Inflation-Indexed Debt Instruments

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8709]

RIN 1545-AU44

Inflation-Indexed Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary and final regulations.

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SUMMARY: This document contains temporary regulations relating to the

federal income tax treatment of inflation-indexed debt instruments,

including Treasury Inflation-Indexed Securities. The text of the

temporary regulations also serves as the text of the proposed

regulations set forth in the notice of proposed rulemaking on this

subject in the Proposed Rules section of this issue of the Federal

Register. This document also contains amendments to final regulations

to reflect the addition of the temporary regulations. The regulations

in this document provide needed guidance to holders and issuers of

inflation-indexed debt instruments.

EFFECTIVE DATE: The regulations are effective January 6, 1997.

FOR FURTHER INFORMATION CONTACT: Jeffrey W. Maddrey, (202) 622-3940, or

William E. Blanchard, (202) 622-3950 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

The Department of the Treasury published final rules describing the

terms and conditions of new debt instruments that it plans to issue.

The payments on these debt instruments (Treasury Inflation-Indexed

Securities) will be indexed for inflation and deflation.

On June 14, 1996, the IRS published final regulations in the

Federal Register relating to certain debt instruments that provide for

contingent payments (61 FR 30133). The preamble to the final

regulations indicates that the noncontingent bond method described in

Sec. 1.1275-4(b) might be inappropriate for the Treasury Inflation-

Indexed Securities. On October 15, 1996, the IRS published Notice 96-51

(1996-42 I.R.B. 6), which announced the IRS's intention to issue

temporary and proposed regulations that would provide guidance on the

federal income tax treatment of the Treasury Inflation-Indexed

Securities and other debt instruments with similar terms. This document

contains the temporary regulations described in Notice 96-51.

Explanation of Provisions

A. In General

The temporary regulations provide rules for the treatment of

certain debt instruments that are indexed for inflation and deflation,

including Treasury Inflation-Indexed Securities. The temporary

regulations generally require holders and issuers of inflation-indexed

debt instruments to account for interest and original issue discount

(OID) using constant yield principles. In addition, the temporary

regulations generally require holders and issuers of inflation-indexed

debt instruments to account for inflation and deflation by making

current adjustments to their OID accruals.

B. Applicability

The temporary regulations apply to inflation-indexed debt

instruments. In general, an inflation-indexed debt instrument is a debt

instrument that (1) Is issued for cash, (2) is indexed for inflation

and deflation (as described

[[Page 616]]

below), and (3) is not otherwise a contingent payment debt instrument.

The temporary regulations do not apply, however, to certain debt

instruments, such as debt instruments issued by qualified state tuition

programs.

C. Indexing Methodology

A debt instrument is considered indexed for inflation and deflation

if the payments on the instrument are indexed by reference to the

change in value of a general price or wage index over the term of the

instrument. Specifically, the amount of each payment on an inflation-

indexed debt instrument must equal the product of (1) The amount of the

payment that would be payable on the instrument (determined as if there

were no inflation or deflation over the term of the instrument) and (2)

the ratio of the value of the reference index for the payment date to

the value of the reference index for the issue date.

The reference index for a debt instrument is the mechanism for

measuring inflation and deflation over the term of the instrument. This

mechanism associates the value of a single qualified inflation index

for a particular month with a specified day of a succeeding month. For

example, under the terms of the Treasury Inflation-Indexed Securities,

the reference index for the first day of a month is the value of a

qualified inflation index for the third preceding month. The reference

index must be reset once a month to the current value of a qualified

inflation index. Between reset dates, the value of the reference index

is determined through straight-line interpolation.

A qualified inflation index is a general price or wage index that

is updated and published at least monthly by an agency of the United

States Government. A general price or wage index is an index that

measures price or wage changes in the economy as a whole. An index is

not general if it only measures price or wage changes in a particular

segment of the economy. For example, the non-seasonally adjusted U.S.

City Average All Items Consumer Price Index for All Urban Consumers

(CPI-U), which is published by the Bureau of Labor Statistics of the

Department of Labor, is a qualified inflation index because it measures

general price changes in the economy. By contrast, the gasoline price

component of the CPI-U is not a qualified inflation index because it

only measures price changes in a particular segment of the economy.

D. Coupon Bond Method

The temporary regulations provide a simplified method of accounting

for qualified stated interest and inflation adjustments on certain

inflation-indexed debt instruments (the coupon bond method). To qualify

for the coupon bond method, an inflation-indexed debt instrument must

satisfy two conditions. First, there must be no more than a de minimis

difference between the debt instrument's issue price and its principal

amount for the issue date. Second, all stated interest on the debt

instrument must be qualified stated interest. Because Treasury

Inflation-Indexed Securities that are not stripped into principal and

interest components satisfy both of these conditions, the coupon bond

method applies to these securities.

If an inflation-indexed debt instrument qualifies for the coupon

bond method, the stated interest payable on the debt instrument is

taken into account under the taxpayer's regular method of accounting.

Any increase in the inflation-adjusted principal amount is treated as

OID for the period in which the increase occurs. Any decrease in the

inflation-adjusted principal amount is taken into account under the

rules for deflation adjustments described below.

For example, if a taxpayer holds a Treasury Inflation-Indexed

Security for an entire calendar year and the taxpayer uses the cash

receipts and disbursements method of accounting (cash method), the

taxpayer generally includes in income the interest payments received on

the security during the year. In addition, the taxpayer includes in

income an amount of OID measured by subtracting the inflation-adjusted

principal amount of the security at the beginning of the year from the

inflation-adjusted principal amount of the security at the end of the

year. If the taxpayer uses an accrual method of accounting rather than

the cash method, the taxpayer includes in income the qualified stated

interest that accrued on the debt instrument during the year and an

amount of OID measured by subtracting the inflation-adjusted principal

amount of the security at the beginning of the year from the inflation-

adjusted principal amount of the security at the end of the year.

E. Discount Bond Method

If an inflation-indexed debt instrument does not qualify for the

coupon bond method (for example, because it is issued at a discount),

the instrument is subject to the discount bond method. In general, the

discount bond method requires holders and issuers to make current

adjustments to their OID accruals to account for inflation and

deflation.

Under the discount bond method, a taxpayer determines the amount of

OID allocable to an accrual period by using steps similar to those

provided in Sec. 1.1272-1(b)(1). First, the taxpayer determines the

yield to maturity of the debt instrument as if there were no inflation

or deflation over the term of the instrument. Second, the taxpayer

determines the length of the accrual periods to be used to allocate OID

over the term of the debt instrument, provided no accrual period is

longer than one month. Third, the taxpayer determines the percentage

change in the value of the reference index during the accrual period by

comparing the value at the beginning of the period to the value at the

end of the period. Fourth, the taxpayer determines the OID allocable to

the accrual period by using a formula that takes into account both the

yield of the debt instrument and the percentage change in the value of

the reference index during the period. Fifth, the taxpayer allocates to

each day in the accrual period a ratable portion of the OID for the

accrual period (the daily portions). If the daily portions for an

accrual period are positive amounts, these amounts are taken into

account under section 163(e) by an issuer and under section 1272 by a

holder. If the daily portions for an accrual period are negative

amounts, these amounts are taken into account under the rules for

deflation adjustments described below.

Under Notice 96-51, the discount bond method would have allowed

qualified stated interest. The temporary regulations, however, provide

that no interest payments on an inflation-indexed debt instrument

subject to the discount bond method are qualified stated interest. The

Treasury and the IRS believe that this change simplifies the taxation

of an inflation-indexed debt instrument subject to the discount bond

method.

F. Deflation Adjustments

The temporary regulations treat deflation adjustments in a manner

consistent with the treatment of net negative adjustments on contingent

payment debt instruments under Sec. 1.1275-4(b)(6)(iii). If a holder

has a deflation adjustment for a taxable year, the deflation adjustment

first reduces the amount of interest otherwise includible in income

with respect to the debt instrument for the taxable year. If the amount

of the deflation adjustment exceeds the interest otherwise includible

in income for the taxable

[[Page 617]]

year, the holder treats the excess as an ordinary loss in the taxable

year. However, the amount treated as an ordinary loss is limited to the

amount by which the holder's total interest inclusions on the debt

instrument in prior taxable years exceed the total amount treated by

the holder as an ordinary loss on the debt instrument in prior taxable

years. If the deflation adjustment exceeds the interest otherwise

includible in income by the holder with respect to the debt instrument

for the taxable year and the amount treated as an ordinary loss for the

taxable year, the excess is carried forward to offset interest income

on the debt instrument in subsequent taxable years. Similar rules apply

to determine an issuer's interest deductions and income for the debt

instrument.

G. Minimum Guarantee

Certain inflation-indexed debt instruments may provide for an

additional payment at maturity (a minimum guarantee payment) if the

total amount of inflation-adjusted principal paid on the debt

instrument is less than the instrument's stated principal amount. Under

both the coupon bond method and the discount bond method, a minimum

guarantee payment is ignored until the payment is made. If a minimum

guarantee payment is made, the payment is treated as interest on the

date it is paid.

In general, the temporary regulations only allow a debt instrument

that is indexed by reference to the CPI-U to provide for a minimum

guarantee payment. The Treasury and the IRS believe that there is only

a small possibility that the total amount of principal paid on a debt

instrument indexed to the CPI-U will be less than the instrument's

stated principal amount. In this case, it is appropriate to ignore the

minimum guarantee payment until it is paid.

H. Principal Amount for the Issue Date

For purposes of the temporary regulations, if an inflation-indexed

debt instrument is issued with pre-issuance accrued interest, the

principal amount of the instrument for the issue date includes an

adjustment for inflation or deflation. This adjustment is measured by

the change in the value of the reference index between the date on

which interest starts to accrue (the dated date in the case of a

Treasury Inflation-Indexed Security) and the issue date. The stated

principal amount of a debt instrument under the regulations, however,

is not adjusted for inflation or deflation between the date on which

interest starts to accrue and the issue date. Therefore, the stated

principal amount of the debt instrument is the same regardless of

whether interest accrues on the instrument from the issue date or from

an earlier date. The stated principal amount of a Treasury Inflation-

Indexed Security is the par amount of the security, as defined in the

final rules published by the Treasury Department describing the terms

and conditions of Treasury Inflation-Indexed Securities.

When there is a difference between the stated principal amount of

an inflation-indexed debt instrument and its principal amount for the

issue date, the instrument's principal amount for the issue date

generally is used for purposes of applying the rules in the temporary

regulations to the instrument. For example, the debt instrument's

principal amount for the issue date is used to determine whether the

instrument qualifies for the coupon bond method. The temporary

regulations require the use of a debt instrument's stated principal

amount rather than its principal amount for the issue date to measure

the amount of a minimum guarantee payment.

I. Strips

Treasury Inflation-Indexed Securities are eligible for the

Department of the Treasury's Separate Trading of Registered Interest

and Principal of Securities (STRIPS) program. Under this program, the

interest and principal components of a Treasury Inflation-Indexed

Security may be transferred as separate instruments (stripped bonds and

coupons). In general, section 1286 treats the holder of a stripped bond

(or coupon) as if the holder purchased a newly issued debt instrument

that has OID. The temporary regulations provide that the holder of a

component of a Treasury Inflation-Indexed Security that is stripped

under the Treasury STRIPS program must use the discount bond method to

account for the OID on the component.

J. Information Reporting

The temporary regulations do not provide any new information

reporting rules for inflation-indexed debt instruments. The OID and any

qualified stated interest on an inflation-indexed debt instrument

should be reported on Form 1099-OID. The IRS plans to issue guidance

for the reporting of OID on Treasury Inflation-Indexed Securities that

are stripped under the STRIPS program.

K. Effective Date

The temporary regulations apply to an inflation-indexed debt

instrument issued on or after January 6, 1997.

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)

does not apply to these regulations and, because the regulations do not

impose a collection of information on small entities, the Regulatory

Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue Code, these temporary

regulations will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on their impact on small

business.

Drafting Information

The principal author of the regulations is Jeffrey W. Maddrey,

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.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

two entries in numerical order to read as follows:

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

Section 1.1275-7T also issued under 26 U.S.C. 1275(d). * * *

Section 1.1286-2T also issued under 26 U.S.C. 1286(f). * * *

Par. 2. Section 1.1271-0 is amended by--

1. Revising the second sentence of paragraph (a);

2. Revising the introductory text of paragraph (b); and

3. Adding entries for Sec. 1.1275-7T in paragraph (b).

The revisions and additions read as follows:

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

contents.

(a) * * * Taxpayers, however, may rely on these sections (as

contained in

[[Page 618]]

26 CFR part 1 revised April 1, 1996) for debt instruments issued after

December 21, 1992, and before April 4, 1994.

(b) Table of contents. This section lists captioned paragraphs

contained in Secs. 1.1271-1 through 1.1275-7T.

* * * * *

Sec. 1.1275-7T Inflation-indexed debt instruments (temporary).

(a) Overview.

(b) Applicability.

(1) In general.

(2) Exceptions.

(c) Definitions.

(1) Inflation-indexed debt instrument.

(2) Reference index.

(3) Qualified inflation index.

(4) Inflation-adjusted principal amount.

(5) Minimum guarantee payment.

(d) Coupon bond method.

(1) In general.

(2) Applicability.

(3) Qualified stated interest.

(4) Inflation adjustments.

(5) Example.

(e) Discount bond method.

(1) In general.

(2) No qualified stated interest.

(3) OID.

(4) Example.

(f) Special rules.

(1) Deflation adjustments.

(2) Adjusted basis.

(3) Subsequent holders.

(4) Minimum guarantee.

(5) Temporary unavailability of a qualified inflation index.

(g) Reopenings.

(h) Effective date.

* * * * *

Sec. 1.1275.4 [Amended]

Par. 3. Section 1.1275-4 is amended by--

1. Removing the word ``or'' from the end of paragraph (a)(2)(vi);

2. Redesignating paragraph (a)(2)(vii) as paragraph (a)(2)(viii);

and

3. Adding a new paragraph (a)(2)(vii).

The addition reads as follows:

Sec. 1.1275-4 Contingent payment debt instruments.

(a) * * *

(2) * * *

(vii) An inflation-indexed debt instrument (as defined in

Sec. 1.1275-7T); or

* * * * *

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

Sec. 1.1275-7T Inflation-indexed debt instruments (temporary).

(a) Overview. This section provides rules for the federal income

tax treatment of an inflation-indexed debt instrument. If a debt

instrument is an inflation-indexed debt instrument, one of two methods

will apply to the instrument: the coupon bond method (as described in

paragraph (d) of this section) or the discount bond method (as

described in paragraph (e) of this section). Both methods determine the

amount of OID that is taken into account each year by a holder or an

issuer of an inflation-indexed debt instrument.

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

(b)(2) of this section, this section applies to an inflation-indexed

debt instrument as defined in paragraph (c)(1) of this section. For

example, this section applies to Treasury Inflation-Indexed Securities.

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

debt instrument that is also--

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

described in section 1272(a)(2) (for example, U.S. savings bonds,

certain loans between natural persons, and short-term taxable

obligations); or

(ii) A debt instrument subject to section 529 (certain debt

instruments issued by qualified state tuition programs).

(c) Definitions. The following definitions apply for purposes of

this section:

(1) Inflation-indexed debt instrument. An inflation-indexed debt

instrument is a debt instrument that satisfies the following

conditions:

(i) Issued for cash. The debt instrument is issued for U.S. dollars

and all payments on the instrument are denominated in U.S. dollars.

(ii) Indexed for inflation and deflation. Except for a minimum

guarantee payment (as defined in paragraph (c)(5) of this section),

each payment on the debt instrument is indexed for inflation and

deflation. A payment is indexed for inflation and deflation if the

amount of the payment is equal to--

(A) The amount that would be payable if there were no inflation or

deflation over the term of the debt instrument, multiplied by

(B) A ratio, the numerator of which is the value of the reference

index for the date of the payment and the denominator of which is the

value of the reference index for the issue date.

(iii) No other contingencies. No payment on the debt instrument is

subject to a contingency other than the inflation contingency or the

contingencies described in this paragraph (c)(1)(iii). A debt

instrument may provide for--

(A) A minimum guarantee payment as defined in paragraph (c)(5) of

this section; or

(B) Payments under one or more alternate payment schedules if the

payments under each payment schedule are indexed for inflation and

deflation and a payment schedule for the debt instrument can be

determined under Sec. 1.1272-1(c). (For purposes of this section, the

rules of Sec. 1.1272-1(c) are applied to the debt instrument by

assuming that no inflation or deflation will occur over the term of the

instrument.)

(2) Reference index. The reference index is an index used to

measure inflation and deflation over the term of a debt instrument. To

qualify as a reference index, an index must satisfy the following

conditions:

(i) The value of the index is reset once a month to a current value

of a single qualified inflation index (as defined in paragraph (c)(3)

of this section). For this purpose, a value of a qualified inflation

index is current if the value has been updated and published within the

preceding six month period.

(ii) The reset occurs on the same day of each month (the reset

date).

(iii) The value of the index for any date between reset dates is

determined through straight-line interpolation.

(3) Qualified inflation index. A qualified inflation index is a

general price or wage index that is updated and published at least

monthly by an agency of the United States Government (for example, the

non-seasonally adjusted U.S. City Average All Items Consumer Price

Index for All Urban Consumers (CPI-U), which is published by the Bureau

of Labor Statistics of the Department of Labor).

(4) Inflation-adjusted principal amount. For any date, the

inflation-adjusted principal amount of an inflation-indexed debt

instrument is an amount equal to--

(i) The outstanding principal amount of the debt instrument

(determined as if there were no inflation or deflation over the term of

the instrument), multiplied by

(ii) A ratio, the numerator of which is the value of the reference

index for the date and the denominator of which is the value of the

reference index for the issue date.

(5) Minimum guarantee payment. In general, a minimum guarantee

payment is an additional payment made at maturity on a debt instrument

if the total amount of inflation-adjusted principal paid on the

instrument is less than the instrument's stated principal amount. The

amount of the additional payment must be no more than the excess, if

any, of the debt instrument's stated principal amount over the total

amount of inflation-adjusted principal paid on the instrument. An

additional payment is not a minimum guarantee

[[Page 619]]

payment unless the qualified inflation index used to determine the

reference index is either the CPI-U or an index designated for this

purpose by the Commissioner in the Federal Register or the Internal

Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter). See

paragraph (f)(4) of this section for the treatment of a minimum

guarantee payment.

(d) Coupon bond method--(1) In general. This paragraph (d)

describes the method (coupon bond method) to be used to account for

qualified stated interest and inflation adjustments (OID) on an

inflation-indexed debt instrument described in paragraph (d)(2) of this

section.

(2) Applicability. The coupon bond method applies to an inflation-

indexed debt instrument that satisfies the following conditions:

(i) Issued at par. The debt instrument is issued at par. A debt

instrument is issued at par if the difference between its issue price

and principal amount for the issue date is less than the de minimis

amount. For this purpose, the de minimis amount is determined using the

principles of Sec. 1.1273-1(d).

(ii) All stated interest is qualified stated interest. All stated

interest on the debt instrument is qualified stated interest. For

purposes of this paragraph (d), stated interest is qualified stated

interest if the interest is unconditionally payable in cash, or is

constructively received under section 451, at least annually at a

single fixed rate. Stated interest is payable at a single fixed rate if

the amount of each interest payment is determined by multiplying the

inflation adjusted principal amount for the payment date by the single

fixed rate.

(3) Qualified stated interest. Under the coupon bond method,

qualified stated interest is taken into account under the taxpayer's

regular method of accounting. The amount of accrued but unpaid

qualified stated interest as of any date is determined by using the

principles of Sec. 1.446-3(e)(2)(ii) (relating to notional principal

contracts). For example, if the interval between interest payment dates

spans two taxable years, a taxpayer using an accrual method of

accounting determines the amount of accrued qualified stated interest

for the first taxable year by reference to the inflation-adjusted

principal amount at the end of the first taxable year.

(4) Inflation adjustments--(i) Current accrual. Under the coupon

bond method, an inflation adjustment is taken into account for each

taxable year in which the debt instrument is outstanding.

(ii) Amount of inflation adjustment. For any relevant period (such

as the taxable year or the portion of the taxable year during which a

taxpayer holds an inflation-indexed debt instrument), the amount of the

inflation adjustment is equal to--

(A) The sum of the inflation-adjusted principal amount at the end

of the period and the principal payments made during the period, minus

(B) The inflation-adjusted principal amount at the beginning of the

period.

(iii) Positive inflation adjustments. A positive inflation

adjustment is OID.

(iv) Negative inflation adjustments. A negative inflation

adjustment is a deflation adjustment that is taken into account under

the rules of paragraph (f)(1) of this section.

(5) Example. The following example illustrates the coupon bond

method:

Example. (i) Facts. On October 15, 1997, X purchases at original

issue, for $100,000, a debt instrument that is indexed for inflation

and deflation. The debt instrument matures on October 15, 1999, has

a stated principal amount of $100,000, and has a stated interest

rate of 5 percent, compounded semiannually. The debt instrument

provides that the principal amount is indexed to the CPI-U. Interest

is payable on April 15 and October 15 of each year. The amount of

each interest payment is determined by multiplying the inflation-

adjusted principal amount for each interest payment date by the

stated interest rate, adjusted for the length of the accrual period.

The debt instrument provides for a single payment of the inflation-

adjusted principal amount at maturity. In addition, the debt

instrument provides for an additional payment at maturity equal to

the excess, if any, of $100,000 over the inflation-adjusted

principal amount at maturity. X uses the cash receipts and

disbursements method of accounting and the calendar year as its

taxable year.

(ii) Indexing methodology. The debt instrument provides that the

inflation-adjusted principal amount for any day is determined by

multiplying the principal amount of the instrument for the issue

date by a ratio, the numerator of which is the value of the

reference index for the day the inflation-adjusted principal amount

is to be determined and the denominator of which is the value of the

reference index for the issue date. The value of the reference index

for the first day of a month is the value of the CPI-U for the third

preceding month. The value of the reference index for any day other

than the first day of a month is determined based on a straight-line

interpolation between the value of the reference index for the first

day of the month and the value of the reference index for the first

day of the next month.

(iii) Inflation-indexed debt instrument subject to the coupon

bond method. Under paragraph (c)(1) of this section, the debt

instrument is an inflation-indexed debt instrument. Because there is

no difference between the debt instrument's issue price ($100,000)

and its principal amount for the issue date ($100,000) and because

all stated interest is qualified stated interest, the coupon bond

method applies to the instrument.

(iv) Reference index values. Assume the following table lists

the relevant reference index values for 1997 through 1999:

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

Reference

Date index

value

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

Oct. 15, 1997................................................ 100

Jan. 1, 1998................................................. 101

Apr. 15, 1998................................................ 103

Oct. 15, 1998................................................ 105

Jan. 1, 1999................................................. 99

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

(v) Treatment of X in 1997. X does not receive any payments of

interest on the debt instrument in 1997. Therefore, X has no

qualified stated interest income for 1997. X, however, must take

into account the inflation adjustment for 1997. The inflation-

adjusted principal amount for January 1, 1998, is $101,000 ($100,000

x 101/100). Therefore, the inflation adjustment for 1997 is

$1,000, the inflation-adjusted principal amount for January 1, 1998

($101,000) minus the principal amount for the issue date ($100,000).

X includes the $1,000 inflation adjustment in income as OID in 1997.

(vi) Treatment of X in 1998. In 1998, X receives two payments of

interest: On April 15, 1998, X receives a payment of $2,575

($100,000 x 103/100 x .05/2), and on October 15, 1998, X

receives a payment of $2,625 ($100,000 x 105/100 x .05/2).

Therefore, X's qualified stated interest income for 1998 is $5,200

($2,575 + $2,625). X also must take into account the inflation

adjustment for 1998. The inflation-adjusted principal amount for

January 1, 1999, is $99,000 ($100,000 x 99/100). Therefore, the

inflation adjustment for 1998 is negative $2,000, the inflation-

adjusted principal amount for January 1, 1999 ($99,000) minus the

inflation-adjusted principal amount for January 1, 1998 ($101,000).

Because the amount of the inflation adjustment is negative, it is a

deflation adjustment. Under paragraph (f)(1)(i) of this section, X

uses this $2,000 deflation adjustment to reduce the interest

otherwise includible in income by X with respect to the debt

instrument in 1998. Therefore, X includes $3,200 in income for 1998,

the qualified stated interest income for 1998 ($5,200) minus the

deflation adjustment ($2,000).

(e) Discount bond method--(1) In general. This paragraph (e)

describes the method (discount bond method) to be used to account for

OID on an inflation-indexed debt instrument that does not qualify for

the coupon bond method.

(2) No qualified stated interest. Under the discount bond method,

no interest on an inflation-indexed debt instrument is qualified stated

interest.

(3) OID. Under the discount bond method, the amount of OID that

accrues on an inflation-indexed debt instrument is determined as

follows:

[[Page 620]]

(i) Step one: Determine the debt instrument's yield to maturity.

The yield of the debt instrument is determined under the rules of

Sec. 1.1272-1(b)(1)(i). In calculating the yield under those rules for

purposes of this paragraph (e)(3)(i), the payment schedule of the debt

instrument is determined as if there were no inflation or deflation

over the term of the instrument.

(ii) Step two: Determine the accrual periods. The accrual periods

are determined under the rules of Sec. 1.1272-1(b)(1)(ii). However, no

accrual period can be longer than 1 month.

(iii) Step three: Determine the percentage change in the reference

index during the accrual period. The percentage change in the reference

index during the accrual period is equal to--

(A) The ratio of the value of the reference index at the end of the

period to the value of the reference index at the beginning of the

period,

(B) Minus one.

(iv) Step four: Determine the OID allocable to each accrual period.

The OID allocable to an accrual period (n) is determined by using the

following formula:

OID(n) = AIP(n) x [r + inf(n) + (r x inf(n))]

in which,

r = yield of the debt instrument as determined under paragraph

(e)(3)(i) of this section (adjusted for the length of the accrual

period);

inf(n) = percentage change in the value of the reference index for

period (n) as determined under paragraph (e)(3)(iii) of this section;

and

AIP(n) = adjusted issue price at the beginning of period (n).

(v) Step five: Determine the daily portions of OID. The daily

portions of OID are determined and taken into account under the rules

of Sec. 1.1272-1(b)(1)(iv). If the daily portions determined under this

paragraph (e)(3)(v) are negative amounts, however, these amounts

(deflation adjustments) are taken into account under the rules for

deflation adjustments described in paragraph (f)(1) of this section.

(4) Example. The following example illustrates the discount bond

method:

Example. (i) Facts. On November 15, 1997, X purchases at

original issue, for $91,403, a zero-coupon debt instrument that is

indexed for inflation and deflation. The principal amount of the

debt instrument for the issue date is $100,000. The debt instrument

provides for a single payment on November 15, 2000. The amount of

the payment will be determined by multiplying $100,000 by a

fraction, the numerator of which is the CPI-U for September 2000,

and the denominator of which is the CPI-U for September 1997. The

debt instrument also provides that in no event will the payment on

November 15, 2000, be less than $100,000. X uses the cash receipts

and disbursements method of accounting and the calendar year as its

taxable year.

(ii) Inflation-indexed debt instrument. Under paragraph (c)(1)

of this section, the instrument is an inflation-indexed debt

instrument. The debt instrument's principal amount for the issue

date ($100,000) exceeds its issue price ($91,403) by $8,597, which

is more than the de minimis amount for the debt instrument ($750).

Therefore, the coupon bond method does not apply to the debt

instrument. As a result, the discount bond method applies to the

debt instrument.

(iii) Yield and accrual period. Assume X chooses monthly accrual

periods ending on the 15th day of each month. The yield of the debt

instrument is determined as if there were no inflation or deflation

over the term of the instrument. Therefore, based on the issue price

of $91,403 and an assumed payment at maturity of $100,000, the yield

of the debt instrument is 3 percent, compounded monthly.

(iv) Percentage change in reference index. Assume that the CPI-U

for September 1997 is 160; for October 1997 is 161.2; and for

November 1997 is 161.7. The value of the reference index for

November 15, 1997, is 160, the value of the CPI-U for September

1997. Similarly, the value of the reference index for December 15,

1997, is 161.2, and for January 15, 1998, is 161.7. The percentage

change in the reference index from November 15, 1997, to December

15, 1997, (inf1) is 0.0075 (161.2/160-1); the percentage change

in the reference index from December 15, 1997, to January 15, 1998,

(inf2) is 0.0031 (161.7/161.2-1).

(v) Treatment of X in 1997. For the accrual period ending on

December 15, 1997, r is .0025 (.03/12), inf1 is .0075, and the

product of r and inf1 is .00001875. Under paragraph (e)(3) of

this section, the amount of OID allocable to the accrual period

ending on December 15, 1997, is $916. This amount is determined by

multiplying the issue price of the debt instrument ($91,403) by

.01001875 (the sum of r, inf1, and the product of r and

inf1). The adjusted issue price of the debt instrument on

December 15, 1997, is $92,319 ($91,403+$916). For the accrual period

ending on January 15, 1998, r is .0025 (.03/12), inf2 is .0031,

and the product of r and inf2 is .00000775. Under paragraph

(e)(3) of this section, the amount of OID allocable to the accrual

period ending on January 15, 1998, is $518. This amount is

determined by multiplying the adjusted issue price of the debt

instrument ($92,319) by .00560775 (the sum of r, inf2, and the

product of r and inf2). Because the accrual period ending on

January 15, 1998, spans two taxable years, only $259 of this amount

($518/30 days x 15 days) is allocable to 1997. Therefore, X includes

$1,175 of OID in income for 1997 ($916+$259).

(f) Special rules. The following rules apply to an inflation-

indexed debt instrument:

(1) Deflation adjustments--(i) Holder. A deflation adjustment

reduces the amount of interest otherwise includible in income by a

holder with respect to the debt instrument for the taxable year. For

purposes of this paragraph (f)(1)(i), interest includes OID, qualified

stated interest, and market discount. If the amount of the deflation

adjustment exceeds the interest otherwise includible in income by the

holder with respect to the debt instrument for the taxable year, the

excess is treated as an ordinary loss by the holder for the taxable

year. However, the amount treated as an ordinary loss is limited to the

amount by which the holder's total interest inclusions on the debt

instrument in prior taxable years exceed the total amount treated by

the holder as an ordinary loss on the debt instrument in prior taxable

years. If the deflation adjustment exceeds the interest otherwise

includible in income by the holder with respect to the debt instrument

for the taxable year and the amount treated as an ordinary loss for the

taxable year, this excess is carried forward to reduce the amount of

interest otherwise includible in income by the holder with respect to

the debt instrument for subsequent taxable years.

(ii) Issuer. A deflation adjustment reduces the interest otherwise

deductible by the issuer with respect to the debt instrument for the

taxable year. For purposes of this paragraph (f)(1)(ii), interest

includes OID and qualified stated interest. If the amount of the

deflation adjustment exceeds the interest otherwise deductible by the

issuer with respect to the debt instrument for the taxable year, the

excess is treated as ordinary income by the issuer for the taxable

year. However, the amount treated as ordinary income is limited to the

amount by which the issuer's total interest deductions on the debt

instrument in prior taxable years exceed the total amount treated by

the issuer as ordinary income on the debt instrument in prior taxable

years. If the deflation adjustment exceeds the interest otherwise

deductible by the issuer with respect to the debt instrument for the

taxable year and the amount treated as ordinary income for the taxable

year, this excess is carried forward to reduce the interest otherwise

deductible by the issuer with respect to the debt instrument for

subsequent taxable years. If there is any excess remaining upon the

retirement of the debt instrument, the issuer takes the excess amount

into account as ordinary income.

(2) Adjusted basis. A holder's adjusted basis in an inflation-

indexed debt instrument is determined under Sec. 1.1272-1(g). However,

a holder's adjusted basis in the debt instrument is decreased by the

amount of any

[[Page 621]]

deflation adjustment the holder takes into account to reduce the amount

of interest otherwise includible in income or treats as an ordinary

loss with respect to the instrument during the taxable year. The

decrease occurs when the deflation adjustment is taken into account

under paragraph (f)(1) of this section.

(3) Subsequent holders. A holder determines the amount of

acquisition premium or market discount on an inflation-indexed debt

instrument by reference to the adjusted issue price of the instrument

on the date the holder acquires the instrument. A holder determines the

amount of bond premium on an inflation-indexed debt instrument by

assuming that the amount payable at maturity on the instrument is equal

to the instrument's inflation-adjusted principal amount for the day the

holder acquires the instrument. Any premium or market discount is taken

into account over the remaining term of the debt instrument as if there

were no further inflation or deflation. See section 171 for additional

rules relating to the amortization of bond premium and sections 1276

through 1278 for additional rules relating to market discount.

(4) Minimum guarantee. Under both the coupon bond method and the

discount bond method, a minimum guarantee payment is ignored until the

payment is made. If there is a minimum guarantee payment, the payment

is treated as interest on the date it is paid.

(5) Temporary unavailability of a qualified inflation index.

Notwithstanding any other rule of this section, an inflation-indexed

debt instrument may provide for a substitute value of the qualified

inflation index if and when the publication of the value of the

qualified inflation index is temporarily delayed. The substitute value

may be determined by the issuer under any reasonable method. For

example, if the CPI-U is not reported for a particular month, the debt

instrument may provide that a substitute value may be determined by

increasing the last reported value by the average monthly percentage

increase in the qualified inflation index over the preceding twelve

months. The use of a substitute value does not result in a reissuance

of the debt instrument.

(g) Reopenings. For purposes of Sec. 1.1275-2(d)(2), a reopening of

Treasury Inflation-Indexed Securities is a qualified reopening if--

(1) The terms of the securities issued in the reopening are the

same as the terms of the original securities; and

(2) The reopening occurs not more than one year after the original

securities were first issued to the public.

(h) Effective date. This section applies to an inflation-indexed

debt instrument issued on or after January 6, 1997.

Par. 5. Section 1.1286-2T is added to read as follows:

Sec. 1.1286-2T Stripped inflation-indexed debt instruments

(temporary).

Stripped inflation-indexed debt instruments. If a Treasury

Inflation-Indexed Security is stripped under the Department of the

Treasury's Separate Trading of Registered Interest and Principal of

Securities (STRIPS) program, the holders of the principal and coupon

components must use the discount bond method (as described in

Sec. 1.1275-7T(e)) to account for the original issue discount on the

components.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: December 6, 1996.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 96-33398 Filed 12-31-96; 12:57 pm]

BILLING CODE 4830-01-U