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

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URL: https://www.frixlaw.com/law-library/documents/fr%3A94-2073

## Record

- **Collection:** Federal Register
- **Document type:** Uncategorized Document
- **Published:** February 2, 1994

## Text

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.

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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 di

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A94-2073. Public record. Not legal advice.