\[4830-01-P\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

\[REG-106486-98; INTL-0015-91\]

RIN 1545-AW33; RIN 1545-PP78

Guidance Regarding the Treatment of Certain Contingent Payment Debt
Instruments with One or More Payments that Are Denominated in, or
Determined by Reference to, a Nonfunctional Currency

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; notice of public hearing; and
withdrawal of previous proposed regulations section.

SUMMARY: This document contains proposed regulations regarding the
treatment of contingent payment debt instruments for which one or more
payments are denominated in, or determined by reference to, a currency
other than the taxpayer's functional currency. These regulations are
necessary because current regulations do not provide guidance concerning
the tax treatment of such instruments. The proposed regulations
generally provide that taxpayers should apply the existing rules under
section 1275 of the Internal Revenue Code, with certain modifications,
to nonfunctional currency contingent payment debt instruments. This
document also withdraws existing proposed regulations and provides
notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments and requests to speak (with
outlines of oral comments to be discussed) at the public hearing
scheduled for December 3, 2003, at 10 a.m. must be submitted by November
12, 2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-106486-98), room 5203,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC
20044. Submissions may be hand delivered between the hours of 8 a.m. and
4 p.m. to: REG-106486-98, Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC. or sent electronically, via
the IRS Internet site at: www.irs.gov/regs. The public hearing will be
held in room 6718, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Milton Cahn at (202) 622-3870; concerning submission and delivery of
comments and the public hearing, Treena Garrett, (202) 622-7180 (not
toll-free numbers).

SUPPLEMENTARY INFORMATION:

**PAPERWORK REDUCTION ACT**

The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collections of information should be
sent to the **Office of Management and Budget**, Attn: Desk Officer for
the Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the **Internal Revenue**
**Service**, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP
Washington, DC 20224. Comments on the collection of Information should
be received by October 28, 2003. Comments are specifically requested
concerning:

Whether the proposed collections of information is necessary for the
proper performance of the functions of the **Internal Revenue Service**,
including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed
collection of information (see below);

How the quality, utility, and clarity of the information to be collected
may be enhanced;

How the burden of complying with the proposed collections of information
may be minimized, including through the application of automated
collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.

The collections of information in this proposed regulation are in
§1.988-6(a)(1) (cross reference to §1.1275-4) and §1.988-6(d)(3). This
information is required to ensure consistency in the treatment of the
debt instrument between the issuer and the holders. This information
will be used for audit and examination purposes. The disclosure of
information is mandatory as regards the issuers of nonfunctional
currency contingent payment debt instruments. The reporting of
information is mandatory as regards holders of debt instruments which
determine their own projected payment schedule. The recordkeeping
requirement is mandatory for any party that determines the comparable
yield and projected payment schedule for a debt instrument. The likely
respondents are business or other for-profit institutions.

Taxpayers provide the information on a statement attached to its timely
filed federal income tax return for the taxable year that includes the
acquisition date of the debt instrument.

Estimated total annual reporting, and/or recordkeeping burden: 100
hours.

Estimated average annual burden hours per respondent and/or
recordkeeper: 1 hour.

Estimated number of respondents and/or recordkeepers: 100

Estimated annual frequency of responses: on occasion.

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

**Background**

On March 17, 1992, Treasury and the IRS issued proposed regulations
(INTL-0015-91), §§1.988-1(a)(3), (4) and (5), regarding contingent
payment debt instruments, dual currency debt instruments and
multi-currency debt instruments. The proposed regulations followed the
general approach in the then-proposed §1.1275-4(g) contingent payment
debt regulations (LR-189-84; 51 FR 12022 (1986)*,* amended at 56 FR 8308
(1991)) and bifurcated such debt instruments into contingent and
noncontingent components. After an instrument was bifurcated, the
proposed regulations applied the rules in §§1.988-1 through 1.988-5, as
appropriate, to the resulting components.

On December 16, 1994, Treasury and the IRS withdrew the then proposed
§1.1275-4(g) regulations and proposed a new set of §1.1275-4 regulations
(FI-59-91, 59 FR-64884). These regulations were finalized on June 14,
1996.

Section 1.1275-4 of the final regulations adopted the \"noncontingent
bond method\" for certain contingent payment debt instruments. Under the
noncontingent bond method, interest accrues on a contingent payment debt
instrument at a rate equal to the instrument's comparable yield, which
is the yield at which an issuer would issue a fixed rate debt instrument
with terms and conditions similar to those of the contingent payment
debt instrument. In addition, the noncontingent bond method treats all
interest on a debt instrument as original issue discount, which must be
taken into account as it accrues, regardless of the taxpayer\'s normal
method of accounting.

Under the noncontingent bond method, the comparable yield is used to
construct a projected payment schedule for the debt instrument, which
includes a projected amount for each contingent payment. If the actual
amount of a contingent payment is greater than the projected amount, the
difference is treated as additional interest. If the actual amount of a
contingent payment is less than the projected amount, the difference
generally offsets current interest accruals. In some cases, the
difference may result in a loss to the holder and income to the issuer.

On August 2, 1999, as a result of the withdrawal of the 1994 proposed
§1.1275-4(g) regulations and the promulgation of the final §1.1275-4
regulations, the IRS issued Announcement 99-76 (1999-2 C.B. 223) which
provided a description of a regulatory approach that Treasury and the
IRS were considering as a replacement to the proposed regulations in
§§1.988-1(a)(3), (4) and (5) for contingent payment debt instruments
with one or more payments denominated in, or determined by reference to,
a nonfunctional currency. Announcement 99-76 stated that Treasury and
the IRS were considering issuing regulations that would apply the
noncontingent bond method in the taxpayer's nonfunctional currency and
would translate payments received on the instrument into functional
currency under the rules of §§1.988-1 through 1.988-5. Announcement
99-76 requested comments on this approach. No comments were received.

Treasury and the IRS believe that proposed regulations §1.988-1(a)(3),
(4) and (5) should be withdrawn because they incorporate the bifurcation
approach rather than the noncontingent bond method ultimately adopted
under §1.1275-4. Treasury and the IRS believe, as reflected in
Announcement 99-76, that nonfunctional currency contingent payment debt
instruments should be accounted for under rules similar to those that
govern the treatment of functional currency contingent payment debt
instruments. Treasury and the IRS believe that providing a consistent
set of rules in this area is in the best interests of sound tax
administration.

**Explanation of Provisions**

[In General]{.underline}

These proposed regulations provide guidance for four different types of
debt instruments: (1) debt instruments issued for money or
publicly-traded property for which all payments of principal and
interest are denominated in, or determined by reference to, a single
nonfunctional currency and which have one or more non-currency
contingencies, (2) debt instruments issued for money or publicly-traded
property for which payments of principal or interest are denominated in,
or determined by reference to, more than one currency and which have no
non-currency contingencies, (3) debt instruments issued for money or
publicly-traded property for which payments of principal or interest are
denominated in, or determined by reference to, more than one currency
and which also have one or more non-currency contingencies, and (4) debt
instruments which otherwise would fall into one of the three foregoing
categories but for the fact that the instruments are not issued for
money or publicly-traded property. These proposed regulations do not
discuss the treatment of tax-exempt obligations described in
§1.1275-4(d) which are denominated in one or more nonfunctional
currencies. Comments are requested as to the proper treatment of such
instruments.

Consistent with the approach described in Announcement 99-76, these
proposed regulations generally apply the rules of §1.1275-4(b) (i.e.,
the noncontingent bond method) to nonfunctional currency contingent
payment debt instruments issued for money or publicly traded property.
The proposed regulations generally provide that the noncontingent bond
method is applied in the currency in which the instrument is denominated
(the denomination currency).

Application of the §1.1275-4(b) rules to nonfunctional currency
contingent instruments generally requires taxpayers (i) to accrue
interest in the denomination currency at a yield at which the issuer
would issue a fixed rate debt instrument denominated in the denomination
currency with terms and conditions similar to those of the contingent
payment debt instrument, (ii) to translate the interest accrued from the
denomination currency into the functional currency (and account for
foreign currency gain or loss on payments of interest and principal)
under the principles of §1.988-2(b), and (iii) to account for gain or
loss arising from contingencies in a manner consistent with the rules of
§1.1275-4(b).

[Applying the Noncontingent Bond Method in the Denomination
Currency]{.underline}

As noted, the proposed regulations require taxpayers to apply the
noncontingent bond method in the instrument's denomination currency. For
example, in the case of an instrument whose denomination currency is the
British pound, an issuer whose functional currency is the U.S. dollar
would first determine the comparable yield of the instrument, that is,
the yield at which the issuer would issue a fixed rate instrument in
British pounds with terms and conditions similar to those of the
instrument actually being issued. Second, the issuer would construct a
projected payment schedule applying that yield. Third, the amount of
interest accrued in each taxable year would be determined in British
pounds based on the comparable yield and translated into dollars under
the principles of section 988. Fourth, the issuer and holder would
account for differences between the projected amount of payments and the
actual amount of payments (so-called positive adjustments and negative
adjustments) under rules similar to those in §1.1275-4(b). Consistent
with the rules of §1.1275-4(b), the proposed regulations provide that
net positive adjustments are treated as additional interest on the
instrument. Net negative adjustments generally offset current interest
accruals, and in some cases may result in a loss to the holder and
income to the issuer. Finally, the issuer and holders would determine
foreign currency gain or loss with respect to interest and principal
payments on the instrument.

[Determination of the comparable yield and projected payment
schedule]{.underline}

Consistent with §1.1275-4(b)(4)(iv), the holder uses the yield and
projected payment schedule determined by the issuer to determine the
holder's interest accruals and adjustments for a debt instrument. If the
issuer does not determine a comparable yield and projected payment
schedule for the debt instrument, or if the issuer's comparable yield or
projected payment schedule is unreasonable, the holder of the debt
instrument must determine the comparable yield and the projected payment
schedule for the debt instrument under the rules of the proposed
regulations. A holder that determines its own comparable yield and
projected payment schedule must explicitly disclose, in the manner set
forth in §1.1275-4(b)(4)(iv), both this fact and the reason why the
holder made its own determination.

[Determination of Basis]{.underline}

In general, the proposed regulations provide that a holder maintains its
adjusted basis in functional currency by computing basis adjustments in
the denomination currency under the rules of §1.1275-4(b)(7)(iii) and
then translating such adjustments into functional currency. Thus, the
proposed regulations provide that a holder\'s basis is increased by the
holder\'s accrued but unpaid interest inclusions on the debt instrument,
generally without regard to any positive or negative adjustments, and
decreased by the amount of any noncontingent payment and the projected
amount of any contingent payment previously made on the debt instrument
to the holder. These amounts are translated into functional currency
under the principles of §1.988-2(b).

[Determination of Amount Realized]{.underline}

The proposed regulations generally follow §1.1275-4(b)(7)(iv) in
determining the amount realized, but do so in the denomination currency.
Thus, for purposes of determining the amount realized by a holder on the
scheduled retirement of a debt instrument, the holder generally is
treated as receiving the projected amount of any contingent payment due
at maturity. In the case of a sale, exchange or unscheduled retirement
of a debt instrument, general recognition principles of tax law
generally apply (e.g., section 1001(b)). However, the amount realized by
a holder on either the scheduled retirement, or the sale, exchange, or
unscheduled retirement of a debt instrument, is reduced by any negative
adjustment carryforward existing in the taxable year of the sale,
exchange or retirement.

To calculate gain or loss other than foreign currency gain or loss, the
proposed regulations require the translation of the amount realized into
functional currency. Foreign currency gain or loss is computed
separately, as described below. The proposed regulations generally
translate the amount realized by reference to the rates used to
translate the components of interest and principal that make up adjusted
basis. The amount realized is translated using the adjusted basis rates
in order to separate from the foreign currency gain or loss the amount
of gain or loss on the sale, exchange or retirement of the debt
instrument which does not result from changes in foreign exchange rates.
Thus, where the amount realized in the denomination currency equals the
adjusted basis of the instrument in the denomination currency prior to
translation, the amount realized is translated in its entirety by
reference to the rates used to translate adjusted basis. Where the
amount realized differs from the adjusted basis prior to translation,
additional attribution and translation rules are required.

Where the amount realized in the denomination currency is less than the
adjusted basis in the denomination currency, that is, where the holder
realizes a loss (not taking into account foreign currency gain or loss),
the following rules apply as to which parts of adjusted basis are not
recovered. In the case of a scheduled retirement at maturity, the loss
is attributable to principal (the amount in denomination currency which
the holder paid to purchase the debt instrument). The loss is
attributable to principal because the holder will not entirely recover
the holder's original investment in the debt instrument. In the case of
a sale or exchange, the loss is first attributable to accrued interest.
Attributing the loss first to interest results in symmetrical treatment
between a loss resulting from a negative adjustment and a loss resulting
from a sale.

When the holder's amount realized in the denomination currency exceeds
the amount of its basis in the denomination currency prior to
translation, that is, where the holder realizes a gain (not taking into
account foreign currency gain or loss), the excess of amount realized
over adjusted basis is translated at the spot rate on the date of
receipt. This rule ensures symmetrical treatment between a positive
adjustment and a gain on the instrument.

[Determination of Foreign Currency Gain or Loss]{.underline}

The proposed regulations provide that foreign currency gain or loss is
determined on an instrument with respect to principal and interest based
on the comparable yield and projected payment schedule under the
principles of §1.988-2(b). In general, no foreign currency gain or loss
is recognized until payment is made or received pursuant to the
instrument, and no foreign currency gain or loss is computed with
respect to positive or negative adjustments. However, foreign currency
gain or loss is determined with respect to positive adjustments
described in §1.1275-4(b)(9)(ii) (relating to certain fixed but deferred
contingent payments), based upon the difference between the spot rate on
the date the positive adjustment becomes fixed and the spot rate on the
date the positive adjustment is paid or received.

[Source Rules]{.underline}

Consistent with the rules of §1.1275-4(b)(6)(ii), the proposed
regulations provide that all gain (other than foreign currency gain) on
an instrument is characterized as interest for all tax purposes,
including source and character rules. Losses of a holder from a
contingent payment debt instrument are generally sourced by reference to
the rules of §1.1275-4(b)(9)(iv). Under §1.1275-4(b)(9)(iv), a holder\'s
deductions or loss related to a contingent payment debt instrument that
are treated as ordinary losses are treated as deductions that are
definitely related to the class of gross income to which income from
such debt instrument belongs. Deductions or losses that the holder
treats as capital losses are allocated, consistently with the general
principles of §1.865-1(b)(2), to the class of gross income with respect
to which interest income from the instrument would give rise.

[Treatment of Subsequent Holders]{.underline}

The proposed regulations provide that the rules of §1.1275-4(b)(9)
generally apply to subsequent holders of an instrument who purchase the
instrument for an amount greater or less than the instrument's adjusted
issue price (determined in the denomination currency). Accordingly, to
the extent that the purchase price for an instrument exceeds the
adjusted issue price of the instrument, the holder is required to
allocate such excess to interest accrued on the instrument or to
projected payments on the instrument in a reasonable manner. Each such
allocation is treated as a negative adjustment on the instrument, and
the holder's basis on the instrument is decreased as these negative
adjustments are taken into account.

To the extent that the adjusted issue price of the instrument exceeds
its purchase price, the holder is required to allocate such excess to
interest accrued on the instrument or to projected payments on the
instrument in a reasonable manner. As the difference is taken into
account, the holder is treated as receiving a positive adjustment on the
instrument, and the holder's basis is increased as these positive
adjustments are taken into account.

The proposed regulations generally translate the difference between the
purchase price and adjusted issue price into functional currency at the
rate used to translate the interest or projected payment subject to the
adjustment. Thus, for example, a positive adjustment attributable to
interest is translated at the same rate used to translate interest in
the period in which it accrues (e.g., the average rate for the accrual
period). The basis adjustment corresponding to such a positive or
negative adjustment is translated at the same rate applicable to the
positive or negative adjustment itself.

[Netting]{.underline}

The proposed regulations do not provide for the netting of market gain
or loss with currency gain or loss on nonfunctional currency contingent
payment debt instruments. On the one hand, different character and
source rules generally apply to market gain or loss and currency gain or
loss, and netting such items may produce results inconsistent with the
tax treatment of other types of instruments. On the other hand, where
market gain or loss and currency gain or loss counteract each other with
respect to a taxpayer, requiring separate recognition of such gain and
loss may not accurately reflect the economic benefits and burdens
associated with the instrument. Accordingly, Treasury and the IRS
request comments regarding the extent to which netting should be
permitted or required. [Examples 2]{.underline} and [4]{.underline} of
the proposed regulations demonstrate cases in which netting potentially
could be permitted or required because both illustrate instances in
which market loss could be netted against currency gain.

[Debt Instruments Denominated in Multiple Currencies]{.underline}

In the case of an instrument for which payments are denominated in, or
determined by reference to, more than one currency, the proposed
regulations provide that the issuer must first determine the
instrument's predominant currency, which will be used as the
instrument's denomination currency for purposes of applying the rules of
the proposed regulations. The predominant currency of the instrument is
determined on the issue date by comparing the present value in
functional currency of the noncontingent and projected payments
denominated in, or determined by reference to, each currency. For this
purpose, the applicable discount rate must be a nonfunctional currency
discount rate, but the rate may be determined using any method,
consistently applied, that reasonably reflects the instrument\'s
economic substance. If a taxpayer does not determine a discount rate
using such a method, the Commissioner may choose a method for
determining the discount rate that does reflect the instrument\'s
economic substance.

After the denomination currency has been determined, all payments on the
instrument that are denominated in, or determined by reference to, a
currency other than the denomination currency are treated as
non-currency related contingent payments for purposes of applying the
rules of the proposed regulations. Treasury and the IRS request comments
regarding whether all gain or loss with respect to a debt instrument for
which payments are denominated in, or determined by reference to, more
than one currency and which has no non-currency contingencies should be
treated as foreign currency gain or loss.

[Debt Instruments Issued for Non-publicly Traded Property]{.underline}

In the case of a nonfunctional currency contingent debt instrument
issued for non-publicly traded property, the instrument is not accounted
for using the noncontingent bond method. Rather, the debt instrument is
separated into its components based on the currency in which the
payments are denominated and whether the payments are contingent or
noncontingent. The noncontingent components in each currency are treated
as a separate debt instrument denominated in the currency in which the
payment (or payments) is denominated. A component consisting of a
contingent payment is generally treated in the manner provided in
§1.1275-4(c)(4). For purposes of the contingent payment, the test rate
(the interest rate which is used to discount the contingent payment so
as to determine the amount of the payment which is treated as principal,
and the amount which is treated as interest) is determined by reference
to the dollar unless the dollar does not reasonably reflect the economic
substance of the contingent component.

**Proposed Effective Dates**

Section 1.988-6 is proposed to apply to nonfunctional currency
contingent payment debt instruments issued 60 days or more after the
date §1.988-6 is published as a final regulation in the **Federal
Register**.

**Special Analysis**

It has been determined that this notice of proposed rulemaking is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required.

It is hereby certified that these regulations will not have a
significant economic impact on a substantial number of small entities.
This certification is based upon the fact that few, if any, small
entities issue or hold foreign currency denominated contingent payment
debt instruments. Generally, it is expected that the only domestic
holders of these instruments will likely be financial institutions,
investment banking firms, investment funds, and other sophisticated
investors, due to the foreign currency risk and other contingencies
inherent in these instruments. Therefore, a Regulatory Flexibility
Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is
not required.

Pursuant to section 7805(f) of the Internal Revenue Code, this notice of
proposed rulemaking will be submitted to the Chief Counsel for Advocacy
of the Small Business Administration for comment on its impact on small
business.

**Comments and Public Hearing**

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a signed
original and eight (8) copies) that are submitted timely to the IRS. The
IRS and Treasury Department request comments on the clarity of the
proposed regulations and how they can be made easier to understand. All
comments will be available for public inspection and copying.

A public hearing has been scheduled for December 3, 2003, at 10 a.m. in
room 6718 Internal Revenue Building, 1111 Constitution Avenue, NW.,
Washington, DC. Due to building security procedures, visitors must enter
at the Constitution Avenue entrance. In addition, all visitors must
present photo identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate
entrance area more than 30 minutes before the hearing starts. For
information about having your name placed on the building access list to
attend the hearing, see the "FOR FURTHER INFORMATION CONTACT" section of
this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish
to present oral comments at the hearing must submit electronic or
written comments and an outline of the topics to be discussed and the
time to be devoted to each topic (signed original and eight (8) copies)
by November 12, 2003. A period of 10 minutes will be allotted to each
person for making comments. An agenda showing the scheduling of the
speakers will be prepared after the deadline for receiving outlines has
passed. Copies of the agenda will be available free of charge at the
hearing.

**Drafting Information**

The principal author of these regulations is Milton Cahn of the Office
of the Associate Chief Counsel (International). 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.

Section 1.988-1(a)(3), (4) and (5) as proposed on March 17, 1992 at 57
FR 9218 income tax regulations are withdrawn, and 26 CFR part 1 is
proposed to be amended as follows:

Part 1\--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part
as follows:

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

Par. 2. Section 1.988-2 is amended by:

1\. Adding the text of paragraph (b)(2)(i)(B)([1]{.underline}).

2\. Removing the last sentence of paragraph
(b)(2)(i)(B)([2]{.underline}).

The addition reads as follows:

[§1.988-2 Recognition and computation of exchange gain or
loss]{.underline}.

\* \* \* \* \*

\(b\) \* \* \*

\(2\) \* \* \*

\(i\) \* \* \*

\(B\) \* \* \* ([1]{.underline}) [Operative rules]{.underline}. See
§1.988-6 for rules applicable to contingent debt instruments for which
one or more payments are denominated in, or determined by reference to,
a nonfunctional currency.

\* \* \* \* \*

Par. 3. Section 1.988-6 is added to read as follows:

[§1.988-6 Nonfunctional currency contingent payment debt
instruments]{.underline}.

\(a\) [In general]{.underline}\--(1) [Scope]{.underline}. This section
determines the accrual of interest and the amount, timing, source, and
character of any gain or loss on nonfunctional currency contingent
payment debt instruments described in this paragraph (a)(1). Except as
set forth by the rule in this section, the rules in §1.1275-4 (relating
to contingent payment debt instruments) apply to the following
instruments\--

\(i\) A debt instrument described in §1.1275-4(b)(1) for which all
payments of principal and interest are denominated in, or determined by
reference to, a single nonfunctional currency and which has one or more
non-currency related contingencies;

\(ii\) A debt instrument described in §1.1275-4(b)(1) for which payments
of principal or interest are denominated in, or determined by reference
to, more than one currency and which has no non-currency related
contingencies;

\(iii\) A debt instrument described in §1.1275-4(b)(1) for which
payments of principal or interest are denominated in, or determined by
reference to, more than one currency and which has one or more
non-currency related contingencies; and

\(iv\) A debt instrument otherwise described in paragraph (a)(1)(i),
(ii) or (iii) of this section, except that the debt instrument is
described in §1.1275-4(c)(1) rather than §1.1275-4(b)(1) (e.g., the
instrument is issued for non-publicly traded property).

\(2\) [Exception for hyperinflationary currencies]{.underline}\--(i) [In
general]{.underline}. Except as provided in paragraph (a)(2)(ii) of this
section, this section shall not apply to an instrument described in
paragraph (a)(1) of this section if any payment made under such
instrument is determined by reference to a hyperinflationary currency,
as defined in §1.985-1(b)(2)(ii)(D). In such case, the amount, timing,
source and character of interest, principal, foreign currency gain or
loss, and gain or loss relating to a non-currency contingency shall be
determined under the method that reflects the instrument's economic
substance.

\(ii\) [Discretion as to method]{.underline}. If a taxpayer does not
account for an instrument described in paragraph (a)(2)(i) of this
section in a manner that reflects the instrument's economic substance,
the Commissioner may apply the rules of this section to such an
instrument or apply the principles of §1.988-2(b)(15), reasonably taking
into account the contingent feature or features of the instrument.

\(b\) [Instruments described in paragraph (a)(1)(i) of this
section]{.underline}\--(1) [In general]{.underline}. Paragraph (b)(2) of
this section provides rules for applying the noncontingent bond method
(as set forth in §1.1275-4(b)) in the nonfunctional currency in which a
debt instrument described in paragraph (a)(1)(i) of this section is
denominated, or by reference to which its payments are determined (the
denomination currency). Paragraph (b)(3) of this section describes how
amounts determined in paragraph (b)(2) of this section shall be
translated from the denomination currency of the instrument into the
taxpayer's functional currency. Paragraph (b)(4) of this section
describes how gain or loss (other than foreign currency gain or loss)
shall be determined and characterized with respect to the instrument.
Paragraph (b)(5) of this section describes how foreign currency gain or
loss shall be determined with respect to accrued interest and principal
on the instrument. Paragraph (b)(6) of this section provides rules for
determining the source and character of any gain or loss with respect to
the instrument. Paragraph (b)(7) of this section provides rules for
subsequent holders of an instrument who purchase the instrument for an
amount other than the adjusted issue price of the instrument. Paragraph
(c) of this section provides examples of the application of paragraph
(b) of this section. See paragraph (d) of this section for the
determination of the denomination currency of an instrument described in
paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of this
section for the treatment of an instrument described in paragraph
(a)(1)(iv) of this section.

\(2\) [Application of noncontingent bond method]{.underline}\--(i)
[Accrued interest]{.underline}. Interest accruals on an instrument
described in paragraph (a)(1)(i) of this section are initially
determined in the denomination currency of the instrument by applying
the noncontingent bond method, set forth in §1.1275-4(b), to the
instrument in its denomination currency. Accordingly, the comparable
yield, projected payment schedule, and comparable fixed rate debt
instrument, described in §1.1275-4(b)(4), are determined in the
denomination currency. For purposes of applying the noncontingent bond
method to instruments described in this paragraph, the applicable
Federal rate described in §1.1275-4(b)(4)(i) shall be the rate described
in §1.1274-4(d) with respect to the denomination currency.

\(ii\) [Net positive and negative adjustments]{.underline}. Positive and
negative adjustments, and net positive and net negative adjustments,
with respect to an instrument described in paragraph (a)(1)(i) of this
section are determined by applying the rules of §1.1275-4(b)(6) (and
§1.1275-4(b)(9)(i) and (ii), if applicable) in the denomination
currency. Accordingly, a net positive adjustment is treated as
additional interest (in the denomination currency) on the instrument. A
net negative adjustment first reduces interest that otherwise would be
accrued by the taxpayer during the current tax year in the denomination
currency. If a net negative adjustment exceeds the interest that would
otherwise be accrued by the taxpayer during the current tax year in the
denomination currency, the excess is treated as ordinary loss (if the
taxpayer is a holder of the instrument) or ordinary income (if the
taxpayer is the issuer of the instrument). The amount treated as
ordinary loss by a holder with respect to a net negative adjustment is
limited, however, to the amount by which the holder's total interest
inclusions on the debt instrument (determined in the denomination
currency) exceed the total amount of the holder's net negative
adjustments treated as ordinary loss on the debt instrument in prior
taxable years (determined in the denomination currency). Similarly, the
amount treated as ordinary income by an issuer with respect to a net
negative adjustment is limited to the amount by which the issuer's total
interest deductions on the debt instrument (determined in the
denomination currency) exceed the total amount of the issuer's net
negative adjustments treated as ordinary income on the debt instrument
in prior taxable years (determined in the denomination currency). To the
extent a net negative adjustment exceeds the current year's interest
accrual and the amount treated as ordinary loss to a holder (or ordinary
income to the issuer), the excess is treated as a negative adjustment
carryforward, within the meaning of §1.1275-4(b)(6)(iii)(C), in the
denomination currency.

\(iii\) [Adjusted issue price]{.underline}. The adjusted issue price of
an instrument described in paragraph (a)(1)(i) of this section is
determined by applying the rules of §1.1275-4(b)(7) in the denomination
currency. Accordingly, the adjusted issue price is equal to the debt
instrument's issue price in the denomination currency, increased by the
interest previously accrued on the debt instrument (determined without
regard to any net positive or net negative adjustments on the
instrument) and decreased by the amount of any noncontingent payment and
the projected amount of any contingent payment previously made on the
instrument. All adjustments to the adjusted issue price are calculated
in the denomination currency.

\(iv\) [Adjusted basis]{.underline}. The adjusted basis of an instrument
described in paragraph (a)(1)(i) of this section is determined by
applying the rules of §1.1275-4(b)(7) in the taxpayer's functional
currency. In accordance with those rules, a holder's basis in the debt
instrument is increased by the interest previously accrued on the debt
instrument (translated into functional currency), without regard to any
net positive or net negative adjustments on the instrument (except as
provided in paragraph (b)(7) or (8) of this section, if applicable), and
decreased by the amount of any noncontingent payment and the projected
amount of any contingent payment previously made on the instrument to
the holder (translated into functional currency). See paragraph
(b)(3)(iii) of this section for translation rules.

\(v\) [Amount realized]{.underline}. The amount realized by a holder and
the repurchase price paid by the issuer on the scheduled or unscheduled
retirement of a debt instrument described in paragraph (a)(1)(i) of this
section are determined by applying the rules of §1.1275-4(b)(7) in the
denomination currency. For example, with regard to a scheduled
retirement at maturity, the holder is treated as receiving the projected
amount of any contingent payment due at maturity, reduced by the amount
of any negative adjustment carryforward. For purposes of translating the
amount realized by the holder into functional currency, the rules of
paragraph (b)(3)(iv) of this section shall apply.

\(3\) [Treatment and translation of amounts determined under
noncontingent bond method]{.underline}\--(i) [Accrued
interest]{.underline}. The amount of accrued interest, determined under
paragraph (b)(2)(i) of this section, is translated into the taxpayer's
functional currency at the average exchange rate, as described in
§1.988-2(b)(2)(iii)(A), or, at the taxpayer\'s election, at the
appropriate spot rate, as described in §1.988-2(b)(2)(iii)(B).

\(ii\) [Net positive and negative adjustments]{.underline}\--(A) [Net
positive adjustments]{.underline}. A net positive adjustment, as
referenced in paragraph (b)(2)(ii) of this section, is translated into
the taxpayer's functional currency at the spot rate on the last day of
the taxable year in which the adjustment is taken into account under
§1.1275-4(b)(6), or, if earlier, the date the instrument is disposed of
or otherwise terminated.

\(B\) [Net negative adjustments]{.underline}. A net negative adjustment
is treated and, where necessary, is translated from the denomination
currency into the taxpayer's functional currency under the following
rules:

([1]{.underline}) The amount of a net negative adjustment determined in
the denomination currency that reduces the current year's interest in
that currency shall first reduce the current year's accrued but unpaid
interest, and then shall reduce the current year's interest which was
accrued and paid. No translation is required.

([2]{.underline}) The amount of a net negative adjustment treated as
ordinary income or loss under §1.1275-4(b)(6)(iii)(B) first is
attributable to accrued but unpaid interest accrued in prior taxable
years. For this purpose, the net negative adjustment shall be treated as
attributable to any unpaid interest accrued in the immediately preceding
taxable year, and thereafter to unpaid interest accrued in each
preceding taxable year. The amount of the net negative adjustment
applied to accrued but unpaid interest is translated into functional
currency at the same rate used, in each of the respective prior taxable
years, to translate the accrued interest.

([3]{.underline}) Any amount of the net negative adjustment remaining
after the application of paragraphs (b)(3)(ii)(B)([1]{.underline}) and
([2]{.underline}) of this section is attributable to interest accrued
and paid in prior taxable years. The amount of the net negative
adjustment applied to such amounts is translated into functional
currency at the spot rate on the date the debt instrument was issued or,
if later, acquired.

([4]{.underline}) Any amount of the net negative adjustment remaining
after application of paragraphs (b)(3)(ii)(B)([1]{.underline}),
([2]{.underline}) and ([3]{.underline}) of this section is a negative
adjustment carryforward, within the meaning of §1.1275-4(b)(6)(iii)(C).
A negative adjustment carryforward is carried forward in the
denomination currency and is applied to reduce interest accruals in
subsequent years. In the year in which the instrument is sold, exchanged
or retired, any negative adjustment carryforward not applied to interest
reduces the holder's amount realized on the instrument (in the
denomination currency). An issuer of a debt instrument described in
paragraph (a)(1)(i) of this section who takes into income a negative
adjustment carryforward (that is not applied to interest) in the year
the instrument is retired, as described in §1.1275-4(b)(6)(iii)(C),
translates such income into functional currency at the spot rate on the
date the instrument was issued.

\(iii\) [Adjusted basis]{.underline}\--(A) [In general]{.underline}.
Except as otherwise provided in this paragraph and paragraphs (b)(7) or
(8) of this section, a holder determines and maintains adjusted basis by
translating the denomination currency amounts determined under
§1.1275-4(b)(7)(iii) into functional currency as follows:

([1]{.underline}) The holder's initial basis in the instrument is
determined by translating the amount paid by the holder to acquire the
instrument (in the denomination currency) into functional currency at
the spot rate on the date the instrument was issued or, if later,
acquired.

([2]{.underline}) An increase in basis attributable to interest accrued
on the instrument is translated at the rate applicable to such interest
under paragraph (b)(3)(i) of this section.

([3]{.underline}) Any noncontingent payment and the projected amount of
any contingent payments determined in the denomination currency that
decrease the holder's basis in the instrument under §1.1275-4(b)(7)(iii)
are translated as follows:

([i]{.underline}) The payment first is attributable to the most recently
accrued interest to which prior amounts have not already been
attributed. The payment is translated into functional currency at the
rate at which the interest was accrued.

([ii]{.underline}) Any amount remaining after the application of
paragraph (b)(3)(iii)(A)([3]{.underline})([i]{.underline}) of this
section is attributable to principal. Such amounts are translated into
functional currency at the spot rate on the date the instrument was
issued or, if later, acquired.

\(B\) [Exception for interest reduced by a negative adjustment
carryforward]{.underline}. Solely for purposes of this §1.988-6, any
amounts of accrued interest income that are reduced as a result of a
negative adjustment carryforward shall be treated as principal and
translated at the spot rate on the date the instrument was issued or, if
later, acquired.

\(iv\) [Amount realized]{.underline}*\--*(A) [Instrument held to
maturity]{.underline}\--([1]{.underline}) [In general]{.underline}. With
respect to an instrument held to maturity, a holder translates the
amount realized by separating such amount in the denomination currency
into the component parts of interest and principal that make up adjusted
basis prior to translation under paragraph (b)(3)(iii) of this section,
and translating each of those component parts of the amount realized at
the same rate used to translate the respective component parts of basis
under paragraph (b)(3)(iii) of this section. The amount realized first
shall be translated by reference to the component parts of basis
consisting of accrued interest during the taxpayer's holding period as
determined under paragraph (b)(3)(iii) of this section and ordering such
amounts on a last in first out basis. Any remaining portion of the
amount realized shall be translated by reference to the rate used to
translate the component of basis consisting of principal as determined
under paragraph (b)(3)(iii) of this section.

([2]{.underline}) [Subsequent purchases at discount and fixed but
deferred contingent payments]{.underline}. For purposes of this
paragraph (b)(3)(iv) of this section, any amount which is required to be
added to adjusted basis under paragraph (b)(7) or (8) of this section
shall be treated as additional interest which was accrued on the date
the amount was added to adjusted basis. To the extent included in amount
realized, such amounts shall be translated into functional currency at
the same rates at which they were translated for purposes of determining
adjusted basis. See paragraphs (b)(7)(iv) and (b)(8) of this section for
rules governing the rates at which the amounts are translated for
purposes of determining adjusted basis.

\(B\) [Sale, exchange, or unscheduled
retirement]{.underline}\--([1]{.underline}) [Holder]{.underline}. In the
case of a sale, exchange, or unscheduled retirement, application of the
rule stated in paragraph (b)(3)(iv)(A) of this section shall be as
follows. The holder's amount realized first shall be translated by
reference to the principal component of basis as determined under
paragraph (b)(3)(iii) of this section, and then to the component of
basis consisting of accrued interest as determined under paragraph
(b)(3)(iii) of this section and ordering such amounts on a first in
first out basis. Any gain recognized by the holder (i.e., any excess of
the sale price over the holder's basis, both expressed in the
denomination currency) is translated into functional currency at the
spot rate on the payment date.

([2]{.underline}) [Issuer]{.underline}. In the case of an unscheduled
retirement of the debt instrument, any excess of the adjusted issue
price of the debt instrument over the amount paid by the issuer
(expressed in denomination currency) shall first be attributable to
accrued unpaid interest, to the extent the accrued unpaid interest had
not been previously offset by a negative adjustment, on a
last-in-first-out basis, and then to principal. The accrued unpaid
interest shall be translated into functional currency at the rate at
which the interest was accrued. The principal shall be translated at the
spot rate on the date the debt instrument was issued.

\(C\) [Effect of negative adjustment carryforward with respect to the
issuer]{.underline}. Any amount of negative adjustment carryforward
treated as ordinary income under §1.1275-4(b)(6)(iii)(C) shall be
translated at the exchange rate on the day the debt instrument was
issued.

\(4\) [Determination of gain or loss not attributable to foreign
currency]{.underline}. A holder of a debt instrument described in
paragraph (a)(1)(i) of this section shall recognize gain or loss upon
sale, exchange, or retirement of the instrument equal to the difference
between the amount realized with respect to the instrument, translated
into functional currency as described in paragraph (b)(3)(iv) of this
section, and the adjusted basis in the instrument, determined and
maintained in functional currency as described in paragraph (b)(3)(iii)
of this section. The amount of any gain or loss so determined is
characterized as provided in §1.1275-4(b)(8), and sourced as provided in
paragraph (b)(6) of this section.

\(5\) [Determination of foreign currency gain or loss]{.underline}\--(i)
[In general]{.underline}. Other than in a taxable disposition of the
debt instrument, foreign currency gain or loss is recognized with
respect to a debt instrument described in paragraph (a)(1)(i) of this
section only when payments are made or received. No foreign currency
gain or loss is recognized with respect to a net positive or negative
adjustment, as determined under paragraph (b)(2)(ii) of this section
(except with respect to a positive adjustment described in paragraph
(b)(8) of this section). As described in this paragraph (b)(5), foreign
currency gain or loss is determined in accordance with the rules of
§1.988-2(b).

\(ii\) [Foreign currency gain or loss attributable to accrued
interest]{.underline}. The amount of foreign currency gain or loss
recognized with respect to payments of interest previously accrued on
the instrument is determined by translating the amount of interest paid
or received into functional currency at the spot rate on the date of
payment and subtracting from such amount the amount determined by
translating the interest paid or received into functional currency at
the rate at which such interest was accrued under the rules of paragraph
(b)(3)(i) of this section. For purposes of this paragraph, the amount of
any payment that is treated as accrued interest shall be reduced by the
amount of any net negative adjustment treated as ordinary loss (to the
holder) or ordinary income (to the issuer), as provided in paragraph
(b)(2)(ii) of this section. For purposes of determining whether the
payment consists of interest or principal, see the payment ordering
rules in paragraph (b)(5)(iv) of this section.

\(iii\) [Principal]{.underline}. The amount of foreign currency gain or
loss recognized with respect to payment or receipt of principal is
determined by translating the amount paid or received into functional
currency at the spot rate on the date of payment or receipt and
subtracting from such amount the amount determined by translating the
principal into functional currency at the spot rate on the date the
instrument was issued or, in case of the holder, if later, acquired. For
purposes of determining whether the payment consists of interest or
principal, see the payment ordering rules in paragraph (b)(5)(iv) of
this section.

\(iv\) [Payment ordering rules]{.underline}\--(A) [In
general]{.underline}. Except as provided in paragraph (b)(5)(iv)(B) of
this section, payments with respect to an instrument described in
paragraph (a)(1)(i) of this section shall be treated as follows:

([1]{.underline}) A payment shall first be attributable to any net
positive adjustment on the instrument that has not previously been taken
into account.

([2]{.underline}) Any amount remaining after applying paragraph
(b)(5)(iv)(A)([1]{.underline}) of this section shall be attributable to
accrued but unpaid interest, remaining after reduction by any net
negative adjustment, and shall be attributable to the most recent
accrual period to the extent prior amounts have not already been
attributed to such period.

([3]{.underline}) Any amount remaining after applying paragraphs
(b)(5)(iv)(A)([1]{.underline}) and ([2]{.underline}) of this section
shall be attributable to principal. Any interest paid in the current
year that is reduced by a net negative adjustment shall be considered a
payment of principal for purposes of determining foreign currency gain
or loss.

\(B\) [Special rule for sale or exchange or unscheduled
retirement]{.underline}. Payments made or received upon a sale or
exchange or unscheduled retirement shall first be applied against the
principal of the debt instrument (or in the case of a subsequent
purchaser, the purchase price of the instrument in denomination
currency) and then against accrued unpaid interest (in the case of a
holder, accrued while the holder held the instrument).

\(C\) [Subsequent purchaser that has a positive adjustment allocated to
a daily portion of interest]{.underline}. A positive adjustment that is
allocated to a daily portion of interest pursuant to paragraph
(b)(7)(iv) of this section shall be treated as interest for purposes of
applying the payment ordering rule of this paragraph (b)(5)(iv).

\(6\) [Source of gain or loss]{.underline}. The source of foreign
currency gain or loss recognized with respect to an instrument described
in paragraph (a)(1)(i) of this section shall be determined pursuant to
§1.988-4. Consistent with the rules of §1.1275-4(b)(8), all gain (other
than foreign currency gain) on an instrument described in paragraph
(a)(1)(i) of this section is treated as interest income for all
purposes. The source of an ordinary loss (other than foreign currency
loss) with respect to an instrument described in paragraph (a)(1)(i) of
this section shall be determined pursuant to §1.1275-4(b)(9)(iv). The
source of a capital loss with respect to an instrument described in
paragraph (a)(1)(i) of this section shall be determined pursuant to
§1.865-1(b)(2).

\(7\) [Basis different from adjusted issue price]{.underline}\--(i) [In
general]{.underline}. The rules of §1.1275-4(b)(9)(i), except as set
forth in this paragraph (b)(7), shall apply to an instrument described
in paragraph (a)(1)(i) of this section purchased by a subsequent holder
for more or less than the instrument's adjusted issue price.

\(ii\) [Determination of basis]{.underline}. If an instrument described
in paragraph (a)(1)(i) of this section is purchased by a subsequent
holder, the subsequent holder's initial basis in the instrument shall
equal the amount paid by the holder to acquire the instrument,
translated into functional currency at the spot rate on the date of
acquisition.

\(iii\) [Purchase price greater than adjusted issue price]{.underline}.
If the purchase price of the instrument (determined in the denomination
currency) exceeds the adjusted issue price of the instrument, the holder
shall, consistent with the rules of §1.1275-4(b)(9)(i)(B), reasonably
allocate such excess to the daily portions of interest accrued on the
instrument or to a projected payment on the instrument. To the extent
attributable to interest, the excess shall be reasonably allocated over
the remaining term of the instrument to the daily portions of interest
accrued and shall be a negative adjustment on the dates the daily
portions accrue. On the date of such adjustment, the holder's adjusted
basis in the instrument is reduced by the amount treated as a negative
adjustment under this paragraph (b)(7)(iii), translated into functional
currency at the rate used to translate the interest which is offset by
the negative adjustment. To the extent related to a projected payment,
such excess shall be treated as a negative adjustment on the date the
payment is made. On the date of such adjustment, the holder's adjusted
basis in the instrument is reduced by the amount treated as a negative
adjustment under this paragraph (b)(7)(iii), translated into functional
currency at the spot rate on the date the instrument was acquired.

\(iv\) [Purchase price less than adjusted issue price]{.underline}. If
the purchase price of the instrument (determined in the denomination
currency) is less than the adjusted issue price of the instrument, the
holder shall, consistent with the rules of §1.1275-4(b)(9)(i)(C),
reasonably allocate the difference to the daily portions of interest
accrued on the instrument or to a projected payment on the instrument.
To the extent attributable to interest, the difference shall be
reasonably allocated over the remaining term of the instrument to the
daily portions of interest accrued and shall be a positive adjustment on
the dates the daily portions accrue. On the date of such adjustment, the
holder's adjusted basis in the instrument is increased by the amount
treated as a positive adjustment under this paragraph (b)(7)(iv),
translated into functional currency at the rate used to translate the
interest to which it relates. For purposes of determining adjusted basis
under paragraph (b)(3)(iii) of this section, such increase in adjusted
basis shall be treated as an additional accrual of interest during the
period to which the positive adjustment relates. To the extent related
to a projected payment, such difference shall be treated as a positive
adjustment on the date the payment is made. On the date of such
adjustment, the holder's adjusted basis in the instrument is increased
by the amount treated as a positive adjustment under this paragraph
(b)(7)(iv), translated into functional currency at the spot rate on the
date the adjustment is taken into account. For purposes of determining
the amount realized on the instrument in functional currency under
paragraph (b)(3)(iv) of this section, amounts attributable to the excess
of the adjusted issue price of the instrument over the purchase price of
the instrument shall be translated into functional currency at the same
rate at which the corresponding adjustments are taken into account under
this paragraph (b)(7)(iv) for purposes of determining the adjusted basis
of the instrument.

\(8\) [Fixed but deferred contingent payments]{.underline}. In the case
of an instrument with a contingent payment that becomes fixed as to
amount before the payment is due, the rules of §1.1275-4(b)(9)(ii) shall
be applied in the denomination currency of the instrument. For this
purpose, foreign currency gain or loss shall be recognized on the date
payment is made or received with respect to the instrument under the
principles of paragraph (b)(5) of this section. Any increase or decrease
in basis required under §1.1275-4(b)(9)(ii)(D) shall be taken into
account at the same exchange rate as the corresponding net positive or
negative adjustment is taken into account.

\(c\) [Examples]{.underline}. The provisions of paragraph (b) of this
section may be illustrated by the following examples. In each example,
assume that the instrument described is a debt instrument for federal
income tax purposes. No inference is intended, however, as to whether
the instrument is a debt instrument for federal income tax purposes. The
examples are as follows:

[Example 1]{.underline}. [Treatment of net positive
adjustment]{.underline}\--(i) [Facts]{.underline}. On December 31, 2004,
Z, a calendar year U.S. resident taxpayer whose functional currency is
the U.S. dollar, purchases from a foreign corporation, at original
issue, a zero-coupon debt instrument with a non-currency contingency for
£1000. All payments of principal and interest with respect to the
instrument are denominated in, or determined by reference to, a single
nonfunctional currency (the British pound). The debt instrument would be
subject to §1.1275-4(b) if it were denominated in dollars. The debt
instrument\'s comparable yield, determined in British pounds under
paragraph (b)(2)(i) of this section and §1.1275-4(b), is 10 percent,
compounded annually, and the projected payment schedule, as constructed
under the rules of §1.1275-4(b), provides for a single payment of £1210
on December 31, 2006 (consisting of a noncontingent payment of £975 and
a projected payment of £235). The debt instrument is a capital asset in
the hands of Z. Z does not elect to use the spot‑rate convention
described in §1.988‑2(b)(2)(iii)(B). The payment actually made on
December 31, 2006, is £1300. The relevant pound/dollar spot rates over
the term of the instrument are as follows:

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Date Spot rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Dec. 31, 2004 £1.00=\$ 1.00

Dec. 31, 2005 £1.00=\$ 1.10

Dec. 31, 2006 £1.00=\$ 1.20

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Accrual period Average rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

2005 £1.00=\$ 1.05

2006 £1.00=\$ 1.15

\(ii\) [Treatment in 2005]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £100 of interest on the debt
instrument for 2005 (issue price of £1000 x 10 percent). Under paragraph
(b)(3)(i) of this section, Z translates the £100 at the average exchange
rate for the accrual period (\$1.05 x £100 = \$105). Accordingly, Z has
interest income in 2005 of \$105.

\(B\) [Adjusted issue price and basis]{.underline}. Under paragraphs
(b)(2)(iii) and (iv) of this section, the adjusted issue price of the
debt instrument determined in pounds and Z\'s adjusted basis in dollars
in the debt instrument are increased by the interest accrued in 2005.
Thus, on January 1, 2006, the adjusted issue price of the debt
instrument is £1100. For purposes of determining Z\'s dollar basis in
the debt instrument, the \$1000 basis (\$1.00 x £1000 original cost
basis) is increased by the £100 of accrued interest, translated at the
rate at which interest was accrued for 2005. See paragraph (b)(3)(iii)
of this section. Accordingly, Z\'s adjusted basis in the debt instrument
as of January 1, 2006, is \$1105.

\(iii\) [Treatment in 2006]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £110 of interest on the debt
instrument for 2006 (adjusted issue price of £1100 x 10 percent). Under
paragraph (b)(3)(i) of this section, Z translates the £110 at the
average exchange rate for the accrual period (\$1.15 x £110 = \$126.50).
Accordingly, Z has interest income in 2006 of \$126.50.

\(B\) [Effect of net positive adjustment]{.underline}. The payment
actually made on December 31, 2006, is £1300, rather than the projected
£1210. Under paragraph (b)(2)(ii) of this section, Z has a net positive
adjustment of £90 on December 31, 2006, attributable to the difference
between the amount of the actual payment and the amount of the projected
payment. Under paragraph (b)(3)(ii)(A) of this section, the £90 net
positive adjustment is treated as additional interest income and is
translated into dollars at the spot rate on the last day of the year
(\$1.20 x £90 = \$108). Accordingly, Z has a net positive adjustment of
\$108 resulting in a total interest inclusion for 2006 of \$234.50
(\$126.50 + \$108 = \$234.50).

\(C\) [Adjusted issue price and basis]{.underline}. Based on the
projected payment schedule, the adjusted issue price of the debt
instrument immediately before the payment at maturity is £1210 (£1100
plus £110 of accrued interest for 2006). Z\'s adjusted basis in dollars,
based only on the noncontingent payment and the projected amount of the
contingent payment to be received, is \$1231.50 (\$1105 plus \$126.50 of
accrued interest for 2006).

\(D\) [Amount realized]{.underline}. Even though Z receives £1300 at
maturity, for purposes of determining the amount realized, Z is treated
under paragraph (b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31, 2006. Therefore, Z is
treated as receiving £1210 on December 31, 2006. Under paragraph
(b)(3)(iv) of this section, Z translates its amount realized into
dollars and computes its gain or loss on the instrument (other than
foreign currency gain or loss) by breaking the amount realized into its
component parts. Accordingly, £100 of the £1210 (representing the
interest accrued in 2005) is translated at the rate at which it was
accrued (£1 = \$1.05), resulting in an amount realized of \$105; £110 of
the £1210 (representing the interest accrued in 2006) is translated into
dollars at the rate at which it was accrued (£1 = \$1.15), resulting in
an amount realized of \$126.50; and £1000 of the £1210 (representing a
return of principal) is translated into dollars at the spot rate on the
date the instrument was purchased (£1 = \$1), resulting in an amount
realized of \$1000. Z\'s total amount realized is \$1231.50, the same as
its basis, and Z recognizes no gain or loss (before consideration of
foreign currency gain or loss) on retirement of the instrument.

\(E\) [Foreign currency gain or loss]{.underline}. Under paragraph
(b)(5) of this section Z recognizes foreign currency gain under section
988 on the instrument with respect to the consideration actually
received at maturity (except for the net positive adjustment), £1210.
The amount of recognized foreign currency gain is determined based on
the difference between the spot rate on the date the instrument matures
and the rates at which the principal and interest were taken into
account. With respect to the portion of the payment attributable to
interest accrued in 2005, the foreign currency gain is \$15 \[£100 x
(\$1.20 - \$1.05)\]. With respect to interest accrued in 2006, the
foreign currency gain equals \$5.50 \[£110 x (\$1.20 - \$1.15)\]. With
respect to principal, the foreign currency gain is \$200 \[£1000 x
(\$1.20 - \$1.00)\]. Thus, Z recognizes a total foreign currency gain on
December 31, 2006, of \$220.50.

\(F\) [Source]{.underline}. Z has interest income of \$105 in 2005,
interest income of \$234.50 in 2006 (attributable to £110 of accrued
interest and the £90 net positive adjustment), and a foreign currency
gain of \$220.50 in 2006. Under paragraph (b)(6) of this section and
section 862(a)(1), the interest income is sourced by reference to the
residence of the payor and is therefore from sources without the United
States. Under paragraph (b)(6) of this section and §1.988-4, Z's foreign
currency gain of \$220.50 is sourced by reference to Z\'s residence and
is therefore from sources within the United States.

[Example 2]{.underline}. [Treatment of net negative
adjustment]{.underline}\--(i) [Facts]{.underline}. Assume the same facts
as in [Example 1]{.underline}, except that Z receives £975 at maturity
instead of £1300.

\(ii\) [Treatment in 2005]{.underline}. The treatment of the debt
instrument in 2005 is the same as in Example 1. Thus, Z has interest
income in 2005 of \$105. On January 1, 2006, the adjusted issue price of
the debt instrument is £1100, and Z\'s adjusted basis in the instrument
is \$1105.

\(iii\) [Treatment in 2006]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section and
based on the comparable yield, Z\'s accrued interest for 2006 is £110
(adjusted issue price of £1100 x 10 percent). Under paragraph (b)(3)(i)
of this section, the £110 of accrued interest is translated at the
average exchange rate for the accrual period (\$1.15 x £110 = \$126.50).

\(B\) [Effect of net negative adjustment]{.underline}. The payment
actually made on December 31, 2006, is £975, rather than the projected
£1210. Under paragraph (b)(2)(ii) of this section, Z has a net negative
adjustment of £235 on December 31, 2006, attributable to the difference
between the amount of the actual payment and the amount of the projected
payment. Z\'s accrued interest income of £110 in 2006 is reduced to zero
by the net negative adjustment. Under paragraph
(b)(3)(ii)(B)([1]{.underline}) of this section the net negative
adjustment which reduces the current year's interest is not translated
into functional currency. Under paragraph (b)(2)(ii) of this section, Z
treats the remaining £125 net negative adjustment as an ordinary loss to
the extent of the £100 previously accrued interest in 2005. This £100
ordinary loss is attributable to interest accrued but not paid in the
preceding year. Therefore, under paragraph
(b)(3)(ii)(B)([2]{.underline}) of this section, Z translates the loss
into dollars at the average rate for such year (£1 = \$1.05).
Accordingly, Z has an ordinary loss of \$105 in 2006. The remaining £25
of net negative adjustment is a negative adjustment carryforward under
paragraph (b)(2)(ii) of this section.

\(C\) [Adjusted issue price and basis]{.underline}. Based on the
projected payment schedule, the adjusted issue price of the debt
instrument immediately before the payment at maturity is £1210 (£1100
plus £110 of accrued interest for 2006). Z\'s adjusted basis in dollars,
based only on the noncontingent payments and the projected amount of the
contingent payments to be received, is \$1231.50 (\$1105 plus \$126.50
of accrued interest for 2006).

\(D\) [Amount realized]{.underline}. Even though Z receives £975 at
maturity, for purposes of determining the amount realized, Z is treated
under paragraph (b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31, 2006, reduced by the
amount of Z\'s negative adjustment carryforward of £25. Therefore, Z is
treated as receiving £1185 (£1210 - £25) on December 31, 2006. Under
paragraph (b)(3)(iv) of this section, Z translates its amount realized
into dollars and computes its gain or loss on the instrument (other than
foreign currency gain or loss) by breaking the amount realized into its
component parts. Accordingly, £100 of the £1185 (representing the
interest accrued in 2005) is translated at the rate at which it was
accrued (£1 = \$1.05), resulting in an amount realized of \$105; £110 of
the £1185 (representing the interest accrued in 2006) is translated into
dollars at the rate at which it was accrued (£1 = \$1.15), resulting in
an amount realized of \$126.50; and £975 of the £1185 (representing a
return of principal) is translated into dollars at the spot rate on the
date the instrument was purchased (£1 = \$1), resulting in an amount
realized of \$975. Z\'s amount realized is \$1206.50 (\$105 +\$126.50 +
\$975 = \$1206.50), and Z recognizes a capital loss (before
consideration of foreign currency gain or loss) of \$25 on retirement of
the instrument (\$1206.50 - \$1231.50 = -\$25).

\(E\) [Foreign currency gain or loss]{.underline}. Z recognizes foreign
currency gain with respect to the consideration actually received at
maturity, £975. Under paragraph (b)(5)(ii) of this section, no foreign
currency gain or loss is recognized with respect to unpaid accrued
interest reduced to zero by the net negative adjustment resulting in
2006. In addition, no foreign currency gain or loss is recognized with
respect to unpaid accrued interest from 2005, also reduced to zero by
the ordinary loss. Accordingly, Z recognizes foreign currency gain with
respect to principal only. Thus, Z recognizes a total foreign currency
gain on December 31, 2006, of \$195 \[£975 x (\$1.20 - \$1.00)\].

\(F\) [Source]{.underline}. In 2006, Z has an ordinary loss of \$105, a
capital loss of \$25, and a foreign currency gain of \$195. Under
paragraph (b)(6) of this section and §1.1275-4(b)(9)(iv), the \$105
ordinary loss generally reduces Z's foreign source passive income under
section 904(d) and the regulations thereunder. Under paragraph (b)(6) of
this section and §1.865-1(b)(2), the \$25 capital loss is sourced by
reference to how interest income on the instrument would have been
sourced. Therefore, the \$25 capital loss generally reduces Z's foreign
source passive income under section 904(d) and the regulations
thereunder. Under paragraph (b)(6) of this section and §1.988-4, Z's
foreign currency gain of \$195 is sourced by reference to Z\'s residence
and is therefore from sources within the United States.

[Example 3]{.underline}. [Negative adjustment and periodic interest
payments]{.underline}\--(i) [Facts]{.underline}. On December 31, 2004,
Z, a calendar year U.S. resident taxpayer whose functional currency is
the U.S. dollar, purchases from a foreign corporation, at original
issue, a two-year debt instrument with a non-currency contingency for
£1000. All payments of principal and interest with respect to the
instrument are denominated in, or determined by reference to, a single
nonfunctional currency (the British pound). The debt instrument would be
subject to §1.1275-4(b) if it were denominated in dollars. The debt
instrument\'s comparable yield, determined in British pounds under
§§1.988-2(b)(2) and 1.1275-4(b), is 10 percent, compounded semiannually.
The debt instrument provides for semiannual interest payments of £30
payable each June 30, and December 31, and a contingent payment at
maturity on December 31, 2006, which is projected to equal £1086.20
(consisting of a noncontingent payment of £980 and a projected payment
of £106.20) in addition to the interest payable at maturity. The debt
instrument is a capital asset in the hands of Z. Z does not elect to use
the spot‑rate convention described in §1.988‑2(b)(2)(iii)(B). The
payment actually made on December 31, 2006, is £981.00. The relevant
pound/dollar spot rates over the term of the instrument are as follows:

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Date Spot rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Dec. 31, 2004 £1.00=\$ 1.00

June 30, 2005 £1.00=\$ 1.20

Dec. 31, 2005 £1.00=\$ 1.40

June 30, 2006 £1.00=\$ 1.60

Dec. 31, 2006 £1.00=\$ 1.80

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Accrual period Average rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Jan. - June 2005 £1.00=\$ 1.10

July - Dec. 2005 £1.00=\$ 1.30

Jan. - June 2006 £1.00=\$ 1.50

July - Dec. 2006 £1.00=\$ 1.70

\(ii\) [Treatment in 2005]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £50 of interest on the debt
instrument for the January-June accrual period (issue price of £1000 x
10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates
the £50 at the average exchange rate for the accrual period (\$1.10 x
£50 = \$55.00). Similarly, Z accrues £51 of interest in the
July-December accrual period \[(£1000 + £50 - £30) x 10 percent/2\],
which is translated at the average exchange rate for the accrual period
(\$1.30 x £51 = \$66.30). Accordingly, Z accrues \$121.30 of interest
income in 2005.

\(B\) [Adjusted issue price and basis]{.underline}\--([1]{.underline})
[January-June accrual period]{.underline}. Under paragraphs (b)(2)(iii)
and (iv) of this section, the adjusted issue price of the debt
instrument determined in pounds and Z\'s adjusted basis in dollars in
the debt instrument are increased by the interest accrued, and decreased
by the interest payment made, in the January-June accrual period. Thus,
on July 1, 2005, the adjusted issue price of the debt instrument is
£1020 (£1000 + £50 - £30 = £1020). For purposes of determining Z\'s
dollar basis in the debt instrument, the \$1000 basis is increased by
the £50 of accrued interest, translated, under paragraph (b)(3)(iii) of
this section, at the rate at which interest was accrued for the
January-June accrual period (\$1.10 x £50 = \$55). The resulting amount
is reduced by the £30 payment of interest made during the accrual
period, translated, under paragraph (b)(3)(iii) of this section and
§1.988-2(b)(7), at the rate applicable to accrued interest (\$1.10 x £30
= \$33). Accordingly, Z\'s adjusted basis as of July 1, 2005, is \$1022
(\$1000 + \$55 - \$33).

([2]{.underline}) [July-December accrual period]{.underline}. Under
paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue
price of the debt instrument determined in pounds and Z\'s adjusted
basis in dollars in the debt instrument are increased by the interest
accrued, and decreased by the interest payment made, in the
July-December accrual period. Thus, on January 1, 2006, the adjusted
issue price of the instrument is £1041 (£1020 + £51 - £30 = £1041). For
purposes of determining Z\'s dollar basis in the debt instrument, the
\$1022 basis is increased by the £51 of accrued interest, translated,
under paragraph (b)(3)(iii) of this section, at the rate at which
interest was accrued for the July-December accrual period (\$1.30 x £51
= \$66.30). The resulting amount is reduced by the £30 payment of
interest made during the accrual period, translated, under paragraph
(b)(3)(iii) of this section and §1.988-2(b)(7), at the rate applicable
to accrued interest (\$1.30 x £30 = \$39). Accordingly, Z\'s adjusted
basis as of January 1, 2006, is \$1049.30 (\$1022 + \$66.30 - \$39).

\(C\) [Foreign currency gain or loss]{.underline}. Z will recognize
foreign currency gain on the receipt of each £30 payment of interest
actually received during 2005. The amount of foreign currency gain in
each case is determined, under paragraph (b)(5)(ii) of this section, by
reference to the difference between the spot rate on the date the £30
payment was made and the average exchange rate for the accrual period
during which the interest accrued. Accordingly, Z recognizes \$3 of
foreign currency gain on the January-June interest payment \[£30 x
(\$1.20 - \$1.10)\], and \$3 of foreign currency gain on the
July-December interest payment \[£30 x (\$1.40 - \$1.30)\]. Z recognizes
in 2005 a total of \$6 of foreign currency gain.

\(D\) [Source]{.underline}. Z has interest income of \$121.30 and a
foreign currency gain of \$6. Under paragraph (b)(6) of this section and
section 862(a)(1), the interest income is sourced by reference to the
residence of the payor and is therefore from sources without the United
States. Under paragraph (b)(6) of this section and §1.988-4, Z's foreign
currency gain of \$6 is sourced by reference to Z\'s residence and is
therefore from sources within the United States.

\(iii\) [Treatment in 2006]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z\'s accrued interest for the
January-June accrual period is £52.05 (adjusted issue price of £1041 x
10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates
the £52.05 at the average exchange rate for the accrual period (\$1.50 x
£52.05 = \$78.08). Similarly, Z accrues £53.15 of interest in the
July-December accrual period \[(£1041 + £52.05 - £30) x 10 percent/2\],
which is translated at the average exchange rate for the accrual period
(\$1.70 x £53.15 = \$90.35). Accordingly, Z accrues £105.20, or
\$168.43, of interest income in 2006.

\(B\) [Effect of net negative adjustment]{.underline}. The payment
actually made on December 31, 2006, is £981.00, rather than the
projected £1086.20. Under paragraph (b)(2)(ii)(B) of this section, Z has
a net negative adjustment of £105.20 on December 31, 2006, attributable
to the difference between the amount of the actual payment and the
amount of the projected payment. Z\'s accrued interest income of £105.20
in 2006 is reduced to zero by the net negative adjustment. Elimination
of the 2006 accrued interest fully utilizes the net negative adjustment.

\(C\) [Adjusted issue price and basis]{.underline}\--([1]{.underline})
[January-June accrual period]{.underline}. Under paragraphs (b)(2)(iii)
and (iv) of this section, the adjusted issue price of the debt
instrument determined in pounds and Z\'s adjusted basis in dollars in
the debt instrument are increased by the interest accrued, and decreased
by the interest payment made, in the January-June accrual period. Thus,
on July 1, 2006, the adjusted issue price of the debt instrument is
£1063.05 (£1041 + £52.05 - £30 = £1063.05). For purposes of determining
Z\'s dollar basis in the debt instrument, the \$1049.30 adjusted basis
is increased by the £52.05 of accrued interest, translated, under
paragraph (b)(3)(iii) of this section, at the rate at which interest was
accrued for the January-June accrual period (\$1.50 x £52.05 = \$78.08).
The resulting amount is reduced by the £30 payment of interest made
during the accrual period, translated, under paragraph (b)(3)(iii) of
this section and §1.988-2(b)(7), at the rate applicable to accrued
interest (\$1.50 x £30 = \$45). Accordingly, Z\'s adjusted basis as of
July 1, 2006, is \$1082.38 (\$1049.30 + \$78.08 - \$45).

([2]{.underline}) [July-December accrual period]{.underline}. Under
paragraphs (b)(2)(iii) and (iv) of this section, the adjusted issue
price of the debt instrument determined in pounds and Z\'s adjusted
basis in dollars in the debt instrument are increased by the interest
accrued, and decreased by the interest payment made, in the
July-December accrual period. Thus, immediately before maturity on
December 31, 2006, the adjusted issue price of the instrument is
£1086.20 (£1063.05 + £53.15 - £30 = £1086.20). For purposes of
determining Z\'s dollar basis in the debt instrument, the \$1082.38
adjusted basis is increased by the £53.15 of accrued interest,
translated, under paragraph (b)(3)(iii) of this section, at the rate at
which interest was accrued for the July-December accrual period (\$1.70
x £53.15 = \$90.36). The resulting amount is reduced by the £30 payment
of interest made during the accrual period, translated, under paragraph
(b)(3)(iii) of this section and §1.988-2(b)(7), at the rate applicable
to accrued interest (\$1.70 x £30 = \$51). Accordingly, Z\'s adjusted
basis on December 31, 2006, immediately prior to maturity is \$1121.74
(\$1082.38 + \$90.36 - \$51).

\(D\) [Amount realized]{.underline}. Even though Z receives £981.00 at
maturity, for purposes of determining the amount realized, Z is treated
under paragraph (b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31, 2006. Therefore, Z is
treated as receiving £1086.20 on December 31, 2006. Under paragraph
(b)(3)(iv) of this section, Z translates its amount realized into
dollars and computes its gain or loss on the instrument (other than
foreign currency gain or loss) by breaking the amount realized into its
component parts. Accordingly, £20 of the £1086.20 (representing the
interest accrued in the January-June 2005 accrual period, less £30
interest paid) is translated into dollars at the rate at which it was
accrued (£1 = \$1.10), resulting in an amount realized of \$22; £21 of
the £1086.20 (representing the interest accrued in the July-December
2005 accrual period, less £30 interest paid) is translated into dollars
at the rate at which it was accrued (£1 = \$1.30), resulting in an
amount realized of \$27.30; £22.05 of the £1086.20 (representing the
interest accrued in the January-June 2006 accrual period, less £30
interest paid) is translated into dollars at the rate at which it was
accrued (£1 = \$1.50), resulting in an amount realized of \$33.08;
£23.15 of the £1086.20 (representing the interest accrued in the July
1-December 31, 2006 accrual period, less the £30 interest payment) is
translated into dollars at the rate at which it was accrued (£1 =
\$1.70), resulting in an amount realized of \$39.36; and £1000
(representing principal) is translated into dollars at the spot rate on
the date the instrument was purchased (£1 = \$1), resulting in an amount
realized of \$1000. Accordingly, Z\'s total amount realized is \$1121.74
(\$22 + \$27.30 + \$33.08 + \$39.36 + \$1000), the same as its basis,
and Z recognizes no gain or loss (before consideration of foreign
currency gain or loss) on retirement of the instrument.

\(E\) [Foreign currency gain or loss]{.underline}. Z recognizes foreign
currency gain with respect to each £30 payment actually received during
2006. These payments, however, are treated as payments of principal for
this purpose because all 2006 accrued interest is reduced to zero by the
net negative adjustment. See paragraph (b)(5)(iv)(A)([3]{.underline}) of
this section. The amount of foreign currency gain in each case is
determined, under paragraph (b)(5)(iii) of this section, by reference to
the difference between the spot rate on the date the £30 payment is made
and the spot rate on the date the debt instrument was issued.
Accordingly, Z recognizes \$18 of foreign currency gain on the
January-June 2006 interest payment \[£30 x (\$1.60 - \$1.00)\], and \$24
of foreign currency gain on the July-December 2006 interest payment
\[£30 x (\$1.80 - \$1.00)\]. Z separately recognizes foreign currency
gain with respect to the consideration actually received at maturity,
£981.00. The amount of such gain is determined based on the difference
between the spot rate on the date the instrument matures and the rates
at which the principal and interest were taken into account. With
respect to the portion of the payment attributable to interest accrued
in January-June 2005 (other than the £30 payments), the foreign currency
gain is \$14 \[£20 x (\$1.80 - \$1.10)\]. With respect to the portion of
the payment attributable to interest accrued in July-December 2005
(other than the £30 payments), the foreign currency gain is \$10.50
\[£21 x (\$1.80 - \$1.30)\]. With respect to the portion of the payment
attributable to interest accrued in 2006 (other than the £30 payments),
no foreign currency gain or loss is recognized under paragraph
(b)(5)(ii) of this section because such interest was reduced to zero by
the net negative adjustment. With respect to the portion of the payment
attributable to principal, the foreign currency gain is \$752 \[£940 x
(\$1.80 - \$1.00)\]. Thus, Z recognizes a foreign currency gain of \$42
on receipt of the two £30 payments in 2006, and \$776.50 (\$14 +
\$10.50 + \$752) on receipt of the payment at maturity, for a total 2006
foreign currency gain of \$818.50.

\(F\) [Source]{.underline}. Under paragraph (b)(6) of this section and
§1.988-4, Z's foreign currency gain of \$818.50 is sourced by reference
to Z\'s residence and is therefore from sources within the United
States.

[Example 4]{.underline}. [Purchase price greater than adjusted issue
price]{.underline}---(i) [Facts]{.underline}. On July 1, 2005, Z, a
calendar year U.S. resident taxpayer whose functional currency is the
U.S. dollar, purchases a debt instrument with a non-currency contingency
for £1405. All payments of principal and interest with respect to the
instrument are denominated in, or determined by reference to, a single
nonfunctional currency (the British pound). The debt instrument would be
subject to §1.1275-4(b) if it were denominated in dollars. The debt
instrument was originally issued by a foreign corporation on December
31, 2003, for an issue price of £1000, and matures on December 31, 2006.
The debt instrument\'s comparable yield, determined in British pounds
under §§1.988-2(b)(2) and 1.1275-4(b), is 10.25 percent, compounded
semiannually, and the projected payment schedule for the debt instrument
(determined as of the issue date under the rules of §1.1275-4(b))
provides for a single payment at maturity of £1349.70 (consisting of a
noncontingent payment of £1000 and a projected payment of £349.70). At
the time of the purchase, the adjusted issue price of the debt
instrument is £1161.76, assuming semiannual accrual periods ending on
June 30 and December 31 of each year. The increase in the value of the
debt instrument over its adjusted issue price is due to an increase in
the expected amount of the contingent payment. The debt instrument is a
capital asset in the hands of Z. Z does not elect to use the spot‑rate
convention described in §1.988‑2(b)(2)(iii)(B). The payment actually
made on December 31, 2006, is £1400. The relevant pound/dollar spot
rates over the term of the instrument are as follows:

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Date Spot rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

July 1, 2005 £1.00=\$ 1.00

Dec. 31, 2006 £1.00=\$ 2.00

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Accrual period Average rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

July 1 - December 31, 2005 £1.00=\$ 1.50

January 1 - June 30, 2006 £1.00=\$ 1.50

July 1 - December 31, 2006 £1.00=\$ 1.50

\(ii\) [Initial basis]{.underline}. Under paragraph (b)(7)(ii) of this
section, Z's initial basis in the debt instrument is \$1405, Z's
purchase price of £1405, translated into functional currency at the spot
rate on the date the debt instrument was purchased (£1 = \$1).

\(iii\) [Allocation of purchase price differential]{.underline}. Z
purchased the debt instrument for £1405 when its adjusted issue price
was £1161.76. Under paragraph (b)(7)(iii) of this section, Z allocates
the £243.24 excess of purchase price over adjusted issue price to the
contingent payment at maturity. This allocation is reasonable because
the excess is due to an increase in the expected amount of the
contingent payment and not, for example, to a decrease in prevailing
interest rates.

\(iv\) [Treatment in 2005]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £59.54 of interest on the debt
instrument for the July-December 2005 accrual period (issue price of
£1161.76 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section,
Z translates the £59.54 of interest at the average exchange rate for the
accrual period (\$1.50 x £59.54 = \$89.31). Accordingly, Z has interest
income in 2005 of \$89.31.

\(B\) [Adjusted issue price and basis]{.underline}. Under paragraphs
(b)(2)(iii) and (iv) of this section, the adjusted issue price of the
debt instrument determined in pounds and Z\'s adjusted basis in dollars
in the debt instrument are increased by the interest accrued in
July-December 2005. Thus, on January 1, 2006, the adjusted issue price
of the debt instrument is £1221.30 (£1161.76 + £59.54). For purposes of
determining Z\'s dollar basis in the debt instrument on January 1, 2006,
the \$1405 basis is increased by the £59.54 of accrued interest,
translated at the rate at which interest was accrued for the
July-December 2005 accrual period. Paragraph (b)(3)(iii) of this
section. Accordingly, Z\'s adjusted basis in the instrument, as of
January 1, 2006, is \$1494.31 \[\$1405 + (£59.54 x \$1.50)\].

\(v\) [Treatment in 2006]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £62.59 of interest on the debt
instrument for the January-June 2006 accrual period (issue price of
£1221.30 x 10.25 percent/2). Under paragraph (b)(3)(i) of this section,
Z translates the £62.59 of accrued interest at the average exchange rate
for the accrual period (\$1.50 x £62.59 = \$93.89). Similarly, Z accrues
£65.80 of interest in the July-December 2006 accrual period
\[(£1221.30 + £62.59) x 10.25 percent/2\], which is translated at the
average exchange rate for the accrual period (\$1.50 x £65.80 =
\$98.70). Accordingly, Z accrues £128.39, or \$192.59, of interest
income in 2006.

\(B\) [Effect of positive and negative
adjustments]{.underline}\--([1]{.underline}) [Offset of positive
adjustment]{.underline}. The payment actually made on December 31, 2006,
is £1400, rather than the projected £1349.70. Under paragraph (b)(2)(ii)
of this section, Z has a positive adjustment of £50.30 on December 31,
2006, attributable to the difference between the amount of the actual
payment and the amount of the projected payment. Under paragraph
(b)(7)(iii) of this section, however, Z also has a negative adjustment
of £243.24, attributable to the excess of Z's purchase price for the
debt instrument over its adjusted issue price. Accordingly, Z will have
a net negative adjustment of £192.94 (£50.30 - £243.24 = -£192.94) for
2006.

([2]{.underline}) [Offset of accrued interest]{.underline}. Z\'s accrued
interest income of £128.39 in 2006 is reduced to zero by the net
negative adjustment. The net negative adjustment which reduces the
current year's interest is not translated into functional currency.
Under paragraph (b)(2)(ii) of this section, Z treats the remaining
£64.55 net negative adjustment as an ordinary loss to the extent of the
£59.54 previously accrued interest in 2005. This £59.54 ordinary loss is
attributable to interest accrued but not paid in the preceding year.
Therefore, under paragraph (b)(3)(ii)(B)([2]{.underline}) of this
section, Z translates the loss into dollars at the average rate for such
year (£1 = \$1.50). Accordingly, Z has an ordinary loss of \$89.31 in
2006. The remaining £5 of net negative adjustment is a negative
adjustment carryforward under paragraph (b)(2)(ii) of this section.

\(C\) [Adjusted issue price and basis]{.underline}\--([1]{.underline})
[January-June accrual period]{.underline}. Under paragraph (b)(2)(iii)
of this section, the adjusted issue price of the debt instrument on July
1, 2006, is £1283.89 (£1221.30 + £62.59 = £1283.89). Under paragraphs
(b)(2)(iv) and (b)(3)(iii) of this section, Z\'s adjusted basis as of
July 1, 2006, is \$1588.20 (\$1494.31 + \$93.89).

([2]{.underline}) [July-December accrual period]{.underline}. Based on
the projected payment schedule, the adjusted issue price of the debt
instrument immediately before the payment at maturity is £1349.70
(£1283.89 + £65.80 accrued interest for July-December). Z\'s adjusted
basis in dollars, based only on the noncontingent payments and the
projected amount of the contingent payments to be received, is \$1686.90
(\$1588.20 plus \$98.70 of accrued interest for July-December).

([3]{.underline}) [Adjustment to basis upon contingent
payment]{.underline}. Under paragraph (b)(7)(iii) of this section, Z's
adjusted basis in the debt instrument is reduced at maturity by £243.24,
the excess of Z's purchase price for the debt instrument over its
adjusted issue price. For this purpose, the adjustment is translated
into functional currency at the spot rate on the date the instrument was
acquired (£1 = \$1). Accordingly, Z's adjusted basis in the debt
instrument at maturity is \$1443.66 (\$1686.90 - \$243.24).

\(D\) [Amount realized]{.underline}. Even though Z receives £1400 at
maturity, for purposes of determining the amount realized, Z is treated
under paragraph (b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31, 2006, reduced by the
amount of Z\'s negative adjustment carryforward of £5.01. Therefore, Z
is treated as receiving £1344.69 (£1349.70 - £5.01) on December 31,
2006. Under paragraph (b)(3)(iv) of this section, Z translates its
amount realized into dollars and computes its gain or loss on the
instrument (other than foreign currency gain or loss) by breaking the
amount realized into its component parts. Accordingly, £59.54 of the
£1344.69 (representing the interest accrued in 2005) is translated at
the rate at which it was accrued (£1 = \$1.50), resulting in an amount
realized of \$89.31; £62.59 of the £1344.69 (representing the interest
accrued in January-June 2006) is translated into dollars at the rate at
which it was accrued (£1 = \$1.50), resulting in an amount realized of
\$93.89; £65.80 of the £1344.69 (representing the interest accrued in
July-December 2006) is translated into dollars at the rate at which it
was accrued (£1 = \$1.50), resulting in an amount realized of \$98.70;
and £1156.76 of the £1344.69 (representing a return of principal) is
translated into dollars at the spot rate on the date the instrument was
purchased (£1 = \$1), resulting in an amount realized of \$1156.76. Z\'s
amount realized is \$1438.66 (\$89.31 + \$93.89 + \$98.70 + \$1156.76),
and Z recognizes a capital loss (before consideration of foreign
currency gain or loss) of \$5 on retirement of the instrument
(\$1438.66 - \$1443.66 = -\$5).

\(E\) [Foreign currency gain or loss]{.underline}. Z recognizes foreign
currency gain under section 988 on the instrument with respect to the
entire consideration actually received at maturity, £1400. While foreign
currency gain or loss ordinarily would not have arisen with respect to
£50.30 of the £1400, which was initially treated as a positive
adjustment in 2006, the larger negative adjustment in 2006 reduced this
positive adjustment to zero. Accordingly, foreign currency gain or loss
is recognized with respect to the entire £1400. Under paragraph
(b)(5)(ii) of this section, however, no foreign currency gain or loss is
recognized with respect to unpaid accrued interest reduced to zero by
the net negative adjustment resulting in 2006, and no foreign currency
gain or loss is recognized with respect to unpaid accrued interest from
2005, also reduced to zero by the ordinary loss. Therefore, the entire
£1400 is treated as a return of principal for the purpose of determining
foreign currency gain or loss, and Z recognizes a total foreign currency
gain on December 31, 2001, of \$1400 \[£1400 x (\$2.00 - \$1.00)\].

\(F\) [Source]{.underline}. Z has an ordinary loss of \$89.31, a capital
loss of \$5, and a foreign currency gain of \$1400. Under paragraph
(b)(6) of this section and §1.1275-4(b)(9)(iv), the \$89.31 ordinary
loss generally reduces Z's foreign source passive income under
section 904(d) and the regulations thereunder. Under paragraph (b)(6) of
this section and §1.865-1(b)(2), the \$5 capital loss is sourced by
reference to how interest income on the instrument would have been
sourced. Therefore, the \$5 capital loss generally reduces Z's foreign
source passive income under section 904(d) and the regulations
thereunder. Under paragraph (b)(6) of this section and §1.988-4, Z's
foreign currency gain of \$1400 is sourced by reference to Z\'s
residence and is therefore from sources within the United States.

[Example 5]{.underline}. [Sale of an instrument with a negative
adjustment carryforward]{.underline}---(i) [Facts]{.underline}. On
December 31, 2003, Z, a calendar year U.S. resident taxpayer whose
functional currency is the U.S. dollar, purchases at original issue a
debt instrument with non-currency contingencies for £1000. All payments
of principal and interest with respect to the instrument are denominated
in, or determined by reference to, a single nonfunctional currency (the
British pound). The debt instrument would be subject to §1.1275-4(b) if
it were denominated in dollars. The debt instrument\'s comparable yield,
determined in British pounds under §§1.988-2(b)(2) and 1.1275-4(b), is
10 percent, compounded annually, and the projected payment schedule for
the debt instrument provides for payments of £310 on December 31, 2005
(consisting of a noncontingent payment of £50 and a projected amount of
£260) and £990 on December 31, 2006 (consisting of a noncontingent
payment of £940 and a projected amount of £50). The debt instrument is a
capital asset in the hands of Z. Z does not elect to use the spot‑rate
convention described in §1.988‑2(b)(2)(iii)(B). The payment actually
made on December 31, 2005, is £50. On December 30, 2006, Z sells the
debt instrument for £940. The relevant pound/dollar spot rates over the
term of the instrument are as follows:

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Date Spot rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Dec. 31, 2003 £1.00=\$ 1.00

Dec. 31, 2005 £1.00=\$ 2.00

Dec. 30, 2006 £1.00=\$ 2.00

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

Accrual period Average rate (pounds to dollars)

\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\-\--

January 1 - December 31, 2004 £1.00=\$ 2.00

January 1 - December 31, 2005 £1.00=\$ 2.00

January 1 - December 31, 2006 £1.00=\$ 2.00

\(ii\) [Treatment in 2004]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £100 of interest on the debt
instrument for 2004 (issue price of £1000 x 10 percent). Under paragraph
(b)(3)(i) of this section, Z translates the £100 at the average exchange
rate for the accrual period (\$2.00 x £100 = \$200). Accordingly, Z has
interest income in 2004 of \$200.

\(B\) [Adjusted issue price and basis]{.underline}. Under paragraphs
(b)(2)(iii) and (iv) of this section, the adjusted issue price of the
debt instrument determined in pounds and Z\'s adjusted basis in dollars
in the debt instrument are increased by the interest accrued in 2004.
Thus, on January 1, 2005, the adjusted issue price of the debt
instrument is £1100. For purposes of determining Z\'s dollar basis in
the debt instrument, the \$1000 basis (\$1.00 x £1000 original cost
basis) is increased by the £100 of accrued interest, translated at the
rate at which interest was accrued for 2004. See paragraph (b)(3)(iii)
of this section. Accordingly, Z\'s adjusted basis in the debt instrument
as of January 1, 2005, is \$1200 (\$1000 + \$200).

\(iii\) [Treatment in 2005]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z\'s accrued interest for 2005 is £110
(adjusted issue price of £1100 x 10 percent). Under paragraph (b)(3)(i)
of this section, the £110 of accrued interest is translated at the
average exchange rate for the accrual period (\$2.00 x £110 = \$220).

\(B\) [Effect of net negative adjustment]{.underline}. The payment
actually made on December 31, 2005, is £50, rather than the projected
£310. Under paragraph (b)(2)(ii) of this section, Z has a net negative
adjustment of £260 on December 31, 2005, attributable to the difference
between the amount of the actual payment and the amount of the projected
payment. Z\'s accrued interest income of £110 in 2005 is reduced to zero
by the net negative adjustment. Under paragraph
(b)(3)(ii)(B)([1]{.underline}) of this section, the net negative
adjustment which reduces the current year's interest is not translated
into functional currency. Under paragraph (b)(2)(ii) of this section, Z
treats the remaining £150 net negative adjustment as an ordinary loss to
the extent of the £100 previously accrued interest in 2004. This £100
ordinary loss is attributable to interest accrued but not paid in the
preceding year. Therefore, under paragraph
(b)(3)(ii)(B)([2]{.underline}) of this section, Z translates the loss
into dollars at the average rate for such year (£1 = \$2.00).
Accordingly, Z has an ordinary loss of \$200 in 2005. The remaining £50
of net negative adjustment is a negative adjustment carryforward under
paragraph (b)(2)(ii) of this section.

\(C\) [Adjusted issue price and basis]{.underline}. Based on the
projected payment schedule, the adjusted issue price of the debt
instrument on January 1, 2006 is £900, i.e., the adjusted issue price of
the debt instrument on January 1, 2005 (£1100), increased by the
interest accrued in 2005 (£110), and decreased by the projected amount
of the December 31, 2005, payment (£310). See paragraph (b)(2)(iii) of
this section. Z\'s adjusted basis in dollars, based only on the
noncontingent payments and the projected amount of the contingent
payments to be received, is \$900 (determined as described below). Z's
adjusted basis on January 1, 2006 is Z's adjusted basis on January 1,
2005 (\$1200), increased by the functional currency amount of interest
accrued in 2005 (\$220), and decreased by the amount of the payments
made in 2005, based solely on the projected payment schedule, (£310).
The amount of the projected payment is first attributable to the
interest accrued in 2005 (£110), and then to the interest accrued in
2004 (£100), and the remaining amount to principal (£100). The interest
component of the projected payment is translated into functional
currency at the rates at which it was accrued, and the principal
component of the projected payment is translated into functional
currency at the spot rate on the date the instrument was issued. See
paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted basis
in the debt instrument, following the increase of adjusted basis for
interest accrued in 2005 (\$1200 + \$220 = \$1420), is decreased by
\$520 (\$220 + \$200 + \$100 = \$520). Z's adjusted basis on January 1,
2006 is therefore, \$900.

\(D\) [Foreign currency gain or loss]{.underline}. Z will recognize
foreign currency gain on the receipt of the £50 payment actually
received on December 31, 2005. Based on paragraph (b)(5)(iv) of this
section, the £50 payment is attributable to principal since the accrued
unpaid interest was completely eliminated by the net negative
adjustment. The amount of foreign currency gain is determined, under
paragraph (b)(5)(iii) of this section, by reference to the difference
between the spot rate on the date the £50 payment was made and the spot
rate on the date the debt instrument was issued. Accordingly, Z
recognizes \$50 of foreign currency gain on the £50 payment. \[(\$2.00 -
\$1.00) x £50 =\$50\]. Under paragraph (b)(6) of this section and
§1.988-4, Z's foreign currency gain of \$50 is sourced by reference to
Z\'s residence and is therefore from sources within the United States.

\(iv\) [Treatment in 2006]{.underline}\--(A) [Determination of accrued
interest]{.underline}. Under paragraph (b)(2)(i) of this section, and
based on the comparable yield, Z accrues £90 of interest on the debt
instrument for 2004 (adjusted issue price of £900 x 10 percent). Under
paragraph (b)(3)(i) of this section, Z translates the £90 at the average
exchange rate for the accrual period (\$2.00 x £90 = \$180).
Accordingly, prior to taking into account the 2005 negative adjustment
carryforward, Z has interest income in 2006 of \$180.

\(B\) [Effect of net negative adjustment]{.underline}. The £50 negative
adjustment carryforward from 2005 is a negative adjustment for 2006.
Since there are no other positive or negative adjustments, there is a
£50 negative adjustment in 2006 which reduces Z's accrued interest
income by £50. Accordingly, after giving effect to the £50 negative
adjustment carryforward, Z will accrue \$80 of interest income.
\[(£90-£50) x \$2.00 = \$80\]

\(C\) [Adjusted issue price]{.underline}. Under paragraph (b)(2)(iii) of
this section, the adjusted issue price of the debt instrument determined
in pounds is increased by the interest accrued in 2006 (prior to taking
into account the negative adjustment carryforward). Thus, on December
30, 2006, the adjusted issue price of the debt instrument is £990.

\(D\) [Adjusted basis]{.underline}. For purposes of determining Z\'s
dollar basis in the debt instrument, Z's \$900 adjusted basis on January
1, 2006 is increased by the accrued interest, translated at the rate at
which interest was accrued for 2006. See paragraph (b)(3)(iii)(A) of
this section. Note, however, that under paragraph (b)(3)(iii)(B) the
amount of accrued interest which is reduced as a result of the negative
adjustment carryforward, i.e., £50, is treated for purposes of this
section as principal, and is translated at the spot rate on the date the
instrument was issued, i.e., £1.00 =\$1.00. Accordingly, Z\'s adjusted
basis in the debt instrument as of December 30, 2006, is \$1030 (\$900 +
\$50 + \$80).

\(E\) [Amount realized]{.underline}. Z's amount realized in denomination
currency is £940, [i.e.]{.underline}, the amount of pounds Z received on
the sale of the debt instrument. Under paragraph
(b)(3)(iv)(B)([1]{.underline}) of this section, Z's amount realized is
first translated by reference to the principal component of basis
(including the amount which is treated as principal under paragraph
(b)(3)(iii)(B) of this section) and then the remaining amount realized,
if any, is translated by reference to the accrued unpaid interest
component of adjusted basis. Thus, £900 of Z's amount realized is
translated by reference to the principal component of adjusted basis.
The remaining £40 of Z's amount realized is treated as principal under
paragraph (b)(3)(iii)(B) of this section, and is also is translated by
reference to the principal component of adjusted basis. Accordingly, Z's
amount realized in functional currency is \$940. (No part of Z's amount
realized is attributable to the interest accrued on the debt
instrument.) Z realizes a loss of \$90 on the sale of the debt
instrument (\$1030 basis - \$940 amount realized). Under paragraph
(b)(4) of this section and § 1.1275-4(b)(8), \$80 of the loss is
characterized as ordinary loss, and the remaining \$10 of loss is
characterized as capital loss. Under §§ 1.988-6(b)(6) and
1.1275-4(b)(9)(iv) the \$80 ordinary loss is treated as a deduction that
is definitely related to the interest income accrued on the debt
instrument. Similarly, under §§ 1.988-6(b)(6) and 1.865-1(b)(2) the \$10
capital loss is also allocated to the interest income from the debt
instrument.

\(F\) [Foreign currency gain or loss]{.underline}. Z recognizes foreign
currency gain with respect to the £940 he received on the sale of the
debt instrument. Under paragraph (b)(5)(iv) of this section, the £940 Z
received is attributable to principal (and the amount which is treated
as principal under paragraph (b)(3)(iii)(B) of this section). Thus, Z
recognizes foreign currency gain on December 31, 2006, of \$940.
\[(\$2.00-\$1.00) x £940\]. Under paragraph (b)(6) of this section and
§1.988-4, Z's foreign currency gain of \$940 is sourced by reference to
Z\'s residence and is therefore from sources within the United States.

\(d\) [Multicurrency debt instruments]{.underline}\--(1) [In
general]{.underline}.

Except as provided in this paragraph (d), a multicurrency debt
instrument described in paragraph (a)(1)(ii) or (iii) of this section
shall be treated as an instrument described in paragraph (a)(1)(i) of
this section and shall be accounted for under the rules of paragraph (b)
of this section. Because payments on an instrument described in
paragraph (a)(1)(ii) or (iii) of this section are denominated in, or
determined by reference to, more than one currency, the issuer and
holder or holders of the instrument are required to determine the
denomination currency of the instrument under paragraph (d)(2) of this
section before applying the rules of paragraph (b) of this section.

\(2\) [Determination of denomination currency]{.underline}. The
denomination currency of an instrument described in paragraph (a)(1)(ii)
or (iii) of this section shall be the predominant currency of the
instrument. The predominant currency of the instrument shall be
determined by comparing the functional currency value of the
noncontingent and projected payments denominated in, or determined by
reference to, each currency on the issue date, discounted to present
value (in each relevant currency), and translated (if necessary) into
functional currency at the spot rate on the issue date. For this
purpose, the applicable discount rate may be determined using any
method, consistently applied, that reasonably reflects the instrument\'s
economic substance. If a taxpayer does not determine a discount rate
using such a method, the Commissioner may choose a method for
determining the discount rate that does reflect the instrument\'s
economic substance. The predominant currency is determined as of the
issue date and does not change based on subsequent events (e.g., changes
in value of one or more currencies).

\(3\) [Issuer/holder consistency]{.underline}. The issuer determines the
denomination currency under the rules of paragraph (d)(2) of this
section and provides this information to the holders of the instrument
in a manner consistent with the issuer disclosure rules of §1.1275-2(e).
If the issuer does not determine the denomination currency of the
instrument, or if the issuer's determination is unreasonable, the holder
of the instrument must determine the denomination currency under the
rules of paragraph (d)(2) of this section. A holder that determines the
denomination currency itself must explicitly disclose this fact on a
statement attached to the holder's timely filed federal income tax
return for the taxable year that includes the acquisition date of the
instrument.

\(4\) [Treatment of payments in currencies other than the denomination
currency]{.underline}. For purposes of applying the rules of paragraph
(b) of this section to debt instruments described in paragraph
(a)(1)(ii) or (iii) of this section, payments not denominated in (or
determined by reference to) the denomination currency shall be treated
as non-currency-related contingent payments. Accordingly, if the
denomination currency of the instrument is determined to be the
taxpayer's functional currency, the instrument shall be accounted for
under §1.1275-4(b) rather than this section.

\(e\) [Instruments issued for nonpublicly traded
property]{.underline}\--(1) [Applicability]{.underline}. This paragraph
(e) applies to debt instruments issued for nonpublicly traded property
that would be described in paragraph (a)(1)(i), (ii), or (iii) of this
section, but for the fact that such instruments are described in
§1.1275-4(c)(1) rather than §1.1275-4(b)(1). For example, this paragraph
(e) generally applies to a contingent debt instrument denominated in a
nonfunctional currency that is issued for non-publicly traded property.
Generally the rules of §1.1275-4(c) apply except as set forth by the
rules of this paragraph (e).

\(2\) [Separation into components]{.underline}. An instrument described
in this paragraph (e) is not accounted for using the noncontingent bond
method of §1.1275-4(b) and paragraph (b) of this section. Rather, the
instrument is separated into its component payments. Each noncontingent
payment or group of noncontingent payments which is denominated in a
single currency shall be considered a single component treated as a
separate debt instrument denominated in the currency of the payment or
group of payments. Each contingent payment shall be treated separately
as provided in paragraph (e)(4) of this section.

\(3\) [Treatment of components consisting of one or more noncontingent
payments in the same currency]{.underline}. The issue price of each
component treated as a separate debt instrument which consists of one or
more noncontingent payments is the sum of the present values of the
noncontingent payments contained in the separate instrument. The present
value of any noncontingent payment shall be determined under
§1.1274-2(c)(2), and the test rate shall be determined under §1.1274-4
with respect to the currency in which each separate instrument is
considered denominated. No interest payments on the separate debt
instrument are qualified stated interest payments (within the meaning of
§1.1273-1(c)) and the de minimis rules of section 1273(a)(3) and
§1.1273-1(d) do not apply to the separate debt instrument. Interest
income or expense is translated, and exchange gain or loss is recognized
on the separate debt instrument as provided in §1.988-2(b)(2), if the
instrument is denominated in a nonfunctional currency.

\(4\) [Treatment of components consisting of contingent
payments]{.underline}\--(i) [General rule]{.underline}. A component
consisting of a contingent payment shall generally be treated in the
manner provided in §1.1275-4(c)(4). However, except as provided in
paragraph (e)(4)(ii) of this section, the test rate shall be determined
by reference to the U.S. dollar unless the dollar does not reasonably
reflect the economic substance of the contingent component. In such
case, the test rate shall be determined by reference to the currency
which most reasonably reflects the economic substance of the contingent
component. Any amount received in nonfunctional currency from a
component consisting of a contingent payment shall be translated into
functional currency at the spot rate on the date of receipt. Except in
the case when the payment becomes fixed more than six months before the
payment is due, no foreign currency gain or loss shall be recognized on
a contingent payment component.

\(ii\) [Certain delayed contingent payments]{.underline}\--(A) [Separate
debt instrument relating to the fixed component]{.underline}. The rules
of §1.1275-4(c)(4)(iii) shall apply to a contingent component the
payment of which becomes fixed more than 6 months before the payment is
due. For this purpose, the denomination currency of the separate debt
instrument relating to the fixed payment shall be the currency in which
payment is to be made and the test rate for such separate debt
instrument shall be determined in the currency of that instrument. If
the separate debt instrument relating to the fixed payment is
denominated in nonfunctional currency, the rules of §1.988-2(b)(2) shall
apply to that instrument for the period beginning on the date the
payment is fixed and ending on the payment date.

\(B\) [Contingent component]{.underline}. With respect to the contingent
component, the issue price considered to have been paid by the issuer to
the holder under §1.1275-4(c)(4)(iii)(A) shall be translated, if
necessary, into the functional currency of the issuer or holder at the
spot rate on the date the payment becomes fixed.

\(5\) [Basis different from adjusted issue price]{.underline}. The rules
of §1.1275-4(c)(5) shall apply to an instrument subject to this
paragraph (e).

\(6\) [Treatment of a holder on sale, exchange, or
retirement]{.underline}. The rules of §1.1275-4(c)(6) shall apply to an
instrument subject to this paragraph (e).

\(f\) [Rules for nonfunctional currency tax exempt obligations described
in §1.1275-4(d)]{.underline}. \[RESERVED\]

\(g\) [Effective date]{.underline}. This section shall apply to debt
instruments issued 60 days or more after the date final regulations are
published in the **Federal Register**.

Par. 4. In §1.1275-4, paragraph (a)(2)(iv) is revised to read as
follows:

[§1.1275-4 Contingent payment debt instruments]{.underline}.

(a)\*\*\*

(2)\*\*\*

\(iv\) A debt instrument subject to section 988 (except as provided in
§1.988-6);

\*\*\*\*\*

David A. Mader

Acting Deputy Commissioner of Internal Revenue.