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

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URL: https://www.frixlaw.com/law-library/documents/fr%3A96-14918

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** June 14, 1996
- **Citation:** 61 FR 30133

## Text

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

[[Page 30134]]

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

[[Page 30135]]

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

[[Page 30137]]

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

[[Page 30138]]

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.

(c) Effective date. This section applies to sales and exchanges
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-
5.
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

* * * * *
(c) * * *
(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.
(c) Method for debt instruments not subject to the noncontingent
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.
* * * * *
(c) * * *
(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.
(c) Integrated transaction.
(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
* * * * *
(c) Yield and maturity of certain debt instruments subject to
contingencies--(1) Applicability. This paragraph (c) provides rules to
determine the yield and maturity of certain debt instruments that
provide for an alternative payment schedule (or schedules) applicable
upon the occurrence of a contingency (or contingencies). This paragraph
(c) applies, however, only if the timing and amounts of the payments
that comprise each payment schedule are known as of the issue date 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.

* * * * *
(c) * * * (1) * * *
(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
(C) A payment subject to an incidental contingency described in
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
(C) Contingent payments on the debt instrument are related to such
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.
(C) Adjustments to the projected payment schedule. The projected
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.
(C) Exception. Paragraph (b)(4)(v)(A) of this section does not
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.
(C) Carryforward. If the net negative adjustment exceeds the sum of
the amounts treated by the taxpayer as a reduction of interest and as
ordinary income or loss (as the case may be) on the debt instrument for
the taxable year, the excess is a negative adjustment carryforward for
the taxable year. 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.
(C) Basis less than adjusted issue price. If the holder's basis in
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,

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A96-14918. Public record. Not legal advice.