# Debt Instruments With Original Issue Discount; Contingent Payments

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URL: https://www.frixlaw.com/law-library/documents/fr%3A94-30728

## Record

- **Collection:** Federal Register
- **Document type:** Uncategorized Document
- **Published:** December 16, 1994

## Text

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 pa

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A94-30728. Public record. Not legal advice.