):

(i) Definition of family members. The members of an individual's

family are determined as of the date of the sale or exchange. The

members of an individual's family include those individuals described

in section 267(c)(4) and the spouses of those individuals. In addition,

for purposes of section 267(c)(4), full effect is given to a legal

adoption, ancestor means parents and grandparents, and lineal

descendants means children and grandchildren.

(ii) $500,000 limitation. Section 483(e) does not apply to the

extent that the stated principal amount of the debt instrument issued

in the sale or exchange, when added to the aggregate stated principal

amount of any other debt instruments to which section 483(e) applies

that were issued in prior qualified sales between the same two

individuals during the same calendar year, exceeds $500,000. See

Example 3 of paragraph (b)(3) of this section.

(iii) Other limitations. Section 483(e) does not apply if the

parties to a contract include persons other than the related

individuals and the parties enter into the contract with an intent to

circumvent the purposes of section 483(e). In addition, if the property

sold or exchanged includes any property other than land, section 483(e)

applies only to the extent that the stated principal amount of the debt

instrument issued in the sale or exchange is attributable to the land

(based on the relative fair market values of the land and the other

property).

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

paragraph (b).

Example 1. On January 1, 1995, A sells land to B, A's child, for

$650,000. The contract for sale calls for B to make a $250,000 down

payment and issue a debt instrument with a stated principal amount

of $400,000. Because the stated principal amount of the debt

instrument is less than $500,000, the sale is a qualified sale and

section 483(e) applies to the debt instrument.

Example 2. The facts are the same as in Example 1 of paragraph

(b)(3) of this section, except that on June 1, 1995, A sells

additional land to B under a contract that calls for B to issue a

debt instrument with a stated principal amount of $100,000. The

stated principal amount of this debt instrument ($100,000) when

added to the stated principal amount of the prior debt instrument

($400,000) does not exceed $500,000. Thus, section 483(e) applies to

both debt instruments.

Example 3. The facts are the same as in Example 1 of paragraph

(b)(3) of this section, except that on June 1, 1995, A sells

additional land to B under a contract that calls for B to issue a

debt instrument with a stated principal amount of $150,000. The

stated principal amount of this debt instrument when added to the

stated principal amount of the prior debt instrument ($400,000)

exceeds $500,000. Thus, for purposes of section 483(e), the debt

instrument issued in the sale of June 1, 1995, is treated as two

separate debt instruments: a $100,000 debt instrument (to which

section 483(e) applies) and a $50,000 debt instrument (to which

section 1274, if otherwise applicable, applies).

(c) Effective date. This section applies to sales and exchanges

that occur on or after April 4, 1994. Taxpayers, however, may rely on

this section for sales and exchanges that occur after December 21,

1992, and before April 4, 1994.

Par. 7. In Sec. 1.1001-1, paragraph (g) is revised to read as

follows:

Sec. 1.1001-1 Computation of gain or loss.

* * * * *

(g) Debt instruments issued in exchange for property. 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 Sec. 1.1273-2 or Sec. 1.1274-2(b),

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).

This paragraph (g) applies to sales or exchanges that occur on or after

April 4, 1994. Taxpayers, however, may rely on this paragraph (g) for

sales and exchanges that occur after December 21, 1992, and before

April 4, 1994.

Par. 8. In Sec. 1.1012-1, paragraph (f) is amended by removing the

last sentence and paragraph (g) is added to read as follows:

Sec. 1.1012-1 Basis of property.

* * * * *

(g) Debt instruments issued in exchange for property. 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 Sec. 1.1273-2 or Sec. 1.1274-2(b), 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).

This paragraph (g) applies to sales or exchanges that occur on or after

April 4, 1994. Taxpayers, however, may rely on this paragraph (g) for

sales and exchanges that occur after December 21, 1992, and before

April 4, 1994.

Par. 9. Sections 1.1271-0, 1.1271-1, 1.1272-1 through 1.1272-3,

1.1273-1, 1.1273-2, 1.1274-1 through 1.1274-3 are added to read as

follows:

Sec. 1.1271-0 Original issue discount; effective date; table of

contents.

(a) Effective date. Except as otherwise provided, Secs. 1.1271-1

through 1.1275-5 apply to debt instruments issued on or after April 4,

1994. Taxpayers, however, may rely on these sections for debt

instruments issued after December 21, 1992, and before April 4, 1994.

(b) Table of contents. This section lists captioned paragraphs

contained in Secs. 1.1271-1 through 1.1275-5.

Sec. 1.1271-1 Special rules applicable to amounts received on

retirement, sale, or exchange of debt instruments.

(a) Intention to call before maturity.

(1) In general.

(2) Exceptions.

(b) Short-term obligations.

(1) In general.

(2) Method of making elections.

(3) Counting conventions.

Sec. 1.1272-1 Current inclusion of OID in income.

(a) Overview.

(1) In general.

(2) Debt instruments not subject to OID inclusion rules.

(b) Accrual of OID.

(1) Constant yield method.

(2) Exceptions.

(3) Modifications.

(4) Special rules for determining the OID allocable to an

accrual period.

(c) Yield and maturity of certain debt instruments subject to

contingencies.

(1) Applicability.

(2) General rule.

(3) Contingencies that are likely to occur.

(4) Consistency rule.

(5) Treatment of certain options.

(6) Subsequent adjustments.

(d) Certain debt instruments that provide for principal payments

uncertain as to time.

(e) Convertible debt instruments.

(f) Special rules to determine whether a debt instrument is a short-

term obligation.

(1) Counting of either the issue date or maturity date.

(2) Coordination with paragraph (c) of this section for certain

sections of the Internal Revenue Code.

(g) Basis adjustment.

(h) Debt instruments denominated in a currency other than the U.S.

dollar.

(i) [Reserved]

(j) Examples.

Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.

(a) In general.

(b) Definitions and special rules.

(1) Purchase.

(2) Premium.

(3) Acquisition premium.

(4) Acquisition premium fraction.

(5) Election to accrue discount on a constant yield basis.

(6) Special rules for determining basis.

(c) Examples.

Sec. 1.1272-3 Election by a holder to treat all interest on a debt

instrument as OID.

(a) Election.

(b) Scope of election.

(1) In general.

(2) Exceptions, limitations, and special rules.

(c) Mechanics of the constant yield method.

(1) In general.

(2) Special rules to determine adjusted basis.

(d) Time and manner of making the election.

(e) Revocation of election.

(f) Effective date.

Sec. 1.1273-1 Definition of OID.

(a) In general.

(b) Stated redemption price at maturity.

(c) Qualified stated interest.

(1) Definition.

(2) Debt instruments subject to contingencies.

(3) Variable rate debt instrument.

(4) Stated interest in excess of qualified stated interest.

(5) Short-term obligations.

(d) De minimis OID.

(1) In general.

(2) De minimis amount.

(3) Installment obligations.

(4) Special rule for interest holidays, teaser rates, and other

interest shortfalls.

(5) Treatment of de minimis OID by holders.

(e) Definitions.

(1) Installment obligation.

(2) Self-amortizing installment obligation.

(3) Weighted average maturity.

(f) Examples.

Sec. 1.1273-2 Determination of issue price and issue date.

(a) Debt instruments issued for money.

(1) Issue price.

(2) Issue date.

(b) Publicly traded debt instruments issued for property.

(1) Issue price.

(2) Issue date.

(c) Debt instruments issued for publicly traded property.

(1) Issue price.

(2) Issue date.

(d) Other debt instruments.

(1) Issue price.

(2) Issue date.

(e) Special rule for certain sales to bond houses, brokers, or

similar persons.

(f) Traded on an established market (publicly traded).

(1) In general.

(2) Exchange listed property.

(3) Market traded property.

(4) Property appearing on a quotation medium.

(5) Readily quotable debt instruments.

(6) Effect of certain temporary restrictions on trading.

(7) Convertible debt instruments.

(g) Treatment of certain cash payments incident to lending

transactions.

(1) Applicability.

(2) Payments from borrower to lender.

(3) Payments from lender to borrower.

(4) Payments between lender and third party.

(5) Examples.

(h) Investment units.

(1) In general.

(2) Consistent allocation by holders and issuer.

(i) [Reserved]

(j) Convertible debt instruments.

(k) Below-market loans subject to section 7872(b).

(l) [Reserved]

(m) Treatment of amounts representing pre-issuance accrued interest.

(1) Applicability.

(2) Exclusion of pre-issuance accrued interest from issue price.

(3) Example.

Sec. 1.1274-1 Debt instruments to which section 1274 applies.

(a) In general.

(b) Exceptions.

(1) Debt instrument with adequate stated interest and no OID .

(2) Exceptions under sections 1274(c)(1)(B), 1274(c)(3),

1274A(c), and 1275(b)(1).

(3) Other exceptions to section 1274.

(c) Examples.

Sec. 1.1274-2 Issue price of debt instruments to which section 1274

applies.

(a) In general.

(b) Issue price.

(1) Debt instruments that provide for adequate stated interest;

stated principal amount.

(2) Debt instruments that do not provide for adequate stated

interest; imputed principal amount.

(3) Debt instruments issued in a potentially abusive situation;

fair market value.

(c) Determination of whether a debt instrument provides for adequate

stated interest.

(1) In general.

(2) Determination of present value.

(d) Treatment of certain options.

(e) Mandatory sinking funds.

(f) Treatment of variable rate debt instruments.

(1) Stated interest at a qualified floating rate.

(2) Stated interest at a single objective rate.

(g) Contingent payments. [Reserved]

(h) Examples.

Sec. 1.1274-3 Potentially abusive situations defined.

(a) In general.

(b) Operating rules.

(1) Debt instrument exchanged for nonrecourse financing.

(2) Nonrecourse debt with substantial down payment.

(3) Clearly excessive interest.

(c) Other situations to be specified by Commissioner.

(d) Consistency rule.

Sec. 1.1274-4 Test rate.

(a) Determination of test rate of interest.

(1) In general.

(2) Test rate for certain debt instruments.

(b) Applicable Federal rate.

(c) Special rules to determine the term of a debt instrument for

purposes of determining the applicable Federal rate.

(1) Installment obligations.

(2) Certain variable rate debt instruments.

(3) Counting of either the issue date or the maturity date.

(4) Certain debt instruments that provide for principal payments

uncertain as to time.

(d) Foreign currency loans.

(e) Examples.

Sec. 1.1274-5 Assumptions.

(a) In general.

(b) Modifications of debt instruments.

(1) In general.

(2) Election to treat buyer as modifying the debt instrument.

(c) Wraparound indebtedness.

(d) Consideration attributable to assumed debt.

Sec. 1.1274A-1 Special rules for certain transactions where stated

principal amount does not exceed $2,800,000.

(a) In general.

(b) Rules for both qualified and cash method debt instruments.

(1) Sale-leaseback transactions.

(2) Debt instruments calling for contingent payments.

(3) Aggregation of transactions.

(4) Inflation adjustment of dollar amounts.

(c) Rules for cash method debt instruments.

(1) Time and manner of making cash method election.

(2) Successors of electing parties.

(3) Modified debt instrument.

(4) Debt incurred or continued to purchase or carry a cash

method debt instrument.

Sec. 1.1275-1 Definitions.

(a) Applicability.

(b) Adjusted issue price.

(1) In general.

(2) Adjusted issue price for subsequent holders.

(c) OID.

(d) Debt instrument.

(e) Tax-exempt obligations.

(f) Issue.

(g) Debt instruments issued by a natural person.

(h) Publicly offered debt instrument.

Sec. 1.1275-2 Special rules relating to debt instruments.

(a) Payment ordering rule.

(1) In general.

(2) Exceptions.

(b) Debt instruments distributed by corporations with respect to

stock.

(1) Treatment of distribution.

(2) Issue date.

(c) Aggregation of debt instruments.

(1) General rule.

(2) Exception if separate issue price established.

(3) Special rule for debt instruments that provide for the

issuance of additional debt instruments.

(4) Examples.

(d) Special rules for Treasury securities.

(1) Issue price and issue date.

(2) Reopenings of Treasury securities.

(e) Disclosure of certain information to holders.

(f) Treatment of pro rata prepayments.

(1) Treatment as retirement of separate debt instrument.

(2) Definition of pro rata prepayment.

(g) Anti-abuse rule. [Reserved]

Sec. 1.1275-2T Special rules relating to debt instruments (temporary).

(a) through (f). [Reserved]

(g) Anti-abuse rule.

(1) In general.

(2) Effective date.

Sec. 1.1275-3 OID information reporting requirements.

(a) In general.

(b) Information required to be set forth on face of debt instruments

that are not publicly offered.

(1) In general.

(2) Time for legending.

(3) Legend must survive reissuance upon transfer.

(4) Exceptions.

(c) Information required to be reported to Secretary upon issuance

of publicly offered debt instruments.

(1) In general.

(2) Time for filing information return.

(3) Exceptions.

(d) Application to foreign issuers and U.S. issuers of

foreigntargeted debt instruments.

(e) Penalties.

(f) Effective date.

Sec. 1.1275-5 Variable rate debt instruments.

(a) Applicability.

(1) In general.

(2) Principal payments.

(3) Stated interest.

(4) Current value.

(b) Qualified floating rate.

(1) In general.

(2) Certain rates based on a qualified floating rate.

(3) Restrictions on the stated rate of interest.

(c) Objective rate.

(1) In general.

(2) Other objective rates to be specified by Commissioner.

(3) Qualified inverse floating rate.

(4) Significant front-loading or back-loading of interest.

(5) Tax-exempt debt.

(d) Examples.

(e) Qualified stated interest and OID with respect to a variable

rate debt instrument.

(1) In general.

(2) Variable rate debt instrument that provides for annual

payments of interest at a single variable rate.

(3) All other variable rate debt instruments except for those

that provide for a fixed rate.

(4) Variable rate debt instrument that provides for a single

fixed rate.

(f) Special rule for certain reset bonds.

Sec. 1.1271-1 Special rules applicable to amounts received on

retirement, sale, or exchange of debt instruments.

(a) Intention to call before maturity--(1) In general. For purposes

of section 1271(a)(2), all or a portion of gain realized on a sale or

exchange of a debt instrument to which section 1271 applies is treated

as interest income if there was an intention to call the debt

instrument before maturity. An intention to call a debt instrument

before maturity means a written or oral agreement or understanding not

provided for in the debt instrument between the issuer and the original

holder of the debt instrument that the issuer will redeem the debt

instrument before maturity. In the case of debt instruments that are

part of an issue, the agreement or understanding must be between the

issuer and the original holders of a substantial amount of the debt

instruments in the issue. An intention to call before maturity can

exist even if the intention is conditional (e.g., the issuer's decision

to call depends on the financial condition of the issuer on the

potential call date) or is not legally binding. For purposes of this

section, original holder means the first holder (other than an

underwriter or dealer that purchased the debt instrument for resale in

the ordinary course of its trade or business).

(2) Exceptions. In addition to the exceptions provided in sections

1271(a)(2)(B) and 1271(b), section 1271(a)(2) does not apply to--

(i) A debt instrument that is publicly offered (as defined in

Sec. 1.1275-1(h));

(ii) A debt instrument to which section 1272(a)(6) applies

(relating to certain interests in or mortgages held by a REMIC, and

certain other debt instruments with payments subject to acceleration);

or

(iii) A debt instrument sold pursuant to a private placement

memorandum that is distributed to more than ten offerees and that is

subject to the sanctions of section 12(2) of the Securities Act of 1933

(15 U.S.C. 77l) or the prohibitions of section 10(b) of the Securities

Exchange Act of 1934 (15 U.S.C. 78j).

(b) Short-term obligations--(1) In general. Under sections

1271(a)(3) and (a)(4), all or a portion of the gain realized on the

sale or exchange of a short-term government or nongovernment obligation

is treated as interest income. Sections 1271(a)(3) and (a)(4), however,

do not apply to any short-term obligation subject to section 1281. See

Sec. 1.1272-1(f) for rules to determine if an obligation is a short-

term obligation.

(2) Method of making elections. Elections to accrue on a constant

yield basis under sections 1271(a)(3)(E) and (a)(4)(D) are made on an

obligation-by-obligation basis by reporting the transaction on the

basis of daily compounding on the taxpayer's timely filed Federal

income tax return for the year of the sale or exchange. These elections

are irrevocable.

(3) Counting conventions. In computing the ratable share of

acquisition discount under section 1271(a)(3) or OID under section

1271(a)(4), any reasonable counting convention may be used (e.g., 30

days per month/360 days per year).

Sec. 1.1272-1 Current inclusion of OID in income.

(a) Overview--(1) In general. Under section 1272(a)(1), a holder of

a debt instrument includes accrued OID in gross income (as interest),

regardless of the holder's regular method of accounting. A holder

includes qualified stated interest (as defined in Sec. 1.1273-1(c)) in

income under the holder's regular method of accounting. See

Secs. 1.446-2 and 1.451-1.

(2) Debt instruments not subject to OID inclusion rules. Sections

1272(a)(2) and 1272(c) list exceptions to the general inclusion rule of

section 1272(a)(1). For purposes of section 1272(a)(2)(E) (relating to

certain loans between natural persons), a loan does not include a

stripped bond or stripped coupon within the meaning of section 1286(e),

and the rule in section 1272(a)(2)(E)(iii), which treats a husband and

wife as 1 person, does not apply to loans made between a husband and

wife.

(b) Accrual of OID--(1) Constant yield method. Except as provided

in paragraphs (b)(2) and (b)(3) of this section, the amount of OID

includible in the income of a holder of a debt instrument for any

taxable year is determined using the constant yield method as described

under this paragraph (b)(1).

(i) Step one: Determine the debt instrument's yield to maturity.

The yield to maturity or yield of a debt instrument is the discount

rate that, when used in computing the present value of all principal

and interest payments to be made under the debt instrument, produces an

amount equal to the issue price of the debt instrument. The yield must

be constant over the term of the debt instrument and, when expressed as

a percentage, must be calculated to at least two decimal places. See

paragraph (c) of this section for rules relating to the yield of

certain debt instruments subject to contingencies.

(ii) Step two: Determine the accrual periods. An accrual period is

an interval of time over which the accrual of OID is measured. Accrual

periods may be of any length and may vary in length over the term of

the debt instrument, provided that each accrual period is no longer

than 1 year and each scheduled payment of principal or interest occurs

either on the final day of an accrual period or on the first day of an

accrual period. In general, the computation of OID is simplest if

accrual periods correspond to the intervals between payment dates

provided by the terms of the debt instrument. In computing the length

of accrual periods, any reasonable counting convention may be used

(e.g., 30 days per month/360 days per year).

(iii) Step three: Determine the OID allocable to each accrual

period. Except as provided in paragraph (b)(4) of this section, the OID

allocable to an accrual period equals the product of the adjusted issue

price of the debt instrument (as defined in Sec. 1.1275-1(b)) at the

beginning of the accrual period and the yield of the debt instrument,

less the amount of any qualified stated interest allocable to the

accrual period. In performing this calculation, the yield must be

stated appropriately taking into account the length of the particular

accrual period. Example 1 in paragraph (j) of this section provides a

formula for converting a yield based upon an accrual period of one

length to an equivalent yield based upon an accrual period of a

different length.

(iv) Step four: Determine the daily portions of OID. The daily

portions of OID are determined by allocating to each day in an accrual

period the ratable portion of the OID allocable to the accrual period.

The holder of the debt instrument includes in income the daily portions

of OID for each day during the taxable year on which the holder held

the debt instrument.

(2) Exceptions. Paragraph (b)(1) of this section does not apply

to--

(i) 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);

(ii) A debt instrument that provides for contingent payments,

except as provided in paragraph (c) of this section or in regulations

under section 1275(d); or

(iii) A variable rate debt instrument to which Sec. 1.1275-5

applies, except as provided in Sec. 1.1275-5.

(3) Modifications. The amount of OID includible in income by a

holder under paragraph (b)(1) of this section is adjusted if--

(i) The holder purchased the debt instrument at a premium or an

acquisition premium (within the meaning of Sec. 1.1272-2); or

(ii) The holder made an election for the debt instrument under

Sec. 1.1272-3 to treat all interest as OID.

(4) Special rules for determining the OID allocable to an accrual

period. The following rules apply to determine the OID allocable to an

accrual period under paragraph (b)(1)(iii) of this section.

(i) Unpaid qualified stated interest allocable to an accrual

period. In determining the OID allocable to an accrual period, if an

interval between payments of qualified stated interest contains more

than 1 accrual period--

(A) The amount of qualified stated interest payable at the end of

the interval (including any qualified stated interest that is payable

on the first day of the accrual period immediately following the

interval) is allocated on a pro rata basis to each accrual period in

the interval; and

(B) The adjusted issue price at the beginning of each accrual

period in the interval must be increased by the amount of any qualified

stated interest that has accrued prior to the first day of the accrual

period but that is not payable until the end of the interval. See

Example 2 of paragraph (j) of this section for an example illustrating

the rules in this paragraph (b)(4)(i).

(ii) Final accrual period. The OID allocable to the final accrual

period is the difference between the amount payable at maturity (other

than a payment of qualified stated interest) and the adjusted issue

price at the beginning of the final accrual period.

(iii) Initial short accrual period. If all accrual periods are of

equal length, except for either an initial shorter accrual period or an

initial and a final shorter accrual period, the amount of OID allocable

to the initial accrual period may be computed using any reasonable

method. See Example 3 in paragraph (j) of this section.

(iv) Payment on first day of an accrual period. The adjusted issue

price at the beginning of an accrual period is reduced by the amount of

any payment (other than a payment of qualified stated interest) that is

made on the first day of the accrual period.

(c) Yield and maturity of certain debt instruments subject to

contingencies--(1) Applicability. This paragraph (c) provides rules to

determine the yield and maturity of a debt instrument that provides 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. 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 regulations under

section 1275(d) for the treatment of debt instruments with payments

that are otherwise contingent as to timing or amount. See Sec. 1.1273-

1(c) to determine whether stated interest on a debt instrument subject

to this paragraph (c) is qualified stated interest.

(2) General rule. In general, the yield and maturity of a debt

instrument subject to this paragraph (c) are determined by assuming

that the payments will be made according to the instrument's stated

payment schedule.

(3) Contingencies that are likely to occur--(i) Contingency taken

into account. Notwithstanding the rule in paragraph (c)(2) of this

section, if, based on all the facts and circumstances as of the issue

date, it is more likely than not that the debt instrument's stated

payment schedule will not occur, then the yield and maturity of the

debt instrument are computed based on the payment schedule most likely

to occur.

(ii) Mandatory sinking fund provision. Paragraph (c)(3)(i) of this

section does not apply to a mandatory sinking fund provision 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 requires the issuer to redeem a certain amount of

debt instruments in an issue prior to maturity, provided that 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), and provided that on

the issue date the specific debt instruments that will be redeemed on

any date prior to maturity cannot be identified.

(4) Consistency rule. The payment schedule determined by the issuer

under paragraphs (c)(2) and (c)(3) of this section is binding on all

holders of the debt instrument. However, the issuer's determination is

not binding on a holder that explicitly discloses that its

determination of the yield and maturity of the debt instrument 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 Sec. 1.1275-2(e) for rules relating to the issuer's obligation to

disclose certain information to holders.

(5) Treatment of certain options. Notwithstanding paragraphs (c)(2)

and (c)(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 will be 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 will be 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. Thus, the deemed

exercise of one option may eliminate other options that are later in

time. See Example 5 through Example 8 in paragraph (j) of this section.

(6) Subsequent adjustments. If a contingency described in this

paragraph (c) (including the exercise of an option 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 the accrual of

OID, the yield and maturity of the debt instrument are redetermined by

treating the debt instrument as reissued on the date of the change in

circumstances for an amount equal to its adjusted issue price on that

date. See Example 5 and Example 7 in paragraph (j) of this section. If,

however, the change in circumstances results in a substantially

contemporaneous pro rata prepayment as defined in Sec. 1.1275-2(f)(2)

(e.g., because a partial put or call option treated under paragraph

(c)(5) of this section as not exercised is, in fact, exercised), 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 Example 6 and Example 8 in paragraph (j) of this section.

(d) Certain debt instruments that provide for principal payments

uncertain as to time. 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 debt instrument at intervals of 1 year or less.

(e) Convertible debt instruments. For purposes of section 1272, an

option is ignored if it is an option to convert a 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.

(f) Special rules to determine whether a debt instrument is a

short-term obligation--(1) Counting of either the issue date or

maturity date. For purposes of determining whether a debt instrument is

a short-term obligation (i.e., a debt instrument with a fixed maturity

date that is not more than 1 year from the date of issue), the term of

the debt instrument includes either the issue date or the maturity

date, but not both dates.

(2) Coordination with paragraph (c) of this section for certain

sections of the Internal Revenue Code. Notwithstanding paragraph (c) of

this section, solely for purposes of determining whether a debt

instrument is a short-term obligation under sections 871(g)(1)(B)(i),

881, 1271(a)(3), 1271(a)(4), 1272(a)(2)(C), and 1283(a)(1), the

maturity date of a debt instrument is the last possible date that the

instrument could be outstanding under the terms of the instrument.

(g) Basis adjustment. The basis of a debt instrument in the hands

of the holder is increased by the amount of OID included in the

holder's gross income and decreased by the amount of any payment from

the issuer to the holder under the debt instrument other than a payment

of qualified stated interest. See, however, Sec. 1.1275-2(f) for rules

regarding basis adjustments on a pro rata prepayment.

(h) Debt instruments denominated in a currency other than the U.S.

dollar. Section 1272 and this section apply to a debt instrument that

provides for all payments denominated in, or determined by reference

to, the functional currency of the taxpayer or qualified business unit

of the taxpayer (even if that currency is other than the U.S. dollar).

See Sec. 1.988-2(b) to determine interest income or expense for debt

instruments that provide for payments denominated in, or determined by

reference to, a nonfunctional currency.

(i) [Reserved]

(j) Examples. The following examples illustrate the rules of this

section. Each example assumes that all taxpayers use the calendar year

as the taxable year. In addition, each example assumes a 30-day month,

360-day year, and that the initial accrual period begins on the issue

date and the final accrual period ends on the day before the stated

maturity date. Although, for purposes of simplicity, the yield as

stated is rounded to two decimal places, the computations do not

reflect any such rounding convention.

Example 1. Accrual of OID on zero coupon debt instrument; choice

of accrual periods--(i) Facts. On July 1, 1994, A purchases at

original issue, for $675,564.17, a debt instrument that matures on

July 1, 1999, and provides for a single payment of $1,000,000 at

maturity.

(ii) Determination of yield. Under paragraph (b)(1)(i) of this

section, the yield of the debt instrument is 8 percent, compounded

semiannually.

(iii) Determination of accrual period. Under paragraph

(b)(1)(ii) of this section, accrual periods may be of any length,

provided that each accrual period is no longer than 1 year and each

scheduled payment of principal or interest occurs either on the

first or final day of an accrual period. The yield to maturity to be

used in computing OID accruals in any accrual period, however, must

reflect the length of the accrual period chosen. A yield based on

compounding b times per year is equivalent to a yield based on

compounding c times per year as indicated by the following formula:

r=c{(1+i/b) b/c-1}

In which:

i=The yield based on compounding b times per year expressed as a

decimal

r=The equivalent yield based on compounding c times per year

expressed as a decimal

b=The number of compounding periods in a year on which i is based

(for example, 12, if i is based on monthly compounding)

c=The number of compounding periods in a year on which r is based

(iv) Determination of OID allocable to each accrual period.

Assume that A decides to compute OID on the debt instrument using

semiannual accrual periods. Under paragraph (b)(1)(iii) of this

section, the OID allocable to the first semiannual accrual period is

$27,022.56: the product of the issue price ($675,564.17) and the

yield properly adjusted for the length of the accrual period (8

percent/2), less qualified stated interest allocable to the accrual

period ($0). The daily portion of OID for the first semiannual

accrual period is $150.13 ($27,022.56/180).

(v) Determination of OID if monthly accrual periods are used.

Alternatively, assume that A decides to compute OID on the debt

instrument using monthly accrual periods. Using the above formula,

the yield on the debt instrument reflecting monthly compounding is

7.87 percent, compounded monthly (12{(1+.08/2)2/12-1}). Under

paragraph (b)(1)(iii) of this section, the OID allocable to the

first monthly accrual period is $4,430.48: the product of the issue

price ($675,564.17) and the yield properly adjusted for the length

of the accrual period (7.87 percent/12), less qualified stated

interest allocable to the accrual period ($0). The daily portion of

OID for the first monthly accrual period is $147.68 ($4,430.48/30).

Example 2. Accrual of OID on debt instrument with qualified

stated interest--(i) Facts. On September 1, 1994, A purchases at

original issue, for $90,000, B corporation's debt instrument that

matures on September 1, 2004, and has a stated principal amount of

$100,000, payable on that date. The debt instrument provides for

semiannual payments of interest of $3,000, payable on September 1

and March 1 of each year, beginning on March 1, 1995.

(ii) Determination of yield. The debt instrument is a 10-year

debt instrument with an issue price of $90,000 and a stated

redemption price at maturity of $100,000. The semiannual payments of

$3,000 are qualified stated interest payments. Under paragraph

(b)(1)(i) of this section, the yield is 7.44 percent, compounded

semiannually.

(iii) Accrual of OID if semiannual accrual periods are used.

Assume that A decides to compute OID on the debt instrument using

semiannual accrual periods. Under paragraph (b)(1)(iii) of this

section, the OID allocable to the first semiannual accrual period

equals the product of the issue price ($90,000) and the yield

properly adjusted for the length of the accrual period (7.44

percent/2), less qualified stated interest allocable to the accrual

period ($3,000). Therefore, the amount of OID for the first

semiannual accrual period is $345.78 ($3,345.78-$3,000).

(iv) Adjustment for accrued but unpaid qualified stated interest

if monthly accrual periods are used. Assume, alternatively, that A

decides to compute OID on the debt instrument using monthly accrual

periods. The yield, compounded monthly, is 7.32 percent. Under

paragraph (b)(1)(iii) of this section, the OID allocable to the

first monthly accrual period is the product of the issue price

($90,000) and the yield properly adjusted for the length of the

accrual period (7.32 percent/12), less qualified stated interest

allocable to the accrual period. Under paragraph (b)(4)(i)(A) of

this section, the qualified stated interest allocable to the first

monthly accrual period is the pro rata amount of qualified stated

interest allocable to the interval between payment dates

($3,000 x \1/6\, or $500). Therefore, the amount of OID for the

first monthly accrual period is $49.18 ($549.18-$500). Under

paragraph (b)(4)(i)(B) of this section, the adjusted issue price of

the debt instrument for purposes of determining the amount of OID

for the second monthly accrual period is $90,549.18 ($90,000 +

$49.18 + $500). Although the adjusted issue price of the debt

instrument for this purpose includes the amount of qualified stated

interest allocable to the first monthly accrual period, A includes

the qualified stated interest in income based on A's regular method

of accounting (e.g., an accrual method or the cash receipts and

disbursements method).

Example 3. Accrual of OID for debt instrument with initial short

accrual period--(i) Facts. On May 1, 1994, G purchases at original

issue, for $80,000, H corporation's debt instrument maturing on July

1, 2004. The debt instrument provides for a single payment at

maturity of $250,000. G computes its OID using 6-month accrual

periods ending on January 1 and July 1 of each year and an initial

short 2-month accrual period from May 1, 1994, through June 30,

1994.

(ii) Determination of yield. The yield on the debt instrument is

11.53 percent, compounded semiannually.

(iii) Determination of OID allocable to initial short accrual

period. Under paragraph (b)(4)(iii) of this section, G may use any

reasonable method to compute OID for the initial short accrual

period. One reasonable method is to calculate the amount of OID

pursuant to the following formula:

OIDshort=IP x (i/k) x f

In which:

OIDshort=The amount of OID allocable to the initial short

accrual period

IP=The issue price of the debt instrument

i=The yield to maturity expressed as a decimal

k=The number of accrual periods in a year

f=A fraction whose numerator is the number of days in the initial

short accrual period, and whose denominator is the number of days in

a full accrual period

(iv) Amount of OID for the initial short accrual period. Under

this method, the amount of OID for the initial short accrual period

is $1,537 ($80,000 x (11.53 percent/2) x (60/180)).

(v) Alternative method. Another reasonable method is to

calculate the amount of OID for the initial short accrual period

using the yield based on bi-monthly compounding, computed pursuant

to the formula set forth in Example 1 of paragraph (j) of this

section. Under this method, the amount of OID for the initial short

accrual period is $1,508.38 ($80,000 x (11.31 percent/6)).

Example 4. Impermissible accrual of OID using a method other

than constant yield method--(i) Facts. On July 1, 1994, B purchases

at original issue, for $100,000, C corporation's debt instrument

that matures on July 1, 1999, and has a stated principal amount of

$100,000. The debt instrument provides for a single payment at

maturity of $148,024.43. The yield of the debt instrument is 8

percent, compounded semiannually.

(ii) Determination of yield. Assume that C uses 6 monthly

accrual periods to compute its OID for 1994. The yield must reflect

monthly compounding (as determined using the formula described in

Example 1 of paragraph (j) of this section). As a result, the

monthly yield of the debt instrument is 7.87 percent, divided by 12.

C may not compute its monthly yield for the last 6 months in 1994 by

dividing 8 percent by 12.

Example 5. Debt instrument subject to put option--(i) Facts. On

January 1, 1995, G purchases at original issue, for $70,000, H

corporation's debt instrument maturing on January 1, 2010, with a

stated principal amount of $100,000, payable at maturity. The debt

instrument provides for semiannual payments of interest of $4,000,

payable on January 1 and July 1 of each year, beginning on July 1,

1995. The debt instrument gives G an unconditional right to put the

bond back to H, exercisable on January 1, 2005, in return for

$85,000 (exclusive of the $4,000 of stated interest payable on that

date).

(ii) Determination of yield and maturity. Yield determined

without regard to the put option is 12.47 percent, compounded

semiannually. Yield determined by assuming that the put option is

exercised (i.e., by using January 1, 2005, as the maturity date and

$85,000 as the stated principal amount payable on that date) is

12.56 percent, compounded semiannually. Thus, under paragraph (c)(5)

of this section, it is assumed that G will exercise the put option,

because exercise of the option would increase the yield of the debt

instrument. Thus, for purposes of calculating OID, the debt

instrument is assumed to be a 10-year debt instrument with an issue

price of $70,000, a stated redemption price at maturity of $85,000,

and a yield of 12.56 percent, compounded semiannually.

(iii) Consequences if put option is, in fact, not exercised. If

the put option is, in fact, not exercised, then, under paragraph

(c)(6) of this section, the debt instrument is treated, solely for

purposes of determining yield and maturity, as if it were reissued

on January 1, 2005, for an amount equal to its adjusted issue price

on that date, $85,000. The new debt instrument matures on January 1,

2010, with a stated principal amount of $100,000 payable on that

date and provides for semiannual payments of interest of $4,000. The

yield of the new debt instrument is 12.08 percent, compounded

semiannually.

Example 6. Debt instrument subject to partial call option--(i)

Facts. On January 1, 1995, H purchases at original issue, for

$95,000, J corporation's debt instrument that matures on January 1,

2000, and has a stated principal amount of $100,000, payable on that

date. The debt instrument provides for semiannual payments of

interest of $4,000, payable on January 1 and July 1 of each year,

beginning on July 1, 1995. On January 1, 1998, J has an

unconditional right to call 50 percent of the principal amount of

the debt instrument for $55,000 (exclusive of the $4,000 of stated

interest payable on that date). If the call is exercised, the

semiannual payments of interest made after the call date will be

reduced to $2,000.

(ii) Determination of yield and maturity. Yield determined

without regard to the call option is 9.27 percent, compounded

semiannually. Yield determined by assuming J exercises its call

option is 10.75 percent, compounded semiannually. Thus, under

paragraph (c)(5) of this section, it is assumed that J will not

exercise the call option because exercise of the option would

increase the yield of the debt instrument. Thus, for purposes of

calculating OID, the debt instrument is assumed to be a 5-year debt

instrument with a single principal payment at maturity of $100,000,

and a yield of 9.27 percent, compounded semiannually.

(iii) Consequences if the call option is, in fact, exercised. If

the call option is, in fact, exercised, then under paragraph (c)(6)

of this section, the debt instrument is treated as if the issuer

made a pro rata prepayment of $55,000 that is subject to

Sec. 1.1275-2(f). Consequently, under Sec. 1.1275-2(f)(1), the

instrument is treated as consisting of two debt instruments, one

that is retired on the call date and one that remains outstanding

after the call date. The adjusted issue price, adjusted basis in the

hands of the holder, and accrued OID of the original debt instrument

is allocated between the two instruments based on the portion of the

original instrument treated as retired. Since each payment remaining

to be made after the call date is reduced by one-half, one-half of

the adjusted issue price, adjusted basis, and accrued OID is

allocated to the debt instrument that is treated as retired. The

adjusted issue price of the original debt instrument immediately

prior to the call date is $97,725.12, which equals the issue price

of the original debt instrument ($95,000) increased by the OID

previously includible in gross income ($2,725.12). One-half of this

adjusted issue price is allocated to the debt instrument treated as

retired, and the other half is allocated to the debt instrument that

is treated as remaining outstanding. Thus, the debt instrument

treated as remaining outstanding has an adjusted issue price

immediately after the call date of $97,725.12/2, or $48,862.56. The

yield of this debt instrument continues to be 9.27 percent,

compounded semiannually. In addition, the portion of H's adjusted

basis allocated to the debt instrument treated as retired is

$97,725.12/2 or $48,862.56. Accordingly, under section 1271, H

realizes a gain on the deemed retirement equal to $6,137.44 ($55,000

- $48,862.56).

Example 7. Debt instrument issued at par that provides for

payment of interest in kind--(i) Facts. On January 1, 1995, A

purchases at original issue, for $100,000, X corporation's debt

instrument maturing on January 1, 2000, at a stated principal amount

of $100,000, payable on that date. The debt instrument provides for

annual payments of interest of $6,000 on January 1 of each year,

beginning on January 1, 1996. The debt instrument gives X the

unconditional right to issue, in lieu of the first interest payment,

a second debt instrument (PIK instrument) maturing on January 1,

2000, with a stated principal amount of $6,000. The PIK instrument,

if issued, would provide for annual payments of interest of $360 on

January 1 of each year, beginning on January 1, 1997.

(ii) Aggregation of PIK instrument with original debt

instrument. Under Sec. 1.1275-2(c)(3), the issuance of the PIK

instrument is not considered a payment made on the original debt

instrument, and the PIK instrument is aggregated with the original

debt instrument. The issue date of the PIK instrument is the same as

the original debt instrument.

(iii) Determination of yield and maturity. The right to issue

the PIK instrument is treated as an option to defer the initial

interest payment until maturity. Yield determined without regard to

the option is 6 percent, compounded annually, Yield determined by

assuming X exercises the option is 6 percent, compounded annually.

Thus, under paragraph (c)(5) of this section, it is assumed that X

will not exercise the option by issuing the PIK instrument because

exercise of the option would not decrease the yield of the debt

instrument. For purposes of calculating OID, the debt instrument is

assumed to be a 5-year debt instrument with a single principal

payment at maturity of $100,000 and ten semiannual interest payments

of $6,000, beginning on January 1, 1996. As a result, the debt

instrument's yield is 6 percent, compounded annually.

(iv) Determination of OID. Under the payment schedule that would

result if the option was exercised, none of the interest on the debt

instrument would be qualified stated interest. Accordingly, under

Sec. 1.1273-1(c)(2), no payments on the debt instrument are

qualified stated interest payments. Thus, $6,000 of OID accrues

during the first annual accrual period. If the PIK instrument is not

issued, $6,000 of OID accrues during each annual accrual period.

(v) Consequences if the PIK instrument is issued. Under

paragraph (c)(6) of this section, if X issues the PIK instrument on

January 1, 1996, the issuance of the PIK instrument is not a payment

on the debt instrument. Solely for purposes of determining yield and

maturity, the debt instrument is deemed reissued on January 1, 1996,

for an issue price of $106,000. The recomputed yield is 6 percent,

compounded annually. The OID for the first annual accrual period

after the deemed reissuance is $6,360. The adjusted issue price of

the debt instrument at the beginning of the next annual accrual

period is $106,000 ($106,000 + $6,360 - $6,360). The OID for each of

the four remaining annual accrual periods is $6,360.

Example 8. Debt instrument issued at a discount that provides

for payment of interest in kind--(i) Facts. On January 1, 1995, T

purchases at original issue, for $75,500, U corporation's debt

instrument maturing on January 1, 2000, at a stated principal amount

of $100,000, payable on that date. The debt instrument provides for

annual payments of interest of $4,000 on January 1 of each year,

beginning on January 1, 1996. The debt instrument gives U the

unconditional right to issue, in lieu of the first interest payment,

a second debt instrument (PIK instrument) maturing on January 1,

2000, with a stated principal amount of $4,000. The PIK instrument,

if issued, would provide for annual payments of interest of $160 on

January 1 of each year, beginning on January 1, 1997.

(ii) Aggregation of PIK instrument with original debt

instrument. Under Sec. 1.1275-2(c)(3), the issuance of the PIK

instrument is not considered a payment made on the original debt

instrument, and the PIK instrument is aggregated with the original

debt instrument. The issue date of the PIK instrument is the same as

the original debt instrument.

(iii) Determination of yield and maturity. The right to issue

the PIK instrument is treated as an option to defer the initial

interest payment until maturity. Yield determined without regard to

the option is 10.55 percent, compounded annually. Yield determined

by assuming U exercises the option is 10.32 percent, compounded

annually. Thus, under paragraph (c)(5) of this section, it is

assumed that U will exercise the option by issuing the PIK

instrument because exercise of the option would decrease the yield

of the debt instrument. For purposes of calculating OID, the debt

instrument is assumed to be a 5-year debt instrument with a single

principal payment at maturity of $104,000 and four annual interest

payments of $4,160, beginning on January 1, 1997. As a result, the

yield is 10.32 percent, compounded annually.

(iv) Consequences if the PIK instrument is not issued. Assume

that T chooses to compute OID accruals on the basis of an annual

accrual period. On January 1, 1996, the adjusted issue price of the

debt instrument, and T's adjusted basis in the instrument, is

$83,295.15. Under paragraph (c)(6) of this section, if U actually

makes the $4,000 interest payment on January 1, 1996, the debt

instrument is treated as if U made a pro rata prepayment (within the

meaning of Sec. 1.1275-2(f)(2)) of $4,000, which reduces the amount

of each payment remaining on the instrument by a factor of 4/104, or

1/26. Thus, under Sec. 1.1275-2(f)(1) and section 1271, T realizes a

gain of $796.34 ($4,000 -($83,295.15/26)). The adjusted issue price

of the debt instrument and T's adjusted basis immediately after the

payment is $80,091.49 ($83,295.15 x 25/26) and the yield continues

to be 10.32 percent, compounded annually.

Example 9. Debt instrument with stepped interest rate--(i)

Facts. On July 1, 1994, G purchases at original issue, for $85,000,

H corporation's debt instrument maturing on July 1, 2004. The debt

instrument has a stated principal amount of $100,000, payable on the

maturity date and provides for semiannual interest payments on

January 1 and July 1 of each year, beginning on January 1, 1995. The

amount of each payment is $2,000 for the first 5 years and $5,000

for the final 5 years.

(ii) Determination of OID. Assume that G computes its OID using

6-month accrual periods ending on January 1 and July 1 of each year.

The yield of the debt instrument, determined under paragraph

(b)(1)(i) of this section, is 8.65 percent, compounded semiannually.

Interest is unconditionally payable at a fixed rate of at least 4

percent, compounded semiannually, for the entire term of the debt

instrument. Consequently, under Sec. 1.1273-1(c)(1), the semiannual

payments are qualified stated interest payments to the extent of

$2,000. The amount of OID for the first 6-month accrual period is

$1,674.34 (the issue price of the debt instrument ($85,000) times

the yield of the debt instrument for that accrual period (.0865/2)

less the amount of any qualified stated interest allocable to that

accrual period ($2,000)).

Example 10. Debt instrument payable on demand that provides for

interest at a constant rate--(i) Facts. On January 1, 1995, V

purchases at original issue, for $100,000, W corporation's debt

instrument. The debt instrument calls for interest to accrue at a

rate of 9 percent, compounded annually. The debt instrument is

redeemable at any time at the option of V for an amount equal to

$100,000, plus accrued interest. V uses annual accrual periods to

accrue OID on the debt instrument.

(ii) Amount of OID. Pursuant to paragraph (d) of this section,

the yield of the debt instrument is 9 percent, compounded annually.

If the debt instrument is not redeemed during 1995, the amount of

OID allocable to the year is $9,000.

Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.

(a) In general. Under section 1272(c)(1), if a holder purchases a

debt instrument at a premium, the holder does not include any OID in

gross income. Under section 1272(a)(7), if a holder purchases a debt

instrument at an acquisition premium, the holder reduces the amount of

OID includible in gross income by the fraction determined under

paragraph (b)(4) of this section.

(b) Definitions and special rules--(1) Purchase. For purposes of

section 1272 and this section, purchase means any acquisition of a debt

instrument, including the acquisition of a newly issued debt instrument

in a debt-for-debt exchange or the acquisition of a debt instrument

from a donor.

(2) Premium. A debt instrument is purchased at a premium if its

adjusted basis, immediately after its purchase by the holder (including

a purchase at original issue), exceeds the sum of all amounts payable

on the instrument after the purchase date other than payments of

qualified stated interest (as defined in Sec. 1.1273-1(c)).

(3) Acquisition premium. A debt instrument is purchased at an

acquisition premium if its adjusted basis, immediately after its

purchase (including a purchase at original issue), is--

(i) Less than or equal to the sum of all amounts payable on the

instrument after the purchase date other than payments of qualified

stated interest (as defined in Sec. 1.1273-1(c)); and

(ii) Greater than the instrument's adjusted issue price (as defined

in Sec. 1.1275-1(b)).

(4) Acquisition premium fraction. In applying section 1272(a)(7),

the cost of a debt instrument is its adjusted basis immediately after

its acquisition by the purchaser. Thus, the numerator of the fraction

determined under section 1272(a)(7)(B) is the excess of the adjusted

basis of the debt instrument immediately after its acquisition by the

purchaser over the adjusted issue price of the debt instrument. The

denominator of the fraction determined under section 1272(a)(7)(B) is

the excess of the sum of all amounts payable on the debt instrument

after the purchase date, other than payments of qualified stated

interest, over the instrument's adjusted issue price.

(5) Election to accrue discount on a constant yield basis. Rather

than applying the acquisition premium fraction, a holder of a debt

instrument purchased at an acquisition premium may elect under

Sec. 1.1272-3 to compute OID accruals by treating the purchase as a

purchase at original issuance and applying the mechanics of the

constant yield method.

(6) Special rules for determining basis--(i) Debt instruments

acquired in exchange for other property. For purposes of section

1272(a)(7), section 1272(c)(1), and this section, if a debt instrument

is acquired in an exchange for other property (other than in a

reorganization defined in section 368) and the basis of the debt

instrument is determined, in whole or in part, by reference to the

basis of the other property, the basis of the debt instrument may not

exceed its fair market value immediately after the exchange. For

example, if a debt instrument is distributed by a partnership to a

partner in a liquidating distribution and the partner's basis in the

debt instrument would otherwise be determined under section 732, the

partner's basis in the debt instrument may not exceed its fair market

value for purposes of this section.

(ii) Acquisition by gift. For purposes of this section, a donee's

adjusted basis in a debt instrument is the donee's basis for

determining gain under section 1015(a).

(c) Examples. The following examples illustrate the rules of this

section.

Example 1. Debt instrument purchased at an acquisition premium--

(i) Facts. On July 1, 1994, A purchased at original issue, for $500,

a debt instrument issued by Corporation X. The debt instrument

matures on July 1, 1999, and calls for a single payment at maturity

of $1,000. Under section 1273(a), the debt instrument has a stated

redemption price at maturity of $1,000 and, thus, OID of $500. On

July 1, 1996, when the debt instrument's adjusted issue price is

$659.75, A sells the debt instrument to B for $750 in cash.

(ii) Acquisition premium fraction. Because the cost to B of the

debt instrument is less than the amount payable on the debt

instrument after the purchase date, but is greater than the debt

instrument's adjusted issue price, B has paid an acquisition premium

for the debt instrument. Accordingly, the daily portion of OID for

any day that B holds the debt instrument is reduced by a fraction,

the numerator of which is $90.25 (the excess of the cost of the debt

instrument over its adjusted issue price) and the denominator of

which is $340.25 (the excess of the sum of all payments after the

purchase date over its adjusted issue price).

Example 2. Debt-for-debt exchange where holder is considered to

purchase new debt instrument at a premium--(i) Facts. On January 1,

1995, H purchases at original issue, for $1,000, a debt instrument

issued by Corporation X. On July 1, 1997, when H's adjusted basis in

the debt instrument is $1,000, Corporation X issues a new debt

instrument with a stated redemption price at maturity of $750 to H

in exchange for the old debt instrument. Assume that the issue price

of the new debt instrument is $600. Thus, under section 1273(a), the

debt instrument has OID of $150. The exchange qualifies as a

recapitalization under section 368(a)(1)(E), with the consequence

that, under sections 354 and 358, H recognizes no loss on the

exchange and has an adjusted basis in the new debt instrument of

$1,000.

(ii) Application of section 1272(c)(1). Under paragraphs (b)(1)

and (b)(2) of this section, H purchases the new debt instrument at a

premium of $250. Accordingly, under section 1272(c)(1), H is not

required to include OID in income with respect to the new debt

instrument.

Example 3. Debt-for-debt exchange where holder is considered to

purchase new debt instrument at an acquisition premium--(i) Facts.

The facts are the same as in Example 2 of paragraph (c) of this

section, except that H purchases the old debt instrument from

another holder on July 1, 1995, and on July 1, 1997, H's adjusted

basis in the old debt instrument is $700. Under section 1273(a), the

new debt instrument is issued with OID of $150.

(ii) Application of section 1272(a)(7). Under paragraphs (b)(1)

and (b)(3) of this section, H purchases the new debt instrument at

an acquisition premium of $100. Accordingly, the daily portion of

OID that is includible in H's income is reduced by the fraction

determined under section 1272(a)(7).

Example 4. Treatment of acquisition premium for debt instrument

acquired by gift--(i) Facts. On July 1, 1994, D receives as a gift a

debt instrument with a stated redemption price at maturity of $1,000

and an adjusted issue price of $800. On that date, the fair market

value of the debt instrument is $900 and the donor's adjusted basis

in the debt instrument is $950.

(ii) Application of section 1272(a)(7). Under paragraphs (b)(1),

(b)(3), and (b)(6)(ii) of this section, D is considered to have

purchased the debt instrument at an acquisition premium of $150.

Accordingly, the daily portion of OID that is includible in D's

income is reduced by the fraction determined under section

1272(a)(7).

Sec. 1.1272-3 Election by a holder to treat all interest on a debt

instrument as OID.

(a) Election. A holder of a debt instrument may elect to include in

gross income all interest that accrues on the instrument by using the

constant yield method described in paragraph (c) of this section. For

purposes of this election, interest includes stated interest,

acquisition discount, OID, de minimis OID, market discount, de minimis

market discount, and unstated interest, as adjusted by any amortizable

bond premium or acquisition premium.

(b) Scope of election--(1) In general. Except as provided in

paragraph (b)(2) of this section, a holder may make the election for

any debt instrument.

(2) Exceptions, limitations, and special rules--(i) Debt instrument

with amortizable bond premium (as determined under section 171). (A) A

holder may make the election for a debt instrument with amortizable

bond premium only if the instrument qualifies as a bond under section

171(d).

(B) If a holder makes the election under this section for a debt

instrument with amortizable bond premium, the holder is deemed to have

made the election under section 171(c)(2) for the taxable year in which

the instrument was acquired. If the holder has previously made the

election under section 171(c)(2), the requirements of that election

with respect to any debt instrument are satisfied by electing to

amortize the bond premium under the rules provided by this section.

(ii) Debt instrument with market discount. (A) A holder may make

the election under this section for a debt instrument with market

discount only if the holder is eligible to make an election under

section 1278(b).

(B) If a holder makes the election under this section for a debt

instrument with market discount, the holder is deemed to have made both

the election under section 1276(b)(2) for that instrument and the

election under section 1278(b) for the taxable year in which the

instrument was acquired. If the holder has previously made the election

under section 1278(b), the requirements of that election with respect

to any debt instrument are satisfied by electing to include the market

discount in income in accordance with the rules provided by this

section.

(iii) Tax-exempt debt instrument. A holder may not make the

election for a tax-exempt obligation as defined in section 1275(a)(3).

(c) Mechanics of the constant yield method--(1) In general. For

purposes of this section, the amount of interest that accrues during an

accrual period is determined under rules similar to those under section

1272 (the constant yield method). In applying the constant yield

method, however, a debt instrument subject to the election is treated

as if--

(i) The instrument is issued for the holder's adjusted basis

immediately after its acquisition by the holder;

(ii) The instrument is issued on the holder's acquisition date; and

(iii) None of the interest payments provided for in the instrument

are qualified stated interest payments.

(2) Special rules to determine adjusted basis. For purposes of

paragraph (c)(1)(i) of this section--

(i) If the debt instrument is acquired in an exchange for other

property (other than in a reorganization defined in section 368) and

the basis of the debt instrument is determined, in whole or in part, by

reference to the basis of the other property, the adjusted basis of the

debt instrument may not exceed its fair market value immediately after

the exchange; and

(ii) If the debt instrument was acquired with amortizable bond

premium (as determined under section 171), the adjusted basis of the

debt instrument is reduced by an amount equal to the value attributable

to any conversion feature.

(d) Time and manner of making the election. The election must be

made for the taxable year in which the holder acquires the debt

instrument. A holder makes the election by attaching to the holder's

timely filed Federal income tax return a statement that the holder is

making an election under this section and that identifies the debt

instruments subject to the election. A holder may make the election for

a class or group of debt instruments by attaching a statement

describing the type or types of debt instruments being designated for

the election.

(e) Revocation of election. The election may not be revoked unless

approved by the Commissioner.

(f) Effective date. This section applies to debt instruments

acquired on or after April 4, 1994.

Sec. 1.1273-1 Definition of OID.

(a) In general. Section 1273(a)(1) defines OID as the excess of a

debt instrument's stated redemption price at maturity over its issue

price. Section 1.1273-2 defines issue price, and paragraph (b) of this

section defines stated redemption price at maturity. Paragraph (d) of

this section provides rules for de minimis amounts of OID. Although the

total amount of OID for a debt instrument may be indeterminate,

Sec. 1.1272-1(d) provides a rule to determine OID accruals on certain

debt instruments that provide for principal payments uncertain as to

time. See Example 10 in Sec. 1.1272-1(j).

(b) Stated redemption price at maturity. A debt instrument's stated

redemption price at maturity is the sum of all payments provided by the

debt instrument other than qualified stated interest payments. If the

payment schedule of a debt instrument is determined under Sec. 1.1272-

1(c) (relating to certain debt instruments subject to contingencies),

that payment schedule is used to determine the instrument's stated

redemption price at maturity.

(c) Qualified stated interest--(1) Definition--(i) In general.

Qualified stated interest is stated interest that is unconditionally

payable in cash or in property (other than debt instruments of the

issuer), or that will be constructively received under section 451, at

least annually at a single fixed rate (within the meaning of paragraph

(c)(1)(iii) of this section).

(ii) Unconditionally payable. 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. Notwithstanding the

preceding sentence, interest is not unconditionally payable if the

lending transaction does not reflect arm's length dealing and the

holder does not intend to enforce such remedies. 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 right described

in Sec. 1.1272-1(e) is ignored.

(iii) Single fixed rate--(A) In general. Interest is payable at a

single fixed rate only if the rate appropriately takes into account the

length of the interval between payments. Thus, if the interval between

payments varies during the term of the debt instrument, the value of

the fixed rate on which a payment is based generally must be adjusted

to reflect a compounding assumption that is consistent with the length

of the interval preceding the payment. See Example 1 in paragraph (f)

of this section.

(B) Special rule for certain first and final payment intervals.

Notwithstanding paragraph (c)(1)(iii)(A) of this section, if a debt

instrument provides for payment intervals that are equal in length

throughout the term of the instrument, except that the first or final

payment interval differs in length from the other payment intervals,

the first or final interest payment is considered to be made at a fixed

rate if the value of the rate on which the payment is based is adjusted

in any reasonable manner to take into account the length of the

interval. See Example 2 of paragraph (f) of this section. The rule in

this paragraph (c)(1)(iii)(B) also applies if the lengths of both the

first and final payment intervals differ from the length of the other

payment intervals.

(2) Debt instruments subject to contingencies. The determination of

whether a debt instrument described in Sec. 1.1272-1(c) (a debt

instrument providing for an alternative payment schedule (or schedules)

upon the occurrence of one or more contingencies) provides for

qualified stated interest is made by analyzing each alternative payment

schedule (including the stated payment schedule) as if it were the debt

instrument's sole payment schedule. Under this analysis, 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. See Example (4) of paragraph (f) of this

section.

(3) Variable rate debt instrument. In the case of a variable rate

debt instrument, qualified stated interest is determined under

Sec. 1.1275-5(e).

(4) Stated interest in excess of qualified stated interest. To the

extent that stated interest payable under a debt instrument exceeds

qualified stated interest, the excess is included in the debt

instrument's stated redemption price at maturity.

(5) Short-term obligations. In the case of a debt instrument with a

term that is not more than 1 year from the date of issue, no payments

of interest are treated as qualified stated interest payments.

(d) De minimis OID--(1) In general. If the amount of OID with

respect to a debt instrument is less than the de minimis amount, the

amount of OID is treated as zero, and all stated interest (including

stated interest that would otherwise be characterized as OID) is

treated as qualified stated interest.

(2) De minimis amount. The de minimis amount is an amount equal to

0.0025 multiplied by the product of the stated redemption price at

maturity and the number of complete years to maturity from the issue

date.

(3) Installment obligations. In the case of an installment

obligation (as defined in paragraph (e)(1) of this section), paragraph

(d)(2) of this section is applied by substituting for the number of

complete years to maturity the weighted average maturity (as defined in

paragraph (e)(3) of this section). Alternatively, in the case of a debt

instrument that provides for payments of principal no more rapidly than

a self-amortizing installment obligation (as defined in paragraph

(e)(2) of this section), the de minimis amount defined in paragraph

(d)(2) of this section may be calculated by substituting 0.00167 for

0.0025.

(4) Special rule for interest holidays, teaser rates, and other

interest shortfalls--(i) In general. This paragraph (d)(4) provides a

special rule to determine whether a debt instrument with a teaser rate

(or rates), an interest holiday, or any other interest shortfall has de

minimis OID. This rule applies if--

(A) The amount of OID on the debt instrument is more than the de

minimis amount as otherwise determined under paragraph (d) of this

section; and

(B) All stated interest provided for in the debt instrument would

be qualified stated interest under paragraph (c) of this section except

that for 1 or more accrual periods the interest rate is below the rate

applicable for the remainder of the instrument's term (e.g., if as a

result of an interest holiday, none of the stated interest is qualified

stated interest).

(ii) Redetermination of OID for purposes of the de minimis test.

For purposes of determining whether a debt instrument described in

paragraph (d)(4)(i) of this section has de minimis OID, the

instrument's stated redemption price at maturity is treated as equal to

the instrument's issue price plus the greater of the amount of foregone

interest or the excess (if any) of the instrument's stated principal

amount over its issue price. The amount of foregone interest is the

amount of additional stated interest that would be required to be

payable on the debt instrument during the period of the teaser rate,

holiday, or shortfall so that all stated interest would be qualified

stated interest under paragraph (c) of this section. See Example 5 and

Example 6 of paragraph (f) of this section. In addition, for purposes

of computing the de minimis amount of OID, the weighted average

maturity of the debt instrument is determined by treating all stated

interest payments as qualified stated interest payments.

(5) Treatment of de minimis OID by holders--(i) Allocation of de

minimis OID to principal payments. The holder of a debt instrument

includes any de minimis OID (other than de minimis OID treated as

qualified stated interest under paragraph (d)(1) of this section, such

as de minimis OID attributable to a teaser rate or interest holiday) in

income as stated principal payments are made. The amount includible in

income with respect to each principal payment equals the product of the

total amount of de minimis OID on the debt instrument and a fraction,

the numerator of which is the amount of the principal payment made and

the denominator of which is the stated principal amount of the

instrument.

(ii) Character of de minimis OID--(A) De minimis OID treated as

gain recognized on retirement. Any amount of de minimis OID includible

in income under this paragraph (d)(5) is treated as gain recognized on

retirement of the debt instrument. See section 1271 to determine

whether a retirement is treated as an exchange of the debt instrument.

(B) Treatment of de minimis OID on sale or exchange. Any gain

attributable to de minimis OID that is recognized on the sale or

exchange of a debt instrument is capital gain if the debt instrument is

a capital asset in the hands of the seller.

(iii) Treatment of subsequent holders. If a subsequent holder

purchases a debt instrument issued with de minimis OID at a premium (as

defined in Sec. 1.1272-2(b)(2)), the subsequent holder does not include

the de minimis OID in income. Otherwise, a subsequent holder includes

any discount in income under the market discount rules (sections 1276

through 1278) rather than under the rules of this paragraph (d)(5).

(iv) Cross-reference. See Sec. 1.1272-3 for an election by a holder

to treat de minimis OID as OID.

(e) Definitions--(1) Installment obligation. An installment

obligation is a debt instrument that provides for the payment of any

amount other than qualified stated interest before maturity.

(2) Self-amortizing installment obligation. A self-amortizing

installment obligation is an obligation that provides for equal

payments composed of principal and qualified stated interest that are

unconditionally payable at least annually during the entire term of the

debt instrument with no significant additional payment required at

maturity.

(3) Weighted average maturity. The weighted average maturity of a

debt instrument is the sum of the following amounts determined for each

payment under the instrument (other than a payment of qualified stated

interest)--

(i) The number of complete years from the issue date until the

payment is made; multiplied by

(ii) A fraction, the numerator of which is the amount of the

payment and the denominator of which is the debt instrument's stated

redemption price at maturity.

(f) Examples. The following examples illustrate the rules of this

section.

Example 1. Qualified stated interest--(i) Facts. On January 1,

1995, A purchases at original issue, for $100,000, a debt instrument

that matures on January 1, 1999, and has a stated principal amount

of $100,000, payable at maturity. The debt instrument provides for

interest payments of $8,000 on January 1, 1996, and January 1, 1997,

and quarterly interest payments of $1,942.65, beginning on April 1,

1997.

(ii) Amount of qualified stated interest. The annual payments of

$8,000 and the quarterly payments of $1,942.65 are payable at a

single fixed rate because 8 percent, compounded annually, is

equivalent to 7.77 percent, compounded quarterly. Consequently, all

stated interest payments under the debt instrument are qualified

stated interest payments.

Example 2. Qualified stated interest with short initial payment

interval. On October 1, 1994, A purchases at original issue, for

$100,000, a debt instrument that matures on January 1, 1998, and has

a stated principal amount of $100,000, payable at maturity. The debt

instrument provides for an interest payment of $2,000 on January 1,

1995, and interest payments of $8,000 on January 1, 1996, January 1,

1997, and January 1, 1998. Under paragraph (c)(1)(iii)(B) of this

section, all stated interest payments on the debt instrument are

computed at a single fixed rate and are qualified stated interest

payments.

Example 3. Stated interest in excess of qualified stated

interest--(i) Facts. On January 1, 1995, B purchases at original

issue, for $100,000, C corporation's 5-year debt instrument. The

debt instrument provides for a principal payment of $100,000,

payable at maturity, and calls for annual interest payments of

$10,000 for the first 3 years and annual interest payments of

$10,600 for the last 2 years.

(ii) Payments in excess of qualified stated interest. All of the

first three interest payments and $10,000 of each of the last two

interest payments are qualified stated interest payments within the

meaning of paragraph (c)(1) of this section. Under paragraph (c)(4)

of this section, the remaining $600 of each of the last two interest

payments is included in the stated redemption price at maturity, so

that the stated redemption price at maturity is $101,200. Pursuant

to paragraph (e)(3) of this section, the weighted average maturity

of the debt instrument is 4.994 years [(4 years x $600/$101,200)+(5

years x $100,600/$101,200)]. The de minimis amount, or one-fourth of

1 percent of the stated redemption price at maturity multiplied by

the weighted average maturity, is $1,263.50. Because the actual

amount of discount, $1,200, is less than the de minimis amount, the

instrument is treated as having no OID, and, under paragraph (d)(1)

of this section, all of the interest payments are treated as

qualified stated interest payments.

Example 4. Qualified stated interest on a debt instrument that

is subject to a contingency--(i) Facts. On January 1, 1995, 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,

however, the interest payments for each of the final five years will

be reduced to $5,000 if a specified annual level of earnings is not

attained by A by the end of year five.

(ii) Amount of qualified stated interest. If the payment

schedule determined by assuming that the specified earnings level

will be attained is treated as the debt instrument's sole payment

schedule, the instrument would provide for annual qualified stated

interest payments of $10,000. If the payment schedule determined by

assuming that the specified earnings level will not be attained is

treated as the instrument's sole payment schedule, however, only

$5,000 of each annual interest payment would constitute qualified

stated interest. Accordingly, under paragraph (c)(2) of this

section, only $5,000 of each annual interest payment constitutes

qualified stated interest. Any excess of each annual interest

payment over $5,000 is included in the debt instrument's stated

redemption price at maturity.

Example 5. De minimis OID; interest holiday--(i) Facts. On

January 1, 1995, C purchases at original issue, for $97,561, a debt

instrument that matures on January 1, 2007, and has a stated

principal amount of $100,000, payable at maturity. The debt

instrument provides for an initial interest holiday of 1 quarter and

quarterly interest payments of $2,500 thereafter (beginning on July

1, 1995). The issue price of the debt instrument is $97,561. C

chooses to accrue OID based on quarterly accrual periods.

(ii) De minimis amount of OID. But for the interest holiday, all

stated interest on the debt instrument would be qualified stated

interest. Under paragraph (d)(4) of this section, for purposes of

determining whether the debt instrument has de minimis OID, the

stated redemption price at maturity of the instrument is $100,061

($97,561 (issue price) plus $2,500 (the greater of the amount of

foregone interest ($2,500) and the amount equal to the excess of the

instrument's stated principal amount over its issue price ($2,439)).

Thus, the debt instrument is treated as having OID of $2,500

($100,061 minus $97,561). Because this amount is less than the de

minimis amount of $3,001.83 (0.0025 multiplied by $100,061

multiplied by 12 complete years to maturity), the debt instrument is

treated as having no OID, and all stated interest is treated as

qualified stated interest.

Example 6. De minimis OID; teaser rate--(i) Facts. The facts are

the same as in Example 5 of this paragraph (f) except that C uses an

initial semiannual accrual period rather than an initial quarterly

accrual period.

(ii) De minimis amount of OID. The debt instrument provides for

an initial teaser rate because the interest rate for the semiannual

accrual period is less than the interest rate applicable to the

subsequent quarterly accrual periods. But for the initial teaser

rate, all stated interest on the debt instrument would be qualified

stated interest. Under paragraph (d)(4) of this section, for

purposes of determining whether the debt instrument has de minimis

OID, the stated redemption price at maturity of the instrument is

$100,123.50 ($97,561 (issue price) plus $2,562.50 (the greater of

the amount of foregone interest ($2,562.50) and the amount equal to

the excess of the instrument's stated principal amount over its

issue price ($2,439)). Thus, the debt instrument is treated as

having OID of $2,562.50 ($100,123.50 minus $97,561). Because this

amount is less than the de minimis amount of $3,003.71 (0.0025

multiplied by $100,123.50 multiplied by 12 complete years to

maturity), the debt instrument is treated as having no OID, and all

stated interest is treated as qualified stated interest.

Sec. 1.1273-2 Determination of issue price and issue date.

(a) Debt instruments issued for money--(1) Issue price. If a

substantial amount of the debt instruments in an issue is issued for

money, the issue price of each debt instrument in the issue is the

first price at which a substantial amount of the debt instruments is

sold for money. Thus, if an issue consists of a single debt instrument

that is issued for money, the issue price of the debt instrument is the

amount paid for the instrument. For example, in the case of a debt

instrument evidencing a loan to a natural person, the issue price of

the instrument is the amount loaned. See Sec. 1.1275-2(d) for rules

regarding Treasury securities. For purposes of this paragraph (a),

money includes functional currency and, in certain circumstances,

nonfunctional currency. See Sec. 1.988-2(b)(2) for circumstances when

nonfunctional currency is treated as money rather than as property.

(2) Issue date. The issue date of an issue described in paragraph

(a)(1) of this section is the first settlement date or closing date,

whichever is applicable, on which a substantial amount of the debt

instruments in the issue is sold for money.

(b) Publicly traded debt instruments issued for property--(1) Issue

price. If a substantial amount of the debt instruments in an issue is

traded on an established market (within the meaning of paragraph (f) of

this section) and the issue is not described in paragraph (a)(1) of

this section, the issue price of each debt instrument in the issue is

the fair market value of the debt instrument, determined as of the

issue date (as defined in paragraph (b)(2) of this section).

(2) Issue date. The issue date of an issue described in paragraph

(b)(1) of this section is the first date on which a substantial amount

of the traded debt instruments in the issue is issued.

(c) Debt instruments issued for publicly traded property--(1) Issue

price. If a substantial amount of the debt instruments in an issue is

issued for property that is traded on an established market (within the

meaning of paragraph (f) of this section) and the issue is not

described in paragraph (a)(1) or (b)(1) of this section, the issue

price of each debt instrument in the issue is the fair market value of

the property, determined as of the issue date (as defined in paragraph

(c)(2) of this section). For purposes of the preceding sentence,

property means a debt instrument, stock, security, contract, commodity,

or nonfunctional currency. But see Sec. 1.988-2(b)(2) for circumstances

when nonfunctional currency is treated as money rather than as

property.

(2) Issue date. The issue date of an issue described in paragraph

(c)(1) of this section is the first date on which a substantial amount

of the debt instruments in the issue is issued for traded property.

(d) Other debt instruments--(1) Issue price. If an issue of debt

instruments is not described in paragraph (a)(1), (b)(1), or (c)(1) of

this section, the issue price of each debt instrument in the issue is

determined as if the debt instrument were a separate issue. If the

issue price of a debt instrument that is treated as a separate issue

under the preceding sentence is not determined under paragraph (a)(1),

(b)(1), or (c)(1) of this section, and if section 1274 applies to the

debt instrument, the issue price of the instrument is determined under

section 1274. Otherwise, the issue price of the debt instrument is its

stated redemption price at maturity under section 1273(b)(4). See

section 1274(c) and Sec. 1.1274-1 to determine if section 1274 applies

to a debt instrument.

(2) Issue date. The issue date of an issue described in paragraph

(d)(1) of this section is the date on which the debt instrument is

issued for money or in a sale or exchange.

(e) Special rule for certain sales to bond houses, brokers, or

similar persons. For purposes of determining the issue price and issue

date of a debt instrument under this section, sales to bond houses,

brokers, or similar persons or organizations acting in the capacity of

underwriters, placement agents, or wholesalers are ignored.

(f) Traded on an established market (publicly traded)--(1) In

general. Property (including a debt instrument described in paragraph

(b)(1) of this section) is traded on an established market for purposes

of this section if, at any time during the 60-day period ending 30 days

after the issue date, the property is described in paragraph (f)(2),

(f)(3), (f)(4), or (f)(5) of this section.

(2) Exchange listed property. Property is described in this

paragraph (f)(2) if it is listed on--

(i) A national securities exchange registered under section 6 of

the Securities Exchange Act of 1934 (15 U.S.C. 78f);

(ii) An interdealer quotation system sponsored by a national

securities association registered under section 15A of the Securities

Exchange Act of 1934 (15 U.S.C. 78o-3); or

(iii) The International Stock Exchange of the United Kingdom and

the Republic of Ireland, Limited, the Frankfurt Stock Exchange, the

Tokyo Stock Exchange, or any other foreign exchange or board of trade

that is designated by the Commissioner in the Internal Revenue Bulletin

(see Sec. 601.601(d)(2)(ii) of this chapter).

(3) Market traded property. Property is described in this paragraph

(f)(3) if it is property of a kind that is traded either on a board of

trade designated as a contract market by the Commodities Futures

Trading Commission or on an interbank market.

(4) Property appearing on a quotation medium. Property is described

in this paragraph (f)(4) if it appears on a system of general

circulation (including a computer listing disseminated to subscribing

brokers, dealers, or traders) that provides a reasonable basis to

determine fair market value by disseminating either recent price

quotations (including rates, yields, or other pricing information) of

one or more identified brokers, dealers, or traders or actual prices

(including rates, yields, or other pricing information) of recent sales

transactions (a quotation medium). A quotation medium does not include

a directory or listing of brokers, dealers, or traders for specific

securities, such as yellow sheets, that provides neither price

quotations nor actual prices of recent sales transactions.

(5) Readily quotable debt instruments--(i) In general. A debt

instrument is described in this paragraph (f)(5) if price quotations

are readily available from dealers, brokers, or traders.

(ii) Safe harbors. A debt instrument is not considered to be

described in paragraph (f)(5)(i) of this section if--

(A) No other outstanding debt instrument of the issuer (or of any

person who guarantees the debt instrument) is described in paragraph

(f)(2), (f)(3), or (f)(4) of this section (other traded debt);

(B) The original stated principal amount of the issue that includes

the debt instrument does not exceed $25 million;

(C) The conditions and covenants relating to the issuer's

performance with respect to the debt instrument are materially less

restrictive than the conditions and covenants included in all of the

issuer's other traded debt (e.g., the debt instrument is subject to an

economically significant subordination provision whereas the issuer's

other traded debt is senior); or

(D) The maturity date of the debt instrument is more than 3 years

after the latest maturity date of the issuer's other traded debt.

(6) Effect of certain temporary restrictions on trading. If there

is any temporary restriction on trading a purpose of which is to avoid

the characterization of the property as one that is traded on an

established market for Federal income tax purposes, then the property

is treated as traded on an established market. For purposes of the

preceding sentence, a temporary restriction on trading need not be

imposed by the issuer.

(7) Convertible debt instruments. A debt instrument is not treated

as traded on an established market solely because the debt instrument

is convertible into property that is so traded.

(g) Treatment of certain cash payments incident to lending

transactions--(1) Applicability. The provisions of this paragraph (g)

apply to cash payments made incident to private lending transactions

(including seller financing).

(2) Payments from borrower to lender--(i) Money lending

transaction. In a lending transaction to which section 1273(b)(2)

applies, a payment from the borrower to the lender (other than a

payment for property or for services provided by the lender, such as

commitment fees or loan processing costs) reduces the issue price of

the debt instrument evidencing the loan. However, solely for purposes

of determining the tax consequences to the borrower, the issue price is

not reduced if the payment is deductible under section 461(g)(2).

(ii) Section 1274 transaction. In a lending transaction to which

section 1274 applies, a payment from the buyer-borrower to the seller-

lender that is designated as interest or points reduces the stated

principal amount of the debt instrument evidencing the loan, but is

included in the purchase price of the property. If the payment is

deductible under section 461(g)(2), however, the issue price of the

debt instrument (as otherwise determined under section 1274 and the

rule in the preceding sentence) is increased by the amount of the

payment to compute the buyer-borrower's interest deductions under

section 163.

(3) Payments from lender to borrower. A payment from the lender to

the borrower in a lending transaction is treated as an amount loaned.

(4) Payments between lender and third party. If, as part of a

lending transaction, a party other than the borrower (the third party)

makes a payment to the lender, that payment is treated in appropriate

circumstances as made from the third party to the borrower followed by

a payment in the same amount from the borrower to the lender and

governed by the provisions of paragraph (g)(2) of this section. If, as

part of a lending transaction, the lender makes a payment to a third

party, that payment is treated in appropriate circumstances as an

additional amount loaned to the borrower and then paid by the borrower

to the third party. The character of the deemed payment between the

borrower and the third party depends on the substance of the

transaction.

(5) Examples. The following examples illustrate the rules of this

paragraph (g).

Example 1. Payments from borrower to lender in a cash

transaction--(i) Facts. A lends $100,000 to B for a term of 10

years. At the time the loan is made, B pays $4,000 in points to A.

Assume that the points are not deductible by B under section

461(g)(2) and that the stated redemption price at maturity of the

debt instrument is $100,000.

(ii) Payment results in OID. Under paragraph (g)(2)(i) of this

section, the issue price of B's debt instrument evidencing the loan

is $96,000. Because the amount of OID on the debt instrument

($4,000) is more than a de minimis amount of OID, A accounts for the

OID under Sec. 1.1272-1. B accounts for the OID under Sec. 1.163-7.

Example 2. Payments from borrower to lender in a section 1274

transaction--(i) Facts. A sells property to B for $1,000,000 in a

transaction that is not a potentially abusive situation (within the

meaning of Sec. 1.1274-3). In consideration for the property, B

gives A $300,000 and issues a 5-year debt instrument that has a

stated principal amount of $700,000, payable at maturity, and that

calls for semiannual payments of interest at a rate of 8.5 percent.

In addition to the cash downpayment, B pays A $14,000 designated as

points on the loan. Assume that the points are not deductible under

section 461(g)(2).

(ii) Issue price. Under paragraph (g)(2)(ii) of this section,

the stated principal amount of B's debt instrument is -$686,000

($700,000 minus $14,000). Assuming a test rate of 9 percent,

compounded semiannually, the imputed principal amount of B's debt

instrument under Sec. 1.1274-2(c)(1) is $686,153. Under Sec. 1.1274-

2(b)(1), the issue price of B's debt instrument is the stated

principal amount of $686,000. Because the amount of OID on the debt

instrument ($700,000-$686,000, or $14,000) is more than a de minimis

amount of OID, A accounts for the OID under Sec. 1.1272-1 and B

accounts for the OID under Sec. 1.163-7. B's basis in the property

purchased is $1,000,000 ($686,000 debt instrument plus $314,000 cash

payments).

Example 3. Payments between lender and third party (seller-paid

points)--(i) Facts. A sells real property to B for $500,000 in a

transaction that is not a potentially abusive situation (within the

meaning of Sec. 1.1274-3). B makes a cash down payment of $100,000

and borrows $400,000 of the purchase price from a lender, L,

repayable in annual installments over a term of 15 years calling for

interest at a rate of 9 percent, compounded annually. As part of the

transaction, A makes a payment of $8,000 to L to facilitate the loan

to B.

(ii) Payment results in a de minimis amount of OID. Under the

provisions of paragraphs (g)(2)(i) and (g)(4) of this section, B is

treated as having made an $8,000 payment directly to L and a payment

of only $492,000 to A for the property. Thus, B's basis in the

property is $492,000. The payment to L reduces the issue price of

B's debt instrument to $392,000, resulting in $8,000 of OID

($400,000-$392,000). Because the amount of OID is de minimis under

Sec. 1.1273-1(d), L accounts for the de minimis OID under

Sec. 1.1273-1(d)(5). But see Sec. 1.1272-3 (election to treat de

minimis OID as OID). B accounts for the de minimis OID under

Sec. 1.163-7.

(h) Investment units--(1) In general. Under section 1273(c)(2), an

investment unit is treated as if the investment unit were a debt

instrument. The issue price of the investment unit is determined under

paragraph (a)(1), (b)(1), or (c)(1) of this section, if applicable. The

issue price of the investment unit is then allocated between the debt

instrument and the property right (or rights) that comprise the unit

based on their relative fair market values. If paragraphs (a)(1),

(b)(1), and (c)(1) of this section are not applicable, however, the

issue price of the debt instrument that is part of the investment unit

is determined under section 1273(b)(4) or 1274, whichever is

applicable.

(2) Consistent allocation by holders and issuer. The issuer's

allocation of the issue price of the investment unit is binding on all

holders of the investment unit. However, the issuer's determination is

not binding on a holder that explicitly discloses that its allocation

is different from the issuer's allocation. Unless otherwise provided 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 investment unit. See

Sec. 1.1275-2(e) for rules relating to the issuer's obligation to

disclose certain information to holders.

(i) [Reserved]

(j) Convertible debt instruments. The issue price of a debt

instrument includes any amount paid for an option to convert the

instrument into stock (or another debt instrument) of either the issuer

or 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 instrument).

(k) Below-market loans subject to section 7872(b). The issue price

of a below-market loan subject to section 7872(b) (a term loan other

than a gift loan) is the issue price determined under this section,

reduced by the excess amount determined under section 7872(b)(1).

(l) [Reserved]

(m) Treatment of amounts representing pre-issuance accrued

interest--(1) Applicability. Paragraph (m)(2) of this section provides

an alternative to the general rule of this section for determining the

issue price of a debt instrument if--

(i) A portion of the initial purchase price of the instrument is

allocable to interest that has accrued prior to the issue date (pre-

issuance accrued interest); and

(ii) The instrument provides for a payment of stated interest on

the first payment date within 1 year of the issue date that equals or

exceeds the amount of the pre-issuance accrued interest.

(2) Exclusion of pre-issuance accrued interest from issue price. If

a debt instrument meets the requirements of paragraph (m)(1) of this

section, the instrument's issue price may be computed by subtracting

from the issue price (as otherwise computed under this section) the

amount of pre-issuance accrued interest. If the issue price of the debt

instrument is computed in this manner, a portion of the stated interest

payable on the first payment date must be treated as a return of the

excluded pre-issuance accrued interest, rather than as an amount

payable on the instrument.

(3) Example. The following example illustrates the rule of

paragraph (m) of this section.

Example. (i) Facts. On January 15, 1995, A purchases at original

issue, for $1,005, B corporation's debt instrument. The debt

instrument provides for a payment of principal of $1,000 on January

1, 2005, and provides for semiannual interest payments of $60 on

January 1 and July 1 of each year, beginning on July 1, 1995.

(ii) Determination of pre-issuance accrued interest. Under

paragraphs (m)(1) and (m)(2) of this section, $5 of the $1,005

initial purchase price of the debt instrument is allocable to pre-

issuance accrued interest. Accordingly, the debt instrument's issue

price may be computed by subtracting the amount of pre-issuance

accrued interest ($5) from the issue price otherwise computed under

this section ($1,005), resulting in an issue price of $1,000. If the

issue price is computed in this manner, $5 of

This text is long and has been trimmed here. Open the source document for the complete record.