Amortizable Bond Premium

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8746]

RIN 1545-AU09

Amortizable Bond Premium

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations relating to the

federal income tax treatment of bond premium and bond issuance premium.

The regulations reflect changes to the law made by the Tax Reform Act

of 1986 and the Technical and Miscellaneous Revenue Act of 1988. The

regulations will provide needed guidance to holders and issuers of debt

instruments.

DATES: Effective date: March 2, 1998.

Applicability dates: For dates of applicability of the final

regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 622-3950

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

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

in accordance with the requirements of the Paperwork Reduction Act of

1995 (44 U.S.C. 3507(d)) under control number 1545-1491. Responses to

these collections of information are required by the IRS to determine

whether a holder of a bond has elected to amortize bond premium and

whether an issuer or a holder has changed its method of accounting for

premium.

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

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

information displays a valid control number.

The estimated annual burden per respondent varies from 0.25 hours

to 0.75 hours, depending on individual circumstances, with an estimated

average of 0.5 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

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

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

Officer for the Department of Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to the collections of information must be

retained as long as their contents may become material in the

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

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

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 amortizable bond premium be treated as an offset to

interest income.

On June 27, 1996, the IRS published a notice of proposed rulemaking

in the Federal Register (61 FR 33396) relating to the federal income

tax treatment of bond premium and bond issuance premium. A public

hearing was not held because no one requested to speak at the hearing

that had been scheduled for October 23, 1996. The IRS did receive

[[Page 68174]]

a few comments on the proposed regulations. The proposed regulations,

with certain changes to respond to the comments, are adopted as final

regulations.

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 Secs. 1.171-

1 through 1.171-5. The issuer's treatment of bond issuance premium is

addressed in Sec. 1.163-13. In each case, the amortization of premium

is based on constant yield principles. For this reason, the final

regulations use concepts and definitions from the original issue

discount (OID) regulations (in general, see Secs. 1.1271-1 through

1.1275-7T).

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.

The final regulations adopt the rules of the proposed regulations

for determining the amount of bond premium, if any, on a bond. However,

in response to comments, the final regulations clarify the

determination of basis in the case of a convertible bond acquired in a

transferred basis transaction.

Amortization of Bond Premium

(a) In General

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.

The final regulations adopt the rules in the proposed regulations

for amortizing bond premium.

(b) Excess Premium

For certain bonds (for example, 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.

Several commentators stated that this excess premium should be

allowable as a current deduction for the accrual period in which the

excess occurs. In response to these comments, the final regulations

adopt rules for excess premium that are similar to the rules for

negative adjustments on contingent payment debt instruments and

deflation adjustments on inflation-indexed debt instruments. Under the

final regulations, any excess bond premium allocable to an accrual

period is deductible by the holder under section 171(a)(1) for the

accrual period. The amount deductible, however, is limited by the

amount of the holder's prior income inclusions on the bond. If any of

the excess bond premium is not deductible under section 171(a)(1), this

amount is carried forward to the next accrual period and is treated as

bond premium allocable to that period.

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 rules

for making these assumptions. For example, the rules assume that an

issuer will exercise a call option if doing so would minimize the yield

of the debt instrument and that a holder will exercise a put option if

doing so would maximize the yield of the debt instrument.

The proposed regulations under section 171 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 in the OID regulations 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). Thus, under the proposed

regulations, 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 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.

In general, the final regulations adopt the rules of the proposed

regulations. In response to a comment, the final regulations limit the

issuer rule for taxable bonds to call options.

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 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 apply

to all issuers, not just corporate issuers.

In general, the final regulations adopt the rules in the proposed

regulations for bond issuance premium. However, the final regulations

contain several

[[Page 68175]]

important changes from the proposed regulations. First, in response to

comments, the final regulations clarify the treatment of a debt

instrument subject to an alternative payment schedule by explicitly

cross-referencing Sec. 1.1272-1(c). Second, the final regulations

provide that, in the case of a debt instrument subject to a mandatory

sinking fund provision, the issuer must determine the payment schedule

by assuming that a pro rata portion of the debt instrument will be

called under the sinking fund provision. This rule produces more

economic interest accruals than the accruals determined by ignoring the

sinking fund provision as under the proposed regulations. Third, the

final regulations adopt rules for excess bond issuance premium

allocable to an accrual period. These rules are similar to the rules

for excess bond premium described above.

Aggregation Rules

Although the proposed regulations do not provide for an aggregate

method of accounting for premium, comments were requested on the need

for an aggregate method. Because no comments were received, the final

regulations do not provide rules for an aggregate method of accounting

for premium.

Bonds Not Subject to the Final Regulations

The final regulations generally apply to bonds acquired or issued

at a premium. Certain bonds, however, are excluded from the application

of the final regulations. For example, the final regulations exclude

debt instruments described in section 1272(a)(6)(C) (regular interests

in a REMIC, qualified mortgages held by a REMIC, and certain other debt

instruments, or pools of debt instruments, with payments subject to

acceleration). No inference is intended regarding the treatment of debt

instruments described in section 1272(a)(6)(C).

Effective Dates

The final regulations relating to bond premium are effective for

bonds acquired on or after March 2, 1998. However, if a holder makes

the election to amortize bond premium for the taxable year containing

March 2, 1998, or any subsequent taxable year, the regulations apply to

bonds held on or after the first day of the taxable year in which the

election is made.

The final regulations relating to bond issuance premium apply to

debt instruments issued on or after March 2, 1998.

The final regulations also 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 is hereby certified that these regulations do not have

significant economic impact on a substantial number of small entities.

This certification is based upon the fact that the regulations merely

require a taxpayer to attach to the taxpayer's return a statement that

indicates whether the taxpayer is making an election under section 171

or is changing its accounting method for bond premium or bond issuance

premium. Therefore, a Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

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 has also been determined that

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

does not apply to these regulations. Pursuant to section 7805(f) of the

Internal Revenue Code, the notice of proposed rulemaking was submitted

to the Chief Counsel for Advocacy of the Small Business Administration

for comment on its impact on small business.

Drafting Information

Several persons from the Office of Assistant Chief Counsel

(Financial Institutions and Products) and the Treasury Department

participated in the development of these regulations.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by 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. For rules relating to an issuer's interest deduction for a

debt instrument issued with bond issuance premium, see Sec. 1.163-13.

(2) Repurchase--(i) In general. An issuer does not realize gain or

loss upon the repurchase of a debt instrument. However, if a debt

instrument provides for payments denominated in, or determined by

reference to, a nonfunctional currency, an issuer may realize a

currency gain or loss upon the repurchase of the instrument. See

section 988 and the regulations thereunder. 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 (within the meaning of

Sec. 1.1275-1(b)). The amount of discharge of indebtedness income is

equal to the excess of the adjusted issue price over the repurchase

price. See section 108 and the regulations thereunder for additional

rules relating to income from discharge of indebtedness. For example,

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).

(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 (within the meaning

of Sec. 1.1275-1(b)). See Sec. 1.163-7(c) for the treatment of

repurchase premium.

(iv) Effective date. This paragraph (c)(2) applies to debt

instruments repurchased on or after March 2, 1998.

* * * * *

[[Page 68176]]

Par. 3. 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 generally 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, unless otherwise provided, 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 described in section 1272(a)(6)(C) (regular

interests in a REMIC, qualified mortgages held by a REMIC, and certain

other debt instruments, or pools of 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 (as

determined under Sec. 1.171-1(e)(1)(iii)(A)).

(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--

(i) Ordinary income. If the bond issuance premium allocable to an

accrual period exceeds the qualified stated interest allocable to the

accrual period, the excess is treated as ordinary income by the issuer

for the accrual period. 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 accrual periods exceed the

total amount treated by the issuer as ordinary income on the debt

instrument in prior accrual periods.

(ii) Carryforward. If the bond issuance premium allocable to an

accrual period exceeds the sum of the qualified stated interest

allocable to the accrual period and the amount treated as ordinary

income for the accrual period under paragraph (d)(4)(i) of this

section, the excess is carried forward to the next accrual period and

is treated as bond issuance premium allocable to that period. If a

carryforward exists on the date the debt instrument is retired, the

carryforward is treated as ordinary income on that date.

(e) Special rules--(1) Variable rate debt instruments. An issuer

determines bond issuance premium on a variable rate debt instrument by

reference to the stated redemption price at maturity of the equivalent

fixed rate debt instrument constructed for the variable rate debt

instrument. The issuer also allocates any bond issuance premium among

the accrual periods by reference to the equivalent fixed rate debt

instrument. The issuer constructs the equivalent fixed rate debt

instrument, as of the issue date, by using the principles of

Sec. 1.1275-5(e).

(2) Inflation-indexed debt instruments. An issuer determines bond

issuance premium on an inflation-indexed debt instrument by assuming

that there will be no inflation or deflation over the term of the

instrument. The issuer also allocates any bond issuance premium among

the accrual periods by assuming that there will be no inflation or

deflation over the term of the instrument. The bond issuance premium

allocable to an accrual period offsets qualified stated interest

allocable to the period. Notwithstanding paragraph (d)(4) of this

section, if the bond issuance premium allocable to an accrual period

exceeds the qualified stated interest allocable to the period, the

excess is treated as a deflation adjustment under Sec. 1.1275-

7T(f)(1)(ii). See Sec. 1.1275-7T for other rules relating to inflation-

indexed debt instruments.

(3) Certain debt instruments subject to contingencies--(i) In

general. Except as provided in paragraph (e)(3)(ii) of this section,

the rules of Sec. 1.1272-1(c) apply to determine a debt instrument's

payment schedule for purposes of this section. For example, an issuer

uses the payment schedule determined under Sec. 1.1272-1(c) to

determine the amount, if any, of bond issuance premium on the debt

instrument, the yield and maturity of the debt instrument, and the

allocation of bond issuance premium to an accrual period.

(ii) Mandatory sinking fund provision. Notwithstanding paragraph

(e)(3)(i) of this section, if a debt instrument is subject to a

mandatory sinking fund provision described in Sec. 1.1272-1(c)(3), the

issuer must determine the payment schedule by assuming that a pro rata

portion of the debt instrument will be called under the sinking fund

provision.

(4) Remote and incidental contingencies. For purposes of

determining the amount of bond issuance premium and allocating bond

issuance premium among accrual periods, if a bond provides for a

[[Page 68177]]

contingency that is remote or incidental (within the meaning of

Sec. 1.1275-2(h)), the issuer takes the contingency 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 the bond issuance premium allocable

to the period ($1,118.17).

(g) Effective date. This section applies to debt instruments

issued on or after March 2, 1998.

(h) Accounting method changes--(1) Consent to change. An issuer

required to change its method of accounting for bond issuance premium

to comply with this section must secure the consent of the Commissioner

in accordance with the requirements of Sec. 1.446-1(e). Paragraph

(h)(2) of this section provides the Commissioner's automatic consent

for certain changes.

(2) Automatic consent. The Commissioner grants consent for an

issuer to change its method of accounting for bond issuance premium on

debt instruments issued on or after March 2, 1998. Because this change

is made on a cut-off basis, no items of income or deduction are omitted

or duplicated and, therefore, no adjustment under section 481 is

allowed. The consent granted by this paragraph (h)(2) applies

provided--

(i) The change is made to comply with this section;

(ii) The change is made for the first taxable year for which the

issuer must account for a debt instrument under this section; and

(iii) 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. 4. 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 to generally 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, unless otherwise provided, 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 and Sec. 1.171-5, this section and Secs. 1.171-2

through 1.171-4 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 described in section 1272(a)(6)(C) (regular interests in

a REMIC, qualified mortgages held by a REMIC, and certain other debt

instruments, or pools of 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 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 a reasonable method.

(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, an inflation-indexed debt

[[Page 68178]]

instrument, a bond that provides for certain alternative payment

schedules, and a bond that provides for remote or incidental

contingencies. 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 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 such 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), except to the extent that

the holder's basis already reflects a reduction attributable to such

nonamortizable amounts.

(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 inventory items as defined in

section 751. On January 1, 1998, 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, because the distribution is

treated as an exchange for purposes of section 171(b)(4), PR's basis

in the bond is $40,000 for purposes of this section and Secs. 1.171-

2 through 1.171-5. See paragraph (e)(1)(ii) of this section.

Example 2. Convertible bond--(i) Facts. On January 11, 1998, A

purchases for $1,100 B corporation's bond maturing on January 1,

2001, 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, 1998, B corporation's nonconvertible,

publicly-traded, three-year debt with a 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, 1998,

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--(i)

Taxable bonds--(A) Bond premium deduction. In the case of a taxable

bond, if the bond premium allocable to an accrual period exceeds the

qualified stated interest allocable to the accrual period, the excess

is treated by the holder as a bond premium deduction under section

171(a)(1) for the accrual period. However, the amount treated as a bond

[[Page 68179]]

premium deduction is limited to the amount by which the holder's total

interest inclusions on the bond in prior accrual periods exceed the

total amount treated by the holder as a bond premium deduction on the

bond in prior accrual periods. A deduction determined under this

paragraph (a)(4)(i)(A) is not subject to section 67 (the 2-percent

floor on miscellaneous itemized deductions). See Example 1 of

Sec. 1.171-3(e).

(B) Carryforward. If the bond premium allocable to an accrual

period exceeds the sum of the qualified stated interest allocable to

the accrual period and the amount treated as a deduction for the

accrual period under paragraph (a)(4)(i)(A) of this section, the excess

is carried forward to the next accrual period and is treated as bond

premium allocable to that period.

(ii) Tax-exempt obligations. In the case of a tax-exempt

obligation, if the bond premium allocable to an accrual period exceeds

the qualified stated interest allocable to the accrual period, the

excess is a nondeductible loss. If a regulated investment company (RIC)

within the meaning of section 851 has excess bond premium for an

accrual period that would be a nondeductible loss under the prior

sentence, the RIC must use this excess bond premium to reduce its tax-

exempt interest income on other tax-exempt obligations held during the

accrual period.

(5) Additional rules for certain bonds. Additional rules apply to

determine the amortization of bond premium on a variable rate debt

instrument, an inflation-indexed debt instrument, a bond that provides

for certain alternative payment schedules, and a bond that provides for

remote or incidental contingencies. 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 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. The examples are as follows:

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. See paragraph

(a)(3)(iii) of this section and Sec. 1.1272-1(b)(4)(i)(B).

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 an 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

[[Page 68180]]

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. A holder determines bond

premium on a variable rate debt instrument by reference to the stated

redemption price at maturity of the equivalent fixed rate debt

instrument constructed for the variable rate debt instrument. The

holder also allocates any bond premium among the accrual periods by

reference to the equivalent fixed rate debt instrument. The holder

constructs the equivalent fixed rate debt instrument, as of the date

the holder acquires the variable rate debt instrument, by using the

principles of Sec. 1.1275-5(e). See paragraph (e) Example 1 of this

section.

(b) Inflation-indexed debt instruments. A holder determines bond

premium on an inflation-indexed debt instrument by assuming that there

will be no inflation or deflation over the remaining term of the

instrument. The holder also allocates any bond premium among the

accrual periods by assuming that there will be no inflation or

deflation over the remaining term of the instrument. The bond premium

allocable to an accrual period offsets qualified stated interest

allocable to the period. Notwithstanding Sec. 1.171-2(a)(4), if the

bond premium allocable to an accrual period exceeds the qualified

stated interest allocable to the period, the excess is treated as a

deflation adjustment under Sec. 1.1275-7T(f)(1)(i). See Sec. 1.1275-7T

for other rules relating to inflation-indexed debt instruments.

(c) Yield and remaining payment schedule of certain bonds subject

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

(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

(c)(2) of this section, if a bond is subject to a mandatory sinking

fund provision described in Sec. 1.1272-1(c)(3), 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 (c)(2) and (3) of this section, the rules of

this paragraph (c)(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. In general, the issuer 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. However, the issuer of

a taxable bond is deemed to exercise or not exercise a call option or

combination of call 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 (c)(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 (c)(5)(ii) of this section, if a contingency described in

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

paragraph (c)(4) of this section) actually occurs or does not occur,

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

section (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 (e) 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

holder's adjusted acquisition price of the bond over the greater of--

(A) The amount received on redemption; and

(B) The amounts that would have been payable under the bond (other

than payments of qualified stated interest) if no change in

circumstances had occurred.

(d) 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 holder takes the contingency into account under

the rules for remote and incidental contingencies in Sec. 1.1275-2(h).

(e) 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

[[Page 68181]]

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. The examples are as follows:

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..................................... 101,709.51 1,709.51

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

10,000.00

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

(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..................................................... $2,000.00

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 $1,129.29, the qualified stated interest

allocable to the period ($2,000) 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 accrual period

($958.81) exceeds the qualified stated interest allocable to the

period ($0) and, therefore, E does not have interest income for this

accrual period. However, under Sec. 1.171-2(a)(4)(i)(A), E may

deduct as bond premium $958.81, the excess of the bond premium

allocable to the accrual period ($958.81) over the qualified stated

interest allocable to the accrual period ($0). For the accrual

period ending on March 1, 2002, the bond premium allocable to the

accrual period ($1,055.82) exceeds the qualified stated interest

allocable to the accrual period ($0) and, therefore, E does not have

interest income for the accrual period. Under Sec. 1.171-

2(a)(4)(i)(A), E's deduction for bond premium for the accrual period

is limited to $170.48, the excess of E's total interest inclusions

on the bond in prior accrual periods ($1,129.29) over the total

amount treated by E as a bond premium deduction in prior accrual

periods ($958.81). Under Sec. 1.171-2(a)(4)(i)(B), E must carry

forward the remaining $885.34 of bond premium allocable to the

period ending March 1, 2002, and treat it as bond premium allocable

to the period ending March 1, 2003. The amount E includes in income

for each accrual period is shown in the following schedule:

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

Premium

Qualified allocable Interest Premium Premium

Accrual period ending stated to accrual income deduction carryforward

interest period

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

3/1/00........................................ $2,000.00 $870.71 $1,129.29 ........... ............

3/1/01........................................ 0.00 958.81 0.00 $958.81 ............

3/1/02........................................ 0.00 1,055.82 0.00 170.48 $885.34

3/1/03........................................ 10,000.00 1,162.64 7,951.93 ........... ............

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 (c)(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

[[Page 68182]]

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 (c)(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. 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. Because a revocation of

the election is a change in accounting method, a taxpayer must follow

the rules under Sec. 1.446-1(e)(3)(i) to request the Commissioner's

consent to revoke the election. A revocation of the election applies to

all taxable bonds held during or after the taxable year for which the

revocation is effective. The holder may not amortize any remaining bond

premium on bonds held at the beginning of the taxable year for which

the revocation is effective. Therefore, no adjustment under section 481

is allowed upon the revocation of the election because no items of

income or deduction are omitted or duplicated.

Par. 5. 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. Sections 1.171-1 through 1.171-

4 apply to bonds acquired on or after March 2, 1998. However, if a

holder makes the election under Sec. 1.171-4 for the taxable year

containing March 2, 1998, or any subsequent taxable year, Secs. 1.171-1

through 1.171-4 apply to bonds held on or after the first day of the

taxable year in which the election is made.

(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 for the taxable year containing

March 2, 1998, if the holder elected to amortize bond premium under

section 171 and that election is effective on March 2, 1998. If the

holder is deemed to have made the election under Sec. 1.171-4 for the

taxable year containing March 2, 1998, Secs. 1.171-1 through 1.171-4

apply to bonds acquired on or after the first day of that taxable year.

See Sec. 1.171-4(d) for rules relating to a revocation of an election

under section 171.

(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 under

Sec. 1.171-4 does not need the Commissioner's consent to make the

election.

(2) Automatic consent. The Commissioner grants consent for a holder

to change its method of accounting for bond premium with respect to

taxable bonds to which Secs. 1.171-1 through 1.171-3 apply. Because

this change is made on a cut-off basis, no items of income or deduction

are omitted or duplicated and, therefore, no adjustment under section

481 is allowed. 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 March 2, 1998,

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. 6. Section 1.249-1 is amended by revising paragraph (c) and

the first sentence of paragraph (d)(2) to read as follows:

Sec. 1.249-1 Limitation on deduction of bond premium on repurchase.

* * * * *

(c) Repurchase premium. For purposes of this section, the term

repurchase premium means the excess

[[Page 68183]]

of the repurchase price paid or incurred to repurchase the obligation

over its adjusted issue price (within the meaning of Sec. 1.1275-1(b))

as of the repurchase date. For the general rules applicable to the

deductibility of repurchase premium, see Sec. 1.163-7(c). This

paragraph (c) applies to convertible obligations repurchased on or

after March 2, 1998.

(d) * * *

(2) * * * For a convertible obligation repurchased on or after

March 2, 1998, a call premium specified in dollars under the terms of

the obligation is considered to be a normal call premium on a

nonconvertible obligation if the call premium applicable when the

obligation is repurchased does not exceed an amount equal to the

interest (including original issue discount) that otherwise would be

deductible for the taxable year of repurchase (determined as if the

obligation were not repurchased). * * *

* * * * *

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--(1) In general. 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.

(2) Special rules for taxable bonds. 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(c)(5)(ii) (relating to the issuer's call of a

taxable bond) or under Sec. 1.171-2(a)(4)(i)(A) (relating to excess

bond premium).

(3) Special rule for tax-exempt obligations. A holder's basis in a

tax-exempt obligation is reduced by the amount of excess bond premium

that is treated as a nondeductible loss under Sec. 1.171-2(a)(4)(ii).

* * * * *

Sec. 1.1016-9 [Removed]

Par. 8. Section 1.1016-9 is removed.

Par. 9. Section 1.1275-1 is amended by:

1. Redesignating paragraph (b)(2) as paragraph (b)(3).

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

The addition reads as follows:

Sec. 1.1275-1 Definitions.

* * * * *

(b) * * *

(2) Bond issuance premium. If a debt instrument is issued with bond

issuance premium (as defined in Sec. 1.163-13(c)), for purposes of

determining the issuer's adjusted issue price, the adjusted issue price

determined under paragraph (b)(1) of this section is also decreased by

the amount of bond issuance premium previously allocable under

Sec. 1.163-13(d)(3).

* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 10. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 11. Section 602.101, paragraph (c) is amended by:

1. Removing the following entry from the table:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

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

Current OMB

CFR part or section where identified and described control No.

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

* * * * *

1.171-3.................................................... 1545-0172

* * * * *

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

2. Adding entries in numerical order to the table to read as

follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

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

Current OMB

CFR part or section where identified and described control No.

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

* * * * *

1.163-13................................................... 1545-1491

* * * * *

1.171-4.................................................... 1545-1491

1.171-5.................................................... 1545-1491

* * * * *

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

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Approved: December 15, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-33647 Filed 12-30-97; 8:45 am]

BILLING CODE 4830-01-P