Inflation-Indexed Debt Instruments

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8838]

RIN 1545-AU45

Inflation-Indexed Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

federal income tax treatment of inflation-indexed debt instruments,

including Treasury Inflation-Indexed Securities. The regulations in

this document provide needed guidance to holders and issuers of

inflation-indexed debt instruments.

EFFECTIVE DATE: The regulations are effective September 7, 1999.

FOR FURTHER INFORMATION CONTACT: Helen Vanek-Bigelow or William E.

Blanchard, (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 6, 1997, temporary regulations (TD 8709 [1997-1 C.B.

167]) relating to the federal income tax treatment of inflation-indexed

debt instruments under sections 1275 and 1286 of the Internal Revenue

Code (Code) were published in the Federal Register (62 FR 615). A

notice of proposed rulemaking (REG-242996-96 [1997-1 C.B. 784]) cross-

referencing the temporary regulations was published in the Federal

Register for the same day (62 FR 694). A public hearing was held on

April 30, 1997. However, no one requested to speak at the hearing.

No written comments responding to the notice were received.

Therefore, the proposed regulations under sections 1275 and 1286 are

adopted by this Treasury decision with no changes, and the

corresponding temporary regulations are redesignated as final

regulations.

Explanation of Provisions

The following is a general explanation of the provisions in the

final regulations, which are the same as the provisions in the

temporary regulations.

A. In General

The final regulations provide rules for the treatment of certain

debt instruments that are indexed for inflation and deflation,

including Treasury Inflation-Indexed Securities. The final 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 final 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 final 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 below), and (3) is not otherwise a contingent payment

debt instrument. The final 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

changes in the values 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

[[Page 48546]]

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 final 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.

F. Deflation Adjustments

The final 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 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. Miscellaneous Rules

The final regulations provide special rules for reopenings, strips,

subsequent holders, and minimum guarantees.

H. Effective Date

The final 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 Executive Order 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 Code, the notice of proposed

rulemaking preceding these regulations was submitted to the Chief

Counsel for Advocacy of the Small Business Administration for comment

on its impact on small business.

Drafting information. The principal author of the regulations is

Helen Vanek-Bigelow, 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.

[[Page 48547]]

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

removing the entries for Secs. 1.1275-7T and 1.1286-2T and adding two

entries in numerical order to read in part as follows:

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

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

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

Sec. 1.148-4 [Amended]

Par. 2. Section 1.148-4 is amended by:

1. Removing the ``T'' from the reference ``Sec. 1.1275-7T'' in

paragraph (h)(2)(v)(A).

2. Removing the ``T'' from the reference ``Sec. 1.1275-7T'' in

paragraph (h)(2)(v)(B).

Sec. 1.163-13 [Amended]

Par. 3. Section 1.163-13 is amended by:

1. Removing the ``T'' from the reference ``Sec. 1.1275-

7T(f)(1)(ii)'' in the next to the last sentence in paragraph (e)(2).

2. Removing the ``T'' from the reference ``Sec. 1.1275-7T'' in the

last sentence in paragraph (e)(2).

Sec. 1.171-3 [Amended]

Par. 4. Section 1.171-3 is amended by:

1. Removing the ``T'' from the reference ``Sec. 1.1275-

7T(f)(1)(i)'' in the next to last sentence in paragraph (b).

2. Removing the ``T'' from the reference ``Sec. 1.1275-7T'' in the

last sentence in paragraph (b).

Par. 5. In Sec. 1.1271-0, paragraph (b) is amended by revising the

entry for Sec. 1.1275-7T to read as follows:

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

contents.

* * * * *

(b) * * *

* * * * *

Sec. 1.1275-7 Inflation-indexed debt instruments.

* * * * *

Sec. 1.1275-4 [Amended]

Par. 6. Section 1.1275-4 is amended by removing the ``T'' from the

reference ``Sec. 1.1275-7T'' in paragraph (a)(2)(vii).

Sec. 1.1275-7T [Redesignated as Sec. 1.1275-7]

Par. 7. Section 1.1275-7T is redesignated as Sec. 1.1275-7 and the

language ``(temporary)'' is removed from the section heading.

Sec. 1.1286-2T [Redesignated as Sec. 1.1286-2]

Par. 8. Section 1.1286-2T is redesignated as Sec. 1.1286-2 and the

language ``(temporary)'' is removed from the section heading.

Par. 9. Newly designated Sec. 1.1286-2 is amended by removing the

``T'' from the reference ``Sec. 1.1275-7T(e)''.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Approved: August 25, 1999.

Jonathan Talisman,

Deputy Assistant Secretary of the Treasury.

[FR Doc. 99-23082 Filed 9-3-99; 8:45 am]

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