Amortizable Bond Premium
Federal RegisterJun 27, 1996
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DEPARTMENT OF THE TREASURY
26 CFR Part 1
[FI-48-95]
RIN 1545-AU09
Amortizable Bond Premium
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
federal income tax treatment of bond premium and bond issuance premium.
The proposed regulations reflect changes to the law made by the Tax
Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of
1988. The proposed regulations in this document would provide needed
guidance to holders and issuers of debt instruments. This document also
provides a notice of a public hearing on the proposed regulations.
DATES: Written comments must be received by September 25, 1996.
Requests to appear and outlines of topics to be discussed at the public
hearing scheduled for October 23, 1996, at 10 a.m. must be received by
October 2, 1996.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (FI-48-95), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (FI-48-95), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue NW,
Washington, DC. A public hearing will be held in the Commissioner's
Conference Room, Internal Revenue Building, 1111 Constitution Avenue
NW, Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, William P.
Cejudo, (202) 622-4016, or Jeffrey W. Maddrey, (202) 622-3940;
concerning submissions and the hearing, Christina Vasquez, (202) 622-
7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507).
Comments on the collections of information should be sent to the
Office of Management and Budget, Attn: Desk Officer for the Department
of Treasury, Office of Information and Regulatory Affairs, Washington,
DC 20503, with copies to the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the
collections of information should be received by August 26, 1996.
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 collections of information are in proposed Secs. 1.163-
13(h)(3), 1.171-4(a)(1), and 1.171-5(c)(2)(iii). This information is
required by the IRS to monitor compliance with the federal tax rules
for amortizing bond premium and bond issuance premium. The likely
respondents are taxpayers who either
[[Page 33397]]
acquire a bond at a premium or issue a bond at a premium. Responses to
this collection of information are required to determine whether a
holder of a bond has elected to amortize bond premium and to determine
whether an issuer or a holder has changed its method of accounting for
premium.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Estimated total annual reporting burden: 50,000 hours. The
estimated annual burden per respondent varies from 0.25 hours to 0.75
hours, depending on individual circumstances, with an estimated average
of 0.5 hours.
Estimated number of respondents: 100,000.
Estimated annual frequency of responses: One time per respondent.
Background
Sections 1.171-1 through 1.171-4 of the Income Tax Regulations were
promulgated in 1957 and last amended in 1968. In the Tax Reform Act of
1986, section 171(b) was amended to require that bond premium be
amortized by reference to a constant yield. In the Technical and
Miscellaneous Revenue Act of 1988, section 171(e) was amended to
require that bond premium be amortized as an offset to interest income.
The proposed regulations would substantially revise the existing
regulations to reflect these amendments. In addition, the proposed
regulations would revise existing guidance addressing the issuer's
treatment of bond issuance premium.
Explanation of Provisions
In general, bond premium arises when a holder acquires a bond for
more than the principal amount of the bond. Similarly, bond issuance
premium arises when an issuer issues a bond for more than the principal
amount of the bond. A holder will purchase, and an issuer will issue, a
bond for more than its principal amount when the stated interest rate
on the bond is higher than the current market yield for the bond.
The holder's treatment of bond premium is addressed in proposed
regulations under section 171. The issuer's treatment of bond issuance
premium is addressed in proposed regulations under section 163. In each
case, the amortization of premium is based on constant yield
principles. For this reason, the proposed regulations use concepts and
definitions from the original issue discount (OID) regulations
(Secs. 1.1271-0 through 1.1275-6).
Determination of Bond Premium
Under the proposed regulations, bond premium is defined as the
excess of a holder's basis in a bond over the sum of the remaining
amounts payable on the bond other than payments of qualified stated
interest. The holder generally determines the amount of bond premium as
of the date the holder acquires the bond.
The proposed regulations provide special rules that limit a
holder's basis solely for purposes of determining bond premium. For
example, if a bond is convertible into stock of the issuer at the
holder's option, for purposes of determining bond premium, the holder
must reduce its basis in the bond by the value of the conversion
option. This reduction prevents the holder from inappropriately
amortizing the cost of the embedded conversion option.
Amortization of Bond Premium
Under section 171, the holder of a taxable bond acquired at a
premium may elect to amortize bond premium. The holder of a tax-exempt
bond acquired at a premium must amortize the premium. As premium is
amortized, the holder's basis in the bond is reduced by a corresponding
amount under section 1016(a)(5).
Under the proposed regulations, a holder amortizes bond premium by
offsetting qualified stated interest income with bond premium. An
offset is calculated for each accrual period using constant yield
principles. However, the offset for an accrual period is only taken
into account when the holder takes qualified stated interest into
account under the holder's regular method of accounting. Thus, a holder
using the cash receipts and disbursements method of accounting does not
take bond premium into account until a qualified stated interest
payment is received.
For certain bonds (e.g., bonds that pay a variable rate of interest
or that provide for an interest holiday), the amount of bond premium
allocable to an accrual period could exceed the amount of qualified
stated interest allocable to that period. The proposed regulations
address this situation by providing that the excess bond premium is not
allowed as a deduction but is carried forward to future accrual
periods.
Variable Rate Debt Instruments
Because a variable rate debt instrument (VRDI) provides for
variable interest payments, the yield and payment schedule of a VRDI
cannot be determined without making assumptions about the amount of the
variable payments. Under the OID regulations, OID on a VRDI is
determined and allocated among accrual periods by reference to an
equivalent fixed rate debt instrument constructed as of the issue date
of the VRDI. The proposed regulations provide that bond premium on a
VRDI is determined and allocated in a similar manner. Under the
proposed regulations, bond premium on a VRDI is determined and
allocated by reference to an equivalent fixed rate debt instrument.
However, the equivalent fixed rate debt instrument is constructed as of
the date the holder acquires the VRDI rather than the issue date.
Bonds Subject to Certain Contingencies
If a bond provides for one or more alternative payment schedules,
the yield of the bond cannot be determined without making assumptions
about the actual payment schedule. The OID regulations provide three
rules for making these assumptions. First, if one payment schedule is
significantly more likely than not to occur, the yield of the debt
instrument is determined by reference to this payment schedule. Second,
if the debt instrument is subject to a mandatory sinking fund
provision, the yield is determined without regard to the mandatory
sinking fund provision. Third, notwithstanding the first two rules, if
the debt instrument provides for an unconditional option or options to
alter the payment schedule, the yield is determined by assuming that
the issuer will exercise its options in the manner that minimizes the
yield of the debt instrument and that the holder will exercise its
options in the manner that maximizes the yield of the debt instrument.
The proposed regulations generally use similar assumptions to
determine the holder's yield on a bond that provides for alternative
payment schedules. However, in the case of an issuer's option on a
taxable bond, the proposed regulations reverse the assumption by
assuming that the issuer will exercise the option only if doing so
would increase the yield on the bond. See section 171(b)(1)(B)(ii). As
a result of this rule, a holder generally must amortize bond premium on
a taxable bond by reference to the stated maturity date, even if it
appears likely the bond will be called. In this case, if the bond is
actually called, the proposed regulations provide that the holder may
deduct the unamortized premium. If the bond is partially called and the
partial call is not a pro-rata prepayment, the proposed regulations do
not allow the
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holder to deduct a portion of the unamortized premium. Instead, the
holder must recompute the yield of the bond on the date of the partial
call and amortize the remaining premium by reference to the recomputed
yield.
Treasury and IRS request comments on the application of the
alternative payment schedule rules. Specifically, comments are
requested on whether the ``significantly more likely than not to
occur'' standard is appropriate for taxable bonds, whether ignoring
mandatory sinking fund provisions is appropriate for tax-exempt bonds,
and whether the distinction between pro-rata and non-pro-rata calls is
appropriate.
Bond Issuance Premium
Under existing Sec. 1.61-12(c), a corporate issuer treats premium
received upon issuance of a bond as a separate item of income. Over the
term of the bond, the premium is taken into income, and the full amount
of the stated interest is deducted. The proposed regulations would
revise the treatment of bond issuance premium. Under the proposed
regulations, bond issuance premium is amortized as an offset to the
issuer's otherwise allowable interest deduction, not as a separate item
of income. The amount of bond issuance premium amortized in any period
is based on a constant yield. In addition, the proposed regulations
would apply to all issuers, not just corporate issuers.
De Minimis Rules and Aggregate Rules
The proposed regulations do not provide rules for de minimis
amounts of premium or for aggregate methods of accounting for premium.
Treasury and IRS request comments on whether de minimis rules or
aggregate rules are necessary or appropriate.
Bonds Not Subject to the Proposed Regulations
The proposed regulations generally apply to bonds acquired or
issued at a premium. Certain bonds, however, are excluded from the
application of the proposed regulations. For example, the proposed
regulations exclude debt instruments subject to section 1272(a)(6)
(relating to certain prepayable debt instruments). No inference is
intended regarding the treatment of these debt instruments.
Proposed Effective Dates
The proposed regulations relating to bond premium provide that the
final regulations generally will apply to bonds acquired on or after
the date 60 days after the date final regulations are published in the
Federal Register. However, if a holder makes the election to amortize
bond premium for the taxable year containing the date 60 days after the
date final regulations are published, the regulations apply to bonds
held on or after the first day of that taxable year.
The proposed regulations relating to bond issuance premium provide
that the final regulations will apply to debt instruments issued on or
after the date 60 days after the date final regulations are published
in the Federal Register.
The proposed regulations also would provide automatic consent for a
taxpayer to change its method of accounting for premium in certain
circumstances. Because the change is made on a cut-off basis, no items
of income or deduction are omitted or duplicated. Therefore, no
adjustment under section 481 is allowed.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for October 23, 1996, at 10
a.m. in the Commissioner's Conference Room, Internal Revenue Building,
1111 Constitution Avenue NW, Washington, DC. Because of access
restrictions, visitors will not be admitted beyond the building lobby
more than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by September 25, 1996. and submit an outline of
the topics to be discussed and the time to be devoted to each topic
(signed original and eight (8) copies) by October 2, 1996.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
The principal authors of these regulations are William P. Cejudo
and Jeffrey W. Maddrey of the Office of Assistant Chief Counsel
(Financial Institutions and Products). However, other personnel from
the IRS and Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.171-2 also issued under 26 U.S.C. 171(e).
Section 1.171-3 also issued under 26 U.S.C. 171(e).
Section 1.171-4 also issued under 26 U.S.C. 171(c). * * *
Par. 2. Section 1.61-12 is amended by revising paragraph (c) to
read as follows:
Sec. 1.61-12 Income from discharge of indebtedness.
* * * * *
(c) Issuance and repurchase of debt instruments--(1) Issuance. An
issuer does not realize gain or loss upon the issuance of a debt
instrument (as defined in Sec. 1.1275-1(d)).
(2) Repurchase--(i) In general. An issuer does not realize gain or
loss upon the repurchase of a debt instrument. For purposes of this
paragraph (c)(2), the term repurchase includes the retirement of a debt
instrument, the conversion of a debt instrument into stock of the
issuer, and the exchange (including an exchange under section 1001) of
a newly issued debt instrument for an existing debt instrument.
(ii) Repurchase at a discount. An issuer realizes income from the
discharge of indebtedness upon the repurchase of a debt instrument for
an amount less than its adjusted issue price (as defined in Sec. 1.163-
13(d)(5)). The
[[Page 33399]]
amount of discharge of indebtedness income is equal to the excess of
the adjusted issue price over the repurchase price. To determine the
repurchase price of a debt instrument that is repurchased through the
issuance of a new debt instrument, see section 108(e)(10). See
Sec. 1.108-2 for rules relating to the realization of discharge of
indebtedness income upon the acquisition of a debt instrument by a
person related to the issuer.
(iii) Repurchase at a premium. An issuer may be entitled to a
repurchase premium deduction upon the repurchase of a debt instrument
for an amount greater than its adjusted issue price (as defined in
Sec. 1.163-13(d)(5)). See Sec. 1.163-7(c) for the treatment of
repurchase premium.
(3) Bond issuance premium. For rules relating to an issuer's
interest deduction for a debt instrument issued with bond issuance
premium, see Sec. 1.163-13.
(4) Effective date. This paragraph (c) applies to debt instruments
issued on or after the date that is 60 days after the date final
regulations are published in the Federal Register.
* * * * *
Par. 3. Section 1.163-7 is amended by revising the first sentence
of paragraph (c) to read as follows:
Sec. 1.163-7 Deduction for OID on certain debt instruments.
* * * * *
(c) Deduction upon repurchase. Except to the extent disallowed by
any other section of the Internal Revenue Code (e.g., section 249) or
this paragraph (c), if a debt instrument is repurchased by the issuer
for a price in excess of its adjusted issue price (as defined in
Sec. 1.163-13(d)(5)), the excess (repurchase premium) is deductible as
interest for the taxable year in which the repurchase occurs. * * *
* * * * *
Par. 4. Section 1.163-13 is added to read as follows:
Sec. 1.163-13 Treatment of bond issuance premium.
(a) General rule. If a debt instrument is issued with bond issuance
premium, this section limits the amount of the issuer's interest
deduction otherwise allowable under section 163(a). In general, the
issuer determines its interest deduction by offsetting the interest
allocable to an accrual period with the bond issuance premium allocable
to that period. Bond issuance premium is allocable to an accrual period
based on a constant yield. The use of a constant yield to amortize bond
issuance premium is intended to conform the treatment of debt
instruments having bond issuance premium with those having original
issue discount. Unless otherwise provided, the terms used in this
section have the same meaning as those terms in section 163(e),
sections 1271 through 1275, and the corresponding regulations.
Moreover, the provisions of this section apply in a manner consistent
with those of section 163(e), sections 1271 through 1275, and the
corresponding regulations. In addition, the anti- abuse rule in
Sec. 1.1275-2(g) applies for purposes of this section. For rules
dealing with the treatment of bond premium by a holder, see
Secs. 1.171-1 through 1.171-5.
(b) Exceptions. This section does not apply to--
(1) A debt instrument to which section 1272(a)(6) applies (relating
to certain interests in or mortgages held by a REMIC, and certain other
debt instruments with payments subject to acceleration); or
(2) A debt instrument to which Sec. 1.1275-4 applies (relating to
certain debt instruments that provide for contingent payments).
(c) Bond issuance premium. Bond issuance premium is the excess, if
any, of the issue price of a debt instrument over its stated redemption
price at maturity. For purposes of this section, the issue price of a
convertible bond (as defined in Sec. 1.171-1(e)(1)(iii)(C)) does not
include an amount equal to the value of the conversion option.
(d) Offsetting qualified stated interest with bond issuance
premium--(1) In general. An issuer amortizes bond issuance premium by
offsetting the qualified stated interest allocable to an accrual period
with the bond issuance premium allocable to the accrual period. This
offset occurs when the issuer takes the qualified stated interest into
account under its regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See
Sec. 1.446-2(b) to determine the accrual period to which qualified
stated interest is allocable and to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond issuance premium allocable to an accrual period. The bond
issuance premium allocable to an accrual period is determined under
this paragraph (d)(3). Within an accrual period, the bond issuance
premium allocable to the period accrues ratably.
(i) Step one: Determine the debt instrument's yield to maturity.
The yield to maturity of a debt instrument is determined under the
rules of Sec. 1.1272-1(b)(1)(i).
(ii) Step two: Determine the accrual periods. The accrual periods
are determined under the rules of Sec. 1.1272-1(b)(1)(ii).
(iii) Step three: Determine the bond issuance premium allocable to
the accrual period. The bond issuance premium allocable to an accrual
period is the excess of the qualified stated interest allocable to the
accrual period over the product of the adjusted issue price at the
beginning of the accrual period and the yield. In performing this
calculation, the yield must be stated appropriately taking into account
the length of the particular accrual period. Principles similar to
those in Sec. 1.1272-1(b)(4) apply in determining the bond issuance
premium allocable to an accrual period.
(4) Bond issuance premium in excess of qualified stated interest.
If the bond issuance premium allocable to an accrual period exceeds the
qualified stated interest allocable to the accrual period for a debt
instrument, the excess is carried forward to the next accrual period
and offsets qualified stated interest in that accrual period to the
extent of the disallowed amount. If the amount carried forward to an
accrual period exceeds the qualified stated interest for that period,
the excess is carried forward to subsequent accrual periods, beginning
with the next accrual period, and is used to offset qualified stated
interest in those accrual periods to the extent of the excess. If an
excess amount exists on the date the debt instrument is retired, the
issuer takes this amount into account as ordinary income.
(5) Adjusted issue price. In general, the adjusted issue price of a
debt instrument is determined under the rules of Sec. 1.1275-1(b). In
addition, the adjusted issue price of the debt instrument is decreased
by the amount of bond issuance premium previously allocable under
paragraph (d)(3) of this section.
(e) Special rules--(1) Variable rate debt instruments issued with
bond issuance premium. Bond issuance premium on a variable rate debt
instrument is determined by reference to the stated redemption price at
maturity of the equivalent fixed rate debt instrument constructed as of
the issue date. In addition, the issuer allocates bond issuance premium
on a variable rate debt instrument among the accrual periods by
reference to the equivalent fixed rate debt instrument. The equivalent
fixed rate debt instrument is determined using the principles of
Sec. 1.1275-5(e).
(2) Remote and incidental contingencies. For purposes of
determining and amortizing bond issuance premium, if a bond provides
[[Page 33400]]
for a contingency that is remote or incidental (within the meaning of
Sec. 1.1275-2(h)), the contingency is taken into account under the
rules for remote and incidental contingencies in Sec. 1.1275-2(h).
(f) Example. The following example illustrates the rules of this
section.
Example--(i) Facts. On February 1, 1999, X issues for $110,000 a
debt instrument maturing on February 1, 2006, with a stated
principal amount of $100,000, payable at maturity. The debt
instrument provides for unconditional payments of interest of
$10,000, payable on February 1 of each year. X uses the calendar
year as its taxable year, X uses the cash receipts and disbursements
method of accounting, and X decides to use annual accrual periods
ending on February 1 of each year. X's calculations assume a 30-day
month and 360-day year.
(ii) Amount of bond issuance premium. The issue price of the
debt instrument is $110,000. Because the interest payments on the
debt instrument are qualified stated interest, the stated redemption
price at maturity of the debt instrument is $100,000. Therefore, the
amount of bond issuance premium is $10,000 ($110,000 - $100,000).
(iii) Bond issuance premium allocable to the first accrual
period. Based on the payment schedule and the issue price of the
debt instrument, the yield of the debt instrument is 8.07 percent,
compounded annually. (Although, for purposes of simplicity, the
yield as stated is rounded to two decimal places, the computations
do not reflect this rounding convention.) The bond issuance premium
allocable to the accrual period ending on February 1, 2000, is the
excess of the qualified stated interest allocable to the period
($10,000) over the product of the adjusted issue price at the
beginning of the period ($110,000) and the yield (8.07 percent,
compounded annually). Therefore, the bond issuance premium allocable
to the accrual period is $1,118.17 ($10,000 - $8,881.83).
(iv) Premium used to offset interest. Although X makes an
interest payment of $10,000 on February 1, 2000, X only deducts
interest of $8,881.83, the qualified stated interest allocable to
the period ($10,000) offset with bond issuance premium allocable to
the period ($1,118.17).
(g) Effective date. This section applies to debt instruments issued
on or after the date that is 60 days after the date final regulations
are published in the Federal Register.
(h) Consent to change method of accounting. The Commissioner grants
consent for an issuer to change its method of accounting for bond
issuance premium on debt instruments issued on or after the date that
is 60 days after the date final regulations are published in the
Federal Register. However, this consent is granted only if--
(1) The change is made to comply with this section;
(2) The change is made for the first taxable year for which the
issuer must account for a debt instrument under this section; and
(3) The issuer attaches to its federal income tax return for the
taxable year containing the change a statement that it has changed its
method of accounting under this section.
Par. 5. Sections 1.171-1 through 1.171-4 are revised to read as
follows:
Sec. 1.171-1 Bond premium.
(a) Overview--(1) In general. This section and Secs. 1.171-2
through 1.171-5 provide rules for the determination and amortization of
bond premium by a holder. In general, a holder amortizes bond premium
by offsetting the interest allocable to an accrual period with the
premium allocable to that period. Bond premium is allocable to an
accrual period based on a constant yield. The use of a constant yield
to amortize bond premium is intended generally to conform the treatment
of bond premium to the treatment of original issue discount under
sections 1271 through 1275. Unless otherwise provided, the terms used
in this section and Secs. 1.171-2 through 1.171-5 have the same meaning
as those terms in sections 1271 through 1275 and the corresponding
regulations. Moreover, the provisions of this section and Secs. 1.171-2
through 1.171-5 apply in a manner consistent with those of sections
1271 through 1275 and the corresponding regulations. In addition, the
anti-abuse rule in Sec. 1.1275-2(g) applies for purposes of this
section and Secs. 1.171-2 through 1.171-5.
(2) Cross-references. For rules dealing with the adjustments to a
holder's basis to reflect the amortization of bond premium, see
Sec. 1.1016-5(b). For rules dealing with the treatment of bond issuance
premium by an issuer, see Sec. 1.163-13.
(b) Scope--(1) In general. Except as provided in paragraph (b)(2)
of this section, this section and Secs. 1.171-2 through 1.171-5 apply
to any bond that, upon its acquisition by the holder, is held with bond
premium. For purposes of this section and Secs. 1.171-2 through 1.171-
5, the term bond has the same meaning as the term debt instrument in
Sec. 1.1275-1(d).
(2) Exceptions. This section and Secs. 1.171-2 through 1.171-5 do
not apply to--
(i) A bond to which section 1272(a)(6) applies (relating to certain
interests in or mortgages held by a REMIC, and certain other debt
instruments with payments subject to acceleration);
(ii) A bond to which Sec. 1.1275-4 applies (relating to certain
debt instruments that provide for contingent payments);
(iii) A bond held by a holder that has made a Sec. 1.1272-3
election with respect to the bond;
(iv) A bond that is stock in trade of the holder, a bond of a kind
that would properly be included in the inventory of the holder if on
hand at the close of the taxable year, or a bond held primarily for
sale to customers in the ordinary course of the holder's trade or
business; or
(v) A bond issued before September 28, 1985, unless the bond bears
interest and was issued by a corporation or by a government or
political subdivision thereof.
(c) General rule--(1) Tax-exempt obligations. A holder must
amortize bond premium on a bond that is a tax-exempt obligation. See
Sec. 1.171-2(c) Example 4.
(2) Taxable bonds. A holder may elect to amortize bond premium on a
taxable bond. Except as provided in paragraph (c)(3) of this section, a
taxable bond is any bond other than a tax-exempt obligation. See
Sec. 1.171-4 for rules relating to the election to amortize bond
premium on a taxable bond.
(3) Bonds the interest on which is partially excludable. For
purposes of this section and Secs. 1.171-2 through 1.171-5, a bond the
interest on which is partially excludable from gross income (e.g., a
securities acquisition loan under section 133) is treated as two
instruments, a tax-exempt obligation and a taxable bond. The holder's
basis in the bond and each payment on the bond are allocated between
the two instruments based on the ratio of the interest excludable to
the total interest payable on the bond.
(d) Determination of bond premium--(1) In general. A holder
acquires a bond at a premium if the holder's basis in the bond
immediately after its acquisition by the holder exceeds the sum of all
amounts payable on the bond after the acquisition date (other than
payments of qualified stated interest). This excess is bond premium,
which is amortizable under Sec. 1.171-2.
(2) Additional rules for amounts payable on certain bonds.
Additional rules apply to determine the amounts payable on a variable
rate debt instrument and on a bond that provides for certain
alternative payment schedules. See Sec. 1.171-3.
(e) Basis. A holder determines its basis in a bond under this
paragraph (e). This determination of basis applies only for purposes of
this section and Secs. 1.171-2 through 1.171-5. Because of the
application of this paragraph (e), the holder's basis in the bond for
purposes of these sections may differ from the
[[Page 33401]]
holder's basis for determining gain or loss on the sale or exchange of
the bond.
(1) Determination of basis--(i) In general. In general, the
holder's basis in the bond is the holder's basis for determining loss
on the sale or exchange of the bond.
(ii) Bonds acquired in certain exchanges. If the holder acquired
the bond in exchange for other property (other than in a reorganization
defined in section 368) and the holder's basis in the bond is
determined in whole or in part by reference to the holder's basis in
the other property, the holder's basis in the bond may not exceed its
fair market value immediately after the exchange. See paragraph (f)
Example 1 of this section. If the bond is acquired in a reorganization,
see section 171(b)(4)(B).
(iii) Convertible bonds--(A) General rule. If the bond is a
convertible bond, the holder's basis in the bond is reduced by an
amount equal to the value of the conversion option. The value of the
conversion option may be determined under any reasonable method. For
example, the holder may determine the value of the conversion option by
comparing the market price of the convertible bond to the market prices
of similar bonds that do not have conversion options. See paragraph (f)
Example 2 of this section.
(B) Convertible bonds acquired in certain exchanges. If the bond is
a convertible bond acquired in a transaction described in paragraph
(e)(1)(ii) of this section, the holder's basis in the bond may not
exceed its fair market value immediately after the exchange reduced by
the value of the conversion option.
(C) Definition of convertible bond. A convertible bond is a bond
that provides the holder with an option to convert the bond into stock
of the issuer, 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 that stock or debt.
(2) Basis in bonds held by certain transferees. Notwithstanding
paragraph (e)(1) of this section, if the bond is transferred basis
property (as defined in section 7701(a)(43)) and the transferor had
acquired the bond at a premium, the holder's basis in the bond is--
(i) The holder's basis for determining loss on the sale or exchange
of the bond; reduced by
(ii) Any amounts that the transferor could not have amortized under
this paragraph (e) or under Sec. 1.171-4(c).
(f) Examples. The following examples illustrate the rules of this
section.
Example 1. Bond received in liquidation of a partnership
interest--(i) Facts. PR is a partner in partnership PRS. PRS does
not have any unrealized receivables or substantially appreciated
inventory items as defined in section 751. On January 1, 1997, PRS
distributes to PR a taxable bond, issued by an unrelated
corporation, in liquidation of PR's partnership interest. At that
time, the fair market value of PR's partnership interest is $40,000
and the basis is $100,000. The fair market value of the bond is
$40,000.
(ii) Determination of basis. Under section 732(b), PR's basis in
the bond is equal to PR's basis in the partnership interest.
Therefore, PR's basis for determining loss on the sale or exchange
of the bond is $100,000. However, under paragraph (e)(1)(ii) of this
section, PR's basis in the bond is $40,000 for purposes of this
section and Secs. 1.171-2 through 1.171-5.
Example 2. Convertible bond--(i) Facts. On January 1, 1997, A
purchases for $1,100 B corporation's bond maturing on January 1,
2000, with a stated principal amount of $1,000, payable at maturity.
The bond provides for unconditional payments of interest of $30 on
January 1 and July 1 of each year. In addition, the bond is
convertible into 15 shares of B corporation stock at the option of
the holder. On January 1, 1997, B corporation's nonconvertible,
publicly-traded, three-year debt with similar credit rating trades
at a price that reflects a yield of 6.75 percent, compounded
semiannually.
(ii) Determination of basis. A's basis for determining loss on
the sale or exchange of the bond is $1,100. As of January 1, 1997,
discounting the remaining payments on the bond at the yield at which
B's similar nonconvertible bonds trade (6.75 percent, compounded
semiannually) results in a present value of $980. Thus, the value of
the conversion option is $120. Under paragraph (e)(1)(iii)(A) of
this section, A's basis is $980 ($1,100-$120) for purposes of this
section and Secs. 1.171-2 through 1.171-5. The sum of all amounts
payable on the bond other than qualified stated interest is $1,000.
Because A's basis (as determined under paragraph (e)(1)(iii)(A) of
this section) does not exceed $1,000, A does not acquire the bond at
a premium.
Sec. 1.171-2 Amortization of bond premium.
(a) Offsetting qualified stated interest with premium--(1) In
general. A holder amortizes bond premium by offsetting the qualified
stated interest allocable to an accrual period with the bond premium
allocable to the accrual period. This offset occurs when the holder
takes the qualified stated interest into account under the holder's
regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See
Sec. 1.446-2(b) to determine the accrual period to which qualified
stated interest is allocable and to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond premium allocable to an accrual period. The bond premium
allocable to an accrual period is determined under this paragraph
(a)(3). Within an accrual period, the bond premium allocable to the
period accrues ratably.
(i) Step one: Determine the holder's yield. The holder's yield is
the discount rate that, when used in computing the present value of all
remaining payments to be made on the bond (including payments of
qualified stated interest), produces an amount equal to the holder's
basis in the bond as determined under Sec. 1.171-1(e). For this
purpose, the remaining payments include only payments to be made after
the date the holder acquires the bond. The yield is calculated as of
the date the holder acquires the bond, must be constant over the term
of the bond, and must be calculated to at least two decimal places when
expressed as a percentage.
(ii) Step two: Determine the accrual periods. A holder determines
the accrual periods for the bond under the rules of Sec. 1.1272-
1(b)(1)(ii).
(iii) Step three: Determine the bond premium allocable to the
accrual period. The bond premium allocable to an accrual period is the
excess of the qualified stated interest allocable to the accrual period
over the product of the holder's adjusted acquisition price (as defined
in paragraph (b) of this section) at the beginning of the accrual
period and the holder's yield. In performing this calculation, the
yield must be stated appropriately taking into account the length of
the particular accrual period. Principles similar to those in
Sec. 1.1272-1(b)(4) apply in determining the bond premium allocable to
an accrual period.
(4) Bond premium in excess of qualified stated interest. If the
bond premium allocable to an accrual period exceeds the qualified
stated interest allocable to the accrual period for that bond, the
excess is carried forward to the next accrual period and offsets
qualified stated interest in that accrual period to the extent of the
disallowed amount. If the bond premium carried forward to an accrual
period exceeds the qualified stated interest for that period, the
excess is carried forward to subsequent accrual periods, beginning with
the next accrual period, and is used to offset qualified stated
interest in those accrual periods to the extent of the excess.
(5) Additional rules for certain bonds. Additional rules apply to
determine the amortization of bond premium on a variable rate debt
instrument and on a bond that provides for certain alternative payment
schedules. See Sec. 1.171-3.
(b) Adjusted acquisition price. The adjusted acquisition price of a
bond at the beginning of the first accrual period is the holder's basis
as determined under Sec. 1.171-1(e). Thereafter, the
[[Page 33402]]
adjusted acquisition price is the holder's basis in the bond decreased
by--
(1) The amount of bond premium previously allocable under paragraph
(a)(3) of this section; and
(2) The amount of any payment previously made on the bond other
than a payment of qualified stated interest.
(c) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and has elected to amortize bond premium, effective for
all relevant taxable years. In addition, each example assumes a 30-day
month and 360-day year. Although, for purposes of simplicity, the yield
as stated is rounded to two decimal places, the computations do not
reflect this rounding convention.
Example 1. Taxable bond--(i) Facts. On February 1, 1999, A
purchases for $110,000 a taxable bond maturing on February 1, 2006,
with a stated principal amount of $100,000, payable at maturity. The
bond provides for unconditional payments of interest of $10,000,
payable on February 1 of each year. A uses the cash receipts and
disbursements method of accounting, and A decides to use annual
accrual periods ending on February 1 of each year.
(ii) Amount of bond premium. The interest payments on the bond
are qualified stated interest. Therefore, the sum of all amounts
payable on the bond (other than the interest payments) is $100,000.
Under Sec. 1.171-1, the amount of bond premium is $10,000 ($110,000-
$100,000).
(iii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the bond and A's basis in the
bond, A's yield is 8.07 percent, compounded annually. The bond
premium allocable to the accrual period ending on February 1, 2000,
is the excess of the qualified stated interest allocable to the
period ($10,000) over the product of the adjusted acquisition price
at the beginning of the period ($110,000) and A's yield (8.07
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $1,118.17 ($10,000-$8,881.83).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest allocable to the
period ($10,000) offset with bond premium allocable to the period
($1,118.17). Under Sec. 1.1016-5(b), A's basis in the bond is
reduced by $1,118.17 on February 1, 2000.
Example 2. Alternative accrual periods--(i) Facts. The facts are
the same as in Example 1 of this paragraph (c) except that A decides
to use semiannual accrual periods ending on February 1 and August 1
of each year.
(ii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the bond and A's basis in the
bond, A's yield is 7.92 percent, compounded semiannually. The bond
premium allocable to the accrual period ending on August 1, 1999, is
the excess of the qualified stated interest allocable to the period
($5,000) over the product of the adjusted acquisition price at the
beginning of the period ($110,000) and A's yield, stated
appropriately taking into account the length of the accrual period
(7.92 percent/2). Therefore, the bond premium allocable to the
accrual period is $645.29 ($5,000-$4,354.71). Although the accrual
period ends on August 1, 1999, the qualified stated interest of
$5,000 is not taken into income until February 1, 2000, the date it
is received. Likewise, the bond premium of $645.29 is not taken into
account until February 1, 2000. The adjusted acquisition price of
the bond on August 1, 1999, is $109,354.71 (the adjusted acquisition
price at the beginning of the period ($110,000) less the bond
premium allocable to the period ($645.29)).
(iii) Bond premium allocable to the second accrual period.
Because the interval between payments of qualified stated interest
contains more than one accrual period, the adjusted acquisition
price at the beginning of the second accrual period must be adjusted
for the accrued but unpaid qualified stated interest. Therefore, the
adjusted acquisition price on August 1, 1999, is $114,354.71
($109,354.71+$5,000). The bond premium allocable to the accrual
period ending on February 1, 2000, is the excess of the qualified
stated interest allocable to the period ($5,000) over the product of
the adjusted acquisition price at the beginning of the period
($114,354.71) and A's yield, stated appropriately taking into
account the length of the accrual period (7.92 percent/2).
Therefore, the bond premium allocable to the accrual period is
$472.88 ($5,000-$4,527.12).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest of $10,000 ($5,000
allocable to the accrual period ending on August 1, 1999, and $5,000
allocable to the accrual period ending on February 1, 2000) offset
with bond premium of $1,118.17 ($645.29 allocable to the accrual
period ending on August 1, 1999, and $472.88 allocable to the
accrual period ending on February 1, 2000). As indicated in Example
1 of this paragraph (c), this same amount would be taken into income
at the same time had A used annual accrual periods.
Example 3. Holder uses accrual method of accounting--(i) Facts.
The facts are the same as in Example 1 of this paragraph (c) except
that A uses the accrual method of accounting. Thus, for the accrual
period ending on February 1, 2000, the qualified stated interest
allocable to the period is $10,000, and the bond premium allocable
to the period is $1,118.17. Because the accrual period extends
beyond the end of A's taxable year, A must allocate these amounts
between the two taxable years.
(ii) Amounts allocable to the first taxable year. The qualified
stated interest allocable to the first taxable year is $9,166.67
($10,000 x 11/12). The bond premium allocable to the first taxable
year is $1,024.99 ($1,118.17 x 11/12).
(iii) Premium used to offset interest. For 1999, A includes in
income $8,141.68, the qualified stated interest allocable to the
period ($9,166.67) offset with bond premium allocable to the period
($1,024.99). Under Sec. 1.1016-5(b), A's basis in the bond is
reduced by $1,024.99 in 1999.
(iv) Amounts allocable to the next taxable year. The remaining
amounts of qualified stated interest and bond premium allocable to
the accrual period ending on February 1, 2000, are taken into
account for the taxable year ending on December 31, 2000.
Example 4. Tax-exempt obligation--(i) Facts. On January 15,
1999, C purchases for $120,000 a tax-exempt obligation maturing on
January 15, 2006, with a stated principal amount of $100,000,
payable at maturity. The obligation provides for unconditional
payments of interest of $9,000, payable on January 15 of each year.
C uses the cash receipts and disbursements method of accounting, and
C decides to use annual accrual periods ending on January 15 of each
year.
(ii) Amount of bond premium. The interest payments on the
obligation are qualified stated interest. Therefore, the sum of all
amounts payable on the obligation (other than the interest payments)
is $100,000. Under Sec. 1.171-1, the amount of bond premium is
$20,000 ($120,000-$100,000).
(iii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the obligation and C's basis in
the obligation, C's yield is 5.48 percent, compounded annually. The
bond premium allocable to the accrual period ending on January 15,
2000, is the excess of the qualified stated interest allocable to
the period ($9,000) over the product of the adjusted acquisition
price at the beginning of the period ($120,000) and C's yield (5.48
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $2,420.55 ($9,000-$6,579.45).
(iv) Premium used to offset interest. Although C receives an
interest payment of $9,000 on January 15, 2000, C only receives tax-
exempt interest income of $6,579.45, the qualified stated interest
allocable to the period ($9,000) offset with bond premium allocable
to the period ($2,420.55). Under Sec. 1.1016-5(b), C's basis in the
obligation is reduced by $2,420.55 on January 15, 2000.
Sec. 1.171-3 Special rules for certain bonds.
(a) Variable rate debt instruments. Bond premium on a variable rate
debt instrument is determined by reference to the stated redemption
price at maturity of the equivalent fixed rate debt instrument
constructed for the variable rate debt instrument. In addition, a
holder allocates bond premium on a variable rate debt instrument among
the accrual periods by reference to the equivalent fixed rate debt
instrument. The equivalent fixed rate debt instrument is determined as
of the date the variable rate debt instrument is acquired by the holder
and is constructed using the principles of Sec. 1.1275-5(e). See
paragraph (d) Example 1 of this section.
(b) Yield and remaining payment schedule of certain bonds subject
to
[[Page 33403]]
contingencies--(1) Applicability. This paragraph (b) provides rules
that apply in determining the yield and remaining payment schedule of
certain bonds that provide for an alternative payment schedule (or
schedules) applicable upon the occurrence of a contingency (or
contingencies). This paragraph (b) applies, however, only if the timing
and amounts of the payments that comprise each payment schedule are
known as of the date the holder acquires the bond (the acquisition
date) and the bond is subject to paragraph (b)(2), (3), or (4) of this
section. A bond 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 bond that provides for a
contingency that is not described in this paragraph (b).
(2) Remaining payment schedule that is significantly more likely
than not to occur. If, based on all the facts and circumstances as of
the acquisition date, a single remaining payment schedule for a bond is
significantly more likely than not to occur, this remaining payment
schedule is used to determine and amortize bond premium under
Secs. 1.171-1 and 1.171-2.
(3) Mandatory sinking fund provision. Notwithstanding paragraph
(b)(2) of this section, if a bond is subject to a mandatory sinking
fund provision described in Sec. 1.1272-1(c)(3) and the use and terms
of the provision meet reasonable commercial standards, the provision is
ignored for purposes of determining and amortizing bond premium under
Secs. 1.171-1 and 1.171-2.
(4) Treatment of certain options--(i) Applicability.
Notwithstanding paragraphs (b) (2) and (3) of this section, the rules
of this paragraph (b)(4) determine the remaining payment schedule of a
bond that provides the holder or issuer with an unconditional option or
options, exercisable on one or more dates during the remaining term of
the bond, to alter the bond's remaining payment schedule.
(ii) Operating rules. A holder determines the remaining payment
schedule of a bond by assuming that each option will (or will not) be
exercised under the following rules:
(A) Issuer options. The issuer of a tax-exempt obligation is deemed
to exercise or not exercise an option or combination of options in the
manner that minimizes the holder's yield on the obligation. The issuer
of a taxable bond is deemed to exercise or not exercise an option or
combination of options in the manner that maximizes the holder's yield
on the bond.
(B) Holder options. A holder is deemed to exercise or not exercise
an option or combination of options in the manner that maximizes the
holder's yield on the bond.
(C) Multiple options. If both the issuer and the holder have
options, the rules of paragraphs (b)(4)(ii) (A) and (B) of this section
are applied to the options in the order that they may be exercised.
Thus, the deemed exercise of one option may eliminate other options
that are later in time.
(5) Subsequent adjustments--(i) In general. Except as provided in
paragraph (b)(5)(ii) of this section, if a contingency described in
this paragraph (b) (including the exercise of an option described in
paragraph (b)(4) of this section) actually occurs or does not occur,
contrary to the assumption made pursuant to this paragraph (b) (a
change in circumstances), then solely for purposes of section 171, the
bond is treated as retired and reacquired by the holder on the date of
the change in circumstances for an amount equal to the adjusted
acquisition price of the bond as of that date. 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 bond. See
paragraph (d) Example 2 of this section. (ii) Bond premium deduction on
the issuer's call of a taxable bond. If a change in circumstances
results from an issuer's call of a taxable bond or a partial call that
is a pro-rata prepayment, the holder may deduct as bond premium an
amount equal to the excess, if any, of the adjusted acquisition price
of the bond over the greater of the amount received on redemption or
the amount payable on maturity.
(c) Remote and incidental contingencies. For purposes of
determining and amortizing bond premium, if a bond provides for a
contingency that is remote or incidental (within the meaning of
Sec. 1.1275-2(h)), the contingency is taken into account under the
rules for remote and incidental contingencies in Sec. 1.1275-2(h).
(d) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and, except as otherwise stated, has elected to amortize
bond premium, effective for all relevant taxable years. In addition,
each example assumes a 30-day month and 360-day year. Although, for
purposes of simplicity, the yield as stated is rounded to two decimal
places, the computations do not reflect this rounding convention.
Example 1. Variable rate debt instrument--(i) Facts. On March 1,
1999, E purchases for $110,000 a taxable bond maturing on March 1,
2007, with a stated principal amount of $100,000, payable at
maturity. The bond provides for unconditional payments of interest
on March 1 of each year based on the percentage appreciation of a
nationally-known commodity index. On March 1, 1999, it is reasonably
expected that the bond will yield 12 percent, compounded annually. E
uses the cash receipts and disbursements method of accounting, and E
decides to use annual accrual periods ending on March 1 of each
year. Assume that the bond is a variable rate debt instrument under
Sec. 1.1275-5.
(ii) Amount of bond premium. Because the bond is a variable rate
debt instrument, E determines and amortizes its bond premium by
reference to the equivalent fixed rate debt instrument constructed
for the bond as of March 1, 1999. Because the bond provides for
interest at a single objective rate that is reasonably expected to
yield 12 percent, compounded annually, the equivalent fixed rate
debt instrument for the bond is an eight-year bond with a principal
amount of $100,000, payable at maturity. It provides for annual
payments of interest of $12,000. E's basis in the equivalent fixed
rate debt instrument is $110,000. The sum of all amounts payable on
the equivalent fixed rate debt instrument (other than payments of
qualified stated interest) is $100,000. Under Sec. 1.171-1, the
amount of bond premium is $10,000 ($110,000-$100,000).
(iii) Bond premium allocable to each accrual period. E allocates
bond premium to the remaining accrual periods by reference to the
payment schedule on the equivalent fixed rate debt instrument. Based
on the payment schedule of the equivalent fixed rate debt instrument
and E's basis in the bond, E's yield is 10.12 percent, compounded
annually. The bond premium allocable to the accrual period ending on
March 1, 2000, is the excess of the qualified stated interest
allocable to the period for the equivalent fixed rate debt
instrument ($12,000) over the product of the adjusted acquisition
price at the beginning of the period ($110,000) and E's yield (10.12
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $870.71 ($12,000-$11,129.29). The bond
premium allocable to all the accrual periods is listed in the
following schedule:
------------------------------------------------------------------------
Adjusted
acquisition Premium
Accrual period ending price at allocable
beginning of to accrual
accrual period period
------------------------------------------------------------------------
3/1/00..................................... $110,000.00 $870.71
3/1/01..................................... 109,129.29 958.81
3/1/02..................................... 108,170.48 1,055.82
3/1/03..................................... 107,114.66 1,162.64
3/1/04..................................... 105,952.02 1,280.27
3/1/05..................................... 104,671.75 1,409.80
3/1/06..................................... 103,261.95 1,552.44
3/1/07..................................... 101,709.51para
. 1,709.51
------------
10,000.00
------------------------------------------------------------------------
[[Page 33404]]
(iv) Qualified stated interest for each accrual period. Assume
the bond actually pays the following amounts of qualified stated
interest:
------------------------------------------------------------------------
Qualified
Accrual period ending stated
interest
------------------------------------------------------------------------
3/1/00.................................................. $15,000.00
3/1/01.................................................. 0.00
3/1/02.................................................. 0.00
3/1/03.................................................. 10,000.00
3/1/04.................................................. 8,000.00
3/1/05.................................................. 12,000.00
3/1/06.................................................. 15,000.00
3/1/07.................................................. 8,500.00
------------------------------------------------------------------------
(v) Premium used to offset interest. E's interest income for
each accrual period is determined by offsetting the qualified stated
interest allocable to the period with the bond premium allocable to
the period. For the accrual period ending on March 1, 2000, E
includes in income $14,129.29, the qualified stated interest
allocable to the period ($15,000) offset with the bond premium
allocable to the period ($870.71). For the accrual period ending on
March 1, 2001, the bond premium allocable to the period ($958.81)
exceeds the qualified stated interest allocable to the period ($0).
Therefore, the excess of $958.81 ($958.81-$0) is carried forward to
the next accrual period. For the next accrual period, the qualified
stated interest for the period is insufficient to offset the bond
premium allocable to the period ($1,055.82) and the amount carried
forward from the prior period ($958.81). Thus, $2,014.63 ($1,055.82
+ $958.81) is carried forward to the accrual period ending on March
1, 2003, and offsets qualified stated interest allocable to that
period. The amount E includes in income for each accrual period is
shown in the following schedule:
----------------------------------------------------------------------------------------------------------------
Qualified Premium Premium
Accrual period ending stated allocable to Interest carry
interest accrual period income forward
----------------------------------------------------------------------------------------------------------------
3/1/00............................................. $15,000.00 $870.71 $14,129.29 ...........
3/1/01............................................. 0.00 958.81 0.00 958.81
3/1/02............................................. 0.00 1,055.82 0.00 2,014.63
3/1/03............................................. 10,000.00 1,162.64 6,822.73 ...........
3/1/04............................................. 8,000.00 1,280.27 6,719.73 ...........
3/1/05............................................. 12,000.00 1,409.80 10,590.20 ...........
3/1/06............................................. 15,000.00 1,552.44 13,447.56 ...........
3/1/07............................................. 8,500.00 1,709.51 6,790.49 ...........
----------------
10,000.00
----------------------------------------------------------------------------------------------------------------
Example 2. Partial call that results in a pro-rata prepayment--
(i) Facts. On April 1, 1999, M purchases for $110,000 N's taxable
bond maturing on April 1, 2006, with a stated principal amount of
$100,000, payable at maturity. The bond provides for unconditional
payments of interest of $10,000, payable on April 1 of each year. N
has the option to call all or part of the bond on April 1, 2001, at
a 5 percent premium over the principal amount. M uses the cash
receipts and disbursements method of accounting.
(ii) Determination of yield and the remaining payment schedule.
M's yield determined without regard to the call option is 8.07
percent, compounded annually. M's yield determined by assuming N
exercises its call option is 6.89 percent, compounded annually.
Under paragraph (b)(4)(ii)(A) of this section, it is assumed N will
not exercise the call option because exercising the option would
minimize M's yield. Thus, for purposes of determining and amortizing
bond premium, the bond is assumed to be a seven-year bond with a
single principal payment at maturity of $100,000.
(iii) Amount of bond premium. The interest payments on the bond
are qualified stated interest. Therefore, the sum of all amounts
payable on the bond (other than the interest payments) is $100,000.
Under Sec. 1.171-1, the amount of bond premium is $10,000 ($110,000-
$100,000).
(iv) Bond premium allocable to the first two accrual periods.
For the accrual period ending on April 1, 2000, M includes in income
$8,881.83, the qualified stated interest allocable to the period
($10,000) offset with bond premium allocable to the period
($1,118.17). The adjusted acquisition price on April 1, 2000, is
$108,881.83 ($110,000-$1,118.17). For the accrual period ending on
April 1, 2001, M includes in income $8,791.54, the qualified stated
interest allocable to the period ($10,000) offset with bond premium
allocable to the period ($1,208.46). The adjusted acquisition price
on April 1, 2001, is $107,673.37 ($108,881.83-$1,208.46).
(v) Partial call. Assume N calls one-half of M's bond for
$52,500 on April 1, 2001. Because it was assumed the call would not
be exercised, the call is a change in circumstances. However, the
partial call is also a pro-rata prepayment within the meaning of
Sec. 1.1275-2(f)(2). As a result, the call is treated as a
retirement of one-half of the bond. Under paragraph (b)(5)(ii) of
this section, M may deduct $1,336.68, the excess of its adjusted
acquisition price in the retired portion of the bond ($107,673.37/2,
or $53,836.68) over the amount received on redemption ($52,500). M's
adjusted basis in the portion of the bond that remains outstanding
is $53,836.68 ($107,673.37-$53,836.68).
Sec. 1.171-4 Election to amortize bond premium on taxable bonds.
(a) Time and manner of making the election--(1) In general. A
holder makes the election to amortize bond premium by offsetting
interest income with bond premium in the holder's timely filed federal
income tax return for the first taxable year to which the holder
desires the election to apply. The holder should attach to the return a
statement that the holder is making the election under this section.
(2) Coordination with OID election. If a holder makes an election
under Sec. 1.1272-3 for a bond with bond premium, the holder is deemed
to have made the election under this section.
(b) Scope of election. The election under this section applies to
all taxable bonds held during or after the taxable year for which the
election is made.
(c) Election to amortize made in a subsequent taxable year--(1) In
general. If a holder elects to amortize bond premium and holds a
taxable bond acquired before the taxable year for which the election is
made, the holder may not amortize amounts that would have been
amortized in prior taxable years had an election been in effect for
those prior years.
(2) Example. The following example illustrates the rule of this
paragraph (c).
Example--(i) Facts. On May 1, 1999, C purchases for $130,000 a
taxable bond maturing on May 1, 2006, with a stated principal amount
of $100,000, payable at maturity. The bond provides for
unconditional payments of interest of $15,000, payable on May 1 of
each year. C uses the cash receipts and disbursements method of
accounting and the calendar year as its taxable year. C has not
previously elected to amortize bond premium, but does so for 2002.
(ii) Amount to amortize. C's basis for determining loss on the
sale or exchange of the bond is $130,000. Thus, under Sec. 1.171-1,
the amount of bond premium is $30,000. Under Sec. 1.171-2, if a bond
premium election were in effect for the prior taxable years, C would
have amortized $3,257.44 of bond premium on May 1, 2000, and
$3,551.68 of bond premium on May 1, 2001, based on annual accrual
periods ending on May 1.
[[Page 33405]]
Thus, for 2002 and future years to which the election applies, C may
amortize only $23,190.88 ($30,000-$3,257.44-$3,551.68).
(d) Revocation of election. The election under this section may not
be revoked unless approved by the Commissioner.
Par. 6. Section 1.171-5 is added to read as follows:
Sec. 1.171-5 Effective date and transition rules.
(a) Effective date--(1) In general. This section and Secs. 1.171-1
through 1.171-4 apply to bonds acquired on or after the date 60 days
after the date final regulations are published in the Federal Register.
However, if a holder makes the election under Sec. 1.171-4 for the
taxable year containing the date 60 days after the date final
regulations are published in the Federal Register, this section and
Secs. 1.171-1 through 1.171-4 apply to bonds held on or after the first
day of that taxable year.
(2) Transition rule for use of constant yield. Notwithstanding
paragraph (a)(1) of this section, Sec. 1.171-2(a)(3) (providing that
the bond premium allocable to an accrual period is determined with
reference to a constant yield) does not apply to a bond issued before
September 28, 1985.
(b) Coordination with existing election. A holder is deemed to have
made the election under Sec. 1.171-4 if the holder elected to amortize
bond premium under section 171 and that election is effective on the
date 60 days after the date final regulations are published in the
Federal Register.
(c) Accounting method changes--(1) Consent to change. A holder
required to change its method of accounting for bond premium to comply
with Secs. 1.171-1 through 1.171-3 must secure the consent of the
Commissioner in accordance with the requirements of Sec. 1.446-1(e).
Paragraph (c)(2) of this section provides the Commissioner's automatic
consent for certain changes. A holder making the election does not need
the Commissioner's consent.
(2) Automatic consent. The Commissioner grants consent for a holder
to change its method of accounting for bond premium with respect to
bonds to which Secs. 1.171-1 through 1.171-3 apply. The consent granted
by this paragraph (c)(2) applies provided--
(i) The holder elected to amortize bond premium under section 171
for a taxable year prior to the taxable year containing the date 60
days after the date final regulations are published in the Federal
Register and that election has not been revoked;
(ii) The change is made for the first taxable year for which the
holder must account for a bond under Secs. 1.171-1 through 1.171-3; and
(iii) The holder attaches to its return for the taxable year
containing the change a statement that it has changed its method of
accounting under this section.
Par. 7. Section 1.1016-5 is amended by revising paragraph (b) to
read as follows:
Sec. 1.1016-5 Miscellaneous adjustments to basis.
* * * * *
(b) Amortizable bond premium. A holder's basis in a bond is reduced
by the amount of bond premium used to offset qualified stated interest
income under Sec. 1.171-2. This reduction occurs when the holder takes
the qualified stated interest into account under the holder's regular
method of accounting. In addition, a holder's basis in a taxable bond
is reduced by the amount of bond premium allowed as a deduction under
Sec. 1.171-3(b)(5)(ii) (relating to the issuer's call of a taxable
bond).
* * * * *
Sec. 1.1016-9 [Removed]
Par. 8. Section 1.1016-9 is removed.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-16350 Filed 6-26-96; 8:45 am]
BILLING CODE 4830-01-P
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.