Debt Instruments With Original Issue Discount; Contingent Payments

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-59-91]

RIN 1545-AQ86

Debt Instruments With Original Issue Discount; Contingent

Payments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

tax treatment of debt instruments that provide for one or more

contingent payments. This document also contains proposed regulations

that provide for the integration of a contingent payment or variable

rate debt instrument with a related hedge and proposed amendments to

the final original issue discount regulations that were published in

the Federal Register on February 2, 1994. The proposed regulations in

this document would provide needed guidance to holders and issuers of

contingent payment debt instruments. This document also provides a

notice of a public hearing on the proposed regulations.

DATES: Written comments must be received by Thursday, March 16, 1995.

Requests to appear and outlines of topics to be discussed at the public

hearing scheduled for Thursday, March 16, 1995, at 10 a.m. must be

received by Thursday, February 23, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-59-91), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-59-91),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. A public hearing has been scheduled for Thursday, March

16, 1995, at 10 a.m. in the Auditorium, Internal Revenue Building, 1111

Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations (other than

Sec. 1.1275-6), Andrew C. Kittler, (202) 622-3940, or William E.

Blanchard, (202) 622-3950; concerning Sec. 1.1275-6, Michael S. Novey,

(202) 622-3900; concerning submissions and the hearing, Michael

Slaughter, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed

rulemaking have been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collections of information should be sent 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, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC

20224.

The collections of information are in Secs. 1.1275-3(b)(1)(i),

1.1275-4(b)(4)(iv), and 1.1275-6(f). This information is required by

the IRS to determine the amount of income, deductions, gain, or loss

attributable to a contingent payment debt instrument. This information

will be used for audit and examination purposes. The likely respondents

and recordkeepers are businesses and other organizations.

Estimated total annual reporting and recordkeeping burden: 95,000

hours.

The estimated annual burden per respondent/recordkeeper varies from

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

estimated average of .475 hours.

Estimated number of respondents/recordkeepers: 200,000.

Estimated annual frequency of responses: 1.

Background

Section 1275(d) of the Internal Revenue Code of 1986 (Code) grants

the Secretary the authority to prescribe regulations under the original

issue discount (OID) provisions of the Code, including regulations

relating to debt instruments that provide for contingent payments. On

April 8, 1986, the IRS published in the Federal Register a notice of

proposed rulemaking (51 FR 12022) relating to debt instruments with

OID. Section 1.1275-4 of the 1986 proposed regulations provided rules

for contingent payment debt instruments. On February 28, 1991, the IRS

published in the Federal Register a proposed amendment to Sec. 1.1275-4

(56 FR 8308), which would have bifurcated certain contingent payment

debt instruments into their component parts (Sec. 1.1275-4(g)).

On December 22, 1992, the IRS published in the Federal Register a

notice of proposed rulemaking that substantially revised the 1986

proposed regulations (57 FR 60750), and on February 4, 1994, the IRS

published in the Federal Register final OID regulations (59 FR 4799).

However, neither the 1992 proposed regulations nor the final OID

regulations contained rules for contingent payment debt instruments

under Sec. 1.1275-4.

The IRS received numerous written comments on Sec. 1.1275-4, as

originally proposed in 1986 and as amended in 1991. In addition, on

November 17, 1986, the IRS held a public hearing to discuss the 1986

proposed regulations, including Sec. 1.1275-4.

Commentators criticized Sec. 1.1275-4 of the 1986 proposed

regulations because the regulations ignored the economics of many

contingent payment debt instruments. In particular, commentators

believed that the 1986 proposed regulations did not reflect the

reasonable expectations of the parties because the regulations used a

``wait and see'' approach to the accrual of interest determined by

reference to contingencies. The commentators noted that, with respect

to certain contingent payment debt instruments, the 1986 proposed

regulations resulted in a significant backloading of interest.

Commentators also criticized the 1991 proposed amendment to

Sec. 1.1275-4. Commentators argued that there is rarely a unique set of

components into which a contingent payment debt instrument can be

bifurcated. In addition, commentators questioned whether it is

appropriate to bifurcate a contingent payment debt instrument because

it is often unclear how the contingent components should be taxed.

Some commentators suggested that it is preferable to determine

interest accruals on a contingent payment debt instrument by assuming

that the issue price of the debt instrument will bear a return at the

applicable Federal rate (AFR) or some other specified rate. Other

commentators suggested that it is preferable to determine interest

accruals by constructing a projected payment schedule and accruing on

the basis of the projections.

Explanation of Provisions

In general

The proposed regulations in this document contain new rules for the

treatment of contingent payment debt instruments (Sec. 1.1275-4). The

proposed regulations provide separate rules for debt instruments that

are issued for cash or publicly traded property and for debt

instruments that are issued for nonpublicly traded property. The

proposed regulations also provide special rules for tax-exempt

obligations. Section 1.1275-4, as proposed on April 8, 1986, and

amended on February 28, 1991, is superseded as of December 16, 1994.

The proposed regulations provide a rule to determine the imputed

principal amount of a contingent payment debt instrument issued for

nonpublicly traded property. The proposed regulations also provide

rules for the integration of certain debt instruments with related

hedges (Sec. 1.1275-6). In addition, the proposed regulations amend the

rules for variable rate debt instruments in Sec. 1.1275-5 of the final

OID regulations. Finally, the proposed regulations make conforming

changes to certain provisions of the final OID regulations, such as the

regulations under section 483.

Section 1.1275-4 Contingent payment debt instruments.

A. Applicability

Section 1.1275-4 of the proposed regulations generally applies to

any debt instrument that provides for one or more contingent payments.

The proposed regulations, however, do not apply to a debt instrument

that has an issue price determined under section 1273(b)(4), a variable

rate debt instrument, a debt instrument subject to Sec. 1.1272-1(c)

(certain debt instruments that provide for alternative payment

schedules), a debt instrument subject to section 1272(a)(6) (REMIC

interests and certain other debt instruments that are subject to

prepayment), or, except as provided in section 988, a debt instrument

subject to section 988 (a debt instrument that provides for payments

denominated in, or determined by reference to, a nonfunctional

currency). The IRS and Treasury request comments on whether other types

of debt instruments should be excluded from the rules of Sec. 1.1275-4,

such as certain prepayable obligations included in a pool.

Section 1.1275-4 of the proposed regulations applies only to a

contingent payment debt instrument that constitutes a debt instrument

for federal income tax purposes. No inference is intended under the

proposed regulations as to whether a particular instrument constitutes

a debt instrument for federal income tax purposes.

Although the proposed regulations do not define the term contingent

payment, the proposed regulations treat certain payments as not being

contingent. For example, if a payment is subject to either a remote or

incidental contingency, the payment is not a contingent payment. A

contingency is remote if there is either a remote likelihood that the

contingency will occur or a remote likelihood that the contingency will

not occur. A contingency is incidental if the potential amount of the

payment under any reasonably expected market conditions is

insignificant relative to the total expected payments on the debt

instrument. Under the proposed regulations, a debt instrument does not

provide for contingent payments merely because it is convertible into

stock of the issuer or a related party. However, if a debt instrument

is convertible into stock of an unrelated party, the debt instrument is

a contingent payment debt instrument.

B. The Noncontingent Bond Method

The noncontingent bond method applies to a contingent payment debt

instrument that has an issue price determined under Sec. 1.1273-2 or

Sec. 1.1274-2(b)(3). For example, the noncontingent bond method

generally applies to a contingent payment debt instrument issued for

money or publicly traded property.

Under the noncontingent bond method, a projected payment schedule

is determined for a debt instrument, and interest accrues on the debt

instrument based on this schedule. The projected payment schedule for a

debt instrument consists of all noncontingent payments and a projected

amount for each contingent payment. If the actual amount of a

contingent payment differs from the projected amount of the payment,

appropriate adjustments are taken into account to reflect this

difference.

Although the actual amount of a contingent payment is not fixed or

determinable when a contingent payment debt instrument is issued, the

noncontingent bond method, in effect, treats the projected amounts of

contingent payments like fixed payments and requires interest accruals

based on the projected amounts. The IRS and Treasury believe that this

method is consistent with Congress' intent under the OID provisions to

require a current accrual of interest on a debt instrument.

While other methods suggested by commentators also require a

current accrual of interest, the noncontingent bond method requires

interest accruals based on a rate that is implicit in the debt

instrument and provides a means of determining whether payments are

appropriately treated as interest or principal. The IRS and Treasury

believe that the noncontingent bond method is the most appropriate

method for achieving this purpose. For example, methods that require

accrual at a fixed rate for all debt instruments often will over-accrue

or under-accrue interest on a particular debt instrument. In addition,

the methods may not always provide an appropriate measure of the

interest and principal components of a payment. Because of the

inaccuracies under these methods, the IRS and Treasury rejected these

methods.

1. Projected payment schedule.

The projected payment schedule for a contingent payment debt

instrument is determined as of the debt instrument's issue date. Except

in the case of a contingent payment that is fixed more than 6 months

before it is due, the projected payment schedule remains fixed

throughout the term of the debt instrument and any income, deductions,

gain, or loss attributable to the debt instrument are based on the

schedule.

The projected payment schedule for a debt instrument consists of

all noncontingent payments and a projected amount for each contingent

payment. The proposed regulations provide rules for determining the

projected amount of each contingent payment included in a projected

payment schedule. Under the proposed regulations, contingent payments

are either quotable contingent payments or nonquotable contingent

payments.

A quotable contingent payment is a contingent payment that is

substantially similar to a property right for which forward price

quotes are readily available. In general, the projected amount of a

quotable contingent payment is the forward price of the property right.

If a contingent payment is substantially similar to an option and

forward price quotes are not readily available for the option, the

projected amount of the payment is the spot price of the option on the

issue date, if readily available, compounded at the AFR from the issue

date to the date the payment is due.

Under the proposed regulations, a property right includes a right,

an obligation, or a combination of rights or obligations. For example,

options and forward contracts are property rights. More complicated

contingent payments are constructed from combinations of rights and

obligations.

A contingent payment is substantially similar to a property right

if, under reasonably expected market conditions, the value and timing

of the amount to be paid or received pursuant to the property right are

expected to be substantially the same as the value and timing of the

contingent payment. It is irrelevant for purposes of testing

substantial similarity whether the property right must be settled in

cash or in property or whether the credit rating of the issuer is

different from the party giving the price quote. It is also irrelevant

whether a property right is available in the same denomination as the

measure of the contingent payments.

Quotes for the substantially similar property right are readily

available if they are readily available from brokers, traders, or

dealers during specified time periods. Although price quotes for over-

the-counter property rights often are not widely disseminated because

the rights may be privately tailored for a particular transaction,

quotes for over-the-counter property rights generally will be treated

as readily available if customers could obtain quotes from brokers,

traders, or dealers.

Commentators have stated that any method requiring taxpayers to

create payment schedules using expected values would be difficult to

apply. They have said that there is too much variation in the expected

values of the property rights embedded in contingent payment debt

instruments to allow for the creation of payment schedules that are not

susceptible to abuse or to challenge upon examination on the basis of

hindsight.

The noncontingent bond method, however, generally sets the

projected amounts of market-based contingent payments by using forward

prices for the embedded property rights rather than expected values. It

is the understanding of the IRS and Treasury that forward prices are

available for almost all of the market-based property rights embedded

in contingent payment debt instruments. For example, these property

rights generally may be obtained on a separate basis for hedging

purposes. Moreover, the IRS and Treasury understand that dealers and

certain information services provide daily quotations of the prices of

contingent payment debt instruments held by regulated investment

companies to allow the companies to determine their net asset values.

To do this, the price of the separate elements of the contingent

payment debt instruments, including the embedded property rights, must

be determined. Thus, the IRS and Treasury believe that, in general, it

will not be difficult for issuers of contingent payment debt

instruments to obtain forward price quotes for the property rights

embedded in the debt instruments.

The proposed regulations include a number of provisions designed to

address other concerns with the pricing requirement. First, the pricing

requirement only applies if quotes are readily available. Therefore,

when it is not feasible to obtain a quote, pricing is not required.

Second, the IRS and Treasury understand that the price a broker or

dealer develops for any property right embedded in a contingent payment

debt instrument when pricing the debt instrument as a whole will not

necessarily translate into a forward price for the property right

determined on a separate basis. For example, the price of the property

right embedded in a contingent payment debt instrument may include

charges for financial intermediation that would not be imposed if the

property right were purchased separately. Thus, the rules that apply to

an issuer who must set a projected payment schedule allow substantial

flexibility.

Further, the IRS and Treasury recognize that quotes for thinly

traded property rights may vary and that the bid-ask spread may be

substantial. The proposed regulations, therefore, provide that a

taxpayer may use any reasonable quote to determine the projected amount

of a payment. The proposed regulations also provide that the taxpayer

may use bid price, ask price, or midpoint price quotes to determine the

projected amounts of quotable contingent payments. However, the

taxpayer must make this determination on a consistent basis. For

example, a taxpayer cannot use ask prices to determine the projected

amounts for some contingent payments on a debt instrument and bid

prices to determine the projected amounts for other contingent payments

on the instrument. Finally, if a contingent payment is equivalent to

more than one combination of property rights, taxpayers may use any

reasonable combination. However, it is not reasonable to construct a

combination of property rights that contains property rights for which

forward price quotes are unavailable if there are other possible

combinations that consist only of property rights for which forward

price quotes are readily available.

A nonquotable contingent payment is any contingent payment that is

not a quotable contingent payment. For example, contingent payments

based on oil production or the issuer's gross receipts are generally

nonquotable contingent payments.

The projected amount of a nonquotable contingent payment is

generally based on the projected yield of the contingent payment debt

instrument. The projected yield is a reasonable rate for the debt

instrument that, as of the issue date, reflects general market

conditions, the credit quality of the issuer, and the terms and

conditions of the debt instrument. For this purpose, the proposed

regulations provide that a reasonable rate is not less than the AFR or

the yield on the debt instrument determined without regard to the

nonquotable contingent payments. In many cases, a reasonable rate will

substantially exceed the AFR. Once the projected yield is determined,

the projected amount of each nonquotable contingent payment is

determined so that the projected payment schedule reflects the

projected yield. The projected amount of each payment, however, must

reasonably reflect the relative expected values of the nonquotable

contingent payments.

The proposed regulations provide simplifying rules to determine the

projected payment schedule of a contingent payment debt instrument that

would be a variable rate debt instrument except that it provides for a

single quotable contingent payment at maturity or does not guarantee a

sufficient return of stated principal. Under the proposed regulations,

the projected amounts of the variable interest payments are determined

using the rules of Sec. 1.1275-5(e), rather than the general rules for

quotable contingent payments. For example, if the contingent payment

debt instrument provides for stated interest at a single qualified

floating rate and a quotable contingent payment at maturity, the

projected amounts of the interest payments are based on the value of

the rate as of the instrument's issue date and the projected amount of

the contingent payment is determined under the rules for quotable

contingent payments.

The proposed regulations require the issuer to construct the

projected payment schedule. If an issuer fails to produce a projected

payment schedule as required, the issuer will be treated as failing to

meet the recordkeeping requirements under section 6001 necessary to

support the deduction of interest. To avoid potential audit disputes

about the projected amount of a contingent payment, the proposed

regulations provide that the issuer's projected payment schedule will

be respected unless the schedule is unreasonable. A projected payment

schedule generally will be considered unreasonable if it is set with a

purpose to accelerate or defer interest accruals. In determining

whether a projected payment schedule is unreasonable, consideration

will be given to whether the interest on a contingent payment debt

instrument determined under the schedule has a significant effect on

the issuer's or the holder's U.S. tax liability. For example, a

projected payment schedule prepared by an issuer that is a non-U.S.

taxpayer will be given special scrutiny because no schedule would have

an effect on the issuer's U.S. tax liability.

The proposed regulations provide that all holders of a contingent

payment debt instrument are bound by the issuer's projected payment

schedule and that an issuer must provide the schedule to the holders. A

holder may vary from the projected payment schedule provided by the

issuer only if the projected payment schedule is unreasonable. If an

issuer does not create a projected payment schedule as required or the

issuer's schedule is unreasonable, a holder must apply the projected

payment schedule rules to determine a reasonable projected payment

schedule. If a holder is not using the issuer's projected payment

schedule, the holder must explicitly disclose this fact on its timely

filed federal income tax return and must explain why it is not using

the issuer's schedule.

Because the proposed regulations allow considerable flexibility,

taxpayers may attempt to create uneconomic accruals by intentionally

overstating or understating the projected amounts of the contingent

payments. Taxpayers must use actual prices in setting the payment

schedule and are given flexibility only within the range of reasonable

prices. For example, the prices of an issuer's or a holder's hedges may

be used to determine reasonableness. Under the rules of section 6001,

taxpayers must maintain adequate contemporaneous records to support the

projected payment schedule. In addition, the rules of Sec. 1.1275-2T(g)

(the OID anti-abuse rule) apply to transactions subject to the proposed

regulations, including transactions in which the taxpayer attempts to

create payment schedules that cause uneconomic accruals. Attempts to

overstate or understate the amounts of the projected payments will give

rise to adjustments of tax liability, and, if appropriate, penalties.

2. Adjustments.

Under the noncontingent bond method, if the actual amount of a

contingent payment differs from the projected amount of the payment,

the difference results in either a positive or negative adjustment that

must be taken into account by the taxpayer. The purpose of the

adjustments is to correct the interest accruals that have occurred to

date on the debt instrument. Therefore, the adjustments generally

increase or decrease the amount of interest on a contingent payment

debt instrument.

If the actual amount of a contingent payment is greater than the

projected amount of the payment, the difference is a positive

adjustment. If the projected amount of a contingent payment is greater

than the actual amount of the payment, the difference is a negative

adjustment. Positive and negative adjustments for a taxable year are

netted for each taxable year.

A net positive adjustment for a taxable year is treated by the

taxpayer as additional interest for the year. A net negative adjustment

for a taxable year is taken into account as follows.

First, a net negative adjustment for a taxable year offsets the

interest that accrued on the debt instrument for the year based on the

projected payment schedule.

Second, if the net negative adjustment exceeds the amount of

interest that accrued on the debt instrument for the taxable year, the

excess is treated as an ordinary loss by the holder or as ordinary

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

the holder is limited to the amount by which the holder's total prior

interest inclusions on the debt instrument (including all net positive

adjustments) exceed the total net negative adjustments on the debt

instrument previously treated as ordinary loss by the holder.

Similarly, the amount treated as ordinary income by the issuer is

limited to the amount by which the issuer's total prior interest

deductions on the debt instrument (including all net positive

adjustments) exceed the total net negative adjustments on the debt

instrument previously treated as ordinary income by the issuer.

Third, because a negative adjustment adjusts interest accruals, if

the net negative adjustment exceeds the sum of the amount of interest

that accrued on the debt instrument for the taxable year and the amount

treated as ordinary loss (or income) for the taxable year, the excess

is treated as a negative adjustment that occurs on the first day of the

succeeding taxable year. As a result, the excess offsets interest

accruals on the debt instrument in future taxable years.

Fourth, any unused net negative adjustment reduces the amount

realized by the holder on the sale, exchange, or retirement of a

contingent payment debt instrument. Similarly, any unused net negative

adjustment is taken into account by the issuer on retirement of a

contingent payment debt instrument as income from the discharge of

indebtedness. The IRS and Treasury request comments on whether the

regulations should provide specific rules governing the treatment of

net negative adjustments determined on the occurrence of other events.

The IRS and Treasury chose this method for taking adjustments into

account because it provided a relatively simple method for adjusting

the yield. However, the method may produce inappropriate results, for

example, if there are large adjustments in the early years of a debt

instrument. Other methods, such as a method that spreads adjustments

over the term of the debt instrument, would produce more accurate

results but would be more complex. The IRS and Treasury request

comments on whether another method should be used for taking

adjustments into account.

3. Adjusted issue price, basis, and retirement.

Under the noncontingent bond method, the adjusted issue price of a

contingent payment debt instrument, adjustments to the holder's basis

in the debt instrument, and the amount of any contingent payment

treated as made on the scheduled retirement of the debt instrument are

determined using the projected payment schedule rather than actual

contingent payments. This rule is appropriate because positive or

negative adjustments are used to take into account the difference

between actual amounts and projected amounts of contingent payments.

This difference would be counted twice if adjusted issue price,

adjusted basis, and the amount deemed paid on retirement were based on

the actual amounts of contingent payments rather than the projected

amounts.

4. Character on sale, exchange, or retirement.

Under the noncontingent bond method, any gain recognized by a

holder on the sale, exchange, or retirement of a contingent payment

debt instrument is treated as interest income. Similarly, any loss

recognized by a holder on the sale, exchange, or retirement of a

contingent payment debt instrument is treated as ordinary loss to the

extent of the holder's prior interest inclusions (reduced by prior

ordinary losses attributable to net negative adjustments) on the

instrument. Although this rule is inconsistent with the treatment of

noncontingent debt instruments, the rule is necessary because of the

treatment of net positive and net negative adjustments. The rule

prevents a taxpayer who sells a contingent payment debt instrument

immediately before a positive adjustment occurs from converting the

interest income from the adjustment into capital gain or from

converting the amount by which a negative adjustment would reduce

interest income into capital loss. Consistent with the rule's purpose,

the rule does not apply to a sale, exchange, or retirement that occurs

when there are no outstanding contingent payments due on a debt

instrument.

5. Other special rules.

Although most contingent payment debt instruments can be dealt with

under the above provisions, the proposed regulations provide additional

rules for certain other circumstances. For example, the proposed

regulations provide rules for a holder whose basis in a contingent

payment debt instrument is different from the debt instrument's

adjusted issue price (e.g., a secondary market purchaser of the debt

instrument). Under the proposed regulations, the holder continues to

accrue interest and determine adjustments based on the original

projected payment schedule. The holder, however, must allocate the

difference between basis and adjusted issue price to the accruals or

projected payments on the debt instrument over the remaining term of

the debt instrument. Amounts allocated to a taxable year are recovered

as if they were positive or negative adjustments, as appropriate.

The proposed regulations require only a reasonable, rather than an

exact, allocation of the difference between basis and adjusted issue

price. For example, if almost all of the difference is attributable to

changes in the expected value of a contingent payment, the holder may

allocate the difference to the contingent payment. Similarly, a

taxpayer may allocate a portion of the difference to accruals if the

taxpayer determines that the portion is attributable to changes in

interest rates. A taxpayer may make this determination by comparing

rates on similar debt instruments, by looking to changes in standard

interest rate indices that have occurred since the date the contingent

payment debt instrument was issued, or by other appropriate means. The

proposed regulations require the holder's allocation to be reasonable

based on all the facts and circumstances.

In the case of a contingent payment debt instrument that is

exchange listed property (within the meaning of Sec. 1.1273-2(f)(2)),

the proposed regulations provide a safe harbor that allows holders to

account for the difference between the debt instrument's adjusted issue

price and the holder's basis under the same rules that apply to

acquisition premium on a noncontingent debt instrument under section

1272(a)(7) and Sec. 1.1272-2.

The IRS and Treasury recognize that the method provided in the

proposed regulations for allocating the difference between basis and

adjusted issue price may be difficult to apply because the difference

may be attributable to both changes in interest rates and in the

expected values of the contingent payments. Other methods for making

the allocation were considered in drafting the proposed regulations,

but were not adopted because they were not believed to be sufficiently

accurate. The IRS and Treasury believe that contingent payment debt

instruments (other than exchange listed debt instruments) rarely trade

in the secondary market and, therefore, the need to make the allocation

will occur only infrequently. The IRS and Treasury request comments on

this issue.

The proposed regulations also provide rules for a debt instrument

that has a contingent payment that is fixed more than 6 months before

the payment is due. Under the proposed regulations, an adjustment is

made on the date the payment is fixed, and the amount of the adjustment

is equal to the difference between the present value of the fixed

amount and the present value of the projected amount of the contingent

payment. The adjusted issue price is modified to reflect the adjustment

and the projected payment schedule is changed to reflect the fixed

payment. The IRS and Treasury are concerned about whether this method

may produce inappropriate accelerations of income or deductions and

request comments on whether other methods, such as a method that

spreads the income or deductions, are more appropriate.

In addition, the proposed regulations provide rules for debt

instruments that have both payments that are contingent as to time and

payments that are contingent as to amount. If a taxpayer has an option

to put or call the debt instrument, to exchange the debt instrument for

other property, or to extend the maturity date of the debt instrument,

the projected payment schedule is determined by using the principles of

Sec. 1.1272-1(c)(5). Under the proposed regulations, if an option to

put, call, or exchange the debt instrument is assumed to be exercised

under the principles of Sec. 1.1272-1(c)(5), it is generally reasonable

to assume that the option is exercised immediately before it expires.

If the option is exercised at an earlier time, the exercise is treated

as a sale or exchange of the debt instrument.

The proposed regulations reserve on other types of timing

contingencies. The IRS and Treasury request comments on the appropriate

treatment of other types of timing contingencies.

C. Method for Debt Instruments Not Subject to the Noncontingent Bond

Method

The proposed regulations provide a method for contingent payment

debt instruments not subject to the noncontingent bond method. In

general, the method applies to a debt instrument that has an issue

price determined under Sec. 1.1274-2 (e.g., a nonpublicly traded debt

instrument issued in a sale or exchange of nonpublicly traded

property). The method in the proposed regulations is generally similar

to the rules prescribed in Sec. 1.1275-4(c) of the 1986 proposed

regulations.

Under the proposed regulations, the payments on a contingent

payment debt instrument (the overall debt instrument) are divided into

two components: (1) a noncontingent component consisting of all

noncontingent payments and the projected amounts of any quotable

contingent payments, and (2) a contingent component consisting of all

nonquotable contingent payments.

The noncontingent component is treated as a separate debt

instrument and is taxed under the general OID rules (including the

noncontingent bond method if the separate debt instrument provides for

quotable contingent payments). However, no interest payments on the

separate debt instrument are qualified stated interest payments and the

de minimis rules do not apply to the separate debt instrument. The

issue price of the separate debt instrument is the issue price of the

overall debt instrument. See the discussion below for the determination

of the stated principal amount and the imputed principal amount of the

overall debt instrument for purposes of section 1274.

In general, a nonquotable contingent payment is not taken into

account until the payment is made. When a nonquotable contingent

payment (other than a contingent payment accompanied by a payment of

adequate stated interest) is made, a portion of the payment is treated

as principal, based on the amount determined by discounting the payment

at the AFR from the payment date to the issue date, and the remainder

is treated as interest. Special rules are provided if a nonquotable

contingent payment becomes fixed more than 6 months before it is due.

D. Tax-Exempt Obligations

The proposed regulations provide special rules for tax-exempt

obligations. The IRS and Treasury believe that, given the limited

exclusion provided in section 103, it is generally inappropriate to

treat payments on a property right embedded in a tax-exempt obligation

as interest on an obligation of a State or political subdivision (i.e.,

as tax-exempt interest). Therefore, while the noncontingent bond method

generally applies to tax-exempt contingent payment obligations, all

positive adjustments are treated as taxable gain from the sale or

exchange of the obligation rather than as interest. Negative

adjustments are treated as reducing tax-exempt interest, and,

therefore, are generally not taken into account as deductible losses.

If negative adjustments on a tax-exempt obligation exceed the total

tax-exempt interest a holder receives or accrues on a tax-exempt

obligation, the excess is treated as loss from the sale or exchange of

the obligation. This rule is similar to the rule that applies to

exchange gains and losses on tax-exempt obligations under Sec. 1.988-

3(c)(2). In addition, the proposed regulations provide that the

projected yield determined for a tax-exempt obligation may not exceed

the greater of the yield on the obligation determined without regard to

contingent payments and the tax-exempt AFR that applies to the

obligation. If the projected payment schedule results in a higher

yield, projected payments must be reduced appropriately.

E. Cross Border Transactions

The IRS and Treasury are concerned about various issues relating to

the treatment of foreign holders of contingent payment debt

instruments. For example, the IRS and Treasury are concerned about the

possibility for tax avoidance that may arise when a contingent payment

debt instrument is structured with payments that approximate the yield

on an equity security. The IRS and Treasury invite comments on this

issue and other issues concerning the proper taxation of foreign

holders of contingent payment debt instruments issued by U.S. persons

or U.S. holders of contingent payment debt instruments issued by

foreign persons.

Section 1.1274-2 Imputed Principal Amount

In general, the issue price of a debt instrument subject to section

1274 is determined by reference to the instrument's imputed principal

amount. The 1992 proposed regulations under section 1274 provided that,

in the case of a contingent payment debt instrument, the imputed

principal amount of the debt instrument was the present value of the

fixed payments plus the fair market value of the contingent payments. A

number of commentators objected to the rule, especially because of the

difficulty in valuing the contingent payments typically provided for in

debt instruments subject to section 1274. Other commentators objected

to the rule's effect on the buyer's basis in the property acquired and

the seller's amount realized on the sale or exchange. In response to

these comments, the final OID regulations reserved on the issue to

allow further study and to coordinate the issue with the regulations

relating to contingent payment debt instruments.

Under the proposed regulations, the imputed principal amount of a

contingent payment debt instrument subject to section 1274 is the sum

of the present values of the fixed payments and the present values of

the projected amounts of any quotable contingent payments. Consistent

with the treatment of the fixed payments and any quotable contingent

payments as a separate debt instrument under Sec. 1.1275-4 of the

proposed regulations, nonquotable contingent payments are not taken

into account to determine the stated principal amount or the imputed

principal amount of a contingent payment debt instrument. This rule is

generally consistent with the 1986 proposed regulations under section

1274.

The proposed regulations also provide that the imputed principal

amount of a variable rate debt instrument that provides for payments at

a single objective rate is determined by assuming that the payments on

the debt instrument are the same as the payments on the equivalent

fixed rate debt instrument determined under Sec. 1.1275-5(e).

The IRS and Treasury request comments on the effect of the proposed

regulations on other provisions of the Code, including section

108(e)(11), which measures the amount of discharge of indebtedness

income in a debt-for-debt exchange by the issue price of the newly

issued debt instrument.

Conforming Amendments to Section 483.

The proposed regulations provide rules under section 483 for the

treatment of contingent payments under a contract for the sale or

exchange of property (Sec. 1.483-4). In general, the rules are the same

as the rules for a debt instrument subject to section 1274, except that

a taxpayer takes interest into account under its own method of

accounting.

Section 1.1275-5 Variable Rate Debt Instruments.

In response to comments, the proposed regulations include changes

to the final regulations under Sec. 1.1275-5 regarding the treatment of

variable rate debt instruments. The proposed regulations redefine an

objective rate as a rate (other than a qualified floating rate) that is

determined using a single fixed formula and that is based on objective

financial or economic information. The rate, however, must not be based

on information that is within the control of the issuer (or a related

party) or that is, in general, unique to the circumstances of the

issuer (or a related party), such as dividends, profits, or the value

of the issuer's stock. The new definition of objective rate is broader

than the definition in the final regulations and includes, for example,

a rate based on changes in a general inflation index.

The proposed regulations also make it clear that a variable rate

debt instrument may not provide for any contingent payments other than

certain variable rates of interest. Finally, the proposed regulations

clarify the treatment of a variable rate debt instrument under

Sec. 1.1275-5(e)(2). In general, a variable rate debt instrument

described in Sec. 1.1275-5(e)(2) is treated like a fixed payment debt

instrument for purposes of OID and qualified stated interest accruals.

The changes to Sec. 1.1275-5(e)(2) clarify the final OID regulations

and, therefore, are proposed to be effective for debt instruments

issued on or after April 4, 1994.

Because of the special rules for tax-exempt contingent payment

obligations in the proposed regulations, the IRS and Treasury request

comments on the definition of an objective rate for tax-exempt

obligations under Sec. 1.1275-5(c)(5).

Section 1.1275-6 Integration

Many commentators suggested that the integration of contingent

payment debt instruments with associated hedges provides the best

method of taxing contingent payment debt instruments that are hedged.

The proposed regulations respond to this suggestion by providing for

the integration of contingent or variable rate debt instruments with

certain financial instruments (Sec. 1.1275-6). The integration rules

are issued under the authority of section 1275(d), and until the

proposed regulations under Sec. 1.1275-6 are finalized, the integration

rules are not a permissible means of determining the character and

timing of income, deductions, gains, and losses.

The rules in the proposed regulations are modeled after the

integration rules of section 988(d) and Sec. 1.988-5(a). The rules in

the proposed regulations, however, have been modified to reflect the

different policy concerns underlying the rules for taking currency gain

or loss into account and for taking interest income or deductions into

account. The IRS and Treasury intend to make conforming changes to

Sec. 1.988-5(a) and request comments on the extent to which Sec. 1.988-

5(a) should be modified to conform to the proposed regulations.

The integration rules apply to qualifying debt instruments, which

are defined as contingent payment debt instruments, variable rate debt

instruments, and the synthetic debt instruments that are the result of

integration under the proposed regulations. Thus, the integration rules

do not apply to fixed rate debt instruments.

For a financial instrument to qualify as a hedge under the proposed

regulations (a Sec. 1.1275-6 hedge), the combined cash flows of the

qualifying debt instrument and the financial instrument must permit the

calculation of a yield to maturity or must be the same as the cash

flows on a variable rate debt instrument that pays interest at a

qualified floating rate or rates. Thus, the proposed regulations

generally require a perfect hedge. Section 1.1275-6 hedges, however,

are not limited to hedging transactions as defined in Sec. 1.1221-2(b).

For example, a Sec. 1.1275-6 hedge need not reduce risk from all of the

operations of a business. A debt instrument held by a taxpayer cannot

be a Sec. 1.1275-6 hedge of a debt instrument issued by the taxpayer

and a debt instrument issued by a taxpayer cannot be a Sec. 1.1275-6

hedge of a debt instrument held by the taxpayer. Physical assets, such

as inventory, generally will not be treated as Sec. 1.1275-6 hedges

because they do not provide the predictable cash flows necessary to

create a perfect hedge. A supply or sales contract, however, may

qualify as a Sec. 1.1275-6 hedge. Stock does not qualify as a

Sec. 1.1275-6 hedge.

To qualify as an integrated transaction, the taxpayer must issue or

acquire a qualifying debt instrument, enter into a Sec. 1.1275-6 hedge,

and meet six requirements. First, the taxpayer must satisfy the

identification requirements of the proposed regulations, such as by

entering a description of the qualifying debt instrument and the

Sec. 1.1275-6 hedge in its books and records. Second, the Sec. 1.1275-6

hedge must not be with a related party (other than a member of the same

consolidated group making the separate-entity election under

Sec. 1.1221-2(d)). Third, the same taxpayer must enter into the

qualifying debt instrument and the Sec. 1.1275-6 hedge. Fourth, if the

taxpayer is a foreign person engaged in a U.S. trade or business who

issues or acquires the qualifying debt instrument or enters into the

Sec. 1.1275-6 hedge through the trade or business, all items of income

and expense associated with the debt instrument or hedge (other than

interest expense that is subject to Sec. 1.882-5) must be effectively

connected with the U.S. trade or business. Fifth, the qualifying debt

instrument, any other debt instrument that is part of the same issue as

the qualifying debt instrument, or the Sec. 1.1275-6 hedge cannot have

been part of an integrated transaction that was previously legged out

of by the taxpayer. Finally, the Sec. 1.1275-6 hedge must be entered

into by the taxpayer on or after the date the taxpayer issues or

acquires the qualifying debt instrument. If the taxpayer meets these

requirements, the qualifying debt instrument and the Sec. 1.1275-6

hedge are integrated and the resulting synthetic debt instrument is

taxed accordingly.

The Commissioner may require integration if a qualifying debt

instrument and a financial instrument have, in substance, the same

combined cash flows as a fixed or variable rate debt instrument.

Therefore, even if the taxpayer fails one or more of the requirements

for integration, the Commissioner may integrate a qualifying debt

instrument and a financial instrument. For example, if the taxpayer

fails to meet the identification requirements, or enters into a hedge

with a related party, the Commissioner may integrate the transaction.

The Commissioner also may integrate a transaction even if the hedge is

not perfect. Thus, taxpayers may not avoid integration by altering the

hedge so that there is a small amount of basis risk or the payments

under the hedge do not fully match the payments on the qualifying debt

instrument. The Commissioner will not integrate a debt instrument with

an imperfect hedge, however, if the taxpayer retains substantial risk.

The proposed regulations provide rules for legging into and legging

out of an integrated transaction. Legging into an integrated

transaction generally means entering into the hedge after the

qualifying debt instrument is issued or acquired by the taxpayer. If a

taxpayer legs into an integrated transaction, the qualifying debt

instrument is subject to the separate transaction rules up to the leg-

in date, except that the day before the leg-in date is treated as the

end of an accrual period for purposes of computing OID and interest

accruals on the qualifying debt instrument.

After the taxpayer legs in, the qualifying debt instrument and the

Sec. 1.1275-6 hedge are integrated. Built-in gain or loss on the

qualifying debt instrument is not treated as realized on the leg-in

date (contrary to the rule for currency gain or loss in Sec. 1.988-

5(a)(6)(i)). Because the built-in gain or loss will be reflected in the

accruals on the synthetic debt instrument, the built-in gain or loss on

the leg-in date will be recognized over the term of the synthetic debt

instrument.

This approach allows taxpayers to alter the timing of income or

deductions on a qualifying debt instrument. For example, a taxpayer

expecting a large positive adjustment on a contingent payment debt

instrument before the maturity date can spread the adjustment over the

remaining term of the debt instrument by legging into an integrated

transaction. Other approaches to legging in, however, create similar

opportunities. For example, an approach that would mark a qualifying

debt instrument to market and defer any built-in gain or loss would

present even greater opportunities for deferral. Requiring mark-to-

market gain or loss to be taken into account immediately would provide

opportunities for acceleration. The IRS and Treasury believe that

taking the built-in gain or loss into account over the term of the

qualifying debt instrument produces the most reasonable result. To

prevent abuse, however, the proposed regulations include a special rule

providing that if a taxpayer legs into an integrated transaction with a

principal purpose of deferring or accelerating income, the Commissioner

may treat the qualifying debt instrument as sold or otherwise

terminated and reacquired or reissued on the leg-in date or may refuse

to allow integration.

Legging out of an integrated transaction generally means disposing

of or otherwise terminating the Sec. 1.1275-6 hedge or the qualifying

debt instrument. If the Commissioner has integrated a qualifying debt

instrument and a financial instrument, the taxpayer is treated as

legging out only if the taxpayer ceases to meet the requirements for

Commissioner integration. If a taxpayer legs out, the synthetic debt

instrument is treated as sold or otherwise disposed of for its fair

market value and any income, deduction, gain, or loss is taken into

account immediately. The component the taxpayer retains (either the

Sec. 1.1275-6 hedge or the qualifying debt instrument) is treated as

immediately reacquired for, or entered into at, its fair market value

on the leg-out date. In order to prevent taxpayers from inappropriately

generating tax losses by legging into and immediately legging out of an

integrated transaction, the proposed regulations contain a wash sale

rule that disallows losses if the taxpayer legs out within 30 days of

legging into an integrated transaction.

If a qualifying debt instrument and a Sec. 1.1275-6 hedge are

integrated, the instruments are no longer subject to the rules that

govern each instrument separately, except as specifically provided in

the regulations or by publication in the Internal Revenue Bulletin.

Instead, the instruments are subject to the rules that would govern the

synthetic debt instrument. For example, the qualifying debt instrument

and Sec. 1.1275-6 hedge are not treated as part of a straddle under

section 1092, but the interest on the synthetic debt instrument may be

subject to the interest capitalization rules of section 263(g).

The issue price of the synthetic debt instrument is the adjusted

issue price of the qualifying debt instrument. The issue date of the

synthetic debt instrument is the date the Sec. 1.1275-6 hedge is

acquired. The term of the synthetic debt instrument is the period from

the issue date of the synthetic debt instrument to the maturity date of

the qualifying debt instrument. If the synthetic debt instrument is a

borrowing, its stated redemption price at maturity is the sum of all

amounts paid or to be paid on the qualifying debt instrument and on the

Sec. 1.1275-6 hedge, reduced by all amounts received or to be received

on the hedge and any amounts that would be qualified stated interest on

the synthetic debt instrument. If the synthetic debt instrument is a

loan, its stated redemption price at maturity is the sum of all amounts

received or to be received on the qualifying debt instrument and the

Sec. 1.1275-6 hedge, reduced by all amounts paid or to be paid on the

hedge and any amounts that would be qualified stated interest on the

synthetic debt instrument.

The rules for determining the stated redemption price at maturity

are designed to cover situations where payments on the hedge move

inversely to the payments on the qualifying debt instrument. For

example, if a holder of a qualifying debt instrument purchases an

option to hedge the debt instrument, the amount paid by the holder must

be taken into account as an adjustment to the instrument's stated

redemption price at maturity.

Separate transaction treatment is required for certain limited

purposes. For example, the rules of sections 871(a), 881, 1441, and

1442 must be applied on a separate transaction basis. Similarly, any

information reporting rules for the qualifying debt instrument continue

to apply as if the qualifying debt instrument and the Sec. 1.1275-6

hedge were not part of an integrated transaction. The IRS and Treasury

request comments on whether the regulations should specifically provide

separate transaction treatment for other purposes. The IRS and Treasury

also request comments on whether rules similar to Sec. 1.6045-

1(d)(6)(iii) of the proposed regulations (regarding broker reporting of

an integrated transaction under Sec. 1.988-5) should be adopted for an

integrated transaction under Sec. 1.1275-6.

The IRS and Treasury intend to propose rules coordinating

Sec. 1.1275-6 with section 475. Comments are requested on this issue.

Proposed Effective Date

In general, the proposed regulations in this document are proposed

to be effective for debt instruments issued on or after the date that

is 60 days after the date final regulations are published in the

Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for Thursday, March 16, 1995,

at 10 a.m. in the Auditorium, Internal Revenue Building, 1111

Constitution Avenue NW, Washington, DC. Because of access restrictions,

visitors will not be admitted beyond the Internal Revenue Building

lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons

that wish to present oral comments at the hearing must submit their

written comments and an outline of the topics to be discussed (signed

original and eight (8) copies) by Thursday, February 23, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

two entries in numerical order to read as follows:

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

Section 1.483-4 also issued under 26 U.S.C. 483(f). * * *

Section 1.1275-6 also issued under 26 U.S.C. 1275(d). * * *

Par. 2. Section 1.483-4 is added to read as follows:

Sec. 1.483-4 Contingent payments.

(a) In general. If a contract for the sale or exchange of property

subject to section 483 (the overall contract) provides for one or more

contingent payments, interest under the contract is generally computed

and accounted for under rules similar to those that would be applicable

if the contract were a debt instrument subject to Sec. 1.1275-4(c).

Consequently, all noncontingent payments and quotable contingent

payments (within the meaning of Sec. 1.1275-4(b)(4)(i)) under the

overall contract are treated as if made under a separate contract, and

interest accruals on this separate contract are computed under rules

similar to those contained in Sec. 1.1275-4(c)(3). Each nonquotable

contingent payment (within the meaning of Sec. 1.1275-4(b)(4)(ii)), if

any, under the overall contract is characterized as principal and

interest under rules similar to those contained in Sec. 1.1275-4(c)(4).

However, any interest, or amount treated as interest, on a contract

subject to this section is taken into account by a taxpayer under the

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

cash receipts and disbursements method).

(b) Examples. The following examples illustrate the provisions of

paragraph (a) of this section.

Example 1. Deferred payment sale with contingent interest--(i)

Facts. On January 1, 1996, A sells depreciable personal property to

B. As consideration for the sale, B issues to A a debt instrument

with a maturity date of December 31, 2000. The debt instrument

provides for a principal payment of $200,000 on the maturity date,

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

percentage of the total gross income derived from the property in

that year. However, the total interest payable on the debt

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

Assume that the short-term applicable Federal rate on January 1,

1996, is 4 percent, compounded annually, and the mid-term applicable

Federal rate on January 1, 1996, is 5 percent, compounded annually.

(ii) Treatment of noncontingent payment as separate contract.

Each contingent payment of interest is a nonquotable contingent

payment (within the meaning of Sec. 1.1275-4(b)(4)(ii)).

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

applying section 483 to the debt instrument, the right to the

noncontingent payment of $200,000 at maturity is treated as a

separate contract. The amount of unstated interest on this separate

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

amount of this deferred payment under the contract ($200,000)

exceeds the present value of the deferred payment ($156,705),

calculated using the test rate of 5 percent, compounded annually

(the mid-term applicable Federal rate on the date of the sale). The

$200,000 payment at maturity is thus treated as consisting of a

payment of interest of $43,295 and a payment of principal of

$156,705. The interest is includible in A's gross income, and

deductible by B, under their respective methods of accounting.

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

of the contingent payment that is paid on December 31, 1996, is

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

treated as a payment of principal of $19,231 (the present value, as

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

rate equal to 4 percent, compounded annually) and a payment of

interest of $769. The $769 interest payment is includible in A's

gross income, and deductible by B, in their respective taxable years

in which December 31, 1996 occurs. The amount treated as principal

gives B additional basis in the property on December 31, 1996. The

remaining contingent payments on the debt instrument are accounted

for similarly, using a test rate of 4 percent, compounded annually,

for the payments made on December 31, 1997, and December 31, 1998,

and a test rate of 5 percent, compounded annually, for the payments

made on December 31, 1999, and December 31, 2000.

Example 2. Contingent stock payout--(i) Facts. M Corporation and

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

January 1, 1996, pursuant to a reorganization qualifying under

section 368(a)(1)(B), M contracts to acquire the one-half interest

of O held by N for an initial distribution on that date of 30,000

shares of M voting stock, and a non- assignable right to receive up

to 10,000 additional shares of M's voting stock during the next 3

years, provided the net profits of O exceed certain amounts

specified in the contract. No interest is provided for in the

contract. No additional shares are received in 1996 or in 1997. In

1998, the annual earnings of O exceed the specified amount and on

December 31, 1998, an additional 3,000 M voting shares are

transferred to N. Assume that the fair market value of the 3,000

shares on December 31, 1998, is $300,000 and that the short-term

applicable Federal rate on January 1, 1996, is 4 percent, compounded

annually. Assume also that M and N are calendar year taxpayers.

(ii) Allocation of interest. Assume that the right to receive

the additional shares is a nonquotable contingent payment (within

the meaning of Sec. 1.1275-4(b)(4)(ii)). Section 1274 does not apply

to the right to receive the additional shares because the right is

not a debt instrument for federal income tax purposes. As a result,

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

subject to section 483 and a portion of the shares is treated as

unstated interest under that section. The amount of interest

allocable to the shares is an amount equal to the excess of $300,000

(the fair market value of the shares on December 31, 1998) over

$266,699 (the present value of $300,000, determined by discounting

the payment at the test rate of 4 percent, compounded annually, from

December 31, 1998, to January 1, 1996). As a result, the amount of

interest allocable to the payment of the shares is $33,301 ($300,000

- $266,699). Both M and N take the interest into account in 1998.

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

that occur on or after the date that is 60 days after final regulations

are published in the Federal Register.

Sec. 1.1001-1 [Amended]

Par. 3. In Sec. 1.1001-1, the first sentence of paragraph (g) is

amended by adding the language ``(other than a debt instrument that

provides for one or more contingent payments)'' immediately following

the language ``If a debt instrument''.

Sec. 1.1272-1 [Amended]

Par. 4. Section Sec. 1.1272-1 is amended by:

1. Removing the language ``(or schedules)'' in the first sentence

of paragraph (c)(1) and adding the language ``(or a reasonable number

of schedules)'' in its place.

2. Removing the language ``See regulations under section 1275(d)''

in the fourth sentence of paragraph (c)(1) and adding the language

``See Sec. 1.1275-4'' in its place.

Par. 5. Section 1.1274-2 is amended by revising paragraphs (f)(2)

and (g) to read as follows:

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

applies.

* * * * *

(f) * * *

(2) Stated interest at an objective rate. For purposes of paragraph

(c) of this section, the imputed principal amount of a variable rate

debt instrument (within the meaning of Sec. 1.1275-5(a)) that provides

for stated interest at a single objective rate is determined by

assuming that the debt instrument provides for a fixed rate that

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

paragraph (f)(2) is effective for debt instruments issued on or after

the date that is 60 days after final regulations are published in the

Federal Register.

(g) Treatment of contingent payment debt instruments. For purposes

of paragraph (c) of this section, the stated principal amount of a debt

instrument that provides for one or more contingent payments is the sum

of the noncontingent principal payments and the projected amounts of

any quotable contingent principal payments (as determined under

Sec. 1.1275-4(b)(4)(i)). The imputed principal amount of the debt

instrument is the sum of the present value of each noncontingent

payment and the present value of the projected amount of each quotable

contingent payment. For additional rules relating to a debt instrument

that provides for one or more contingent payments, see Sec. 1.1275-4.

This paragraph (g) is effective for debt instruments issued on or after

the date that is 60 days after final regulations are published in the

Federal Register.

* * * * *

Par. 6. In Sec. 1.1275-3, paragraph (b)(1)(i) is revised to read as

follows:

Sec. 1.1275-3 OID information reporting requirements.

* * * * *

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

(i) Set forth on the face of the debt instrument the issue price,

the amount of OID, the issue date, the yield to maturity, and, in the

case of a debt instrument subject to the rules of Sec. 1.1275-4(b), the

projected payment schedule; or

* * * * *

Par. 7. Section 1.1275-4 is added to read as follows:

Sec. 1.1275-4 Contingent payment debt instruments.

(a) Applicability--(1) In general. Except as provided in paragraph

(a)(2) of this section, this section applies to any debt instrument

that provides for one or more contingent payments. In general,

paragraph (b) of this section applies to a contingent payment debt

instrument that is issued for money or publicly traded property and

paragraph (c) of this section applies to a contingent payment debt

instrument that is issued for nonpublicly traded property. Paragraph

(d) of this section provides special rules for tax-exempt obligations.

If a taxpayer holds (or issues) a contingent payment debt instrument

that the taxpayer hedges, see Sec. 1.1275-6 for the treatment of the

debt instrument and the hedge by the taxpayer.

(2) Exceptions. This section does not apply to--(i) A debt

instrument that has an issue price determined under section 1273(b)(4);

(ii) A variable rate debt instrument (as defined in Sec. 1.1275-5);

(iii) A debt instrument subject to Sec. 1.1272-1(c) (a debt

instrument that provides for an alternative payment schedule (or

schedules) applicable upon the occurrence of a contingency (or

contingencies));

(iv) A debt instrument subject to section 988 (except as provided

in section 988 and the regulations thereunder); or

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

interests in or mortgages held by a REMIC, and certain other debt

instruments with payments subject to acceleration).

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

because of the possibility of impairment by insolvency, default, or

similar circumstances.

(4) Convertible debt instruments. A debt instrument does not

provide for contingent payments merely because it provides for a right

to convert the debt instrument into the stock of the issuer, into the

stock or debt of a related party (within the meaning of section 267(b)

or 707(b)(1)), or into cash or other property in an amount equal to the

approximate value of such stock or debt.

(5) Remote and incidental contingencies. A payment on a debt

instrument is not a contingent payment if, as of the issue date, the

contingency is either remote or incidental. A contingency is remote if

there is either a remote likelihood that the contingency will occur or

a remote likelihood that the contingency will not occur. A contingency

is incidental if the potential amount of the payment under any

reasonably expected market conditions is insignificant relative to the

total expected payments on the debt instrument.

(b) Noncontingent bond method--(1) Applicability. The noncontingent

bond method described in paragraph (b) of this section applies to a

contingent payment debt instrument that has an issue price determined

under Sec. 1.1273-2 (e.g., a contingent payment debt instrument that is

issued for money or publicly traded property). The noncontingent bond

method also applies to a contingent payment debt instrument that has an

issue price determined under Sec. 1.1274-2(b)(3) (a contingent payment

debt instrument issued in a potentially abusive situation).

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

debt instrument must be taken into account whether or not the amount of

any payment is fixed or determinable in the taxable year. The amount of

interest that is taken into account for each accrual period is

determined by constructing a projected payment schedule for the debt

instrument and applying rules similar to those for accruing OID on a

noncontingent debt instrument. The projected payment schedule is

determined as of the issue date and is based on forward prices, if

readily available, or on the projected pattern of expected payments and

a projected yield. If the actual amount of a contingent payment is not

equal to the projected amount, appropriate adjustments are made to

reflect the difference.

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

compute the amount of income, deductions, gain, and loss under the

noncontingent bond method.

(i) Step one: Determine a projected payment schedule. Determine the

projected payment schedule for the debt instrument as of the debt

instrument's issue date under the rules of paragraph (b)(4) of this

section.

(ii) Step two: Determine the projected yield. Based on the issue

price of the debt instrument and the projected payment schedule,

determine the projected yield of the debt instrument in the manner

described in Sec. 1.1272-1(b)(1)(i).

(iii) Step three: Determine the daily portions of interest.

Determine the daily portions of interest on the debt instrument for a

taxable year as follows. The amount of interest that accrues in each

accrual period is the product of the projected yield of the debt

instrument (properly adjusted for the length of the accrual period) and

the debt instrument's adjusted issue price at the beginning of the

accrual period. See paragraph (b)(7)(ii) of this section for rules for

determining the adjusted issue price of the debt instrument. The daily

portions of interest are determined by allocating to each day in the

accrual period the ratable portion of the interest that accrues in the

accrual period. Except as modified by paragraph (b)(3)(iv) of this

section, the daily portions of interest are includible in income by a

holder for each day in the holder's taxable year on which the holder

held the debt instrument, and are deductible by the issuer for each day

during the issuer's taxable year on which the issuer was primarily

liable on the debt instrument.

(iv) Step four: Adjust the amount of income or deductions for

differences between projected and actual contingent payments. Make

appropriate adjustments to the amount of income or deductions

attributable to the debt instrument in a taxable year for any

differences between projected and actual contingent payments. See

paragraph (b)(6) of this section to determine the amount of an

adjustment and the treatment of the adjustment.

(4) Method of determining projected payment schedule. This

paragraph (b)(4) provides rules for determining the projected payment

schedule for a debt instrument. The projected payment schedule includes

each noncontingent payment and the projected amount of each contingent

payment. The schedule is determined as of the issue date and remains

fixed throughout the term of the debt instrument (except under special

rules that apply to a payment that is fixed more than 6 months before

it is due under paragraph (b)(9)(ii) of this section). Under the rules

of section 6001, taxpayers must maintain adequate contemporaneous

records to support the projected payment schedule.

(i) Quotable contingent payments--(A) In general. If a right to a

contingent payment is substantially similar to a property right for

which forward price quotes are readily available (a quotable contingent

payment), the projected amount of the contingent payment is equal to

the forward price of the property right. The forward price of a

property right is an amount one party would agree, as of the issue

date, to pay an unrelated party for the property right on the

settlement date (e.g., the date payments under the property right are

to be made). For purposes of paragraph (b)(4) of this section, a

property right includes a right, an obligation, or a combination of

rights or obligations.

(B) Quotes readily available. For purposes of paragraph (b)(4)(i)

of this section, quotes are readily available for a property right if,

at any time during the 60-day period ending 30 days after the issue

date, one or more quotations for a price on the property right are

readily available from brokers, traders, or dealers.

(C) Substantially similar. A right to a contingent payment is

substantially similar to a property right if, under reasonably expected

market conditions, the value and timing of the amount to be paid or

received pursuant to the property right (whether in the form of a cash

payment or the delivery of property) are expected to be substantially

the same as the value and timing of the contingent payment.

(D) Special rule for contingent payments substantially similar to

options. A right to a contingent payment that is substantially similar

to an option or combination of options, and that is not otherwise a

quotable contingent payment, is treated as a quotable contingent

payment if spot price quotations for the option or options are readily

available. The projected amount of the contingent payment is the spot

price of the option or options on the issue date compounded at the

applicable Federal rate for the debt instrument (within the meaning of

Sec. 1.1274-4(b)) from the issue date to the date the payment is due.

(E) Reasonable determination of projected amounts. The projected

amounts of quotable contingent payments may be determined based on

either the bid, ask, or midpoint price quotes of the substantially

similar property rights, provided the determination is reasonable and

is made on a consistent basis. If price quotations vary among different

quotation sources, any reasonable quotation may be used. If a right to

a contingent payment is substantially similar to more than one

combination of property rights for which forward price quotes are

readily available (or options for which spot prices are readily

available), any reasonable combination may be used.

(ii) Quotes not readily available. If a debt instrument provides

for one or more contingent payments that are not described in paragraph

(b)(4)(i) of this section (nonquotable contingent payments), the

projected amount of each contingent payment on the debt instrument is

determined as follows. First, determine the projected amount of each

quotable contingent payment under paragraph (b)(4)(i) of this section.

Second, determine the projected yield of the debt instrument. The

projected yield is a reasonable rate for the debt instrument. A

reasonable rate is a rate that, as of the issue date, reflects general

market conditions, the credit quality of the issuer, and the terms and

conditions of the debt instrument (e.g., the existence of collateral

securing the debt instrument or the uncertainty inherent in the

contingent payments). A reasonable rate is never less than, and may

substantially exceed, the applicable Federal rate for the debt

instrument (within the meaning of Sec. 1.1274-4(b)), and may not be

less than the yield on the debt instrument based on the projected

payment schedule set without regard to the nonquotable contingent

payments. Third, select a projected amount for each nonquotable

contingent payment so that the projected payment schedule results in

the projected yield and reasonably reflects the relative expected

values of the nonquotable contingent payments.

(iii) Debt instruments similar to variable rate debt instruments.

Notwithstanding paragraphs (b)(4)(i) and (ii) of this section, the

projected payment schedules for certain debt instruments similar to

variable rate debt instruments are determined as follows:

(A) Single quotable contingent payment at maturity. If a debt

instrument would qualify as a variable rate debt instrument under

Sec. 1.1275-5 except that it provides for a single quotable contingent

payment at maturity, the projected payment schedule is determined as

follows. First, construct the equivalent fixed rate debt instrument for

the debt instrument under the principles of Sec. 1.1275-5(e),

disregarding the contingent payment at maturity. Second, determine the

projected amount of the contingent payment at maturity in accordance

with paragraph (b)(4)(i) of this section. Third, set the projected

payment schedule by combining the payment schedule for the equivalent

fixed rate debt instrument with the projected amount of the contingent

payment.

(B) Principal not fully guaranteed. If a debt instrument would

qualify as a variable rate debt instrument under Sec. 1.1275-5 except

that it does not meet the principal payment requirement of Sec. 1.1275-

5(a)(2), the projected payment schedule is determined by constructing

the equivalent fixed rate debt instrument for the debt instrument under

the principles of Sec. 1.1275-5(e).

(iv) Issuer/holder consistency. The projected payment schedule used

by the issuer to compute interest accruals and adjustments determines

the interest accruals and adjustments of the holder. The issuer must

provide the projected payment schedule to the holder in a manner

consistent with the issuer disclosure rules of Sec. 1.1275-2(e). If the

issuer does not create a projected payment schedule for a debt

instrument or the payment schedule set by the issuer is unreasonable,

the holder of the debt instrument must set the projected payment

schedule under the rules of paragraph (b)(4) of this section. A holder

that sets its own projected payment schedule must explicitly disclose

this fact and the reason why the holder set its own schedule (e.g., why

the projected payment schedule prepared by the issuer is unreasonable).

Unless otherwise prescribed by the Commissioner, the disclosure must be

made on a statement attached to the holder's timely filed federal

income tax return for the taxable year that includes the acquisition

date of the debt instrument.

(v) Issuer's determination respected. The issuer's determination of

the projected payment schedule will be respected unless the schedule is

unreasonable. A projected payment schedule will generally be considered

unreasonable if the schedule is set with a purpose to accelerate or

defer interest accruals on the debt instrument. In determining whether

a projected payment schedule is unreasonable, consideration will be

given to whether the interest on the debt instrument determined under

the projected payment schedule has a significant effect on the issuer's

or holder's U.S. tax liability.

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

paragraph (b)(4) of this section. In each example, assume that the debt

instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example 1. Contingent payment substantially similar to an

option--(i) Facts. On January 1, 1996, W corporation issues for

$1,000,000 a debt instrument that matures on December 31, 2000. The

debt instrument has a stated principal amount of $1,000,000, payable

at maturity. The debt instrument also provides for a payment at

maturity equal to $10,000 times the increase, if any, in the value

of a nationally known composite index of stocks from January 1,

1996, to the maturity date.

(ii) Projected payment schedule. Under paragraph (b)(4) of this

section, the projected payment schedule for the debt instrument

consists of the $1,000,000 payment at maturity plus the projected

amount of the contingent payment at maturity. The right to the

contingent payment is substantially similar to a long call option on

the index that is exercisable only on December 31, 2000. Thus, if

quotes for the forward price of the option are readily available,

the projected amount of the contingent payment is the forward price

of the option. If quotes for the forward price are not readily

available and quotes for the spot price of the option are readily

available, the projected amount of the contingent payment is the

option's spot price on the issue date compounded at the applicable

Federal rate for the debt instrument from the issue date to the

maturity date.

Example 2. Contingent payment substantially similar to a forward

contract--(i) Facts. On January 1, 1996, X corporation issues for

$1,000,000 a debt instrument that matures on December 31, 2005. The

debt instrument provides for annual payments of interest at the rate

of 6 percent and for a payment at maturity equal to $1,000,000, plus

the excess, if any, of the price of 1,000 units of a commodity on

the maturity date over $350,000, or less the excess, if any, of

$350,000 over the price of 1,000 units of the commodity on the

maturity date.

(ii) Projected payment schedule. Under paragraph (b)(4) of this

section, the projected payment schedule for the debt instrument

consists of ten annual payments of $60,000 and a projected amount

for the contingent payment at maturity. The right to the contingent

payment is substantially similar to a right to a payment of

$1,000,000 combined with a forward contract for the purchase of

1,000 units of the commodity for $350,000 on December 31, 2005.

Assume forward price quotes to purchase the commodity on December

31, 2005, are readily available on the issue date.

(A) Assume that on the issue date the forward price to purchase

1,000 units of the commodity on December 31, 2005, is $350,000. The

projected amount of the contingent payment is $1,000,000, consisting

of the $1,000,000 base amount and no additional amount to be

received or paid under the forward contract. Although the amount to

be received or paid under the forward contract is projected to be

zero, the contingency is not incidental (within the meaning of

paragraph (a)(5) of this section) because the potential amount to be

received or paid based on the forward contract is not insignificant

relative to the total expected payments on the debt instrument under

any reasonably expected market conditions.

(B) Assume, alternatively, that on the issue date the forward

price to purchase 1,000 units of the commodity on December 31, 2005,

is $370,000. The projected amount of the contingent payment is

$1,020,000, consisting of the $1,000,000 base amount plus the excess

$20,000 of the forward price of the commodity over the purchase

price of the commodity under the forward contract.

(C) Assume, alternatively, that on the issue date the forward

price to purchase 1,000 units of the commodity on December 31, 2005,

is $330,000. The projected amount of the contingent payment is

$980,000, consisting of the $1,000,000 base amount minus the excess

$20,000 of the purchase price of the commodity under the forward

contract over the forward price of the commodity.

Example 3. Contingent payment substantially similar to a

combination of rights--(i) Facts. Assume the same facts as in

Example 2 of this paragraph (b)(4)(vi), except that the debt

instrument also provides for a cap and a floor on the contingent

payment at maturity, so that the payment may not exceed $1,300,000

and may not be less than $700,000.

(ii) Projected payment schedule. Under paragraph (b)(4) of this

section, the projected payment schedule for the debt instrument

consists of ten annual payments of $60,000 and a projected amount

for the contingent payment at maturity. The right to the contingent

payment is substantially similar to a right to a payment of

$1,000,000 combined with a forward contract for the purchase of

1,000 units of the commodity for $350,000 on December 31, 2005, and

two options on 1,000 units of the commodity that are exercisable

only on December 31, 2005: one a long put option with an exercise

price of $50,000, and the other a short call option with an exercise

price of $650,000. The projected amount of the contingent payment is

determined by combining the forward prices of these property rights.

Example 4. Nonquotable contingent payments--(i) Facts. On

January 1, 1996, Y issues for $1,000,000 a debt instrument that

matures on December 31, 1999. The debt instrument has a stated

principal amount of $1,000,000, payable at maturity, and provides

for payments on December 31 of each year of $20,000 plus 5 percent

of Y's gross receipts, if any, for the year. Assume that a

reasonable rate for the debt instrument (within the meaning of

paragraph (b)(4)(ii) of this section) is 7.5 percent, compounded

annually.

(ii) Projected yield. The debt instrument provides for

nonquotable contingent payments. Under paragraph (b)(4)(ii) of this

section, the projected yield is 7.5 percent, compounded annually.

(iii) Projected payment schedule. Assume that Y anticipates that

it will have no gross receipts in 1996, but that it will have gross

receipts in later years, and those gross receipts will grow each

year for the next three years. Based on its business projections, Y

believes that it is not unreasonable to expect that its gross

receipts in 1998 and each year thereafter will grow by between 6

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

expectations into account in establishing a projected payment

schedule for the debt instrument that results in a yield of 7.5

percent, compounded annually. Accordingly, Y could reasonably set

the following projected payment schedule for the debt instrument:

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

Noncontingent Contingent

Date payment payment

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

12/31/1996.................................. $20,000 $0

12/31/1997.................................. 20,000 70,000

12/31/1998.................................. 20,000 75,600

12/31/1999.................................. 1,020,000 83,850

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

Example 5. Debt instrument that provides for a variable rate of

interest and a single quotable contingent payment at maturity--(i)

Facts. On January 1, 1996, W corporation issues for $1,000,000 a

debt instrument that matures on December 31, 2000. The debt

instrument has a stated principal amount of $1,000,000, payable at

maturity. The debt instrument also provides for semiannual payments

of interest and a payment at maturity equal to $5,000 times the

increase, if any, in the value of a nationally known composite index

of stocks from January 1, 1996, to the maturity date. The rate of

interest on the debt instrument is the value of 6-month LIBOR on the

payment date. On the issue date, the value of 6-month LIBOR is 4

percent, compounded semiannually. Assume that the payment at

maturity based on the index is a quotable contingent payment.

(ii) Projected payment schedule. Because the debt instrument

would qualify as a variable rate debt instrument under Sec. 1.1275-5

except that it provides for a single quotable contingent payment at

maturity, paragraph (b)(4)(iii) of this section applies to the debt

instrument. Under paragraph (b)(4)(iii)(A) of this section, the

projected payment schedule is determined by first constructing the

equivalent fixed rate debt instrument for the debt instrument. Under

Sec. 1.1275-5(e), the equivalent fixed rate debt instrument is a 5-

year debt instrument that provides for semiannual payments of

interest at 4 percent, compounded semiannually. Next, the projected

amount of the contingent payment is determined in accordance with

paragraph (b)(4)(i) of this section. The right to the contingent

payment based on the stock index is substantially similar to a long

call option on the index that is exercisable only on December 31,

2000. Thus, the projected amount of the contingent payment is the

forward price of the option, assuming quotes for the forward price

of the option are readily available. Finally, the projected payment

schedule is determined, consisting of 10 semiannual payments of

interest at 4 percent and a payment at maturity equal to $1,000,000

plus the forward price of the option on the index.

(5) Qualified stated interest. No amounts payable on a debt

instrument to which paragraph (b) of this section applies constitute

qualified stated interest within the meaning of Sec. 1.1273-1(c).

(6) Adjustments under the noncontingent bond method. This paragraph

(b)(6) provides rules for the treatment of positive and negative

adjustments under the noncontingent bond method.

(i) Determination of positive and negative adjustments. If the

amount of a contingent payment is more than the projected amount of the

contingent payment, the difference is a positive adjustment on the date

of the payment. If the amount of a contingent payment is less than the

projected amount of the contingent payment, the difference is a

negative adjustment on the date of the projected payment.

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

which total positive adjustments on a debt instrument in a taxable year

exceed the total negative adjustments on the debt instrument in the

taxable year is a net positive adjustment. A net positive adjustment is

treated as additional interest for the taxable year.

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

which total negative adjustments on a debt instrument in a taxable year

exceed the total positive adjustments on the debt instrument in the

taxable year is a net negative adjustment. A taxpayer's net negative

adjustment on a debt instrument for a taxable year is treated as

follows:

(A) Reduction of interest accruals. A net negative adjustment first

reduces interest for the taxable year that the taxpayer would otherwise

account for on the debt instrument under paragraph (b)(3)(iii) of this

section.

(B) Ordinary income or loss. If the net negative adjustment exceeds

the interest for the taxable year that the taxpayer would otherwise

account for on the debt instrument under paragraph (b)(3)(iii) of this

section, the excess is treated as ordinary loss by a holder and

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

loss by a holder is limited to the amount by which the holder's total

interest inclusions on the debt instrument exceed the total amount of

the holder's net negative adjustments treated as ordinary loss on the

debt instrument in prior taxable years. The amount treated as ordinary

income by an issuer is limited to the amount by which the issuer's

total interest deductions on the debt instrument exceed the total

amount of the issuer's net negative adjustments treated as ordinary

income on the debt instrument in prior taxable years.

(C) Carryforward. If the net negative adjustment exceeds the sum of

the amounts treated by the taxpayer as a reduction of interest and as

ordinary income or loss (as the case may be) on the debt instrument for

the taxable year, the excess is a negative adjustment carryforward for

the taxable year.

(1) In general. Except as provided in paragraph (b)(6)(iii)(C)(2)

of this section, a negative adjustment carryforward on a debt

instrument for a taxable year is treated as a negative adjustment on

the debt instrument on the first day of the succeeding taxable year.

(2) In year of sale, exchange, or retirement. Any negative

adjustment carryforward on a debt instrument for a taxable year in

which the debt instrument is sold, exchanged, or retired reduces the

amount realized by the holder on the sale, exchange, or retirement. Any

negative adjustment carryforward for a taxable year in which the debt

instrument is retired is taken into account by the issuer as income

from the discharge of indebtedness under section 61(a)(12).

(iv) Cross references. If a holder has a basis in a debt instrument

that is different than the debt instrument's adjusted issue price, the

holder may have additional positive or negative adjustments under

paragraph (b)(9)(i) of this section. If the amount of a contingent

payment is fixed more than 6 months before the date it is due, the

amount and timing of the adjustment are determined under paragraph

(b)(9)(ii) of this section. If all the remaining contingent payments on

a debt instrument become fixed substantially contemporaneously, the

timing of the adjustment is determined under paragraph (b)(9)(v) of

this section.

(v) Examples. The following examples illustrate the provisions of

paragraph (b)(6) of this section. In each example, assume that the debt

instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example 1. Net negative adjustment--(i) Facts. On June 13, 1996,

Z, a calendar year taxpayer, purchases a debt instrument at original

issue for $1,044. Assume that the debt instrument is subject to

paragraph (b) of this section. The projected payment schedule

provides for projected payments of $100 on December 31, 1996, and

$1,100 on December 31, 1997. Based on the projected payment

schedule, Z's total daily portions of interest would be $56 for 1996

and $100 for 1997.

(ii) Adjustment in 1996. Assume that the payment actually made

on December 31, 1996, is $25, rather than the projected $100. Under

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

$75 on December 31, 1996, attributable to the difference between the

amount of the actual payment and the amount of the projected

payment. Because Z has no positive adjustments for 1996, Z has a net

negative adjustment of $75 on the debt instrument for 1996. This net

negative adjustment reduces to zero the $56 total daily portions of

interest Z would otherwise include in income in 1996. Accordingly, Z

has no interest income on the debt instrument for 1996. Because Z

has no interest inclusions on the debt instrument for prior taxable

years, the remaining $19 of the net negative adjustment is a

negative adjustment carryforward for 1996 that results in a negative

adjustment of $19 on January 1, 1997.

(iii) Adjustments in 1997. Assume that the payment actually made

on December 31, 1997, is $1,150, rather than the projected $1,100.

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

adjustment of $50 on December 31, 1997, attributable to the

difference between the amount of the actual payment and the amount

of the projected payment. Because Z also has a negative adjustment

of $19 on January 1, 1997, Z has a net positive adjustment of $31 on

the debt instrument for 1997 (the excess of the $50 positive

adjustment over the $19 negative adjustment). Therefore, Z has $131

of interest income on the debt instrument for 1997 (the net positive

adjustment plus the $100 total daily portions of interest that are

taken into account by Z in that year).

Example 2. Net negative adjustment at maturity--(i) Facts.

Assume the same facts as in Example 1 of this paragraph (b)(6)(v),

except that the payment actually made on December 31, 1997, is

$1,010, rather than the projected $1,100.

(ii) Adjustments in 1997. Under paragraph (b)(6)(i) of this

section, Z has a negative adjustment of $90 on December 31, 1997,

attributable to the difference between the amount of the actual

payment and the amount of the projected payment. In addition, Z has

a negative adjustment of $19 on January 1, 1997. Because Z has no

positive adjustments in 1997, Z has a net negative adjustment of

$109 for 1997. This net negative adjustment reduces to zero the $100

total daily portions of interest Z would otherwise include in income

for 1997. Therefore, Z has no interest income on the debt instrument

for 1997. Because Z has no interest inclusions on the debt

instrument for prior taxable years, the remaining $9 of the net

negative adjustment constitutes a negative adjustment carryforward

for 1997 that reduces the amount realized by Z on retirement of the

debt instrument.

(7) Adjusted issue price, adjusted basis, and retirement--(i) In

general. Paragraph (b)(7) of this section provides rules under the

noncontingent bond method to determine the adjusted issue price of a

debt instrument, the holder's basis in a debt instrument, and the

amount of any contingent payment made on a scheduled retirement.

Paragraph (b)(7) of this section also provides rules for an unscheduled

retirement. In general, because any difference between the actual

amount of a contingent payment and the projected amount of the payment

is taken into account as an adjustment to income or deduction, the

projected payments are treated as the actual payments for purposes of

making adjustments to issue price and basis and determining the amount

of any contingent payment made on a scheduled retirement. Except as

provided in paragraph (b)(7)(iv) of this section, positive and negative

adjustments are not taken into account for purposes of paragraph (b)(7)

of this section.

(ii) Definition of adjusted issue price. The adjusted issue price

of a debt instrument is equal to the debt instrument's issue price,

increased by the interest previously accrued on the debt instrument

under paragraph (b)(3)(iii) of this section (determined without regard

to any adjustments taken into account under paragraph (b)(3)(iv) of

this section), and decreased by the amount of any noncontingent payment

and the projected amount of any contingent payment previously made on

the debt instrument. See paragraph (b)(9)(ii) of this section for

special rules that apply when a contingent payment is fixed more than 6

months before it is due.

(iii) Adjustments to basis. A holder's basis in a debt instrument

is increased by the interest previously accrued by the holder on the

debt instrument under paragraph (b)(3)(iii) of this section (determined

without regard to any adjustments taken into account under paragraph

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

noncontingent payment and the projected amount of any contingent

payment previously made on the debt instrument to the holder. See

paragraphs (b)(9)(i) and (ii) of this section for special rules that

apply when basis is different than adjusted issue price or a contingent

payment is fixed more than 6 months before it is due.

(iv) Amount realized on a scheduled retirement. For purposes of

determining the amount realized by a holder and the repurchase price

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

holder is treated as receiving, and the issuer is treated as paying,

the projected amount of any contingent payment due at maturity. The

amount realized on a scheduled retirement of a debt instrument and the

issuer's repurchase price on the retirement, however, may be reduced

under paragraph (b)(6)(iii)(C)(2) of this section (regarding the

treatment of negative adjustment carryforwards determined in the

taxable year of the retirement).

(v) Unscheduled retirements. An unscheduled retirement of a debt

instrument (or the receipt of a pro-rata prepayment that is treated as

a retirement of a portion of a debt instrument under Sec. 1.1275-2(f))

is treated as a sale or exchange of the debt instrument (or a pro rata

portion of the debt instrument) by the holder to the issuer for the

amount paid by the issuer to the holder.

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

paragraph (b)(7) of this section. In each example, assume that the debt

instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example 1. Adjusted issue price, adjusted basis, and

retirement--(i) Facts. Assume the same facts as in Example 1 of

paragraph (b)(6)(v) of this section.

(ii) Adjustment to issue price and basis. Based on the projected

payment schedule, Z's total daily portions of interest on the debt

instrument would be $56 for 1996. Therefore, the adjusted issue

price of the debt instrument and Z's adjusted basis in the debt

instrument are increased by this amount ($56), despite the fact

that, under paragraph (b)(6)(iii) of this section, Z has a net

negative adjustment for 1996 of $75 that reduces to zero the $56

total daily portions of interest otherwise accounted for by Z in

that year. In addition, the adjusted issue price of the debt

instrument and Z's adjusted basis in the debt instrument are

decreased on December 31, 1996, by the projected amount of the

payment on that date ($100). Thus, on January 1, 1997, Z's adjusted

basis in the debt instrument and the adjusted issue price of the

debt instrument are $1,000.

(iii) Retirement. Based on the projected payment schedule, Z's

adjusted basis in the debt instrument immediately before the payment

at maturity is $1,100. Even though Z receives $1,150 at maturity,

for purposes of determining the amount realized by Z on retirement

of the debt instrument, Z is treated as receiving the projected

amount of the contingent payment on December 31, 1997. Therefore, Z

is treated as receiving $1,100 on December 31, 1997. Because Z's

adjusted basis in the debt instrument immediately before its

retirement is $1,100, Z recognizes no gain or loss on the

retirement. Z, however, does include $131 as interest income on the

debt instrument in 1997. See Example 1 of paragraph (b)(6)(v) of

this section.

Example 2. Negative adjustment carryforward for year of sale--

(i) Facts. Assume the same facts as in Example 1 of paragraph

(b)(6)(v) of this section, except that Z sells the debt instrument

on January 1, 1997, for $1,075.

(ii) Gain on sale. On the date the debt instrument is sold, Z's

adjusted basis in the debt instrument is $1,000. Because Z has a

negative adjustment on the debt instrument on January 1, 1997, of

$19 under paragraph (b)(6)(iii)(C)(1) of this section, and has no

positive adjustments on the debt instrument in 1997, Z has a net

negative adjustment for 1997 of $19. Because Z has included no

interest on the debt instrument in income in 1997 or previous years,

the entire $19 net negative adjustment constitutes a negative

adjustment carryforward for the taxable year of the sale. Under

paragraph (b)(6)(iii)(C)(2) of this section, the $19 negative

adjustment carryforward reduces the amount realized by Z on the sale

of the debt instrument from $1,075 to $1,056. Thus, Z has a gain on

the sale of $56.

Example 3. Negative adjustment carryforward for year of

retirement--(i) Facts. Assume the same facts as in Example 1 of

paragraph (b)(6)(v) of this section, except that the payment

actually made on December 31, 1997, is $1,010, rather than the

projected $1,100. Thus, Z will have a $9 negative adjustment

carryforward for 1997, the year of retirement. See Example 2 of

paragraph (b)(6)(v) of this section.

(ii) Loss on retirement. Immediately before the payment at

maturity, Z's adjusted basis in the debt instrument is $1,100. Under

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

projected amount of the contingent payment, or $1,100, as the

payment at maturity. Under paragraph (b)(6)(iii)(C)(2) of this

section, however, this amount is reduced by any negative adjustment

carryforward determined for the taxable year of retirement to

calculate the amount Z realizes on retirement of the debt

instrument. Thus, Z has a loss of $9 on the retirement of the debt

instrument, equal to the amount by which Z's adjusted basis in the

debt instrument ($1,100) exceeds the amount Z realizes on the

retirement of the debt instrument ($1,100 minus the $9 negative

adjustment carryforward).

(8) Character on sale, exchange, or retirement--(i) Gain. Any gain

recognized by a holder on the sale, exchange, or retirement of a debt

instrument is interest income.

(ii) Loss. Any loss recognized by a holder on the sale, exchange,

or retirement of the debt instrument is ordinary loss to the extent

that the holder's total interest inclusions on the debt instrument

exceed the total net negative adjustments on the debt instrument the

holder took into account as ordinary loss. Any additional loss is

treated as loss from the sale, exchange, or retirement of the debt

instrument.

(iii) Special rule if there are no remaining contingent payments on

the debt instrument. Notwithstanding paragraphs (b)(8)(i) and (ii) of

this section, if, at the time of the sale, exchange, or retirement of

the debt instrument, there are no remaining contingent payments due on

the debt instrument, any gain or loss recognized by the holder on the

debt instrument is gain or loss from the sale, exchange, or retirement

of the debt instrument.

(iv) Fixed but deferred payments. For purposes of paragraph (b)(8)

of this section, a contingent payment that is fixed within the 6-month

period ending on the due date of the payment is treated as a contingent

payment even after the payment is fixed. See paragraph (b)(9)(ii) of

this section, under which a contingent payment that is fixed more than

6 months before it is due is not treated as a contingent payment after

it is fixed.

(v) Examples. The following examples illustrate the provisions of

paragraph (b)(8) of this section. In each example, assume that the debt

instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example 1. Gain on sale--(i) Facts. On January 1, 1997, D, a

calendar year taxpayer, sells a debt instrument that is subject to

paragraph (b) of this section for $1,350. On that date, D has an

adjusted basis in the debt instrument of $1,200. In addition, D has

a negative adjustment carryforward of $50 for 1996 that results in a

negative adjustment of $50 on January 1, 1997, under paragraph

(b)(6)(iii)(C)(1) of this section. D has no positive adjustments on

the debt instrument on January 1, 1997.

(ii) Character of gain. Under paragraph (b)(6) of this section,

the $50 negative adjustment on January 1, 1997, results in a

negative adjustment carryforward for 1997, the taxable year of the

sale of the debt instrument. Under paragraph (b)(6)(iii)(C)(2) of

this section, the negative adjustment carryforward reduces the

amount realized by D on the sale of the debt instrument from $1,350

to $1,300. As a result, D realizes a $100 gain on the sale of the

debt instrument, equal to the $1,300 amount realized minus D's

$1,200 adjusted basis in the debt instrument. Under paragraph

(b)(8)(i) of this section, the gain is interest income to D.

Example 2. Ordinary loss on sale--(i) Facts. On January 1, 1996,

E, a calendar year taxpayer, purchases a debt instrument at original

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

hands of E. The debt instrument provides for a payment of $1,000 at

maturity on December 31, 2001, and for quotable contingent payments

on December 31, 1997, 1999, and 2001. The projected payment schedule

provides for projected payments of $275 on December 31, 1997, $200

on December 31, 1999, and $1,127 on December 31, 2001. Thus, the

projected yield on the debt instrument is 10 percent, compounded

annually. Based on the projected payment schedule, the total daily

portions of interest would be $100 for 1996, $110 for 1997, and

$93.50 for 1998.

(ii) Adjustment for 1997. Assume that the payment actually made

on December 31, 1997, is $150, rather than the projected $275. Under

paragraph (b)(6)(i) of this section, E has a negative adjustment of

$125 on December 31, 1997. Because E has no positive adjustments for

1997, E has a net negative adjustment of $125 on the debt instrument

for 1997. This net negative adjustment reduces to zero the $110

total daily portions of interest E would otherwise include in income

in 1997. Accordingly, E has no interest income on the debt

instrument for 1997. Because E had $100 of interest inclusions for

1996, the remaining $15 of the net negative adjustment is an

ordinary loss to E for 1997.

(iii) Determination of amount and character of loss on sale.

Assume that E sells the debt instrument for $950 on December 31,

1998. On that date, E has an adjusted basis in the debt instrument

of $1,028.50 ($1,000 original basis, plus total daily portions of

$100 for 1996, $110 for 1997, and $93.50 for 1998, minus the $275

projected amount of the December 31, 1997 payment). As a result, E

realizes a $78.50 loss on the sale of the debt instrument (the

difference between the sales price and E's adjusted basis in the

debt instrument). The total amount of E's interest inclusions on the

debt instrument as of December 31, 1998 ($100 in 1996 and $93.50 in

1998) exceeds the total amount of net negative adjustments on the

debt instrument E treated as ordinary loss as of that date ($15 in

1997) by more than $78.50. Therefore, under paragraph (b)(8)(ii) of

this section, the $78.50 loss on the debt instrument is treated as

an ordinary loss by E.

Example 3. Loss on sale of a debt instrument--(i) Facts. Assume

the same facts as in Example 2 of this paragraph (b)(8)(v), except

that the payment actually made on December 31, 1997, is $0, rather

than the projected $275.

(ii) Adjustment for 1997. Under paragraph (b)(6)(i) of this

section, E has a negative adjustment of $275 on December 31, 1997.

Because E has no positive adjustments for 1997, E has a net negative

adjustment of $275 on the debt instrument for 1997. This net

negative adjustment reduces to zero the $110 total daily portions of

interest E would otherwise include in income in 1997. Accordingly, E

has no interest income on the debt instrument for 1997. Because E

had $100 of interest inclusions for 1996, $100 of the remaining $165

net negative adjustment is treated by E as an ordinary loss for

1997. The remaining $65 of the net negative adjustment is a negative

adjustment carryforward for 1997 that results in a negative

adjustment of $65 on January 1, 1998.

(iii) Determination of amount and character of loss on sale.

Assume that E sells the debt instrument for $900 on January 1, 1998.

On that date, E has an adjusted basis in the debt instrument of $935

($1,000 original basis, plus total daily portions of $100 for 1996

and $110 for 1997, minus the $275 projected amount of the December

31, 1997 payment). Because E has no other adjustments for 1998, and

E's interest inclusions on the debt instrument in prior taxable

years do not exceed the total net negative adjustments E treated as

ordinary loss in those years, the $65 negative adjustment on January

1, 1998, results in a negative adjustment carryforward of $65 for

1998. Under paragraph (b)(6)(iii)(C)(2) of this section, the $65

negative adjustment carryforward reduces the amount E realizes on

the sale of the debt instrument from $900 to $835. As a result, E

realizes a $100 loss on the sale of the debt instrument (the

difference between the amount realized and E's adjusted basis in the

debt instrument). Because E's total interest inclusions on the debt

instrument do not exceed the total net negative adjustments E

treated as ordinary loss on the debt instrument, E's loss on the

sale of the debt instrument is treated as a capital loss.

(9) Operating rules. The rules of this paragraph (b)(9)

notwithstanding any other rule of this paragraph (b).

(i) Basis different than adjusted issue price. This paragraph

(b)(9)(i) provides rules for a holder whose basis in a debt instrument

is different than the adjusted issue price of the debt instrument

(e.g., a subsequent holder that purchases the debt instrument for more

or less than the instrument's adjusted issue price).

(A) General rule. A holder whose basis in a debt instrument is

different than the adjusted issue price of the debt instrument accrues

interest under paragraph (b)(3)(iii) of this section and makes

adjustments under paragraph (b)(3)(iv) of this section based on the

projected payment schedule determined as of the issue date of the debt

instrument. However, upon acquiring the debt instrument, the holder

must reasonably allocate any difference between the adjusted issue

price and the basis to daily portions of interest or projected payments

over the remaining term of the debt instrument. Allocations are taken

into account under paragraphs (b)(9)(i)(B) and (C) of this section.

(B) Basis greater than adjusted issue price. If a holder's basis in

a debt instrument exceeds the debt instrument's adjusted issue price,

the amount allocated to a daily portion of interest or to a projected

payment is treated as a negative adjustment on the date the daily

portion accrues or the payment is made. The holder's adjusted basis in

the debt instrument is reduced by the amount the holder treats as a

negative adjustment under this paragraph (b)(9)(i)(B).

(C) Basis less than adjusted issue price. If a holder's basis in a

debt instrument is less than the debt instrument's adjusted issue

price, the amount allocated to a daily portion of interest or to a

projected payment is treated as a positive adjustment on the date the

daily portion accrues or the payment is made. The holder's adjusted

basis in the debt instrument is increased by the amount the holder

treats as a positive adjustment under this paragraph (b)(9)(i)(C).

(D) Premium and discount rules do not apply. The rules for accruing

premium and discount in sections 171, 1272(a)(7), 1276, and 1281 do not

apply. Other rules of those sections continue to apply to the extent

relevant.

(E) Safe harbor for exchange listed debt instruments. If a

contingent payment debt instrument is exchange listed property (within

the meaning of Sec. 1.1273-2(f)(2)), it is reasonable for a holder of

the debt instrument to allocate any difference between the holder's

basis and the adjusted issue price of the debt instrument pro-rata to

daily portions of interest (as determined under paragraph (b)(3)(iii)

of this section) over the remaining term of the debt instrument.

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

paragraph (b)(9)(i) of this section. In each example, assume that the

debt instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes. In addition, assume that each debt instrument is not exchange

listed property.

Example 1. Basis greater than adjusted issue price--(i) Facts.

On July 1, 1997, Z purchases for $1,405 a debt instrument that

matures on December 31, 1998, and promises to pay on the maturity

date $1,000 plus the increase, if any, in the price of a specified

amount of a commodity from the issue date to the maturity date. The

debt instrument was originally issued on January 1, 1996, for an

issue price of $1,000. Z is a calendar year taxpayer. The projected

payment schedule for the debt instrument (determined as of the issue

date) provides for a single payment at maturity of $1,350. Thus, the

debt instrument has a projected yield of 10.25 percent, compounded

semiannually. At the time of the purchase, the debt instrument has

an adjusted issue price of $1,162, assuming semiannual accrual

periods ending on December 31 and June 30 of each year. The increase

in the value of the debt instrument over its adjusted issue price is

due to an increase in the expected amount of the contingent payment

and not to a decrease in market interest rates.

(ii) Allocation of the difference between basis and adjusted

issue price. Z's basis in the debt instrument on July 1, 1997, is

$1,405. Under paragraph (b)(9)(i)(B) of this section, Z allocates

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

($1,162) to the contingent payment at maturity. Z's allocation of

the difference between basis and adjusted issue price is reasonable

because the increase in the value of the debt instrument over its

adjusted issue price is due to an increase in the expected amount of

the contingent payment.

(iii) Treatment of debt instrument for 1997. Based on the

projected payment schedule, $60 of interest accrues on the debt

instrument from July 1, 1997 to December 31, 1997 (the product of

the debt instrument's adjusted issue price on July 1, 1997 ($1,162)

and the projected yield properly adjusted for the length of the

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

adjustments for 1997. Thus, Z includes in income $60 of total daily

portions of interest for 1997. On December 31, 1997, Z's adjusted

basis in the debt instrument is $1,465 ($1,405 original basis, plus

total daily portions of $60 for 1997).

(iv) Effect of allocation to contingent payment at maturity.

Assume that the payment actually made on December 31, 1998, is

$1,400, rather than the projected $1,350. Under paragraph (b)(6)(i)

of this section, Z has a positive adjustment of $50 on December 31,

1998. Under paragraph (b)(9)(i)(B) of this section, Z has a negative

adjustment of $243 on December 31, 1998. As a result, Z has a net

negative adjustment of $193 for 1998. This net negative adjustment

reduces to zero the $128 total daily portions of interest Z would

otherwise include in income in 1998. Accordingly, Z has no interest

income on the debt instrument for 1998. Because Z had $60 of

interest inclusions for 1997, $60 of the remaining $65 net negative

adjustment is treated by Z as an ordinary loss for 1998. The

remaining $5 of the net negative adjustment is a negative adjustment

carryforward for 1998 that reduces the amount realized by Z on the

retirement of the debt instrument from $1,350 to $1,345.

(v) Loss at maturity. On December 31, 1998, Z's basis in the

debt instrument is $1,350 ($1,405 original basis, plus total daily

portions of $60 for 1997 and $128 for 1998, minus the negative

adjustment of $243). As a result, Z realizes a loss of $5 on the

retirement of the debt instrument (the difference between the amount

realized ($1,345) and Z's adjusted basis in the debt instrument

($1,350)). Under paragraph (b)(8)(ii) of this section, the $5 loss

is treated as loss from the retirement of the debt instrument.

Consequently, Z realizes a total loss of $65 on the debt instrument

for 1998 (a $60 ordinary loss and a $5 loss on the retirement of the

debt instrument).

Example 2. Basis less than adjusted issue price--(i) Facts. On

January 1, 1998, Y purchases for $910 a debt instrument that pays 7

percent interest semiannually on June 30 and December 31 of each

year, and that promises to pay on December 31, 2000, $1,000 plus or

minus $10 times the positive or negative difference, if any, between

a specified amount and the value of an index on December 31, 2000.

However, the payment on December 31, 2000, may not be less than

$650. The debt instrument was originally issued on January 1, 1996,

for an issue price of $1,000. Y is a calendar year taxpayer. The

projected payment schedule for the debt instrument provides for

semiannual payments of $35 and a contingent payment at maturity of

$1,175. On January 1, 1998, the debt instrument has an adjusted

issue price of $1,060, assuming semiannual accrual periods ending on

December 31 and June 30 of each year. Since the time the debt

instrument was issued, market rates of interest on similar debt

instruments have increased from approximately 10 percent to

approximately 13 percent. In addition, because of a decrease in the

relevant index, the expected value of the contingent payment has

declined by about 9 percent.

(ii) Allocation of the difference between basis and adjusted

issue price. Y's basis in the debt instrument on January 1, 1998, is

$910. Under paragraph (b)(9)(i)(B) of this section, Y must allocate

the $150 difference between basis ($910) and adjusted issue price

($1,060) to daily portions of interest or to projected payments.

These amounts will be positive adjustments taken into account at the

time the daily portions accrue or the payments are made.

(A) Based on forward prices on January 1, 1998, Y determines

that approximately $105 of the difference between basis and adjusted

issue price is allocable to the contingent payment. Y allocates the

remaining $45 to daily portions of interest on a pro-rata basis.

This allocation is reasonable.

(B) Assume alternatively that, based on yields of comparable

debt instruments and its purchase price for the debt instrument, Y

determines that approximately $49 of the difference between basis

and adjusted issue price is allocable to daily portions of interest

as follows: $13.32 to the daily portions of interest for the taxable

year ending December 31, 1998; $16.15 to the daily portions of

interest for the taxable year ending December 31, 1999; and $19.53

to the daily portions of interest for the taxable year ending

December 31, 2000. Y allocates the remaining $101 to the contingent

payment at maturity. This allocation is reasonable.

Example 3. Secondary holder sells debt instrument--(i) Facts.

Assume the same facts as in Example 2 of this paragraph (b)(9)(i)(F)

and that Y allocates $49 to daily portions of interest and $101 to

the contingent payment at maturity, on the same basis as in

paragraph (ii)(B) of Example 2 of this paragraph (b)(9)(i)(F). In

1998, Y has a total of $104.68 of daily portions of interest,

receives two semiannual payments of $35, and has a positive

adjustment of $13.32 from the allocation. Thus, Y has $118 of

interest income on the debt instrument for 1998 ($104.68 of interest

and a $13.32 net positive adjustment). On December 31, 1998, Y has

an adjusted basis of $958 in the debt instrument ($910 original

basis, plus $104.68 total daily portions for 1998 and the $13.32

positive adjustment, minus $70 interest payments for 1998), and the

debt instrument has an adjusted issue price of $1,094.68 ($1,060

adjusted issue price on January 1, 1998, plus $104.68 total daily

portions for 1998, minus $70 interest payments for 1998).

(ii) Sale of debt instrument. Assume that Y sells the debt

instrument for $950 on January 15, 1999. In 1999, Y has total daily

portions of interest on the debt instrument (using a semiannual

accrual period ending June 30) of $4.47 and positive adjustments

allocable to the total daily portions of interest in 1999 of $0.64.

Therefore, Y has $5.11 of interest income on the debt instrument for

1999. On January 15, 1999, Y has an adjusted basis in the debt

instrument of $963.11. As a result, Y realizes a $13.11 loss on the

sale of the debt instrument. Under paragraph (b)(8)(ii) of this

section, the loss is an ordinary loss.

(ii) Fixed but deferred contingent payments. This paragraph

(b)(9)(ii) provides rules for computing interest accruals and

adjustments under paragraph (b)(3) of this section when the amount of a

contingent payment becomes fixed more than 6 months before the payment

is due. For purposes of the preceding sentence, a payment is treated as

a fixed payment if all remaining contingencies with respect to the

payment are remote or incidental.

(A) Determining adjustments. The amount of the adjustment

attributable to the payment is equal to the difference between the

present value of the amount that is fixed and the present value of the

projected amount of the contingent payment. The present value of each

amount is determined by discounting the amount from the date the

payment is due to the date the payment becomes fixed, using a discount

rate equal to the projected yield on the debt instrument. The

adjustment is treated as a positive or negative adjustment, as

appropriate, on the date the contingent payment becomes fixed. See

paragraph (b)(9)(v) of this section to determine the timing of the

adjustment if all remaining contingent payments on the debt instrument

become fixed substantially contemporaneously.

(B) Payment schedule. For purposes of paragraph (b) of this

section, the contingent payment is no longer treated as a contingent

payment after the date the amount of the payment becomes fixed. On the

date the contingent payment becomes fixed, the projected payment

schedule for the debt instrument is modified prospectively to reflect

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

paragraph (b)(3)(iv) of this section when the contingent payment is

actually made.

(C) Accrual period. Notwithstanding the determination under

Sec. 1.1272-1(b)(1)(ii) of accrual periods for the debt instrument, an

accrual period ends on the day the contingent payment becomes fixed,

and a new accrual period begins on the day after the day the contingent

payment becomes fixed.

(D) Basis and adjusted issue price. The amount of any positive

adjustment on a debt instrument determined under paragraph

(b)(9)(ii)(A) of this section increases the adjusted issue price of the

instrument and the holder's adjusted basis in the instrument. The

amount of any negative adjustment on a debt instrument determined under

paragraph (b)(9)(ii)(A) of this section decreases the adjusted issue

price of the instrument and the holder's adjusted basis in the

instrument.

(E) Special rule for certain contingent interest payments.

Notwithstanding paragraphs (b)(9)(ii) (A), (B), (C), and (D) of this

section, this paragraph (b)(9)(ii)(E) applies to contingent stated

interest payments that are adjusted to compensate for contingencies

regarding the reasonableness of the debt instrument's stated rate of

interest. For example, this paragraph (b)(9)(ii)(E) applies to a debt

instrument that provides for an increase in the stated rate of interest

if the credit quality of the issuer or liquidity of the debt instrument

deteriorates. Contingent stated interest payments of this type are

recognized over the period to which they relate in a reasonable manner.

(F) Example. The following example illustrates the provisions of

paragraph (b)(9)(ii) of this section. In this example, assume that the

debt instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example. Fixed but deferred payments--(i) Facts. On January 1,

1996, B, a calendar year taxpayer, purchases a debt instrument at

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

31, 2001, and provides for a payment of $1,000 at maturity. In

addition, on December 31, 1998, and December 31, 2001, the debt

instrument provides for payments equal to the excess of the average

daily value of an index for the 6-month period ending on September

30 of the preceding year over a specified amount. The two contingent

payments are substantially similar to options on the index. Assume

that the two contingent payments are quotable contingent payments,

and that, on the issue date, the forward price of the option that is

exercisable on December 31, 1998, is $250 and the forward price of

the option that is exercisable on December 31, 2001, is $440. Assume

that B uses annual accrual periods.

(ii) Interest accrual for 1996. Under paragraph (b)(4) of this

section, the debt instrument's projected payment schedule consists

of a payment of $250 on December 31, 1998, and a payment of $1,440

on December 31, 2001. Thus, the debt instrument's projected yield is

10 percent, compounded annually. B includes a total of $100 of daily

portions of interest in income in 1996. B's adjusted basis in the

debt instrument and the debt instrument's adjusted issue price on

December 31, 1996, is $1,100.

(iii) Interest accrual for 1997--(A) Adjustment. Based on the

projected payment schedule, B would include $110 of total daily

portions of interest in income in 1997. However, assume that on

September 30, 1997, the payment due on December 31, 1998, fixes at

$300, rather than the projected $250. Thus, on September 30, 1997, B

has an adjustment equal to the difference between the present value

of the $300 fixed amount and the present value of the $250 projected

amount of the contingent payment. The present values of the two

payments are determined by discounting each payment from the date

the payment is due (December 31, 1998) to the date the payment

becomes fixed (September 30, 1997), using a discount rate equal to

10 percent, compounded annually. The present value of the fixed

payment is $266.30 and the present value of the projected amount of

the contingent payment is $221.91. Thus, on September 30, 1997, B

has a positive adjustment of $44.39 ($266.30-$221.91).

(B) Effect of adjustment. Under paragraph (b)(9)(ii)(C) of this

section, B's accrual period ends on September 30, 1997. The daily

portions of interest on the debt instrument for the period from

January 1, 1997 to September 30, 1997 total $81.49. The adjusted

issue price of the debt instrument and B's adjusted basis in the

debt instrument are thus increased over this period by $125.88 (the

sum of the daily portions of interest of $81.49 and the positive

adjustment of $44.39 made at the end of the period) to $1,225.88.

For purposes of all future accrual periods, including the new

accrual period from October 1, 1997, to December 31, 1997, the debt

instrument's projected payment schedule is modified to reflect a

fixed payment of $300 on December 31, 1998. Based on the new

adjusted issue price of the debt instrument and the new projected

payment schedule, the projected yield on the debt instrument does

not change.

(C) Interest accrual for 1997. Based on the modified projected

payment schedule, $29.55 of interest accrues during the accrual

period that ends on December 31, 1997. Because B has no other

adjustments during 1997, the $44.39 positive adjustment on September

30, 1997, results in a net positive adjustment for 1997, which is

additional interest for that year. Thus, B includes $155.43 ($81.49

+ $29.55 + $44.39) of interest in income in 1997. B's adjusted basis

in the debt instrument and the debt instrument's adjusted issue

price on December 31, 1997, is $1,255.43 ($1,225.88 from the end of

the prior accrual period plus $29.55 total daily portions for the

current accrual period).

(iv) Interest accrual for 1998. In 1998, B has no adjustments

and, based on the modified projected payment schedule, includes

$125.54 total daily portions of interest in income (rather than $121

as under the original projected payment schedule). On December 31,

1998, B's adjusted basis in the debt instrument and the adjusted

issue price of the debt instrument are increased by the $125.54

total daily portions of interest included in income under the

modified projected payment schedule, and reduced by $300, the amount

of the fixed payment on December 31, 1998, that is reflected on the

modified projected payment schedule.

(iii) Timing contingencies. This paragraph (b)(9)(iii) provides

rules for debt instruments that have both payments that are contingent

as to time and payments that are contingent as to amount.

(A) Treatment of certain options. If a taxpayer has an option to

put or call the debt instrument, to exchange the debt instrument for

other property, or to extend the maturity date of the debt instrument,

the projected payment schedule is determined by using the principles of

Sec. 1.1272-1(c)(5). If an option to put, call, or exchange the debt

instrument is assumed to be exercised under the principles of

Sec. 1.1272-1(c)(5), it is generally reasonable to assume that the

option is exercised immediately before it expires. If the option is

exercised at an earlier time, the exercise is treated as a sale or

exchange of the debt instrument.

(B) Other timing contingencies. [Reserved]

(iv) Allocation of deductions. For purposes of Sec. 1.861-8, any

amount treated as an ordinary loss under paragraph (b)(6)(iii)(B) or

(b)(8)(ii) of this section is considered a deduction that is definitely

related to the class of gross income to which interest on the relevant

debt instrument belongs. Any other deduction or loss relating to the

debt instrument will be subject to the general rules of Sec. 1.861-8.

(v) Special rule when all contingent payments become fixed.

Notwithstanding any other provision of this section, if all the

remaining contingent payments on a debt instrument become fixed

substantially contemporaneously, any positive or negative adjustment on

the instrument is spread over the remaining term of the instrument in a

reasonable manner. For purposes of the preceding sentence, a payment is

treated as a fixed payment if all remaining contingencies with respect

to the payment are remote or incidental.

(c) Method for debt instruments not subject to the noncontingent

bond method--(1) Applicability. Paragraph (c) of this section applies

to a contingent payment debt instrument that has an issue price

determined under Sec. 1.1274-2 (other than a debt instrument issued in

a potentially abusive situation). For example, paragraph (c) of this

section generally applies to a contingent payment debt instrument that

is issued for nonpublicly traded property.

(2) Separation into components. In the case of a debt instrument

subject to paragraph (c) of this section (the overall debt instrument),

the noncontingent payments and any quotable contingent payments (as

defined in paragraph (b)(4)(i) of this section) are subject to the

rules in paragraph (c)(3) of this section, and the nonquotable

contingent payments (as defined in paragraph (b)(4)(ii) of this

section) are accounted for separately under the rules in paragraph

(c)(4) of this section.

(3) Treatment of noncontingent and quotable contingent payments.

The noncontingent payments and any quotable contingent payments are

treated as a separate debt instrument. The issue price of the separate

debt instrument is the issue price of the overall debt instrument,

determined under Sec. 1.1274-2. No interest payments on the separate

debt instrument are qualified stated interest payments (within the

meaning of Sec. 1.1273-1(c)) and the de minimis rules of section

1273(a)(3) and Sec. 1.1273-1(d) do not apply to the separate debt

instrument. If the separate debt instrument provides for a quotable

contingent payment, the rules of paragraph (b) of this section apply to

the instrument, notwithstanding paragraph (b)(1) of this section.

(4) Treatment of nonquotable contingent payments--(i) In general.

Except as provided in paragraph (c)(4)(iii) of this section, the

portion of a nonquotable contingent payment treated as interest under

paragraph (c)(4)(ii)(B) of this section is includible in gross income

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

respective taxable years in which the amount of the payment becomes

fixed.

(ii) Recharacterization of certain nonquotable contingent

payments--(A) Amount treated as principal. In general, a nonquotable

contingent payment is treated as a payment of principal in an amount

equal to the present value of the payment, determined by discounting

the payment at the test rate from the date that the amount of the

payment becomes fixed to the issue date. However, a nonquotable

contingent payment accompanied by a payment of adequate stated interest

is treated entirely as a payment of principal.

(B) Amount treated as interest. If the total amount of a

nonquotable contingent payment exceeds the amount of the payment

treated as principal under paragraph (c)(4)(ii)(A) of this section, the

excess is treated as a payment of interest.

(C) Test rate. The test rate used for purposes of paragraph

(c)(4)(ii)(A) of this section is the rate that would be the test rate

for the overall debt instrument under Sec. 1.1274-4 if the term of the

overall debt instrument began on the issue date of the overall debt

instrument and ended on the date the contingent payment is fixed.

(iii) Certain delayed contingent payments--(A) Deemed issuance of

separate debt instrument. If a nonquotable contingent payment becomes

fixed more than 6 months before the payment is due, the issuer and

holder are treated as if the issuer had issued a separate debt

instrument on the date the amount of the payment becomes fixed,

maturing on the date that the payment is due. This separate debt

instrument is treated as a debt instrument to which section 1274

applies. The stated principal amount of this separate debt instrument

is the amount of the payment that becomes fixed. An amount equal to the

issue price of this debt instrument is characterized as interest or

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

accounted for under paragraph (c)(4)(i) of this section, as if this

amount had been paid by the issuer to the holder on the date that the

amount of the payment becomes fixed. To determine the issue price of

the separate debt instrument, all payments under the separate debt

instrument are discounted at the test rate from the maturity date of

the separate debt instrument to the date that the amount of the payment

becomes fixed. The amount of a contingent payment is treated as fixed

even if, once fixed, the payment is payable in the future together with

interest that is subject to further contingencies.

(B) Test rate. In applying section 1274 to a separate debt

instrument described in paragraph (c)(4)(iii)(A) of this section, the

test rate for the separate debt instrument is the rate that would be

the test rate for the overall debt instrument under Sec. 1.1274-4 if

the term of the overall debt instrument began on the issue date of the

overall debt instrument and ended on the date the contingent payment is

due.

(5) Gain on sale, exchange, or retirement. Any gain recognized by a

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

subject to paragraph (c) of this section is interest income. The

preceding sentence does not apply, however, if, at the time of the

sale, exchange, or retirement, there are no remaining contingent

payments on the debt instrument. For purposes of the preceding

sentence, if a contingent payment becomes fixed more than 6 months

before it is due, it is no longer treated as a contingent payment after

the date it is fixed.

(6) Examples. The following examples illustrate the provisions of

paragraph (c) of this section. In each example, assume that the

instrument described is a debt instrument for federal income tax

purposes. No inference is intended, however, as to whether the debt

instrument constitutes a debt instrument for federal income tax

purposes.

Example 1. Nonquotable contingent interest payments--(i) Facts.

A owns Blackacre, unencumbered depreciable real estate. On January

1, 1996, A sells Blackacre to B. As consideration for the sale, B

makes a downpayment of $1,000,000 and issues to A a debt instrument

that matures on December 31, 2000. The debt instrument provides for

a payment of principal at maturity of $5,000,000 and a contingent

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

percentage of the gross rents B receives from Blackacre in that

year. Assume that the contingent interest payments are nonquotable

contingent payments and that the debt instrument is not issued in a

potentially abusive situation. Assume also that on January 1, 1996,

the short-term applicable Federal rate is 5 percent, compounded

annually, and the mid-term applicable Federal rate is 6 percent,

compounded annually.

(ii) Determination of issue price. Under Sec. 1.1274-2(g), the

stated principal amount of the debt instrument is $5,000,000. The

imputed principal amount of the debt instrument is $3,736,291, which

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

noncontingent payment due at maturity, calculated using a discount

rate equal to the mid-term applicable Federal rate. Therefore, under

Sec. 1.1274-2(c), the issue price of the debt instrument is

$3,736,291. Under Sec. 1.1012-1(g), B's basis in Blackacre on

January 1, 1996, is $4,736,291 ($1,000,000 down payment plus the

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

(iii) Noncontingent payment treated as separate debt instrument.

Under paragraph (c)(3) of this section, the right to the

noncontingent payment of principal at maturity is treated as a

separate debt instrument. The issue price of this separate debt

instrument is $3,736,291 (the issue price of the overall debt

instrument). The separate debt instrument has a stated redemption

price at maturity of $5,000,000 and, therefore, OID of $1,263,709.

(iv) Treatment of contingent payments. Assume that the amount of

contingent interest that is fixed and payable on December 31, 1996,

is $200,000. Under paragraph (c)(4)(ii)(A) of this section, this

payment is treated as consisting of a payment of principal of

$190,476, which is the present value of the payment, determined by

discounting the payment at the test rate of 5 percent, compounded

annually, from the date the payment becomes fixed to the issue date.

Under paragraph (c)(4)(ii)(B) of this section, the remainder of the

$200,000 payment, $9,524, is treated as interest. The additional

amount treated as principal gives B additional basis in Blackacre on

December 31, 1996. The portion of the payment treated as interest is

includible in gross income by A and deductible by B in their

respective taxable years in which December 31, 1996 occurs. The

remaining contingent payments on the debt instrument are accounted

for similarly, using a test rate of 5 percent, compounded annually,

for the contingent payments due on December 31, 1997, and December

31, 1998, and a test rate of 6 percent, compounded annually, for the

contingent payments due on December 31, 1999, and December 31, 2000.

Example 2. Fixed but deferred payment--(i) Facts. The facts are

the same as in Example 1 of this paragraph (c)(6), except that the

contingent payment of interest that is fixed on December 31, 1996,

is not payable until December 31, 2000, the maturity date.

(ii) Determination of issue price. The determination of the

issue price of the debt instrument, and B's initial basis in

Blackacre, is made in a manner the same as that described in

paragraph (ii) of Example 1 of this paragraph (c)(6). Accordingly,

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

(iii) Treatment of noncontingent payment. The right to the

noncontingent payment of principal is treated as a separate debt

instrument in a manner the same as that described in paragraph (iii)

of Example 1 of this paragraph (c)(6).

(iv) Treatment of contingent payments. Assume that the amount of

the payment that becomes fixed on December 31, 1996, is $200,000.

Because this amount is not payable until December 31, 2000 (the

maturity date), under paragraph (c)(4)(iii) of this section, a

separate debt instrument to which section 1274 applies is treated as

issued by B on December 31, 1996 (the date the payment is fixed).

The maturity date of this separate debt instrument is December 31,

2000 (the date on which the payment is due). The stated principal

amount of this separate debt instrument is $200,000, the amount of

the payment that becomes fixed. The imputed principal amount of the

separate debt instrument is $158,419, which is the present value, as

of December 31, 1996, of the $200,000 payment, computed using a

discount rate equal to the test rate of the overall debt instrument

(6 percent, compounded annually). An amount equal to the issue price

of the separate debt instrument is treated as an amount paid on

December 31, 1996, and characterized as interest and principal under

the rules of paragraph (c)(4)(ii) of this section. The amount of the

deemed payment characterized as principal is equal to $150,875,

which is the present value, as of January 1, 1996 (the issue date of

the overall debt instrument) of the deemed payment, computed using a

discount rate of 5 percent, compounded annually. The amount of the

deemed payment characterized as interest is $7,544

($158,419-$150,875) which is includible in gross income by A and

deductible by B in their respective taxable years in which December

31, 1996 occurs. The contingent payments made on December 31, 1997,

December 31, 1998, December 31, 1999, and December 31, 2000, are

treated in a manner the same as that described in paragraph (iv) of

Example 1 of this paragraph (c)(6).

(d) Rules for tax-exempt obligations--(1) Applicability. This

paragraph (d) provides rules for tax-exempt obligations (as defined in

section 1275(a)(3)) subject to this section.

(2) Noncontingent bond method generally applicable--(i) In general.

Except as modified by this paragraph (d), the rules of paragraph (b) of

this section apply to tax-exempt obligations.

(ii) Daily portions. The daily portions of interest determined

under paragraph (b)(3)(iii) of this section are not included in gross

income by the holder.

(iii) Modification to projected payment schedule. The yield on a

tax-exempt obligation may not exceed the greater of the yield on the

obligation determined without regard to the contingent payments, and

the tax-exempt applicable Federal rate, as determined for purposes of

section 1288(b)(1), that applies to the obligation. If the projected

yield determined under paragraph (b)(2)(ii) of this section exceeds the

yield determined under the preceding sentence, appropriate adjustments

must be made to the projected payment schedule to create a projected

yield that meets this requirement.

(iv) Positive adjustments. Positive adjustments on a tax-exempt

obligation are taken into account under this paragraph (d)(2)(iv)

rather than under paragraph (b)(6) of this section. A positive

adjustment on a tax-exempt obligation is treated as taxable gain to the

holder from the sale or exchange of the obligation in the taxable year

of the adjustment.

(v) Negative adjustments. Negative adjustments on a tax-exempt

obligation are taken into account under this paragraph (d)(2)(v) rather

than under paragraph (b)(6) of this section.

(A) Reduction of interest accruals. Total negative adjustments for

a taxable year first reduce the tax-exempt interest the holder would

otherwise account for on the tax-exempt obligation for the taxable year

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

(B) Reduction of other tax-exempt interest for taxable year. If the

total negative adjustments on the tax-exempt obligation for a taxable

year exceed the tax-exempt interest for the taxable year that the

holder would otherwise account for on the tax-exempt obligation under

paragraph (b)(3)(iii) of this section, the excess is treated as a

reduction of the holder's other tax-exempt interest income for the

taxable year. However, the amount treated as a reduction is limited to

the amount by which the total tax-exempt interest the holder accounted

for on the tax-exempt obligation in prior taxable years exceeds the

amount of the holder's total negative adjustments on the tax-exempt

obligation that reduced other tax-exempt interest under this paragraph

(d)(2)(v)(B) in prior taxable years.

(C) Carryforward of negative adjustment. If the total negative

adjustments on the tax-exempt obligation for a taxable year exceed the

sum of the amounts treated as a reduction of tax-exempt interest under

paragraphs (d)(2)(v)(A) and (B) of this section, the excess is a

negative adjustment carryforward for the taxable year.

(1) In general. Except as provided in paragraph (d)(2)(v)(C)(2) of

this section, a negative adjustment carryforward on a tax-exempt

obligation for a taxable year is treated as a negative adjustment on

the tax-exempt obligation on the first day of the succeeding taxable

year.

(2) In year of sale, exchange, or retirement. Any negative

adjustment carryforward on a tax-exempt obligation for a taxable year

in which the debt instrument is sold, exchanged, or retired reduces the

amount realized by the holder on the sale, exchange, or retirement.

(vi) Gains. Notwithstanding paragraph (b)(8) of this section, any

gain recognized on the sale, exchange, or retirement of a tax-exempt

obligation is gain from the sale or exchange of the obligation.

(vii) Losses--(A) Reduction of tax-exempt interest income.

Notwithstanding paragraph (b)(8) of this section, any loss recognized

on the sale, exchange, or retirement of a tax-exempt obligation is

treated as a reduction of the holder's tax-exempt interest income for

the taxable year of the sale, exchange, or retirement. However, the

amount treated as a reduction of tax- exempt interest income by the

holder is limited to the amount by which the holder's total tax-exempt

interest on the obligation exceeds the holder's total negative

adjustments on the obligation that were treated as reductions of tax-

exempt interest income under paragraph (d)(2)(v)(B) of this section. If

the amount that would reduce tax-exempt interest income measured under

the preceding sentence exceeds the holder's total tax-exempt interest

income for the taxable year, the excess is carried forward to reduce

the holder's tax-exempt interest income in subsequent taxable years.

(B) Treatment of excess losses. If the loss recognized by a holder

on the sale, exchange, or retirement of a tax-exempt obligation exceeds

the amount measured under paragraph (d)(2)(vii)(A) of this section, the

excess is treated as loss from the sale or exchange of the tax-exempt

obligation.

(e) Timing of income and deductions from notional principal

contracts. For the rules governing the timing of income and deductions

with respect to notional principal contracts characterized as including

a loan, see Sec. 1.446-3.

(f) Effective date. This section is effective for debt instruments

issued on or after the date that is 60 days after final regulations are

published in the Federal Register.

Par. 8. Section 1.1275-5 is amended by:

1. Revising paragraph (a)(1).

2. Adding the word ``only'' immediately following the parenthetical

in the introductory language of paragraph (a)(3)(i).

3. Removing the language ``less than 1 year'' in the first sentence

of paragraph (a)(3)(ii) and adding the language ``1 year or less'' in

its place.

4. Adding paragraph (a)(5).

5. Revising paragraph (c)(1).

6. Revising the text of paragraph (d) preceding the examples,

revising Examples 4 through 6, and adding Example 10.

7. Revising paragraph (e)(2).

8. Revising the text of paragraph (e)(3)(v) preceding the examples

and revising Example 3.

The revisions and additions read as follows:

Sec. 1.1275-5 Variable rate debt instruments.

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

variable rate debt instruments. A variable rate debt instrument is a

debt instrument that meets the conditions described in paragraphs (a)

(2), (3), (4), and (5) of this section. If a debt instrument that

provides for a variable rate of interest does not qualify as a variable

rate debt instrument, the debt instrument is a contingent payment debt

instrument. See Sec. 1.1275-4 for the treatment of a contingent payment

debt instrument. If a taxpayer holds (or issues) a variable rate debt

instrument that the taxpayer hedges, see Sec. 1.1275-6 for the

treatment of the debt instrument and the hedge by the taxpayer.

* * * * *

(5) No contingent principal payments. The debt instrument must not

provide for any principal payments that are contingent (within the

meaning of Sec. 1.1275-4(a)).

* * * * *

(c) Objective rate--(1) In general--(i) Debt instruments issued on

or after the date that is 60 days after final regulations are published

in the Federal Register--(A) In general. Except as provided in

paragraph (c)(1)(i)(B) of this section, for debt instruments issued on

or after the date that is 60 days after final regulations are published

in the Federal Register, an objective rate is a rate (other than a

qualified floating rate) that is determined using a single fixed

formula and that is based on objective financial or economic

information. For example, an objective rate generally includes a rate

that is based on one or more qualified floating rates or on the yield

of actively traded personal property (within the meaning of section

1092(d)(1)).

(B) Exception. For purposes of paragraph (c)(1)(i)(A) of this

section, an objective rate does not include a rate based on information

that is within the control of the issuer (or a related party within the

meaning of section 267(b) or 707(b)(1)) or that is unique to the

circumstances of the issuer (or a related party within the meaning of

section 267(b) or 707(b)(1)), such as dividends, profits, or the value

of the issuer's stock. However, a rate does not fail to be an objective

rate merely because it is based on the credit quality of the issuer.

(ii) Debt instruments issued after April 3, 1994, and before the

date that is 60 days after final regulations are published in the

Federal Register. For debt instruments issued after April 3, 1994, and

before the date that is 60 days after final regulations are published

in the Federal Register, an objective rate is a rate (other than a

qualified floating rate) that is determined using a single fixed

formula and that is based on--

(A) One or more qualified floating rates;

(B) One or more rates where each rate would be a qualified floating

rate for a debt instrument denominated in a currency other than the

currency in which the debt instrument is denominated;

(C) The yield or changes in the price of one or more items of

personal property (other than stock or debt of the issuer or a related

party within the meaning of section 267(b) or 707(b)(1)), provided each

item of property is actively traded within the meaning of section

1092(d)(1) (determined without regard to section 1092(d)(3)); or

(D) A combination of rates described in paragraphs (c)(1)(ii)(A),

(B), and (C) of this section.

* * * * *

(d) Examples. The following examples illustrate the rules of

paragraphs (b) and (c) of this section. For purposes of these examples,

assume that the debt instrument is not a tax-exempt obligation. In

addition, unless otherwise provided, assume that the rate is not

reasonably expected to result in a significant front-loading or back-

loading of interest and that the rate is not based on objective

financial or economic information that is within the control of the

issuer (or a related party) or that is unique to the circumstances of

the issuer (or a related party).

* * * * *

Example 4. Rate based on changes in the value of a commodity

index. X issues a debt instrument that provides for annual interest

payments at the end of each year at a rate equal to the percentage

increase, if any, in the value of an index for the year immediately

preceding the payment. The index is based on the prices of several

actively traded commodities. Variations in the value of this

interest rate cannot reasonably be expected to measure

contemporaneous variations in the cost of newly borrowed funds.

Accordingly, the rate is not a qualified floating rate. However,

because the rate is based on objective financial information, the

rate is an objective rate.

Example 5. Rate based on a percentage of S&P 500 Index. X issues

a debt instrument that provides for annual interest payments at the

end of each year based on a fixed percentage of the value of the S&P

500 Index. Variations in the value of this interest rate cannot

reasonably be expected to measure contemporaneous variations in the

cost of newly borrowed funds and, therefore, the rate is not a

qualified floating rate. Although the rate would be an objective

rate under paragraph (c)(1)(i) of this section, the rate is not an

objective rate because it is reasonably expected that the average

value of the rate during the first half of the instrument's term

will be significantly less than the average value of the rate during

the final half of the instrument's term.

Example 6. Rate based on issuer's profits. Z issues a debt

instrument that provides for annual interest payments equal to 20

percent of Z's net profits earned during the year immediately

preceding the payment. Variations in the value of this interest rate

cannot reasonably be expected to measure contemporaneous variations

in the cost of newly borrowed funds. Accordingly, the rate is not a

qualified floating rate. In addition, because the stated rate is

based on objective financial information that is unique to the

issuer's circumstances, the rate is not an objective rate.

* * * * *

Example 10. Rate based on an inflation index. On January 1,

1996, X issues a debt instrument that provides for annual interest

payments at the end of each year at a rate equal to 400 basis points

(4 percent) plus the annual percentage change in a general inflation

index (e.g., the Consumer Price Index, U.S. City Average, All Items,

for all Urban Consumers, seasonally unadjusted). Variations in the

value of this interest rate cannot reasonably be expected to measure

contemporaneous variations in the cost of newly borrowed funds.

Accordingly, the rate is not a qualified floating rate. However,

because the rate is based on objective economic information, the

rate is an objective rate.

(e) ***

(2) Variable rate debt instrument that provides for annual payments

of interest at a single variable rate. If a variable rate debt

instrument provides for stated interest at a single qualified floating

rate or objective rate that is unconditionally payable in cash or in

property (other than debt instruments of the issuer), or that will be

constructively received under section 451, at least annually--

(i) All stated interest with respect to the debt instrument is

quali

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