Debt Instruments With Original Issue Discount; Contingent Payments; Anti-Abuse Rule

Federal RegisterJun 14, 1996

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8674]

RIN 1545-AQ86; 1545-AS35

Debt Instruments With Original Issue Discount; Contingent

Payments; Anti-Abuse Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the tax

treatment of debt instruments that provide for one or more contingent

payments. This document also contains final regulations that treat a

debt instrument and a related hedge as an integrated transaction. In

addition, this document contains amendments to the original issue

discount regulations, and finalizes the anti-abuse rule relating to

those regulations. The final regulations in this document provide

needed guidance to holders and issuers of contingent payment debt

instruments.

DATES: Except as noted below, the regulations are effective August 13,

1996. The amendments to Sec. 1.1275-5 are effective June 14, 1996,

except for paragraphs (a)(6), (b)(2), and (c)(1), which are effective

August 13, 1996. The removal of Sec. 1.483-2T is effective June 14,

1996. The removal of Sec. 1.1275-2T is effective August 13, 1996.

For dates of applicability of these regulations, see Effective

Dates under Supplementary Information.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations (other than

Sec. 1.1275-6), William E. Blanchard, (202) 622-3950, or Jeffrey W.

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

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

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

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

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

control number 1545-1450. Responses to these collections of information

are required to determine a taxpayer's interest income or deductions on

a contingent payment debt instrument.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated annual burden per respondent/recordkeeper varies from

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

estimated average of .47 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and to the Office of Management and Budget, Attn: Desk

Officer for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to the collections of information must be

retained as long as their contents may become material in the

administration

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of any internal revenue law. Generally, tax returns and tax return

information are confidential, as required by 26 U.S.C. 6103.

Background

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

Secretary the authority to prescribe regulations under the original

issue discount (OID) provisions of the Code (sections 163(e) and 1271

through 1275), including regulations relating to debt instruments that

provide for contingent payments. On February 2, 1994, the IRS published

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

the final OID regulations did not contain rules for contingent payment

debt instruments.

On December 16, 1994, the IRS published a notice of proposed

rulemaking in the Federal Register (59 FR 62884) relating to the tax

treatment of debt instruments that provide for one or more contingent

payments. The notice also contained proposed amendments to the

regulations under sections 483 (relating to unstated interest), 1001

(relating to the amount realized on a sale, exchange, or other

disposition of property), 1272 (relating to the accrual of OID), 1274

(relating to debt instruments issued for nonpublicly traded property),

and 1275(c) (relating to OID information reporting requirements), and

to Sec. 1.1275-5 (relating to variable rate debt instruments). In

addition, the notice contained proposed regulations relating to the

integration of a contingent payment or variable rate debt instrument

with a related hedge. The notice withdrew the proposed regulations

relating to contingent payment debt instruments that were previously

published in the Federal Register on April 8, 1986 (51 FR 12087), and

February 28, 1991 (56 FR 8308).

On March 16, 1995, the IRS held a public hearing on the proposed

regulations. In addition, the IRS received a number of written comments

on the proposed regulations. The proposed regulations, with certain

changes to respond to comments, are adopted as final regulations. In

addition, certain clarifying and conforming amendments are made to the

OID regulations that were published in the Federal Register on February

2, 1994. The comments and significant changes are discussed below.

Explanation of Provisions

Section 1.1275-4 Contingent Payment Debt Instruments

A. Noncontingent Bond Method

Under the noncontingent bond method in the proposed regulations, a

taxpayer computes interest accruals on a contingent payment debt

instrument by setting a payment schedule as of the issue date and

applying the OID rules to the payment schedule. The payment schedule

consists of all fixed payments on the debt instrument and a projected

amount for each contingent payment. For market-based contingencies

(i.e., contingencies for which price quotes are readily available), the

projected amount is the forward price of the contingency. For other

contingencies, the issuer first determines a reasonable yield for the

debt instrument and then sets projected amounts equal to the relative

expected payments on the contingencies so that the payment schedule

produces the reasonable yield. These rules were designed to produce a

yield similar to the yield the issuer would obtain on a fixed rate debt

instrument.

Commentators suggested that the regulations could be simplified if

they used the same basic methodology for both market-based and non-

market-based contingencies. In addition, commentators suggested that

forward price quotes would be variable or manipulable and that

taxpayers will set more appropriate payment schedules if they first

determine yield and then set the payment schedule to fit the yield.

The final regulations adopt these suggestions and generally conform

the treatment of debt instruments that provide for either market-based

or non-market-based contingent payments. Thus, for any contingent

payment debt instrument subject to the noncontingent bond method, a

taxpayer first determines the yield on the instrument and then sets the

payment schedule to fit the yield. The yield is determined by the yield

at which the issuer would issue a fixed rate debt instrument with terms

and conditions similar to the contingent payment debt instrument (the

comparable yield). Relevant terms and conditions include the level of

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

For example, if a hedge is available such that the issuer or holder

could integrate the debt instrument and the hedge into a synthetic

fixed-rate debt instrument under the rules of Sec. 1.1275-6, the

comparable yield is the yield that the synthetic fixed-rate debt

instrument would have. If a Sec. 1.1275-6 hedge (or the substantial

equivalent) is not available, but similar fixed rate debt instruments

of the issuer trade at a price that reflects a spread above a benchmark

rate, the comparable yield is the sum of the value of the benchmark

rate on the issue date and the spread. In all cases, the yield must be

a reasonable yield for the issuer and may not be less than the

applicable Federal rate (AFR).

Once the comparable yield is determined, the payment schedule is

set to produce the comparable yield. The final regulations retain the

general approach of the proposed regulations in determining the payment

schedule. Thus, for market-based payments, the projected payment is the

forward price of the payment. For non-market-based payments, the

projected payment is the expected amount of the payment as of the issue

date.

Commentators were concerned that a taxpayer could overstate the

yield on a contingent payment debt instrument and, therefore, claim

excess interest deductions during the term of the instrument. They were

particularly concerned about a long-term debt instrument that has non-

market-based payments because the taxpayer's determination would be

hard to verify and any excess interest deductions would not be

recaptured for a long time.

The final regulations address this concern by providing that the

comparable yield for a debt instrument is presumed to be the AFR if the

instrument provides for a non-market-based payment and is part of an

issue that is marketed or sold in substantial part to tax-exempt

investors or other investors for whom the treatment of the debt

instrument is not expected to have a substantial effect on their U.S.

tax liability. A taxpayer may overcome this presumption only with clear

and convincing evidence that the comparable yield for the debt

instrument should be a specific yield that is higher than the AFR.

Appraisals and other valuations of nonpublicly traded property cannot

be used to overcome the presumption, nor can references to general

market rates. An issuer may, for example, overcome the presumption by

showing that recently issued similar debt instruments of the issuer

trade at a price that reflects a specific yield.

One commentator suggested that the use of the term projected

payment schedule caused securities law problems because the issuer

could be seen as making representations to the holder about the

expected payments. The comparable yield and projected payment schedule

determined under these regulations are for tax purposes only and are

not assurances by the

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issuer with respect to the payments. The final regulations retain the

term projected payment schedule, but an issuer may use a different term

to describe the payment schedule (e.g., payment schedule determined

under Sec. 1.1275-4) if the language used by the issuer is clear.

Under the proposed regulations, projected payments rather than

actual payments are used to determine the adjusted issue price of a

debt instrument, the holder's basis in a debt instrument, and the

amount of any contingent payment treated as made on the scheduled

retirement of a debt instrument. One commentator questioned the use of

projected payments to make these determinations. The approach in the

proposed regulations is appropriate, however, because a positive or

negative adjustment is used to take into account the difference between

the actual amount and the projected amount of a contingent payment.

This difference would be counted twice if the adjusted issue price, the

holder's basis, and the amount deemed paid on retirement were based on

the actual amount rather than the projected amount of a contingent

payment. Thus, the approach used in the proposed regulations is

retained in the final regulations.

B. Tax-Exempt Obligations

In response to comments, the rules contained in Sec. 1.1275-4(d)

relating to tax-exempt contingent payment obligations have been

revised. Under the proposed regulations, tax-exempt obligations are

generally subject to the noncontingent bond method, with the following

modifications: (1) The yield on which interest accruals are based may

not exceed the greater of the yield on the obligation, determined

without regard to the non-market-based contingent payments, and the

tax-exempt AFR that applies to the obligation; (2) Positive adjustments

are treated as gain from the sale or exchange of the obligation rather

than as interest; and (3) Negative adjustments reduce the amount of

tax-exempt interest, and, therefore, are generally not taken into

account as deductible losses. These modifications to the noncontingent

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

Treasury believe that when a property right is embedded in a tax-exempt

obligation it is generally inappropriate to treat payments on the right

as interest on an obligation of a state or political subdivision.

Several commentators suggested that the proposed regulations

relating to tax-exempt obligations are overly restrictive. These

commentators questioned the reason for limiting the rate of accrual to

the tax-exempt AFR and characterizing positive adjustments as taxable

gain rather than interest. They also questioned the fairness of

treating negative adjustments as nondeductible adjustments to tax-

exempt interest when positive adjustments are treated as taxable gain.

Some of the commentators suggested that, at a minimum, the interest

limitations should not apply to contingent obligations that pay

interest based on interest rate formulas that reflect the cost of funds

rather than changes in the value of embedded property rights. Finally,

commentators noted that programs involving municipal refinancings of

real estate projects (for example, low-income multi-family housing

projects) would be jeopardized by the proposed regulations because

payments on tax-exempt obligations issued to finance these projects are

in certain cases contingent in part on the revenues or appreciation in

value of the project.

The IRS and Treasury continue to believe that gain from a property

right should not be recharacterized as tax-exempt interest merely

because the property right is embedded in a tax- exempt obligation. The

IRS and Treasury nevertheless recognize that certain types of

traditional tax-exempt financings should not be subject to the interest

limitations of the proposed regulations (e.g., financings on which

interest is computed in a manner that relates to the cost of funds).

Accordingly, Sec. 1.1275-4(d) has been revised to include a category of

tax-exempt obligations that will be subject to the noncontingent bond

method without the tax-exempt interest limitations contained in the

proposed regulations. This category of tax-exempt obligations includes

(1) obligations that would qualify as variable rate debt instruments

(VRDIs) except for the failure to meet certain of the technical

requirements of the VRDI definition (such as the cap and floor

limitations, or the requirement that interest be paid or compounded at

least annually), and (2) certain obligations issued to refinance an

obligation, the proceeds of which were used to finance a project.

For other tax-exempt obligations, the interest restrictions of the

proposed regulations are adopted in final form. Section 1.1275-4(d) has

been revised, however, to provide that a negative adjustment is treated

as a taxable loss from the sale or exchange of the obligation, rather

than as a nondeductible adjustment to tax-exempt interest.

C. Prepaid Tuition Plans

A number of commentators asked whether contracts issued under

state-sponsored prepaid tuition plans are subject to Sec. 1.1275-4.

Although the terms of the contracts vary, the contracts generally are

issued pursuant to a plan created by a state to enable the participants

in the plan to save for post- secondary education for themselves or

other designated beneficiaries. In addition, the plans generally

provide protection against increases in the costs of higher education

or otherwise subsidize these costs, often by providing for contingent

payments that are linked to the future costs of post-secondary

education.

The commentators argue that Sec. 1.1275-4 does not apply to the

contracts because the contracts are not debt instruments for federal

income tax purposes. In addition, the commentators argue that, even if

the contracts are debt instruments, the noncontingent bond method would

be unduly burdensome and inappropriate for contracts of this type.

The final regulations under Sec. 1.1275-4 do not affect the

treatment of contracts issued pursuant to state-sponsored prepaid

tuition plans, whether or not the contracts are debt instruments. The

final regulations, like the proposed regulations, only apply to debt

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

issued pursuant to a plan created by a state to enable participants to

save for post-secondary education if the contracts are not debt

instruments. In addition, the final regulations provide an exception

for any debt instrument issued pursuant to a state-sponsored prepaid

tuition plan.

This exception applies to a contract issued pursuant to a plan or

arrangement if: The plan or arrangement is created by a state statute;

the plan or arrangement has a primary objective of enabling the

participants to pay for the costs of post-secondary education for

themselves or their designated beneficiaries; and the contingencies

under the contract are related to such purpose. These characteristics

are intended to describe all existing state-sponsored prepaid tuition

plans. Therefore, the final regulations do not change the tax treatment

of a contract issued pursuant to these plans. As a result, if the

contract is a debt instrument, the contingent payments on the contract

are not taken into account by an individual until the payments are

made.

The exception in the final regulations is intended to apply only to

the existing

[[Page 30136]]

state-sponsored prepaid tuition plans and to any future plans that are

substantially similar to the existing plans. In addition, no inference

is intended as to whether contracts issued by any state-sponsored

prepaid tuition plan are debt instruments.

D. Debt Instruments Subject to Section 1274

The proposed regulations provide a method for contingent payment

debt instruments not subject to the noncontingent bond method (i.e., a

nonpublicly traded debt instrument issued in a sale or exchange of

nonpublicly traded property). Under the method, a debt instrument's

noncontingent payments are treated as a separate debt instrument, which

is generally taxed under the rules for noncontingent debt instruments.

The debt instrument's contingent payments are taken into account when

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

based on the amount determined by discounting the payment at the AFR

from the payment date to the issue date, and the remainder is treated

as interest. Special rules are provided if a contingent payment becomes

fixed more than 6 months before it is due.

The final regulations generally adopt the method in the proposed

regulations. In addition, the final regulations contain rules for a

holder whose basis in a debt instrument is different from the

instrument's adjusted issue price (e.g., a subsequent holder).

E. Inflation-Indexed Bonds

The Treasury recently announced that it was considering issuing

bonds indexed to inflation (61 FR 25164). Depending on their ultimate

structure, the noncontingent bond method might be inappropriate for

these bonds. If the Treasury issues these bonds, the Treasury and IRS

may issue regulations to provide a simplified tax treatment for the

bonds. The treatment would require current accrual of the inflation

component.

Other Amendments to the OID Regulations

A. Alternative Payment Schedules Under Sec. 1.1272-1(c)

Section 1.1272-1(c) provides rules to determine the yield and

maturity of certain debt instruments that provide for one or more

alternative payment schedules applicable upon the occurrence of a

contingency (or contingencies), provided that the timing and amounts of

the payments that comprise each payment schedule are known as of the

issue date. Under these rules, the yield and maturity of a debt

instrument are generally determined by assuming that the payments will

be made under the payment schedule most likely to occur (based on all

the facts and circumstances as of the issue date). Special rules are

provided for unconditional options and mandatory sinking funds.

The general rules in Sec. 1.1272-1(c) produce a reasonable result

when a debt instrument has one stated payment schedule that is very

likely to occur and one or more alternative payment schedules that are

unlikely to occur. In this case, adherence to the stated payment

schedule will result in accruals on the debt instrument that reasonably

reflect the expected return on the instrument. The rules can lead to

unreasonable results, however, if a debt instrument provides for a

stated payment schedule and one or more alternative payment schedules

that differ significantly and that have a comparable likelihood of

occurring. In this case, the accruals based on the payment schedule

identified as most likely to occur could differ significantly from the

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

payment schedules and their relative probabilities of occurrence.

Because the general rules of Sec. 1.1272-1(c) could produce

unreasonable results, these rules have been modified. Under the final

regulations, if a single payment schedule is significantly more likely

than not to occur, the yield and maturity of the debt instrument are

calculated based on that payment schedule. As a result, any other debt

instrument that provides for an alternative payment schedule (other

than because of an unconditional option or mandatory sinking fund) will

generally be subject to the rules in Sec. 1.1275-4 for contingent

payment debt instruments. The final regulations generally retain the

rules for mandatory sinking funds and unconditional options.

B. Remote and Incidental Contingencies

The proposed regulations provide that a payment subject to a remote

or incidental contingency is not considered a contingent payment for

purposes of Sec. 1.1275-4. In response to a comment, the rule relating

to remote and incidental contingencies has been broadened, through the

addition of new Sec. 1.1275-2(h), to provide that remote and incidental

contingencies are generally ignored for purposes of sections 163(e)

(other than section 163(e)(5)) and 1271 through 1275 and the

regulations thereunder. Thus, for example, if an otherwise fixed

payment debt instrument provides for an additional payment that will be

made upon the occurrence of a contingency and there is a remote

likelihood that the contingency will occur, the contingent payment is

ignored for purposes of computing OID accruals on the instrument. If

the contingency occurs, however, then, solely for purposes of sections

1272 and 1273, the debt instrument is treated as reissued. Therefore,

OID on the debt instrument is redetermined.

C. Definition of Qualified Stated Interest

The addition of the rules for remote or incidental contingencies

and the changes to the rules for alternative payment schedules allow

simplification of the definition of qualified stated interest. Under

Sec. 1.1273-1(c), as published in the Federal Register on February 2,

1994, qualified stated interest must be unconditionally payable in cash

or property at least annually at a single fixed rate. Interest is

unconditionally payable only if late payment (other than a late payment

that occurs within a reasonable grace period) or nonpayment is expected

to be penalized or reasonable remedies exist to compel payment.

This definition of unconditionally payable can be read to conflict

with the alternative payment schedule rules. For example, if a debt

instrument has two alternative payment schedules, one schedule can be

stated as the required payment schedule and the other schedule can be

stated as a penalty if the required payments are not made. The required

payments might then be treated as unconditionally payable and,

therefore, as being qualified stated interest even if they would not be

qualified stated interest if treated under the alternative payment

schedule rules. Under this treatment, if a payment is not made, the

reissuance rules of the alternative payment schedule regime do not

apply. Holders can thus argue that no OID would accrue with respect to

the debt instrument even though OID would accrue if the instrument were

treated as having an alternative payment schedule and holders fully

expect any unmade payment to be made in the future.

The remote or incidental rules in Sec. 1.1275-2(h) provide a better

mechanism for determining whether a payment is qualified stated

interest and determining the treatment if no payment is made. Thus, the

final regulations modify the definition of unconditionally payable so

that interest is unconditionally payable only if reasonable legal

remedies exist to compel payment or the debt instrument otherwise

provides terms and

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conditions that make the likelihood of late payment (other than a late

payment that occurs within a reasonable grace period) or nonpayment

remote. If the payment is not made (other than because of insolvency,

default, or similar circumstances), the final regulations require a

deemed reissuance for OID purposes, which ensures that OID will accrue.

This approach should simplify the treatment of many debt instruments

and yet ensure that OID accrues in appropriate circumstances.

D. OID Anti-Abuse Rule

On February 2, 1994, the IRS published in the Federal Register

temporary and proposed regulations that contained an anti-abuse rule

for purposes of the OID regulations (Sec. 1.1275-2T (59 FR 4831);

Sec. 1.1275-2(g) (59 FR 4878)). Under the anti-abuse rule, the

Commissioner can apply or depart from the regulations under section

163(e) or sections 1271 through 1275 as necessary to achieve a

reasonable result if a principal purpose in structuring a debt

instrument or engaging in a transaction is to achieve a result under

the regulations that is unreasonable in light of the applicable

statutes. This rule is adopted as a final regulation with some

clarifying changes and the addition of an example to illustrate its

application to certain contingent payment debt instruments.

E. Determination of Issue Price Under Section 1274

Under the proposed regulations, the issue price of a contingent

payment debt instrument that is subject to section 1274 (i.e., a debt

instrument issued in exchange for nonpublicly traded property) is

determined without taking into account the instrument's contingent

payments. Thus, the issue price of the debt instrument (and the buyer's

initial basis in the property) is limited to an amount determined by

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

in the property, however, is increased by the amount of a contingent

payment treated as principal. This approach was adopted primarily

because it is inappropriate to allow a buyer a basis in property that

reflects anticipated contingent payments that are uncertain in amount.

In addition, this approach limits the ability of the buyer to overstate

interest deductions over the term of the debt instrument. The approach

of the proposed regulations has been adopted in the final regulations

for taxable debt instruments subject to section 1274. See Sec. 1.1274-

2(g).

It is not appropriate, however, to apply this approach to tax-

exempt contingent payment obligations subject to section 1274. Because

the present value of projected contingent payments generally is not

included in the issue price of a taxable debt instrument subject to

section 1274, the instrument is accounted for under Sec. 1.1275-4(c).

This regime is not appropriate for tax-exempt obligations because it

does not distinguish between tax-exempt interest and gain attributable

to an embedded property right. Thus, in order to permit tax-exempt

obligations to be subject to the noncontingent bond method under

Sec. 1.1275-4(b), the final regulations provide special rules to

determine the issue price of a tax-exempt contingent payment obligation

subject to section 1274.

Under these rules, the issue price of a tax-exempt contingent

payment obligation subject to section 1274 is equal to the fair market

value of the obligation on the issue date (or, in the case of an

obligation that provides for interest-based or revenue-based payments,

the greater of the obligation's fair market value or stated principal

amount). In addition, the obligation is subject to the rules of

Sec. 1.1275-4(d) (the noncontingent bond method for tax-exempt

contingent payment obligations) rather than Sec. 1.1275-4(c). However,

to ensure that the buyer's basis is the same as if the buyer had issued

a taxable debt instrument, the final regulations limit the buyer's

basis to the present value of the fixed payments.

Section 1.1275-6 Integration Rules

Commentators generally approved of the integration rules in the

proposed regulations, and those rules are adopted with only two

significant changes.

First, the final regulations allow (but do not require) the

integration of a hedge with a fixed rate debt instrument. For example,

a taxpayer may integrate a fixed rate debt instrument and a swap into a

VRDI. Although the hedging transaction regulations (Sec. 1.446-4) cover

many of these transactions, the integration rules provide more certain

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

Commissioner to integrate a hedge with either a fixed rate debt

instrument or a VRDI that provides for interest at a qualified floating

rate. In these cases, treating the hedge and the debt instrument

separately is a longstanding rule that generally clearly reflects

income.

Second, in limited circumstances, the final regulations allow a

hedge to be entered into prior to the date the taxpayer issues or

acquires the debt instrument. In these circumstances, however, the

taxpayer must identify the hedge as part of an integrated transaction

on the day the hedge is entered into by the taxpayer. Under the final

regulations, if the hedging transaction has not yet had any cash flows

(including amounts paid to enter into or purchase the hedge), the

integration rules work appropriately so that any built-in gain or loss

on the hedge at the time of integration is included over the term of

the synthetic debt instrument. Thus, the final regulations put no

restriction on the time the hedging transaction has to be entered into

in this case. If there have been cash flows on the hedge, the final

regulations require the hedge to be entered into no earlier than a date

that is substantially contemporaneous with the date on which the debt

instrument is acquired. This approach should allow commercially

reasonable transactions to be integrated without the need to create

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

hedging transaction.

The rules for remote and incidental contingencies in Sec. 1.1275-

2(h) apply for purposes of the integration rules. Thus, if there is an

incidental mismatch between a Sec. 1.1275-6 hedge and a qualifying debt

instrument, a taxpayer may still integrate the hedge and the

instrument. The mismatch is dealt with according to the rules for

incidental contingencies.

The final regulations also clarify the timing of income,

deductions, gains, and losses from a hedge of a contingent payment debt

instrument not subject to integration. Under Sec. 1.446-4, the income,

deductions, gains, and losses must match the income, deductions, gains,

and losses from the debt instrument. The final regulations clarify that

gain or loss realized on a transaction that hedges a contingent payment

on a debt instrument subject to Sec. 1.1275-4(c) is taken into account

when the contingent payment is taken into account under Sec. 1.1275-

4(c). This treatment does not allow the taxpayer to change the timing

of the income, deductions, gains, and losses from the debt instrument.

Effective Dates

In general, the final regulations apply to debt instruments issued

on or after August 13, 1996. Section 1.1275-6 applies to a qualifying

debt instrument issued on or after August 13, 1996. Section 1.1275-6

also applies to a qualifying debt instrument acquired by the taxpayer

on or after August 13, 1996, if the qualifying debt instrument is a

fixed rate debt instrument or a VRDI or if the qualifying debt

instrument and the Sec. 1.1275-6 hedge are acquired by the

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taxpayer substantially contemporaneously. Except as otherwise provided

in the regulations, the changes to Sec. 1.1275-5 apply to debt

instruments issued on or after April 4, 1994.

Debt Instruments Issued Before the Effective Date of the Final

Regulations

For a contingent payment debt instrument issued before August 13,

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

instrument, including a method that would have been required under the

proposed regulations when the debt instrument was issued. However,

unless Sec. 1.1275-6 applies to the debt instrument, integration is not

a reasonable method to account for the instrument.

Consent To Change Accounting Method

The Commissioner grants consent for a taxpayer to change its method

of accounting to follow the final regulations in this document. This

consent is granted, however, only for a change for the first taxable

year in which the taxpayer must account for a debt instrument under the

final regulations. The change is made on a cut-off basis (i.e., the new

method only applies to debt instruments issued on or after August 13,

1996. Therefore, no items of income or deduction are omitted or

duplicated, and no adjustment under section 481 is allowed.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

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

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

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

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department, including Andrew C. Kittler, formerly of the Office of the

Assistant Chief Counsel (Financial Institutions and Products),

participated in developing these regulations.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

removing the entry for Sec. 1.1275-2T and adding two entries in

numerical order to read as follows:

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

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

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

Par. 2. Section 1.163-7 is amended by adding a sentence at the end

of paragraph (a) to read as follows:

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

(a) * * * To determine the amount of interest (OID) that is

deductible each year on a debt instrument that provides for contingent

payments, see Sec. 1.1275-4.

* * * * *

Par. 3. Section 1.446-4 is amended by:

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

paragraphs (a)(2)(iii) and (a)(2)(iv), respectively.

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

3. Adding a sentence at the end of paragraph (e)(4).

The additions read as follows:

Sec. 1.446-4 Hedging transactions.

(a) * * *

(2) * * *

(ii) An integrated transaction subject to Sec. 1.1275-6;

* * * * *

(e) * * *

(4) * * * Similarly, gain or loss realized on a transaction that

hedges a contingent payment on a debt instrument subject to

Sec. 1.1275-4(c) (a contingent payment debt instrument issued for

nonpublicly traded property) is taken into account when the contingent

payment is taken into account under Sec. 1.1275-4(c).

* * * * *

Sec. 1.483-2T [Removed]

Par. 4. Section 1.483-2T is removed effective June 14, 1996.

Par. 5. Section 1.483-4 is added to read as follows:

Sec. 1.483-4 Contingent payments.

(a) In general. This section applies to a contract for the sale or

exchange of property (the overall contract) if the contract provides

for one or more contingent payments and the contract is subject to

section 483. This section applies even if the contract provides for

adequate stated interest under Sec. 1.483-2. If this section applies to

a contract, interest under the contract is generally computed and

accounted for using rules similar to those that would apply if the

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

Consequently, all noncontingent payments under the overall contract are

treated as if made under a separate contract, and interest accruals on

this separate contract are computed under rules similar to those

contained in Sec. 1.1275-4(c)(3). Each contingent payment under the

overall contract is characterized as principal and interest under rules

similar to those contained in 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 December 31, 1996, A sells depreciable personal property

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

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

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

and a payment of interest on December 31 of each year, beginning in

1997, equal to a percentage of the total gross income derived from

the property in that year. However, the total interest payable on

the debt instrument over its entire term is limited to a maximum of

$50,000. Assume that on December 31, 1996, the short-term applicable

Federal rate is 4 percent, compounded annually, and the mid-term

applicable Federal rate is 5 percent, compounded annually.

(ii) Treatment of noncontingent payment as separate contract.

Each payment of interest is a contingent payment. Accordingly, under

paragraph (a) of this section, for purposes of applying section 483

to the debt instrument, the right to the noncontingent payment of

$200,000 is treated as a separate contract. The amount of unstated

interest on this separate contract is equal to $43,295, which is the

amount by which the payment ($200,000) exceeds the present value of

the payment ($156,705), calculated using the test rate of 5 percent,

compounded annually. The $200,000 payment is thus treated as

consisting of a

[[Page 30139]]

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

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

deductible by B, under their respective methods of accounting.

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

of the contingent payment that is paid on December 31, 1997, is

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

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

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

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

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

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

in which the payment occurs. The amount treated as principal gives B

additional basis in the property on December 31, 1997. The remaining

contingent payments on the debt instrument are accounted for

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

the payments made on December 31, 1998, and December 31, 1999, and a

test rate of 5 percent, compounded annually, for the payments made

on December 31, 2000, and December 31, 2001.

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

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

December 31, 1996, pursuant to a reorganization qualifying under

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

N in exchange for 30,000 shares of M voting stock and a non-

assignable right to receive up to 10,000 additional shares of M's

voting stock during the next 3 years, provided the net profits of O

exceed certain amounts specified in the contract. No interest is

provided for in the contract. No additional shares are received in

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

specified amount, and, on December 31, 1999, an additional 3,000 M

voting shares are transferred to N. The fair market value of the

3,000 shares on December 31, 1999, is $300,000. Assume that on

December 31, 1996, the short-term applicable Federal rate is 4

percent, compounded annually. M and N are calendar year taxpayers.

(ii) Allocation of interest. Section 1274 does not apply to the

right to receive the additional shares because the right is not a

debt instrument for federal income tax purposes. As a result, the

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

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

unstated interest under that section. The amount of interest

allocable to the shares is equal to the excess of $300,000 (the fair

market value of the shares on December 31, 1999) over $266,699 (the

present value of $300,000, determined by discounting the payment at

the test rate of 4 percent, compounded annually, from December 31,

1999, to December 31, 1996). As a result, the amount of interest

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

$266,699). Both M and N take the interest into account in 1999.

that occur on or after August 13, 1996.

Par. 6. Section 1.1001-1 is amended by revising paragraph (g) to

read as follows:

Sec. 1.1001-1 Computation of gain or loss.

* * * * *

(g) Debt instruments issued in exchange for property--(1) In

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

amount realized attributable to the debt instrument is the issue price

of the debt instrument as determined under Sec. 1.1273-2 or

Sec. 1.1274-2, whichever is applicable. If, however, the issue price of

the debt instrument is determined under section 1273(b)(4), the amount

realized attributable to the debt instrument is its stated principal

amount reduced by any unstated interest (as determined under section

483).

(2) Certain debt instruments that provide for contingent payments--

(i) In general. Paragraph (g)(1) of this section does not apply to a

debt instrument subject to either Sec. 1.483-4 or Sec. 1.1275-4(c)

(certain contingent payment debt instruments issued for nonpublicly

traded property).

(ii) Special rule to determine amount realized. If a debt

instrument subject to Sec. 1.1275-4(c) is issued in exchange for

property, and the income from the exchange is not reported under the

installment method of section 453, the amount realized attributable to

the debt instrument is the issue price of the debt instrument as

determined under Sec. 1.1274-2(g), increased by the fair market value

of the contingent payments payable on the debt instrument. If a debt

instrument subject to Sec. 1.483-4 is issued in exchange for property,

and the income from the exchange is not reported under the installment

method of section 453, the amount realized attributable to the debt

instrument is its stated principal amount, reduced by any unstated

interest (as determined under section 483), and increased by the fair

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

This paragraph (g)(2)(ii), however, does not apply to a debt instrument

if the fair market value of the contingent payments is not reasonably

ascertainable. Only in rare and extraordinary cases will the fair

market value of the contingent payments be treated as not reasonably

ascertainable.

(3) Coordination with section 453. If a debt instrument is issued

in exchange for property, and the income from the exchange is not

reported under the installment method of section 453, this paragraph

(g) applies rather than Sec. 15a.453-1(d)(2) to determine the

taxpayer's amount realized attributable to the debt instrument.

(4) Effective date. This paragraph (g) applies to sales or

exchanges that occur on or after August 13, 1996.

Par. 7. Section 1.1012-1 is amended by revising paragraph (g) to

read as follows:

Sec. 1.1012-1 Basis of property.

* * * * *

(g) Debt instruments issued in exchange for property--(1) In

general. For purposes of paragraph (a) of this section, if a debt

instrument is issued in exchange for property, the cost of the property

that is attributable to the debt instrument is the issue price of the

debt instrument as determined under Sec. 1.1273-2 or Sec. 1.1274-2,

whichever is applicable. If, however, the issue price of the debt

instrument is determined under section 1273(b)(4), the cost of the

property attributable to the debt instrument is its stated principal

amount reduced by any unstated interest (as determined under section

483).

(2) Certain tax-exempt obligations. This paragraph (g)(2) applies

to a tax-exempt obligation (as defined in section 1275(a)(3)) that is

issued in exchange for property and that has an issue price determined

under Sec. 1.1274-2(j) (concerning tax-exempt contingent payment

obligations and certain tax-exempt variable rate debt instruments

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

section, if this paragraph (g)(2) applies to a tax-exempt obligation,

for purposes of paragraph (a) of this section, the cost of the property

that is attributable to the obligation is the sum of the present values

of the noncontingent payments (as determined under Sec. 1.1274-2(c)).

(3) Effective date. This paragraph (g) applies to sales or

exchanges that occur on or after August 13, 1996.

Par. 8. Section 1.1271-0(b) is amended by:

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

(d) of Sec. 1.1272-1.

2. Adding an entry for paragraph (c)(7) of Sec. 1.1272-1.

3. Revising the entry for paragraph (g) and adding entries for

paragraphs (i) and (j) of Sec. 1.1274-2.

4. Revising the entry for paragraph (g) and adding entries for

paragraphs (g), (h), (i), and (j) of Sec. 1.1275-2.

5. Removing the entries for Sec. 1.1275-2T.

6. Adding entries for Sec. 1.1275-4.

7. Adding entries for paragraphs (a)(5) and (a)(6) of Sec. 1.1275-

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

Sec. 1.1275-5.

[[Page 30140]]

9. Adding entries for Sec. 1.1275-6.

The revisions and additions read as follows:

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

contents.

* * * * *

(b) * * *

* * * * *

Sec. 1.1272-1 Current Inclusion of OID in Income

* * * * *

(2) Payment schedule that is significantly more likely than not

to occur.

(3) Mandatory sinking fund provision.

(4) Consistency rule. [Reserved]

* * * * *

(7) Effective date.

(d) Certain debt instruments that provide for a fixed yield.

* * * * *

Sec. 1.1274-2 Issue Price of Debt Instruments to Which Section

1274 Applies

* * * * *

(g) Treatment of contingent payment debt instrument.

* * * * *

(i) [Reserved]

(j) Special rules for tax-exempt obligations.

(1) Certain variable rate debt instruments.

(2) Contingent payment debt instruments.

(3) Effective date.

* * * * *

Sec. 1.1275-2 Special Rules Relating to Debt Instruments

* * * * *

(g) Anti-abuse rule.

(1) In general.

(2) Unreasonable result.

(3) Examples.

(4) Effective date.

(h) Remote and incidental contingencies.

(1) In general.

(2) Remote contingencies.

(3) Incidental contingencies.

(4) Aggregation rule.

(5) Consistency rule.

(6) Subsequent adjustments.

(7) Effective date.

(i) [Reserved]

(j) Treatment of certain modifications.

* * * * *

Sec. 1.1275-4 Contingent Payment Debt Instruments

(a) Applicability.

(1) In general.

(2) Exceptions.

(3) Insolvency and default.

(4) Convertible debt instruments.

(5) Remote and incidental contingencies.

(b) Noncontingent bond method.

(1) Applicability.

(2) In general.

(3) Description of method.

(4) Comparable yield and projected payment schedule.

(5) Qualified stated interest.

(6) Adjustments.

(7) Adjusted issue price, adjusted basis, and retirement.

(8) Character on sale, exchange, or retirement.

(9) Operating rules.

bond method.

(1) Applicability.

(2) Separation into components.

(3) Treatment of noncontingent payments.

(4) Treatment of contingent payments.

(5) Basis different from adjusted issue price.

(6) Treatment of a holder on sale, exchange, or retirement.

(7) Examples.

(d) Rules for tax-exempt obligations.

(1) In general.

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

revenue-based payments

(3) All other tax-exempt obligations.

(4) Basis different from adjusted issue price.

(e) Amounts treated as interest under this section.

(f) Effective date.

Sec. 1.1275-5 Variable Rate Debt Instruments

(a) * * *

(5) No contingent principal payments.

(6) Special rule for debt instruments issued for nonpublicly

traded property.

* * * * *

(1) Definition.

* * * * *

(5) Tax-exempt obligations.

* * * * *

Sec. 1.1275-6 Integration of Qualifying Debt Instruments

(a) In general.

(b) Definitions.

(1) Qualifying debt instrument.

(2) Section 1.1275-6 hedge.

(3) Financial instrument.

(4) Synthetic debt instrument.

(1) Integration by taxpayer.

(2) Integration by Commissioner.

(d) Special rules for legging into and legging out of an

integrated transaction.

(1) Legging into.

(2) Legging out.

(e) Identification requirements.

(f) Taxation of integrated transactions.

(1) General rule.

(2) Issue date.

(3) Term.

(4) Issue price.

(5) Adjusted issue price.

(6) Qualified stated interest.

(7) Stated redemption price at maturity.

(8) Source of interest income and allocation of expense.

(9) Effectively connected income.

(10) Not a short-term obligation.

(11) Special rules in the event of integration by the

Commissioner.

(12) Retention of separate transaction rules for certain

purposes.

(13) Coordination with consolidated return rules.

(g) Predecessors and successors.

(h) Examples.

(i) [Reserved]

(j) Effective date.

Par. 9. Section 1.1272-1 is amended by:

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

2. Adding a sentence at the end of paragraph (f)(2).

3. Removing the language ``determining yield and maturity'' from

the first sentence of paragraph (j) Example 5 (iii) and adding the

language ``sections 1272 and 1273'' in its place.

4. Removing the language ``determining yield and maturity'' from

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

language ``sections 1272 and 1273'' in its place.

The revisions and addition read as follows:

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

* * * * *

(b) * * *

(2) * * *

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

than a debt instrument described in paragraph (c) or (d) of this

section or except as provided in Sec. 1.1275-4; or

* * * * *

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

determine the yield and maturity of certain debt instruments that

provide for an alternative payment schedule (or schedules) applicable

upon the occurrence of a contingency (or contingencies). This paragraph

that comprise each payment schedule are known as of the issue date and

the debt instrument is subject to paragraph (c) (2), (3), or (5) of

this section. A debt instrument does not provide for an alternative

payment schedule merely because there is a possibility of impairment of

a payment (or payments) by insolvency, default, or similar

circumstances. See Sec. 1.1275-4 for the treatment of a debt instrument

that provides for a contingency that is not described in this paragraph

(c). See Sec. 1.1273-1(c) to determine whether stated interest on a

debt instrument subject to this paragraph (c) is qualified stated

interest.

(2) Payment schedule that is significantly more likely than not to

occur. If, based on all the facts and circumstances as of the issue

date, a single payment schedule for a debt instrument, including the

stated payment schedule, is significantly more likely than not to

occur, the yield and maturity of the debt instrument are computed based

on this payment schedule.

[[Page 30141]]

(3) Mandatory sinking fund provision. Notwithstanding paragraph

(c)(2) of this section, if a debt instrument is subject to a mandatory

sinking fund provision, the provision is ignored for purposes of

computing the yield and maturity of the debt instrument if the use and

terms of the provision meet reasonable commercial standards. For

purposes of the preceding sentence, a mandatory sinking fund provision

is a provision that meets the following requirements:

(i) The provision requires the issuer to redeem a certain amount of

debt instruments in an issue prior to maturity.

(ii) The debt instruments actually redeemed are chosen by lot or

purchased by the issuer either in the open market or pursuant to an

offer made to all holders (with any proration determined by lot).

(iii) On the issue date, the specific debt instruments that will be

redeemed on any date prior to maturity cannot be identified.

(4) Consistency rule. [Reserved]

(5) Treatment of certain options. Notwithstanding paragraphs (c)

(2) and (3) of this section, the rules of this paragraph (c)(5)

determine the yield and maturity of a debt instrument that provides the

holder or issuer with an unconditional option or options, exercisable

on one or more dates during the term of the debt instrument, that, if

exercised, require payments to be made on the debt instrument under an

alternative payment schedule or schedules (e.g., an option to extend or

an option to call a debt instrument at a fixed premium). Under this

paragraph (c)(5), an issuer is deemed to exercise or not exercise an

option or combination of options in a manner that minimizes the yield

on the debt instrument, and a holder is deemed to exercise or not

exercise an option or combination of options in a manner that maximizes

the yield on the debt instrument. If both the issuer and the holder

have options, the rules of this paragraph (c)(5) are applied to the

options in the order that they may be exercised. See paragraph (j)

Example 5 through Example 8 of this section.

(6) Subsequent adjustments. If a contingency described in this

paragraph (c) (including the exercise of an option described in

paragraph (c)(5) of this section) actually occurs or does not occur,

contrary to the assumption made pursuant to this paragraph (c) (a

change in circumstances), then, solely for purposes of sections 1272

and 1273, the debt instrument is treated as retired and then reissued

on the date of the change in circumstances for an amount equal to its

adjusted issue price on that date. See paragraph (j) Example 5 and

Example 7 of this section. If, however, the change in circumstances

results in a substantially contemporaneous pro-rata prepayment as

defined in Sec. 1.1275-2(f)(2), the pro-rata prepayment is treated as a

payment in retirement of a portion of the debt instrument, which may

result in gain or loss to the holder. See paragraph (j) Example 6 and

Example 8 of this section.

(7) Effective date. This paragraph (c) applies to debt instruments

issued on or after August 13, 1996.

(d) Certain debt instruments that provide for a fixed yield. If a

debt instrument provides for one or more contingent payments but all

possible payment schedules under the terms of the instrument result in

the same fixed yield, the yield of the debt instrument is the fixed

yield. For example, the yield of a debt instrument with principal

payments that are fixed in total amount but that are uncertain as to

time (such as a demand loan) is the stated interest rate if the issue

price of the instrument is equal to the stated principal amount and

interest is paid or compounded at a fixed rate over the entire term of

the instrument. This paragraph (d) applies to debt instruments issued

on or after August 13, 1996.

* * * * *

(f) * * *

(2) * * * For purposes of the preceding sentence, the last possible

date that the debt instrument could be outstanding is determined

without regard to Sec. 1.1275-2(h) (relating to payments subject to

remote or incidental contingencies).

* * * * *

Par. 10. Section 1.1273-1 is amended by:

1. Removing the language ``principal payments uncertain as to

time'' in the fourth sentence of paragraph (a) and adding the language

``a fixed yield'' in its place.

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

3. Revising paragraph (f) Example 4.

The revisions read as follows:

Sec. 1.1273-1 Definition of OID.

* * * * *

(ii) Unconditionally payable. Interest is unconditionally payable

only if reasonable legal remedies exist to compel timely payment or the

debt instrument otherwise provides terms and conditions that make the

likelihood of late payment (other than a late payment that occurs

within a reasonable grace period) or nonpayment a remote contingency

(within the meaning of Sec. 1.1275-2(h)). For purposes of the preceding

sentence, remedies or other terms and conditions are not taken into

account if the lending transaction does not reflect arm's length

dealing and the holder does not intend to enforce the remedies or other

terms and conditions. For purposes of determining whether interest is

unconditionally payable, the possibility of nonpayment due to default,

insolvency, or similar circumstances, or due to the exercise of a

conversion option described in Sec. 1.1272-1(e) is ignored. This

paragraph (c)(1)(ii) applies to debt instruments issued on or after

August 13, 1996.

* * * * *

(f) * * *

Example 4. Qualified stated interest on a debt instrument that

is subject to an option--(i) Facts. On January 1, 1997, A issues,

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

principal payment at maturity and for annual interest payments of

$10,000. Under the terms of the debt instrument, A has the option,

exercisable on January 1, 2002, to lower the annual interest

payments to $8,000. In addition, the debt instrument gives the

holder an unconditional right to put the debt instrument back to A,

exercisable on January 1, 2002, in return for $100,000.

(ii) Amount of qualified stated interest. Under paragraph (c)(2)

of this section, the debt instrument provides for qualified stated

interest to the extent of the lowest fixed rate at which qualified

stated interest would be payable under any payment schedule. If the

payment schedule determined by assuming that the issuer's option

will be exercised and the put option will not be exercised were

treated as the debt instrument's sole payment schedule, only $8,000

of each annual interest payment would be qualified stated interest.

Under any other payment schedule, the debt instrument would provide

for annual qualified stated interest payments of $10,000.

Accordingly, only $8,000 of each annual interest payment is

qualified stated interest. Any excess of each annual interest

payment over $8,000 is included in the debt instrument's stated

redemption price at maturity.

* * * * *

Par. 11. Section 1.1274-2 is amended by:

1. Removing the language ``Sec. 1.1272-1(c)(3)(ii)'' from paragraph

(e) and adding the language ``Sec. 1.1272-1(c)(3)'' in its place.

2. Revising paragraph (g).

3. Adding and reserving paragraph (i) and adding paragraph (j).

The revisions and additions read as follows:

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

applies.

* * * * *

(g) Treatment of contingent payment debt instruments.

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

subject to section 1274 provides for one or more contingent

[[Page 30142]]

payments, the issue price of the debt instrument is the lesser of the

instrument's noncontingent principal payments and the sum of the

present values of the noncontingent payments (as determined under

paragraph (c) of this section). However, if the debt instrument is

issued in a potentially abusive situation, the issue price of the debt

instrument is the fair market value of the noncontingent payments. For

additional rules relating to a debt instrument that provides for one or

more contingent payments, see Sec. 1.1275-4. This paragraph (g) applies

to debt instruments issued on or after August 13, 1996.

* * * * *

(i) [Reserved]

(j) Special rules for tax-exempt obligations--(1) Certain variable

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

if a tax-exempt obligation (as defined in section 1275(a)(3)) is a

variable rate debt instrument (within the meaning of Sec. 1.1275-5)

that pays interest at an objective rate and is subject to section 1274,

the issue price of the obligation is the greater of the obligation's

fair market value and its stated principal amount.

(2) Contingent payment debt instruments. Notwithstanding paragraphs

(b) and (g) of this section, if a tax-exempt obligation (as defined in

section 1275(a)(3)) is subject to section 1274 and Sec. 1.1275-4, the

issue price of the obligation is the fair market value of the

obligation. However, in the case of a tax-exempt obligation that is

subject to Sec. 1.1275-4(d)(2) (an obligation that provides for

interest-based or revenue-based payments), the issue price of the

obligation is the greater of the obligation's fair market value and its

stated principal amount.

(3) Effective date. This paragraph (j) applies to debt instruments

issued on or after August 13, 1996.

Par. 12. Section 1.1275-2 is amended by adding the text of

paragraph (g), and adding paragraph (h), adding and reserving paragraph

(i), and adding paragraph (j) to read as follows:

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

* * * * *

(g) Anti-abuse rule--(1) In general. If a principal purpose in

structuring a debt instrument or engaging in a transaction is to

achieve a result that is unreasonable in light of the purposes of

section 163(e), sections 1271 through 1275, or any related section of

the Code, the Commissioner can apply or depart from the regulations

under the applicable sections as necessary or appropriate to achieve a

reasonable result. For example, if this paragraph (g) applies to a debt

instrument that provides for a contingent payment, the Commissioner can

treat the contingency as if it were a separate position.

(2) Unreasonable result. Whether a result is unreasonable is

determined based on all the facts and circumstances. In making this

determination, a significant fact is whether the treatment of the debt

instrument is expected to have a substantial effect on the issuer's or

a holder's U.S. tax liability. In the case of a contingent payment debt

instrument, another significant fact is whether the result is

obtainable without the application of Sec. 1.1275-4 and any related

provisions (e.g., if the debt instrument and the contingency were

entered into separately). A result will not be considered unreasonable,

however, in the absence of an expected substantial effect on the

present value of a taxpayer's tax liability.

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

this paragraph (g):

Example 1. A issues a current-pay, increasing-rate note that

provides for an early call option. Although the option is deemed

exercised on the call date under Sec. 1.1272-1(c)(5), the option is

not expected to be exercised by A. In addition, a principal purpose

of including the option in the terms of the note is to limit the

amount of interest income includible by the holder in the period

prior to the call date by virtue of the option rules in Sec. 1.1272-

1(c)(5). Moreover, the application of the option rules is expected

to substantially reduce the present value of the holder's tax

liability. Based on these facts, the application of Sec. 1.1272-

1(c)(5) produces an unreasonable result. Therefore, under this

paragraph (g), the Commissioner can apply the regulations (in whole

or in part) to the note without regard to Sec. 1.1272-1(c)(5).

Example 2. C, a foreign corporation not subject to U.S.

taxation, issues to a U.S. holder a debt instrument that provides

for a contingent payment. The debt instrument is issued for cash and

is subject to the noncontingent bond method in Sec. 1.1275-4(b). Six

months after issuance, C and the holder modify the debt instrument

so that there is a deemed reissuance of the instrument under section

1001. The new debt instrument is subject to the rules of

Sec. 1.1275-4(c) rather than Sec. 1.1275-4(b). The application of

Sec. 1.1275-4(c) is expected to substantially reduce the present

value of the holder's tax liability as compared to the application

of Sec. 1.1275-4(b). In addition, a principal purpose of the

modification is to substantially reduce the present value of the

holder's tax liability through the application of Sec. 1.1275-4(c).

Based on these facts, the application of Sec. 1.1275-4(c) produces

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

Commissioner can apply the noncontingent bond method to the modified

debt instrument.

Example 3. D issues a convertible debt instrument rather than an

economically equivalent investment unit consisting of a debt

instrument and a warrant. The convertible debt instrument is issued

at par and provides for annual payments of interest. D issues the

convertible debt instrument rather than the investment unit so that

the debt instrument would not have OID. See Sec. 1.1273-2(j). In

general, this is a reasonable result in light of the purposes of the

applicable statutes. Therefore, the Commissioner generally will not

use the authority under this paragraph (g) to depart from the

application of Sec. 1.1273-2(j) in this case.

(4) Effective date. This paragraph (g) applies to debt instruments

issued on or after August 13, 1996.

(h) Remote and incidental contingencies--(1) In general. This

paragraph (h) applies to a debt instrument if one or more payments on

the instrument are subject to either a remote or incidental

contingency. Whether a contingency is remote or incidental is

determined as of the issue date of the debt instrument, including any

date there is a deemed reissuance of the debt instrument under

paragraph (h)(6) (ii) or (j) of this section or Sec. 1.1272-1(c)(6).

Except as otherwise provided, the treatment of the contingency under

this paragraph (h) applies for all purposes of sections 163(e) (other

than sections 163(e)(5)) and 1271 through 1275 and the regulations

thereunder. For purposes of this paragraph (h), the possibility of

impairment of a payment by insolvency, default, or similar

circumstances is not a contingency.

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

remote likelihood either that the contingency will occur or that the

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

contingency will occur, it is assumed that the contingency will not

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

occur, it is assumed that the contingency will occur.

(3) Incidental contingencies--(i) Contingency relating to amount. A

contingency relating to the amount of a payment is incidental if, under

all reasonably expected market conditions, the potential amount of the

payment is insignificant relative to the total expected amount of the

remaining payments on the debt instrument. If a payment on a debt

instrument is subject to an incidental contingency described in this

paragraph (h)(3)(i), the payment is ignored until the payment is made.

However, see paragraph (h)(6)(i)(B) of this section for the treatment

of the debt instrument if a change in circumstances

[[Page 30143]]

occurs prior to the date the payment is made.

(ii) Contingency relating to time. A contingency relating to the

timing of a payment is incidental if, under all reasonably expected

market conditions, the potential difference in the timing of the

payment (from the earliest date to the latest date) is insignificant.

If a payment on a debt instrument is subject to an incidental

contingency described in this paragraph (h)(3)(ii), the payment is

treated as made on the earliest date that the payment could be made

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

taxpayer makes appropriate adjustments to take into account the delay

in payment. However, see paragraph (h)(6)(i)(C) of this section for the

treatment of the debt instrument if the delay is not insignificant.

(4) Aggregation rule. For purposes of paragraph (h)(2) of this

section, if a debt instrument provides for multiple contingencies each

of which has a remote likelihood of occurring but, when all of the

contingencies are considered together, there is a greater than remote

likelihood that at least one of the contingencies will occur, none of

the contingencies is treated as a remote contingency. For purposes of

paragraph (h)(3)(i) of this section, if a debt instrument provides for

multiple contingencies each of which is incidental but the potential

total amount of all of the payments subject to the contingencies is

not, under reasonably expected market conditions, insignificant

relative to the total expected amount of the remaining payments on the

debt instrument, none of the contingencies is treated as incidental.

(5) Consistency rule. For purposes of paragraphs (h)(2) and (3) of

this section, the issuer's determination that a contingency is either

remote or incidental is binding on all holders. However, the issuer's

determination is not binding on a holder that explicitly discloses that

its determination is different from the issuer's determination. Unless

otherwise prescribed by the Commissioner, the disclosure must be made

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

return for the taxable year that includes the acquisition date of the

debt instrument. See Sec. 1.1275-2(e) for rules relating to the

issuer's obligation to disclose certain information to holders.

(6) Subsequent adjustments--(i) Applicability. This paragraph

(h)(6) applies to a debt instrument when there is a change in

circumstances. For purposes of the preceding sentence, there is a

change in circumstances if--

(A) A remote contingency actually occurs or does not occur,

contrary to the assumption made in paragraph (h)(2) of this section;

(B) A payment subject to an incidental contingency described in

paragraph (h)(3)(i) of this section becomes fixed in an amount that is

not insignificant relative to the total expected amount of the

remaining payments on the debt instrument; or

paragraph (h)(3)(ii) of this section becomes fixed such that the

difference between the assumed payment date and the due date of the

payment is not insignificant.

(ii) In general. If a change in circumstances occurs, solely for

purposes of sections 1272 and 1273, the debt instrument is treated as

retired and then reissued on the date of the change in circumstances

for an amount equal to the instrument's adjusted issue price on that

date.

(iii) Contingent payment debt instruments. Notwithstanding

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

payment debt instrument subject to Sec. 1.1275-4, if a change in

circumstances occurs, no retirement or reissuance is treated as

occurring, but any payment that is fixed as a result of the change in

circumstances is governed by the rules in Sec. 1.1275-4 that apply when

the amount of a contingent payment becomes fixed.

(7) Effective date. This paragraph (h) applies to debt instruments

issued on or after August 13, 1996.

(i) [Reserved]

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

instrument are modified to defer one or more payments, and the

modification does not cause an exchange under section 1001, then,

solely for purposes of sections 1272 and 1273, the debt instrument is

treated as retired and then reissued on the date of the modification

for an amount equal to the instrument's adjusted issue price on that

date. This paragraph (j) applies to debt instruments issued on or after

August 13, 1996.

Sec. 1.1275-2T [Removed]

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

Par. 14. 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

comparable yield and projected payment schedule; or

* * * * *

Par. 15. 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.

See Sec. 1.1275-6 for a taxpayer's treatment of a contingent payment

debt instrument and a hedge.

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

(i) A debt instrument that has an issue price determined under

section 1273(b)(4) (e.g., a debt instrument subject to section 483);

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

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

instrument that provides for certain contingencies) or Sec. 1.1272-1(d)

(a debt instrument that provides for a fixed yield);

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

in section 988 and the regulations thereunder);

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

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

instruments with payments subject to acceleration);

(vi) A debt instrument (other than a tax-exempt obligation)

described in section 1272(a)(2) (e.g., U.S. savings bonds, certain

loans between natural persons, and short-term taxable obligations); or

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

if--

(A) The plan or arrangement is created by a state statute;

(B) A primary objective of the plan or arrangement is to enable the

participants to pay for the costs of post-secondary education for

themselves or their designated beneficiaries; and

objective.

[[Page 30144]]

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

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

similar circumstances.

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

provide for contingent payments merely because it provides for an

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

into the stock or debt of a related party (within the meaning of

section 267(b) or 707(b)(1)), or into cash or other property in an

amount equal to the approximate value of such stock or debt.

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

contingent payment merely because of a contingency that, as of the

issue date, is either remote or incidental. See Sec. 1.1275-2(h) for

the treatment of remote and incidental contingencies.

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

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

payment debt instrument that has an issue price determined under

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

issued for money or publicly traded property).

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

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

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

interest that is taken into account for each accrual period is

determined by constructing a projected payment schedule for the debt

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

noncontingent debt instrument. If the actual amount of a contingent

payment is not equal to the projected amount, appropriate adjustments

are made to reflect the difference.

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

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

noncontingent bond method:

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

comparable yield for the debt instrument under the rules of paragraph

(b)(4) of this section. The comparable yield is determined as of the

debt instrument's issue date.

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

the projected payment schedule for the debt instrument under the rules

of paragraph (b)(4) of this section. The projected payment schedule is

determined as of the issue date and remains fixed throughout the term

of the debt instrument (except under paragraph (b)(9)(ii) of this

section, which applies to a payment that is fixed more than 6 months

before it is due).

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

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

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

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

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

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

accrual period. See paragraph (b)(7)(ii) of this section to determine

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

interest are determined by allocating to each day in the accrual period

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

Except as modified by paragraph (b)(3)(iv) of this section, the daily

portions of interest are includible in income by a holder for each day

in the holder's taxable year on which the holder held the debt

instrument and are deductible by the issuer for each day during the

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

debt instrument.

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

differences between projected and actual contingent payments. Make

appropriate adjustments to the amount of income or deductions

attributable to the debt instrument in a taxable year for any

differences between projected and actual contingent payments. See

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

adjustment and the treatment of the adjustment.

(4) Comparable yield and projected payment schedule. This paragraph

(b)(4) provides rules for determining the comparable yield and

projected payment schedule for a debt instrument. The comparable yield

and projected payment schedule must be supported by contemporaneous

documentation showing that both are reasonable, are based on reliable,

complete, and accurate data, and are made in good faith.

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

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

instrument is the yield at which the issuer would issue a fixed rate

debt instrument with terms and conditions similar to those of the

contingent payment debt instrument (the comparable fixed rate debt

instrument), including the level of subordination, term, timing of

payments, and general market conditions. For example, if a Sec. 1.1275-

6 hedge (or the substantial equivalent) is available, the comparable

yield is the yield on the synthetic fixed rate debt instrument that

would result if the issuer entered into the Sec. 1.1275-6 hedge. If a

Sec. 1.1275-6 hedge (or the substantial equivalent) is not available,

but similar fixed rate debt instruments of the issuer trade at a price

that reflects a spread above a benchmark rate, the comparable yield is

the sum of the value of the benchmark rate on the issue date and the

spread. In determining the comparable yield, no adjustments are made

for the riskiness of the contingencies or the liquidity of the debt

instrument. The comparable yield must be a reasonable yield for the

issuer and must not be less than the applicable Federal rate (based on

the overall maturity of the debt instrument).

(B) Presumption for certain debt instruments. This paragraph

(b)(4)(i)(B) applies to a debt instrument if the instrument provides

for one or more contingent payments not based on market information and

the instrument is part of an issue that is marketed or sold in

substantial part to persons for whom the inclusion of interest under

this paragraph (b) is not expected to have a substantial effect on

their U.S. tax liability. If this paragraph (b)(4)(i)(B) applies to a

debt instrument, the instrument's comparable yield is presumed to be

the applicable Federal rate (based on the overall maturity of the debt

instrument). A taxpayer may overcome this presumption only with clear

and convincing evidence that the comparable yield for the debt

instrument should be a specific yield (determined using the principles

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

applicable Federal rate. The presumption may not be overcome with

appraisals or other valuations of nonpublicly traded property. Evidence

used to overcome the presumption must be specific to the issuer and

must not be based on comparable issuers or general market conditions.

(ii) Projected payment schedule. The projected payment schedule for

a debt instrument includes each noncontingent payment and an amount for

each contingent payment determined as follows:

(A) Market-based payments. If a contingent payment is based on

market information (a market-based payment), the amount of the

projected payment is the forward price of the contingent payment. The

forward price of a contingent payment is the amount one party would

agree, as of the issue date, to pay an unrelated party for the right to

the contingent payment on the settlement date (e.g., the date the

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

[[Page 30145]]

payment is substantially similar to an exchange-traded option, the

forward price is the spot price of the option (the option premium)

compounded at the applicable Federal rate from the issue date to the

date the contingent payment is due.

(B) Other payments. If a contingent payment is not based on market

information (a non-market-based payment), the amount of the projected

payment is the expected value of the contingent payment as of the issue

date.

payment schedule must produce the comparable yield. If the projected

payment schedule does not produce the comparable yield, the schedule

must be adjusted consistent with the principles of this paragraph

(b)(4) to produce the comparable yield. For example, the adjusted

amounts of non-market-based payments must reasonably reflect the

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

accelerate or defer income or deductions. If the debt instrument

contains both market-based and non-market-based payments, adjustments

are generally made first to the non-market-based payments because more

objective information is available for the market-based payments.

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

market information is any information on which an objective rate can be

based under Sec. 1.1275-5(c)(1) or (2).

(iv) Issuer/holder consistency. The issuer's projected payment

schedule is used to determine the holder's interest accruals and

adjustments. The issuer must provide the projected payment schedule to

the holder in a manner consistent with the issuer disclosure rules of

Sec. 1.1275-2(e). If the issuer does not create a projected payment

schedule for a debt instrument or the issuer's projected payment

schedule is unreasonable, the holder of the debt instrument must

determine the comparable yield and projected payment schedule for the

debt instrument under the rules of this paragraph (b)(4). A holder that

determines its own projected payment schedule must explicitly disclose

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

the issuer's projected payment schedule is unreasonable). Unless

otherwise prescribed by the Commissioner, the disclosure must be made

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

return for the taxable year that includes the acquisition date of the

debt instrument.

(v) Issuer's determination respected--(A) In general. If the issuer

maintains the contemporaneous documentation required by this paragraph

(b)(4), the issuer's determination of the comparable yield and

projected payment schedule will be respected unless either is

unreasonable.

(B) Unreasonable determination. For purposes of paragraph

(b)(4)(v)(A) of this section, a comparable yield or projected payment

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

purpose to overstate, understate, accelerate, or defer interest

accruals on the debt instrument. In a determination of whether a

comparable yield or projected payment schedule is unreasonable,

consideration will be given to whether the treatment of the debt

instrument under this section is expected to have a substantial effect

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

taxable issuer markets a debt instrument to a holder not subject to

U.S. taxation, the comparable yield will be given close scrutiny and

will not be respected unless contemporaneous documentation shows that

the yield is not too high.

apply to a debt instrument subject to paragraph (b)(4)(i)(B) of this

section (concerning a yield presumption for certain debt instruments

that provide for non-market-based payments).

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

this paragraph (b)(4). In each example, assume that the instrument

described is a debt instrument for federal income tax purposes. No

inference is intended, however, as to whether the instrument is a debt

instrument for federal income tax purposes.

Example 1. Market-based payment--(i) Facts. On December 31,

1996, X corporation issues for $1,000,000 a debt instrument that

matures on December 31, 2006. The debt instrument provides for

annual payments of interest, beginning in 1997, at the rate of 6

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

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

stock in an unrelated corporation on the maturity date over

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

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

the forward price to purchase 10,000 shares of the stock on December

31, 2006, is $350,000.

(ii) Comparable yield. Under paragraph (b)(4)(i) of this

section, the debt instrument's comparable yield is the yield on the

synthetic debt instrument that would result if X corporation entered

into a Sec. 1.1275-6 hedge. A Sec. 1.1275-6 hedge in this case is a

forward contract to purchase 10,000 shares of the stock on December

31, 2006. If X corporation entered into this hedge, the resulting

synthetic debt instrument would yield 6 percent, compounded

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

percent, compounded annually.

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

this section, the projected payment schedule for the debt instrument

consists of 10 annual payments of $60,000 and a projected amount for

the contingent payment at maturity. Because the right to the

contingent payment is based on market information, the projected

amount of the contingent payment is the forward price of the

payment. The right to the contingent payment is substantially

similar to a right to a payment of $1,000,000 combined with a cash-

settled forward contract for the purchase of 10,000 shares of the

stock for $350,000 on December 31, 2006. Because the forward price

to purchase 10,000 shares of the stock on December 31, 2006, is

$350,000, the amount to be received or paid under the forward

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

of the contingent payment at maturity is $1,000,000, consisting of

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

or paid under the forward contract.

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

price to purchase 10,000 shares of the stock on December 31, 2006,

is $370,000. If X corporation entered into a Sec. 1.1275-6 hedge (a

forward contract to purchase the shares for $370,000), the resulting

synthetic debt instrument would yield 6.15 percent, compounded

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

percent, compounded annually. The projected payment schedule for the

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

projected amount for the contingent payment at maturity. The

projected amount of the contingent payment is $1,020,000, consisting

of the $1,000,000 base amount plus the excess $20,000 of the forward

price of the stock over the purchase price of the stock under the

forward contract.

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

price to purchase 10,000 shares of the stock on December 31, 2006,

is $330,000. If X corporation entered into a Sec. 1.1275-6 hedge,

the resulting synthetic debt instrument would yield 5.85 percent,

compounded annually. Thus, the comparable yield on the debt

instrument is 5.85 percent, compounded annually. The projected

payment schedule for the debt instrument consists of 10 annual

payments of $60,000 and a projected amount for the contingent

payment at maturity. The projected amount of the contingent payment

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

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

contract over the forward price of the stock.

Example 2. Non-market-based payments--(i) Facts. On December 31,

1996, Y issues to Z for $1,000,000 a debt instrument that matures on

December 31, 2000. The debt instrument has a stated principal amount

of $1,000,000, payable at maturity, and provides for payments on

December 31 of each year, beginning in 1997, of $20,000 plus 1

percent of Y's gross receipts, if any, for the year. On the issue

date, Y has outstanding fixed rate debt instruments with maturities

of 2 to 10 years that trade at a price that reflects an average of

100 basis points over Treasury

[[Page 30146]]

bonds. These debt instruments have terms and conditions similar to

those of the debt instrument. Assume that on December 31, 1996, 4-

year Treasury bonds have a yield of 6.5 percent, compounded

annually, and that no Sec. 1.1275-6 hedge is available for the debt

instrument. In addition, assume that the interest inclusions

attributable to the debt instrument are expected to have a

substantial effect on Z's U.S. tax liability.

(ii) Comparable yield. The comparable yield for the debt

instrument is equal to the value of the benchmark rate (i.e., the

yield on 4-year Treasury bonds) on the issue date plus the spread.

Thus, the debt instrument's comparable yield is 7.5 percent,

compounded annually.

(iii) Projected payment schedule. Y anticipates that it will

have no gross receipts in 1997, but that it will have gross receipts

in later years, and those gross receipts will grow each year for the

next three years. Based on its business projections, Y believes that

it is not unreasonable to expect that its gross receipts in 1999 and

each year thereafter will grow by between 6 percent and 13 percent

over the prior year. Thus, Y must take these expectations into

account in establishing a projected payment schedule for the debt

instrument that results in a yield of 7.5 percent, compounded

annually. Accordingly, Y could reasonably set the following

projected payment schedule for the debt instrument:

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

Noncontingent Contingent

Date payment payment

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

12/31/1997................................... $20,000 0

12/31/1998................................... 20,000 70,000

12/31/1999................................... 20,000 75,600

12/31/2000................................... 1,020,000 83,850

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

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

instrument to which this paragraph (b) applies are qualified stated

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

(6) Adjustments. This paragraph (b)(6) provides rules for the

treatment of positive and negative adjustments under the noncontingent

bond method. A taxpayer takes into account only those adjustments that

occur during a taxable year while the debt instrument is held by the

taxpayer or while the taxpayer is primarily liable on the debt

instrument.

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

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

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

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

projected amount of the contingent payment, the difference is a

negative adjustment on the date of the payment (or on the scheduled

date of the payment if the amount of the payment is zero).

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

which total positive adjustments on a debt instrument in a taxable year

exceed the total negative adjustments on the debt instrument in the

taxable year is a net positive adjustment. A net positive adjustment is

treated as additional interest for the taxable year.

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

which total negative adjustments on a debt instrument in a taxable year

exceed the total positive adjustments on the debt instrument in the

taxable year is a net negative adjustment. A taxpayer's net negative

adjustment on a debt instrument for a taxable year is treated as

follows:

(A) Reduction of interest accruals. A net negative adjustment first

reduces interest for the taxable year that the taxpayer would otherwise

account for on the debt instrument under paragraph (b)(3)(iii) of this

section.

(B) Ordinary income or loss. If the net negative adjustment exceeds

the interest for the taxable year that the taxpayer would otherwise

account for on the debt instrument under paragraph (b)(3)(iii) of this

section, the excess is treated as ordinary loss by a holder and

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

loss by a holder is limited to the amount by which the holder's total

interest inclusions on the debt instrument exceed the total amount of

the holder's net negative adjustments treated as ordinary loss on the

debt instrument in prior taxable years. The amount treated as ordinary

income by an issuer is limited to the amount by which the issuer's

total interest deductions on the debt instrument exceed the total

amount of the issuer's net negative adjustments treated as ordinary

income on the debt instrument in prior taxable years.

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. In general, a taxpayer treats a negative adjustment

carryforward for a taxable year as a negative adjustment on the debt

instrument on the first day of the succeeding taxable year. However, if

a holder of a debt instrument has a negative adjustment carryforward on

the debt instrument in a taxable year in which the debt instrument is

sold, exchanged, or retired, the negative adjustment carryforward

reduces the holder's amount realized on the sale, exchange, or

retirement. If an issuer of a debt instrument has a negative adjustment

carryforward on the debt instrument for a taxable year in which the

debt instrument is retired, the issuer takes the negative adjustment

carryforward into account as ordinary income.

(D) Treatment under section 67. A net negative adjustment is not

subject to section 67 (the 2-percent floor on miscellaneous itemized

deductions).

(iv) Cross-references. If a holder has a basis in a debt instrument

that is different from the debt instrument's adjusted issue price, the

holder may have additional positive or negative adjustments under

paragraph (b)(9)(i) of this section. If the amount of a contingent

payment is fixed more than 6 months before the date it is due, the

amount and timing of the adjustment are determined under paragraph

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

(7) Adjusted issue price, adjusted basis, and retirement--(i) In

general. If a debt instrument is subject to the noncontingent bond

method, this paragraph (b)(7) provides rules to determine the adjusted

issue price of the debt instrument, the holder's basis in the debt

instrument, and the treatment of any scheduled or unscheduled

retirements. In general, because any difference between the actual

amount of a contingent payment and the projected amount of the payment

is taken into account as an adjustment to income or deduction, the

projected payments are treated as the actual payments for purposes of

making adjustments to issue price and basis and determining the amount

of any contingent payment made on a scheduled retirement.

(ii) Definition of adjusted issue price. The adjusted issue price

of a debt instrument is equal to the debt instrument's issue price,

increased by the interest previously accrued on the debt instrument

under paragraph (b)(3)(iii) of this section (determined without regard

to any adjustments taken into account under paragraph (b)(3)(iv) of

this section), and decreased by the amount of any noncontingent payment

and the projected amount of any contingent payment previously made on

the debt instrument. See paragraph (b)(9)(ii) of this section for

special rules that apply when a contingent payment is fixed more than 6

months before it is due.

(iii) Adjustments to basis. A holder's basis in a debt instrument

is increased by the interest previously accrued by the holder on the

debt instrument under paragraph (b)(3)(iii) of this section (determined

without regard to any adjustments taken into account under paragraph

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

noncontingent payment and the

[[Page 30147]]

projected amount of any contingent payment previously made on the debt

instrument to the holder. See paragraph (b)(9)(i) of this section for

special rules that apply when basis is different from adjusted issue

price and paragraph (b)(9)(ii) of this section for special rules that

apply when a contingent payment is fixed more than 6 months before it

is due.

(iv) Scheduled retirements. For purposes of determining the amount

realized by a holder and the repurchase price paid by the issuer on the

scheduled retirement of a debt instrument, a holder is treated as

receiving, and the issuer is treated as paying, the projected amount of

any contingent payment due at maturity. If the amount paid or received

is different from the projected amount, see paragraph (b)(6) of this

section for the treatment of the difference by the taxpayer. Under

paragraph (b)(6)(iii)(C) of this section, the amount realized by a

holder on the retirement of a debt instrument is reduced by any

negative adjustment carryforward determined in the taxable year of the

retirement.

(v) Unscheduled retirements. An unscheduled retirement of a debt

instrument (or the receipt of a pro-rata prepayment that is treated as

a retirement of a portion of a debt instrument under Sec. 1.1275-2(f))

is treated as a repurchase of the debt instrument (or a pro-rata

portion of the debt instrument) by the issuer from the holder for the

amount paid by the issuer to the holder.

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

paragraphs (b) (6) and (7) of this section. In each example, assume

that the instrument described is a debt instrument for federal income

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

instrument is a debt instrument for federal income tax purposes.

Example 1. Treatment of positive and negative adjustments--(i)

Facts. On December 31, 1996, Z, a calendar year taxpayer, purchases

a debt instrument subject to this paragraph (b) at original issue

for $1,000. The debt instrument's comparable yield is 10 percent,

compounded annually, and the projected payment schedule provides for

payments of $500 on December 31, 1997 (consisting of a noncontingent

payment of $375 and a projected amount of $125) and $660 on December

31, 1998 (consisting of a noncontingent payment of $600 and a

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

the hands of Z.

(ii) Adjustment in 1997. Based on the projected payment

schedule, Z's total daily portions of interest on the debt

instrument are $100 for 1997 (issue price of $1,000 x 10 percent).

Assume that the payment actually made on December 31, 1997, is $375,

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

section, Z has a negative adjustment of $125 on December 31, 1997,

attributable to the difference between the amount of the actual

payment and the amount of the projected payment. Because Z has no

positive adjustments for 1997, Z has a net negative adjustment of

$125 on the debt instrument for 1997. This net negative adjustment

reduces to zero the $100 total daily portions of interest Z would

otherwise include in income in 1997. Accordingly, Z has no interest

income on the debt instrument for 1997. Because Z had no interest

inclusions on the debt instrument for prior taxable years, the

remaining $25 of the net negative adjustment is a negative

adjustment carryforward for 1997 that results in a negative

adjustment of $25 on January 1, 1998.

(iii) Adjustment to issue price and basis. Z's total daily

portions of interest on the debt instrument are $100 for 1997. The

adjusted issue price of the debt instrument and Z's adjusted basis

in the debt instrument are increased by this amount, despite the

fact that Z does not include this amount in income because of the

net negative adjustment for 1997. In addition, the adjusted issue

price of the debt instrument and Z's adjusted basis in the debt

instrument are decreased on December 31, 1997, by the projected

amount of the payment on that date ($500). Thus, on January 1, 1998,

Z's adjusted basis in the debt instrument and the adjusted issue

price of the debt instrument are $600.

(iv) Adjustments in 1998. Based on the projected payment

schedule, Z's total daily portions of interest are $60 for 1998

(adjusted issue price of $600 x 10 percent). Assume that the payment

actually made on December 31, 1998, is $700, rather than the

projected $660. Under paragraph (b)(6)(i) of this section, Z has a

positive adjustment of $40 on December 31, 1998, attributable to the

difference between the amount of the actual payment and the amount

of the projected payment. Because Z also has a negative adjustment

of $25 on January 1, 1998, Z has a net positive adjustment of $15 on

the debt instrument for 1998 (the excess of the $40 positive

adjustment over the $25 negative adjustment). As a result, Z has $75

of interest income on the debt instrument for 1998 (the $15 net

positive adjustment plus the $60 total daily portions of interest

that are taken into account by Z in that year).

(v) Retirement. Based on the projected payment schedule, Z's

adjusted basis in the debt instrument immediately before the payment

at maturity is $660 ($600 plus $60 total daily portions of interest

for 1998). Even though Z receives $700 at maturity, for purposes of

determining the amount realized by Z on retirement of the debt

instrument, Z is treated as receiving the projected amount of the

contingent payment on December 31, 1998. Therefore, Z is treated as

receiving $660 on December 31, 1998. Because Z's adjusted basis in

the debt instrument immediately before its retirement is $660, Z

recognizes no gain or loss on the retirement.

Example 2. Negative adjustment carryforward for year of sale--

(i) Facts. Assume the same facts as in Example 1 of this paragraph

(b)(7)(vi), except that Z sells the debt instrument on January 1,

1998, for $630.

(ii) Gain on sale. On the date the debt instrument is sold, Z's

adjusted basis in the debt instrument is $600. Because Z has a

negative adjustment of $25 on the debt instrument on January 1,

1998, and has no positive adjustments on the debt instrument in

1998, Z has a net negative adjustment for 1998 of $25. Because Z has

not included in income any interest on the debt instrument, the

entire $25 net negative adjustment is a negative adjustment

carryforward for the taxable year of the sale. Under paragraph

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

carryforward reduces the amount realized by Z on the sale of the

debt instrument from $630 to $605. Thus, Z has a gain on the sale of

$5 ($605-$600). Under paragraph (b)(8)(i) of this section, the gain

is treated as interest income.

Example 3. Negative adjustment carryforward for year of

retirement--(i) Facts. Assume the same facts as in Example 1 of this

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

December 31, 1998, is $615, rather than the projected $660.

(ii) Adjustments in 1998. Under paragraph (b)(6)(i) of this

section, Z has a negative adjustment of $45 on December 31, 1998,

attributable to the difference between the amount of the actual

payment and the amount of the projected payment. In addition, Z has

a negative adjustment of $25 on January 1, 1998. See Example 1(ii)

of this paragraph (b)(7)(vi). Because Z has no positive adjustments

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

negative adjustment reduces to zero the $60 total daily portions of

interest Z would otherwise include in income for 1998. Therefore, Z

has no interest income on the debt instrument for 1998. Because Z

had no interest inclusions on the debt instrument for 1997, the

remaining $10 of the net negative adjustment is a negative

adjustment carryforward for 1998 that reduces the amount realized by

Z on retirement of the debt instrument.

(iii) Loss on retirement. Immediately before the payment at

maturity, Z's adjusted basis in the debt instrument is $660. Under

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

projected amount of the contingent payment, or $660, as the payment

at maturity. Under paragraph (b)(6)(iii)(C) of this section,

however, this amount is reduced by any negative adjustment

carryforward determined for the taxable year of retirement to

calculate the amount Z realizes on retirement of the debt

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

instrument, equal to the amount by which Z's adjusted basis in the

debt instrument ($660) exceeds the amount Z realizes on the

retirement of the debt instrument ($660 minus the $10 negative

adjustment carryforward). Under paragraph (b)(8)(ii) of this

section, the loss is a capital loss.

(8) Character on sale, exchange, or retirement--(i) Gain. Any gain

recognized by a holder on the sale,

[[Page 30148]]

exchange, or retirement of a debt instrument subject to this paragraph

(b) is interest income.

(ii) Loss. Any loss recognized by a holder on the sale, exchange,

or retirement of a debt instrument subject to this paragraph (b) is

ordinary loss to the extent that the holder's total interest inclusions

on the debt instrument exceed the total net negative adjustments on the

debt instrument the holder took into account as ordinary loss. Any

additional loss is treated as loss from the sale, exchange, or

retirement of the debt instrument. However, any loss that would

otherwise be ordinary under this paragraph (b)(8)(ii) and that is

attributable to the holder's basis that could not be amortized under

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

debt instrument.

(iii) Special rule if there are no remaining contingent payments on

the debt instrument--(A) In general. Notwithstanding paragraphs (b)(8)

(i) and (ii) of this section, if, at the time of the sale, exchange, or

retirement of the debt instrument, there are no remaining contingent

payments due on the debt instrument under the projected payment

schedule, any gain or loss recognized by the holder is gain or loss

from the sale, exchange, or retirement of the debt instrument. See

paragraph (b)(9)(ii) of this section to determine whether there are no

remaining contingent payments on a debt instrument that provides for

fixed but deferred contingent payments.

(B) Exception for certain positive adjustments. Notwithstanding

paragraph (b)(8)(iii)(A) of this section, if a positive adjustment on a

debt instrument is spread under paragraph (b)(9)(ii) (F) or (G) of this

section, any gain recognized by the holder on the sale, exchange, or

retirement of the instrument is treated as interest income to the

extent of the positive adjustment that has not yet been accrued and

included in income by the holder.

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

this paragraph (b)(8). In each example, assume that the instrument

described is a debt instrument for federal income tax purposes. No

inference is intended, however, as to whether the instrument is a debt

instrument for federal income tax purposes.

Example 1. Gain on sale--(i) Facts. On January 1, 1998, D, a

calendar year taxpayer, sells a debt instrument that is subject to

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

schedule for the debt instrument provides for contingent payments

after January 1, 1998. On January 1, 1998, D has an adjusted basis

in the debt instrument of $1,200. In addition, D has a negative

adjustment carryforward of $50 for 1997 that, under paragraph

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

$50 on January 1, 1998. D has no positive adjustments on the debt

instrument on January 1, 1998.

(ii) Character of gain. Under paragraph (b)(6) of this section,

the $50 negative adjustment on January 1, 1998, results in a

negative adjustment carryforward for 1998, the taxable year of the

sale of the debt instrument. Under paragraph (b)(6)(iii)(C) of this

section, the negative adjustment carryforward reduces the amount

realized by D on the sale of the debt instrument from $1,350 to

$1,300. As a result, D realizes a $100 gain on the sale of the debt

instrument, equal to the $1,300 amount realized minus D's $1,200

adjusted basis in the debt instrument. Under paragraph (b)(8)(i) of

this section, the gain is interest income to D.

Example 2. Loss on sale--(i) Facts. On December 31, 1996, E, a

calendar year taxpayer, purchases a debt instrument at original

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

hands of E. The debt instrument provides for a single payment on

December 31, 1998 (the maturity date of the instrument), of $1,000

plus an amount based on the increase, if any, in the price of a

specified commodity over the term of the instrument. The comparable

yield for the debt instrument is 9.54 percent, compounded annually,

and the projected payment schedule provides for a payment of $1,200

on December 31, 1998. Based on the projected payment schedule, the

total daily portions of interest are $95 for 1997 and $105 for 1998.

(ii) Ordinary loss. Assume that E sells the debt instrument for

$1,050 on December 31, 1997. On that date, E has an adjusted basis

in the debt instrument of $1,095 ($1,000 original basis, plus total

daily portions of $95 for 1997). Therefore, E realizes a $45 loss on

the sale of the debt instrument ($1,050-$1,095). The loss is

ordinary to the extent E's total interest inclusions on the debt

instrument ($95) exceed the total net negative adjustments on the

instrument that E took into account as an ordinary loss. Because E

has not had any net negative adjustments on the debt instrument, the

$45 loss is an ordinary loss.

(iii) Capital loss. Alternatively, assume that E sells the debt

instrument for $990 on December 31, 1997. E realizes a $105 loss on

the sale of the debt instrument ($990 - $1,095). The loss is

ordinary to the extent E's total interest inclusions on the debt

instrument ($95) exceed the total net negative adjustments on the

instrument that E took into account as an ordinary loss. Because E

has not had any net negative adjustments on the debt instrument, $95

of the $105 loss is an ordinary loss. The remaining $10 of the $105

loss is a capital loss.

(9) Operating rules. The rules of this paragraph (b)(9) apply to a

debt instrument subject to the noncontingent bond method

notwithstanding any other rule of this paragraph (b).

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

(b)(9)(i) provides rules for a holder whose basis in a debt instrument

is different from the adjusted issue price of the debt instrument

(e.g., a subsequent holder that purchases the debt instrument for more

or less than the instrument's adjusted issue price).

(A) General rule. The holder accrues interest under paragraph

(b)(3)(iii) of this section and makes adjustments under paragraph

(b)(3)(iv) of this section based on the projected payment schedule

determined as of the issue date of the debt instrument. However, upon

acquiring the debt instrument, the holder must reasonably allocate any

difference between the adjusted issue price and the basis to daily

portions of interest or projected payments over the remaining term of

the debt instrument. Allocations are taken into account under

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

(B) Basis greater than adjusted issue price. If the holder's basis

in the debt instrument exceeds the debt instrument's adjusted issue

price, the amount of the difference allocated to a daily portion of

interest or to a projected payment is treated as a negative adjustment

on the date the daily portion accrues or the payment is made. On the

date of the adjustment, the holder's adjusted basis in the debt

instrument is reduced by the amount the holder treats as a negative

adjustment under this paragraph (b)(9)(i)(B). See paragraph

(b)(9)(ii)(E) of this section for a special rule that applies when a

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

the debt instrument is less than the debt instrument's adjusted issue

price, the amount of the difference allocated to a daily portion of

interest or to a projected payment is treated as a positive adjustment

on the date the daily portion accrues or the payment is made. On the

date of the adjustment, the holder's adjusted basis in the debt

instrument is increased by the amount the holder treats as a positive

adjustment under this paragraph (b)(9)(i)(C). See paragraph

(b)(9)(ii)(E) of this section for a special rule that applies when a

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

(D) Premium and discount rules do not apply. The rules for accruing

premium and discount in sections 171, 1272(a)(7), 1276, and 1281 do not

apply. Other rules of those sections, such as section 171(b)(4),

continue to apply to the extent relevant.

(E) Safe harbor for exchange listed debt instruments. If the debt

instrument is exchange listed property (within the meaning of

Sec. 1.1273-2(f)(2)), it is reasonable for the holder to allocate any

difference between the holder's basis

[[Page 30149]]

and the adjusted issue price of the debt instrument pro-rata to daily

portions of interest (as determined under paragraph (b)(3)(iii) of this

section) over the remaining term of the debt instrument. A pro-rata

allocation is not reasonable, however, to the extent the holder's yield

on the debt instrument, determined after taking into account the

amounts allocated under this paragraph (b)(9)(i)(E), is less than the

applicable Federal rate for the instrument. For purposes of the

preceding sentence, the applicable Federal rate for the debt instrument

is determined as if the purchase date were the issue date and the

remaining term of the instrument were the term of the instrument.

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

this paragraph (b)(9)(i). In each example, assume that the instrument

described is a debt instrument for federal income tax purposes. No

inference is intended, however, as to whether the instrument is a debt

instrument for federal income tax purposes. In addition, assume that

each instrument is not exchange listed property.

Example 1. Basis greater than adjusted issue price--(i) Facts.

On July 1, 1998, Z purchases for $1,405 a debt instrument that

matures on December 31, 1999, and promises to pay on the maturity

date $1,000 plus the increase, if any, in the price of a specified

amount of a commodity from the issue date to the maturity date. The

debt instrument was originally issued on December 31, 1996, for an

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

is 10.25 percent, compounded semiannually, and the projected payment

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

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

the purchase, the debt instrument has an adjusted issue price of

$1,162, assuming semiannual accrual periods ending on December 31

and June 30 of each year. The increase in the value of the debt

instrument over its adjusted issue price is due to an increase in

the expected amount of the contingent payment and not to a decrease

in market interest rates. The debt instrument is a capital asset in

the hands of Z. Z is a calendar year taxpayer.

(ii) Allocation of the difference between basis and adjusted

issue price. Z's basis in the debt instrument on July 1, 1998, is

$1,405. Under paragraph (b)(9)(i)(A) of this section, Z allocates

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

($1,162) to the contingent payment at maturity. Z's allocation of

the difference between basis and adjusted issue price is reasonable

because the increase in the value of the debt instrument over its

adjusted issue price is due to an increase in the expected amount of

the contingent payment.

(iii) Treatment of debt instrument for 1998. Based on the

projected payment schedule, $60 of interest accrues on the debt

instrument from July 1, 1998 to December 31, 1998 (the product of

the debt instrument's adjusted issue price on July 1, 1998 ($1,162)

and the comparable yield properly adjusted for the length of the

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

adjustments for 1998. Thus, Z includes in income $60 of total daily

portions of interest for 1998. On December 31, 1998, Z's adjusted

basis in the debt instrument is $1,465 ($1,405 original basis, plus

total daily portions of $60 for 1998).

(iv) Effect of allocation to contingent payment at maturity.

Assume that the payment actually made on December 31, 1999, is

$1,400, rather than the projected $1,350. Thus, under paragraph

(b)(6)(i) of this section, Z has a positive adjustment of $50 on

December 31, 1999. In addition, under paragraph (b)(9)(i)(B) of this

section, Z has a negative adjustment of $243 on December 31, 1999,

which is attributable to the difference between Z's basis in the

debt instrument on July 1, 1998, and the instrument's adjusted issue

price on that date. As a result, Z has a net negative adjustment of

$193 for 1999. This net negative adjustment reduces to zero the $128

total daily portions of interest Z would otherwise include in income

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

instrument for 1999. Because Z had $60 of interest inclusions for

1998, $60 of the remaining $65 net negative adjustment is treated by

Z as an ordinary loss for 1999. The remaining $5 of the net negative

adjustment is a negative adjustment carryforward for 1999 that

reduces the amount realized by Z on the retirement of the debt

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

(v) Loss at maturity. On December 31, 1999, Z's basis in the

debt instrument is $1,350 ($1,405 original basis, plus total daily

portions of $60 for 1998 and $128 for 1999, minus the negative

adjustment of $243). As a result, Z realizes a loss of $5 on the

retirement of the debt instrument (the difference between the amount

realized on the retirement ($1,345) and Z's adjusted basis in the

debt instrument ($1,350)). Under paragraph (b)(8)(ii) of this

section, the $5 loss is treated as loss from the retirement of the

debt instrument. Consequently, Z realizes a total loss of $65 on the

debt instrument for 1999 (a $60 ordinary loss and a $5 capital

loss).

Example 2. Basis less than adjusted issue price--(i) Facts. On

January 1, 1999, Y purchases for $910 a debt instrument that pays 7

percent interest semiannually on June 30 and December 31 of each

year, and that promises to pay on December 31, 2001, $1,000 plus or

minus $10 times the positive or negative difference, if any, between

a specified amount and the value of an index on December 31, 2001.

However, the payment on December 31, 2001, may not be less than

$650. The debt instrument was originally issued on December 31,

1996, for an issue price of $1,000. The comparable yield for the

debt instrument is 9.80 percent, compounded semiannually, and the

projected payment schedule for the debt instrument (determined as of

the issue date) provides for semiannual payments of $35 and a

contingent payment at maturity of $1,175. On January 1, 1999, the

debt instrument has an adjusted issue price of $1,060, assuming

semiannual accrual periods ending on December 31 and June 30 of each

year. Y is a calendar year taxpayer.

(ii) Allocation of the difference between basis and adjusted

issue price. Y's basis in the debt instrument on January 1, 1999, is

$910. Under paragraph (b)(9)(i)(A) of this section, Y must allocate

the $150 difference between basis ($910) and adjusted issue price

($1,060) to daily portions of interest or to projected payments.

These amounts will be positive adjustments taken into account at the

time the daily portions accrue or the payments are made.

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

the expected value of the payment at maturity has declined by about

9 percent. Based on forward prices on January 1, 1999, Y determines

that approximately $105 of the difference between basis and adjusted

issue price is allocable to the contingent payment. Y allocates the

remaining $45 to daily portions of interest on a pro-rata basis

(i.e., the amount allocated to an accrual period equals the product

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

portions for the accrual period and the denominator of which is the

total daily portions remaining on the debt instrument on January 1,

1999). This allocation is reasonable.

(B) Assume alternatively that, based on yields of comparable

debt instruments and its purchase price for the debt instrument, Y

determines that an appropriate yield for the debt instrument is 13

percent, compounded semiannually. Based on this determination, Y

allocates $55.75 of the difference between basis and adjusted issue

price to daily portions of interest as follows: $15.19 to the daily

portions of interest for the taxable year ending December 31, 1999;

$18.40 to the daily portions of interest for the taxable year ending

December 31, 2000; and $22.16 to the daily portions of interest for

the taxable year ending December 31, 2001. Y allocates the remaining

$94.25 to the contingent payment at maturity. This allocation is

reasonable.

(ii) Fixed but deferred contingent payments. This paragraph

(b)(9)(ii) provides rules that apply when the amount of a contingent

payment becomes fixed before the payment is due. For purposes of

paragraph (b) of this section, if a contingent payment becomes fixed

within the 6-month period ending on the due date of the payment, the

payment is treated as a contingent payment even after the payment is

fixed. If a contingent payment becomes fixed more than 6 months before

the payment is due, the following rules apply to the debt instrument.

(A) Determining adjustments. The amount of the adjustment

attributable to the contingent payment is equal to the difference

between the present value of the amount that is fixed and the present

value of the projected amount of the contingent payment. The present

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

date the payment is due to the date the

[[Page 30150]]

payment becomes fixed, using a discount rate equal to the comparable

yield on the debt instrument. The adjustment is treated as a positive

or negative adjustment, as appropriate, on the date the contingent

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

determine the timing of the adjustment if all remaining contingent

payments on the debt instrument become fixed substantially

contemporaneously.

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

as a contingent payment after the date the amount of the payment

becomes fixed. On the date the contingent payment becomes fixed, the

projected payment schedule for the debt instrument is modified

prospectively to reflect the fixed amount of the payment. Therefore, no

adjustment is made under paragraph (b)(3)(iv) of this section when the

contingent payment is actually made.

Sec. 1.1272-1(b)(1)(ii) of accrual periods for the debt instrument, an

accrual period ends on the day the contingent payment becomes fixed,

and a new accrual period begins on the day after the day the contingent

payment becomes fixed.

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

any positive adjustment on a debt instrument determined under paragraph

(b)(9)(ii)(A) of this section increases the adjusted issue price of the

instrument and the holder's adjusted basis in the instrument.

Similarly, the amount of any negative adjustment on a debt instrument

determined under paragraph (b)(9)(ii)(A) of this section decreases the

adjusted issue price of the instrument and the holder's adjusted basis

in the instrument.

(E) Basis different from adjusted issue price. If a holder's basis

in a debt instrument exceeds the debt instrument's adjusted issue

price, the amount allocated to a projected payment under paragraph

(b)(9)(i) of this section is treated as a negative adjustment on the

date the payment becomes fixed. If a holder's basis in a debt

instrument is less than the debt instrument's adjusted issue price, the

amount allocated to a projected payment under paragraph (b)(9)(i) of

this section is treated as a positive adjustment on the date the

payment becomes fixed.

(F) Special rule for certain contingent interest payments.

Notwithstanding paragraph (b)(9)(ii)(A) of this section, this paragraph

(b)(9)(ii)(F) applies to contingent stated interest payments that are

adjusted to compensate for contingencies regarding the reasonableness

of the debt instrument's stated rate of interest. For example, this

paragraph (b)(9)(ii)(F) applies to a debt instrument that provides for

an increase in the stated rate of interest if the credit quality of the

issuer or liquidity of the debt instrument deteriorates. Contingent

stated interest payments of this type are recognized over the period to

which they relate in a reasonable manner.

(G) Special rule when all contingent payments become fixed.

Notwithstanding paragraph (b)(9)(ii)(A) of this section, if all the

remaining contingent payments on a debt instrument become fixed

substantially contemporaneously, any positive or negative adjustments

on the instrument are taken into account in a reasonable manner over

the period to which they relate. For purposes of the preceding

sentence, a payment is treated as a fixed payment if all remaining

contingencies with respect to the payment are remote or incidental

(within the meaning of Sec. 1.1275-2(h)).

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

this paragraph (b)(9)(ii). In this example, assume that the instrument

described is a debt instrument for federal income tax purposes. No

inference is intended, however, as to whether the instrument is a debt

instrument for federal income tax purposes.

Example. Fixed but deferred payments--(i) Facts. On December 31,

1996, B, a calendar year taxpayer, purchases a debt instrument at

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

31, 2002, and provides for a payment of $1,000 at maturity. In

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

instrument provides for payments equal to the excess of the average

daily value of an index for the 6-month period ending on September

30 of the preceding year over a specified amount. The debt

instrument's comparable yield is 10 percent, compounded annually,

and the instrument's projected payment schedule consists of a

payment of $250 on December 31, 1999, and a payment of $1,439 on

December 31, 2002. B uses annual accrual periods.

(ii) Interest accrual for 1997. Based on the projected payment

schedule, B includes a total of $100 of daily portions of interest

in income in 1997. B's adjusted basis in the debt instrument and the

debt instrument's adjusted issue price on December 31, 1997, is

$1,100.

(iii) Interest accrual for 1998--(A) Adjustment. Based on the

projected payment schedule, B would include $110 of total daily

portions of interest in income in 1998. However, assume that on

September 30, 1998, the payment due on December 31, 1999, fixes at

$300, rather than the projected $250. Thus, on September 30, 1998, B

has an adjustment equal to the difference between the present value

of the $300 fixed amount and the present value of the $250 projected

amount of the contingent payment. The present values of the two

payments are determined by discounting each payment from the date

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

becomes fixed (September 30, 1998), using a discount rate equal to

10 percent, compounded annually. The present value of the fixed

payment is $266.30 and the present value of the projected amount of

the contingent payment is $221.91. Thus, on September 30, 1998, B

has a positive adjustment of $44.39 ($266.30-$221.91).

(B) Effect of adjustment. Under paragraph (b)(9)(ii)(C) of this

section, B's accrual period ends on September 30, 1998. The daily

portions of interest on the debt instrument for the period from

January 1, 1998 to September 30, 1998 total $81.51. The adjusted

issue price of the debt instrument and B's adjusted basis in the

debt instrument are thus increased over this period by $125.90 (the

sum of the daily portions of interest of $81.51 and the positive

adjustment of $44.39 made at the end of the period) to $1,225.90.

For purposes of all future accrual periods, including the new

accrual period from October 1, 1998, to December 31, 1998, the debt

instrument's projected payment schedule is modified to reflect a

fixed payment of $300 on December 31, 1999. Based on the new

adjusted issue price of the debt instrument and the new projected

payment schedule, the yield on the debt instrument does not change.

payment schedule, $29.56 of interest accrues during the accrual

period that ends on December 31, 1998. Because B has no other

adjustments during 1998, the $44.39 positive adjustment on September

30, 1998, results in a net positive adjustment for 1998, which is

additional interest for that year. Thus, B includes $155.46

($81.51+$29.56+$44.39) of interest in income in 1998. B's adjusted

basis in the debt instrument and the debt instrument's adjusted

issue price on December 31, 1998, is $1,255.46 ($1,225.90 from the

end of the prior accrual period plus $29.56 total daily portions for

the current accrual period).

(iii) Timing contingencies. This paragraph (b)(9)(iii) provides

rules for debt instruments that have payments that are contingent as to

time.

(A) Treatment of certain options. If a taxpayer has an

unconditional option to put or call the debt instrument, to exchange

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

of the debt instrument, the projected payment schedule is determined by

using the principles of Sec. 1.1272-1(c)(5).

(B) Other timing contingencies. [Reserved]

(iv) Cross-border transactions--(A) Allocation of deductions. For

purposes of Sec. 1.861-8, the holder of a debt instrument shall treat

any deduction or loss treated as an ordinary loss under paragraph

(b)(6)(iii)(B) or (b)(8)(ii) of this section as a deduction that is

definitely related to the class of gross

[[Page 30151]]

income to which income from such debt instrument belongs. Accordingly,

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

foreign corporation and, pursuant to section 904(d)(3) and the

regulations thereunder, any interest accrued by such U.S. person with

respect to such debt instrument would be treated as foreign source

general limitation income, any deductions relating to a net negative

adjustment will reduce the U.S. person's foreign source general

limitation income. The holder shall apply the general rules relating to

allocation and apportionment of deductions to any other deduction or

loss realized by the holder with respect to the debt instrument.

(B) Investments in United States real property. Notwithstanding

paragraph (b)(8)(i) of this section, gain on the sale, exchange, or

retirement of a debt instrument that is a United States real property

interest is treated as gain for purposes of sections 897, 1445, and

6039C.

(v) Coordination with subchapter M and related provisions. For

purposes of sections 852(c)(2) and 4982 and Sec. 1.852-11, any positive

adjustment, negative adjustment, income, or loss on a debt instrument

that occurs after October 31 of a taxable year is treated in the same

manner as foreign currency gain or loss that is attributable to a

section 988 transaction.

(vi) Coordination with section 1092. A holder treats a negative

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

respect to a position in a straddle if the debt instrument is a

position in a straddle and the contingency (or any portion of the

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

straddle if entered into as a separate position.

bond method--(1) Applicability. This paragraph (c) applies to a

contingent payment debt instrument (other than a tax-exempt obligation)

that has an issue price determined under Sec. 1.1274-2. For example,

this paragraph (c) generally applies to a contingent payment debt

instrument that is issued for nonpublicly traded property.

(2) Separation into components. If paragraph (c) of this section

applies to a debt instrument (the overall debt instrument), the

noncontingent payments are subject to the rules in paragraph (c)(3) of

this section, and the contingent payments are accounted for separately

under the rules in paragraph (c)(4) of this section.

(3) Treatment of noncontingent payments. The noncontingent payments

are treated as a separate debt instrument. The issue price of the

separate debt instrument is the issue price of the overall debt

instrument, determined under Sec. 1.1274-2(g). No interest payments on

the separate debt instrument are qualified stated interest payments

(within the meaning of Sec. 1.1273-1(c)) and the de minimis rules of

section 1273(a)(3) and Sec. 1.1273-1(d) do not apply to the separate

debt instrument.

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

provided in paragraph (c)(4)(iii) of this section, the portion of a

contingent payment treated as interest under paragraph (c)(4)(ii) of

this section is includible in gross income by the holder and deductible

from gross income by the issuer in their respective taxable years in

which the payment is made.

(ii) Characterization of contingent payments as principal and

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

payment of principal in an amount equal to the present value of the

payment, determined by discounting the payment at the test rate from

the date the payment is made to the issue date. The amount of the

payment in excess of the amount treated as principal under the

preceding sentence is treated as a payment of interest.

(B) Test rate. The test rate used for purposes of paragraph

(c)(4)(ii)(A) of this section is the rate that would be the test rate

for the overall debt instrument under Sec. 1.1274-4 if the term of the

overall debt instrument began on the issue date of the overall debt

instrument and ended on the date the contingent payment is made.

However, in the case of a contingent payment that consists of a payment

of stated principal accompanied by a payment of stated interest at a

rate that exceeds the test rate determined under the preceding

sentence, the test rate is the stated interest rate.

(iii) Certain delayed contingent payments--(A) General rule.

Notwithstanding paragraph (c)(4)(ii) of this section, if a contingent

payment becomes fixed more than 6 months before the payment is due, the

issuer and holder are treated as if the issuer had issued a separate

debt instrument on the date the payment becomes fixed, maturing on the

date the payment is due. This separate debt instrument is treated as a

debt instrument to which section 1274 applies. The stated principal

amount of this separate debt instrument is the amount of the payment

that becomes fixed. An amount equal to the issue price of this debt

instrument is characterized as interest or principal under the rules of

paragraph (c)(4)(ii) of this section and accounted for as if this

amount had been paid by the issuer to the holder on the date that the

amount of the payment becomes fixed. To determine the issue price of

the separate debt instrument, the payment is discounted at the test

rate from the maturity date of the separate debt instrument to the date

that the amount of the payment becomes fixed.

(B) Test rate. The test rate used for purposes of paragraph

(c)(4)(iii)(A) of this section is determined in the same manner as the

test rate under paragraph (c)(4)(ii)(B) of this section is determined

except that the date the contingent payment is due is used rather than

the date the contingent payment is made.

(5) Basis different from adjusted issue price. This paragraph

(c)(5) provides rules for a holder whose basis in a debt instrument is

different from the instrument's adjusted issue price (e.g., a

subsequent holder). This paragraph (c)(5), however, does not apply if

the holder is reporting income under the installment method of section

453.

(i) Allocation of basis. The holder must allocate basis to the

noncontingent component (i.e., the right to the noncontingent payments)

and to any separate debt instruments described in paragraph (c)(4)(iii)

of this section in an amount up to the total of the adjusted issue

price of the noncontingent component and the adjusted issue prices of

the separate debt instruments. The holder must allocate the remaining

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

contingent payments).

(ii) Noncontingent component. Any difference between the holder's

basis in the noncontingent component and the adjusted issue price of

the noncontingent component, and any difference between the holder's

basis in a separate debt instrument and the adjusted issue price of the

separate debt instrument, is taken into account under the rules for

market discount, premium, and acquisition premium that apply to a

noncontingent debt instrument.

(iii) Contingent component. Amounts received by the holder that are

treated as principal payments under paragraph (c)(4)(ii) of this

section reduce the holder's basis in the contingent component. If the

holder's basis in the contingent component is reduced to zero, any

additional principal payments on the contingent component are treated

as gain from the sale or exchange of the debt instrument. Any basis

remaining on the contingent component on the date the final contingent

payment is made increases the holder's adjusted basis in the

noncontingent component

[[Page 30152]]

(or, if there are no remaining noncontingent payments, is treated as

loss from the sale or exchange of the debt instrument).

(6) Treatment of a holder on sale, exchange, or retirement. This

paragraph (c)(6) provides rules for the treatment of a holder on the

sale, exchange, or retirement of a debt instrument subject to this

paragraph (c). Under this paragraph (c)(6), the holder must allocate

the amount received from the sale, exchange, or retirement of a debt

instrument first to the noncontingent component and to any separate

debt instruments described in paragraph (c)(4)(iii) of this section in

an amount up to the total of the adjusted issue price of the

noncontingent component and the adjusted issue prices of the separate

debt instruments. The holder must allocate the remaining amount

received, if any, to the contingent component.

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

allocated to the noncontingent component and any separate debt

instruments is treated as an amount realized from the sale, exchange,

or retirement of the noncontingent component or separate debt

instrument.

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

allocated to the contingent component is treated as a contingent

payment that is made on the date of the sale, exchange, or retirement

and is characterized as interest and principal under the rules of

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

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

this paragraph (c). In each example, assume that the instrument

described is a debt instrument for federal income tax purposes. No

inference is intended, however, as to whether the instrument is a debt

instrument for federal income tax purposes.

Example 1. Contingent interest payments--(i) Facts. A owns

Blackacre, unencumbered depreciable real estate. On January 1, 1997,

A sells Blackacre to B. As consideration for the sale, B makes a

downpayment of $1,000,000 and issues to A a debt instrument that

matures on December 31, 2001. The debt instrument provides for a

payment of principal at maturity of $5,000,000 and a contingent

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

percentage of the gross rents B receives from Blackacre in that

year. Assume that the debt instrument is not issued in a potentially

abusive situation. Assume also that on January 1, 1997, the short-

term applicable Federal rate is 5 percent, compounded annually, and

the mid-term applicable Federal rate is 6 percent, compounded

annually.

(ii) Determination of issue price. Under Sec. 1.1274-2(g), the

issue price of the debt instrument is $3,736,291, which is the

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

payment due at maturity, calculated using a discount rate equal to

the mid-term applicable Federal rate. Under Sec. 1.1012-1(g)(1), B's

basis in Blackacre on January 1, 1997, is $4,736,291 ($1,000,000

down payment plus the $3,736,291 issue price of the debt

instrument).

(iii) Noncontingent payment treated as separate debt instrument.

Under paragraph (c)(3) of this section, the right to the

noncontingent payment of principal at maturity is treated as a

separate debt instrument. The issue price of this separate debt

instrument is $3,736,291 (the issue price of the overall debt

instrument). The separate debt instrument has a stated redemption

price at maturity of $5,000,000 and, therefore, OID of $1,263,709.

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

contingent interest that is fixed and paid on December 31, 1997, is

$200,000. Under paragraph (c)(4)(ii) of this section, this payment

is treated as consisting of a payment of principal of $190,476,

which is the present value of the payment, determined by discounting

the payment at the test rate of 5 percent, compounded annually, from

the date the payment is made to the issue date. The remainder of the

$200,000 payment ($9,524) is treated as interest. The additional

amount treated as principal gives B additional basis in Blackacre on

December 31, 1997. The portion of the payment treated as interest is

includible in gross income by A and deductible by B in their

respective taxable years in which December 31, 1997 occurs. The

remaining contingent payments on the debt instrument are accounted

for similarly, using a test rate of 5 percent, compounded annually,

for the contingent payments due on December 31, 1998, and December

31, 1999, and a test rate of 6 percent, compounded annually, for the

contingent payments due on December 31, 2000, and December 31, 2001.

Example 2. Fixed but deferred payment--(i) Facts. The facts are

the same as in paragraph (c)(7) Example 1 of this section, except

that the contingent payment of interest that is fixed on December

31, 1997, is not payable until December 31, 2001, the maturity date.

(ii) Treatment of deferred contingent payment. Assume that the

amount of the payment that becomes fixed on December 31, 1997, is

$200,000. Because this amount is not payable until December 31,

2001, under paragraph (c)(4)(iii) of this section, a separate debt

instrument to which section 1274 applies is treated as issued by B

on December 31, 1997 (the date the payment is fixed). The maturity

date of this separate debt instrument is December 31, 2001 (the date

on which the payment is due). The stated principal amount of this

separate debt instrument is $200,000, the amount of the payment that

becomes fixed. The imputed principal amount of the separate debt

instrument is $158,419, which is the present value, as of December

31, 1997, of the $200,000 payment, computed using a discount rate

equal to the test rate of the overall debt instrument (6 percent,

compounded annually). An amount equal to the issue price of the

separate debt instrument is treated as an amount paid on December

31, 1997, and characterized as interest and principal under the

rules of paragraph (c)(4)(ii) of this section. The amount of the

deemed payment characterized as principal is equal to $150,875,

which is the present value, as of January 1, 1997 (the issue date of

the overall debt instrument), of the deemed payment, computed using

a discount rate of 5 percent, compounded annually. The amount of the

deemed payment characterized as interest is $7,544 ($158,419

-$150,875), which is includible in gross income by A and deductible

by B in their respective taxable years in which December 31, 1997

occurs.

(d) Rules for tax-exempt obligations--(1) In general. Except as

modified by this paragraph (d), the noncontingent bond method described

in paragraph (b) of this section applies to a tax-exempt obligation (as

defined in section 1275(a)(3)) to which this section applies. Paragraph

(d)(2) of this section applies to certain tax-exempt obligations that

provide for interest-based payments or revenue-based payments and

paragraph (d)(3) of this section applies to all other obligations.

Paragraph (d)(4) of this section provides rules for a holder whose

basis in a tax-exempt obligation is different from the adjusted issue

price of the obligation.

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

based payments--(i) Applicability. This paragraph (d)(2) applies to a

tax-exempt obligation that provides for interest- based payments or

revenue-based payments.

(ii) Interest-based payments. A tax-exempt obligation provides for

interest-based payments if the obligation would otherwise qualify as a

variable rate debt instrument under Sec. 1.1275-5 except that--

(A) The obligation provides for more than one fixed rate;

(B) The obligation provides for one or more caps, floors, or

governors (or similar restrictions) that are fixed as of the issue

date;

least annually; or

(D) The obligation provides for interest at one or more rates equal

to the product of a qualified floating rate and a fixed multiple

greater than zero and less than .65, or at one or more rates equal to

the product of a qualified floating rate and a fixed multiple greater

than zero and less than .65, increased or decreased by a fixed rate.

(iii) Revenue-based payments. A tax-exempt obligation provides for

revenue-based payments if the obligation--

(A) Is issued to refinance (including a series of refinancings) an

obligation (in a series of refinancings, the original

[[Page 30153]]

obligation), the proceeds of which were used to finance a project or

enterprise; and

(B) Would otherwise qualify as a variable rate debt instrument

under Sec. 1.1275-5 except that it provides for stated interest

payments at least annually based on a single fixed percentage of the

revenue, value, change in value, or other similar measure of the

performance of the refinanced project or enterprise.

(iv) Modifications to the noncontingent bond method. If a tax-

exempt obligation is subject to this paragraph (d)(2), the following

modifications to the noncontingent bond method described in paragraph

(b) of this section apply to the obligation.

(A) Daily portions and net positive adjustments. The daily portions

of interest determined under paragraph (b)(3)(iii) of this section and

any net positive adjustment on the obligation are interest for purposes

of section 103.

(B) Net negative adjustments. A net negative adjustment for a

taxable year reduces the amount of tax-exempt interest the holder would

otherwise account for on the obligation for the taxable year under

paragraph (b)(3)(iii) of this section. If the net negative adjustment

exceeds this amount, the excess is a nondeductible, noncapitalizable

loss. If a regulated investment company (RIC) within the meaning of

section 851 has a net negative adjustment in a taxable year that would

be a nondeductible, noncapitalizable loss under the prior sentence, the

RIC must use this loss to reduce its tax-exempt interest income on

other tax-exempt obligations held during the taxable year.

of the obligation is gain from the sale or exchange of the obligation.

(D) Losses. Any loss recognized on the sale, exchange, or

retirement of the obligation is treated the same as a net negative

adjustment under paragraph (d)(2)(iv)(B) of this section.

(E) Special rule for losses and net negative adjustments.

Notwithstanding paragraphs (d)(2)(iv) (B) and (D) of this section, on

the sale, exchange, or retirement of the obligation, the holder may

claim a loss from the sale or exchange of the obligation to the extent

the holder has not received in cash or property the sum of its original

investment in the obligation and any amounts included in income under

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

(3) All other tax-exempt obligations--(i) Applicability. This

paragraph (d)(3) applies to a tax-exempt obligation that is not subject

to paragraph (d)(2) of this section.

(ii) Modifications to the noncontingent bond method. If a tax-

exempt obligation is subject to this paragraph (d)(3), the following

modifications to the noncontingent bond method described in paragraph

(b) of this section apply to the obligation.

(A) Modification to projected payment schedule. The comparable

yield for the obligation is the greater of the obligation's yield,

determined without regard to the contingent payments, and the tax-

exempt applicable Federal rate that applies to the obligation. The

Internal Revenue Service publishes the tax-exempt applicable Federal

rate for each month in the Internal Revenue Bulletin (see

Sec. 601.601(d)(2)(ii) of this chapter).

(B) Daily portions. The daily portions of interest determined under

paragraph (b)(3)(iii) of this section are interest for purposes of

section 103.

treated as gain to the holder from the sale or exchange of the

obligation in the taxable year of the adjustment. A net negative

adjustment on the obligation is treated as a loss to the holder from

the sale or exchange of the obligation in the taxable year of the

adjustment.

(D) Gains and losses. Any gain or loss recognized on the sale,

exchange, or retirement of the obligation is gain or loss from the sale

or exchange of the obligation.

(4) Basis different from adjusted issue price. This paragraph

(d)(4) provides rules for a holder whose basis in a tax-exempt

obligation is different from the adjusted issue price of the

obligation. The rules of paragraph (b)(9)(i) of this section do not

apply to tax-exempt obligations.

(i) Basis greater than adjusted issue price. If the holder's basis

in the obligation exceeds the obligation's adjusted issue price, the

holder, upon acquiring the obligation, must allocate this difference to

daily portions of interest on a yield to maturity basis over the

remaining term of the obligation. The amount allocated to a daily

portion of interest is not deductible by the holder. However, the

holder's basis in the obligation is reduced by the amount allocated to

a daily portion of interest on the date the daily portion accrues.

(ii) Basis less than adjusted issue price. If the holder's basis in

the obligation is less than the obligation's adjusted issue price, the

holder, upon acquiring the obligation, must allocate this difference to

daily portions of interest on a yield to maturity basis over the

remaining term of the obligation. The amount allocated to a daily

portion of interest is includible in income by the holder as ordinary

income on the date the daily portion accrues. The holder's adjusted

basis in the obligation is increased by the amount includible in income

by the holder under this paragraph (d)(4)(ii) on the date the daily

portion accrues.

(iii) Premium and discount rules do not apply. The rules for

accruing premium and discount in sections 171, 1276, and 1288 do not

apply. Other rules of those sections continue to apply to the extent

relevant.

(e) Amounts treated as interest under this section. Amounts treated

as interest under this section are treated as OID for all purposes of

the Internal Revenue Code.

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

on or after August 13, 1996.

Par. 16. Section 1.1275-5 is amended by:

1. Revising paragraph (a)(1).

2. Removing the language ``The debt instrument must provide for

stated interest'' from the introductory language of paragraph (a)(3)(i)

and adding the language ``The debt instrument must not provide for any

stated interest other than stated interest'' in its place.

3. Removing the language ``less than 1 year'' from the first

sentence of paragraph (a)(3)(ii) and adding the language ``1 year or

less'' in its place.

4. Adding paragraphs (a)(5) and (a)(6).

5. Revising paragraph (b)(2).

6. Revising paragraphs (c)(1) and (c)(5).

7. Removing the language ``cost of newly borrowed funds'' from

paragraph (c)(3)(ii) and adding the language ``qualified floating

rate'' in its place.

8. Revising paragraph (d) introductory text; revising Examples 4

through 9; and adding Example 10.

9. Revising paragraph (e)(2).

10. Revising paragraph (e)(3)(v) introductory text; revising

Example 3 (ii); and removing Example 3 (iii).

The revisions and additions read as follows:

Sec. 1.1275-5 Variable rate debt instruments.

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

variable rate debt instruments. Except as provided in paragraph (a)(6)

of this section, a variable rate debt instrument is a debt instrument

that meets the conditions described in paragraphs (a)(2), (3), (4), and

(5) of this section. If a debt instrument that provides for a variable

rate of interest does not qualify as a variable rate debt instrument,

the debt instrument is a contingent payment debt instrument. See

Sec. 1.1275-4 for the

[[Page 30154]]

treatment of a contingent payment debt instrument. See Sec. 1.1275-6

for a taxpayer's treatment of a variable rate debt instrument and a

hedge.

* * * * *

(5) No contingent principal payments. Except as provided in

paragraph (a)(2) of this section, the debt instrument must not provide

for any principal payments that are contingent (within the meaning of

Sec. 1.1275-4(a)).

(6) Special rule for debt instruments issued for nonpublicly traded

property. A debt instrument (other than a tax-exempt obligation) that

would otherwise qualify as a variable rate debt instrument under this

section is not a variable rate debt instrument if section 1274 applies

to the instrument and any stated interest payments on the instrument

are treated as contingent payments under Sec. 1.1274-2. This paragraph

(a)(6) applies to debt instruments issued on or after August 13, 1996.

(b) * * *

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

instrument issued on or after August 13, 1996, a variable rate is a

qualified floating rate if it is equal to either--

(i) The product of a qualified

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