Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68173

less tax than if the election had been timely

made. Assume that paragraphs (c)(2) (i), (iii),

and (iv) of this section do not apply. Under

paragraph (c)(2)(ii) of this section, the

interests of the Government are not deemed

to be prejudiced because the election does

not require an adjustment under section

481(a).

Example 5. Election requiring adjustment

under section 481(a). The facts are the same

as in Example 4 of this paragraph (f) except

that the applicable regulation provides that

the election requires an adjustment under

section 481(a). Under paragraph (c)(2)(ii) of

this section, the interests of the Government

are deemed to be prejudiced except in

unusual or compelling circumstances.

Example 6. Under examination by the IRS.

A regulation permits an automatic change in

method of accounting for an item on a cutoff basis. Taxpayer E reports income on E’s

1997 income tax return using an

impermissible method of accounting for the

item. In 2000, during the examination of the

1997 return by the IRS, the examining agent

notifies E in writing that its method of

accounting for the item is an issue under

consideration. Any change from the

impermissible method made as part of an

examination is made with an adjustment

under section 481(a). E requests relief under

this section to make the change pursuant to

the regulation for 1997. The change on a cutoff basis under the regulation would be more

favorable than if the change were made with

an adjustment under section 481(a) as part of

an examination. Under paragraph (c)(2)(iii) of

this section, the interests of the Government

are deemed to be prejudiced except in

unusual and compelling circumstances

because E seeks to change from an

impermissible method of accounting that is

an issue under consideration in the

examination on a basis that is more favorable

than if the change were made as part of an

examination.

§§ 301.9100–1T, 301.9100–2T, and 301.9100–

3T [Removed]

Par. 8. Sections 301.9100–1T,

301.9100–2T, and 301.9100–3T are

removed.

PART 601—STATEMENT OF

PROCEDURAL RULES

Par. 9. The authority citation for part

601 continues to read as follows:

Authority: 26 U.S.C. 301 and 552, unless

otherwise noted.

§ 601.204 [Amended]

Par. 10. Section 601.204 is amended

as follows:

1. In paragraph (b), the fourth

sentence is amended by removing the

language ‘‘within 180 days after the

beginning of’’ and adding ‘‘during’’ in

its place.

2. In paragraph (b), the last sentence

is removed.

§ 601.204T [Removed]

Par. 11. Section 601.204T is removed.

PART 602—OMB CONTROL NUMBERS

UNDER THE PAPERWORK

REDUCTION ACT

Par. 12. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 13. Section 602.101(c) is

amended by removing the entries for

§§ 301.9001–2T and 301.9001–3T, and

adding the following entry in numerical

order to the table to read as follows:

§ 602.101 OMB control numbers.

* * * * *

(c) * * *

CFR part or section where

identified and described

Current

OMB control No.

* * * * *

301.9100–1 ............................... 1545–1488

* * * * *

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: December 10, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97–33357 Filed 12–30–97; 8:45 am]

BILLING CODE 4830–01–U

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8746]

RIN 1545–AU09

Amortizable Bond Premium

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the federal

income tax treatment of bond premium

and bond issuance premium. The

regulations reflect changes to the law

made by the Tax Reform Act of 1986

and the Technical and Miscellaneous

Revenue Act of 1988. The regulations

will provide needed guidance to holders

and issuers of debt instruments.

DATES: Effective date: March 2, 1998.

Applicability dates: For dates of

applicability of the final regulations, see

Effective Dates under SUPPLEMENTARY

INFORMATION.

FOR FURTHER INFORMATION CONTACT:

William E. Blanchard, (202) 622–3950

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the requirements of the

Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)) under control number

1545–1491. Responses to these

collections of information are required

by the IRS to determine whether a

holder of a bond has elected to amortize

bond premium and whether an issuer or

a holder has changed its method of

accounting for premium.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The estimated annual burden per

respondent varies from 0.25 hours to

0.75 hours, depending on individual

circumstances, with an estimated

average of 0.5 hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the

Office of Management and Budget, Attn:

Desk Officer for the Department of

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

Books or records relating to the

collections of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Background

Sections 1.171–1 through 1.171–4 of

the Income Tax Regulations were

promulgated in 1957 and last amended

in 1968. In the Tax Reform Act of 1986,

section 171(b) was amended to require

that bond premium be amortized by

reference to a constant yield. In the

Technical and Miscellaneous Revenue

Act of 1988, section 171(e) was

amended to require that amortizable

bond premium be treated as an offset to

interest income.

On June 27, 1996, the IRS published

a notice of proposed rulemaking in the

Federal Register (61 FR 33396) relating

to the federal income tax treatment of

bond premium and bond issuance

premium. A public hearing was not held

because no one requested to speak at the

hearing that had been scheduled for

October 23, 1996. The IRS did receive
68174 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations

a few comments on the proposed

regulations. The proposed regulations,

with certain changes to respond to the

comments, are adopted as final

regulations.

Explanation of Provisions

In general, bond premium arises when

a holder acquires a bond for more than

the principal amount of the bond.

Similarly, bond issuance premium

arises when an issuer issues a bond for

more than the principal amount of the

bond. A holder will purchase, and an

issuer will issue, a bond for more than

its principal amount when the stated

interest rate on the bond is higher than

the current market yield for the bond.

The holder’s treatment of bond

premium is addressed in §§ 1.171–1

through 1.171–5. The issuer’s treatment

of bond issuance premium is addressed

in § 1.163–13. In each case, the

amortization of premium is based on

constant yield principles. For this

reason, the final regulations use

concepts and definitions from the

original issue discount (OID) regulations

(in general, see §§ 1.1271–1 through

1.1275–7T).

Determination of Bond Premium

Under the proposed regulations, bond

premium is defined as the excess of a

holder’s basis in a bond over the sum of

the remaining amounts payable on the

bond other than payments of qualified

stated interest. The holder generally

determines the amount of bond

premium as of the date the holder

acquires the bond.

The proposed regulations provide

special rules that limit a holder’s basis

solely for purposes of determining bond

premium. For example, if a bond is

convertible into stock of the issuer at the

holder’s option, for purposes of

determining bond premium, the holder

must reduce its basis in the bond by the

value of the conversion option. This

reduction prevents the holder from

inappropriately amortizing the cost of

the embedded conversion option.

The final regulations adopt the rules

of the proposed regulations for

determining the amount of bond

premium, if any, on a bond. However,

in response to comments, the final

regulations clarify the determination of

basis in the case of a convertible bond

acquired in a transferred basis

transaction.

Amortization of Bond Premium

(a) In General

Under section 171, the holder of a

taxable bond acquired at a premium

may elect to amortize bond premium.

The holder of a tax-exempt bond

acquired at a premium must amortize

the premium. As premium is amortized,

the holder’s basis in the bond is reduced

by a corresponding amount under

section 1016(a)(5).

Under the proposed regulations, a

holder amortizes bond premium by

offsetting qualified stated interest

income with bond premium. An offset

is calculated for each accrual period

using constant yield principles.

However, the offset for an accrual

period is only taken into account when

the holder takes qualified stated interest

into account under the holder’s regular

method of accounting. Thus, a holder

using the cash receipts and

disbursements method of accounting

does not take bond premium into

account until a qualified stated interest

payment is received.

The final regulations adopt the rules

in the proposed regulations for

amortizing bond premium.

(b) Excess Premium

For certain bonds (for example, bonds

that pay a variable rate of interest or that

provide for an interest holiday), the

amount of bond premium allocable to

an accrual period could exceed the

amount of qualified stated interest

allocable to that period. The proposed

regulations address this situation by

providing that the excess bond premium

is not allowed as a deduction but is

carried forward to future accrual

periods.

Several commentators stated that this

excess premium should be allowable as

a current deduction for the accrual

period in which the excess occurs. In

response to these comments, the final

regulations adopt rules for excess

premium that are similar to the rules for

negative adjustments on contingent

payment debt instruments and deflation

adjustments on inflation-indexed debt

instruments. Under the final

regulations, any excess bond premium

allocable to an accrual period is

deductible by the holder under section

171(a)(1) for the accrual period. The

amount deductible, however, is limited

by the amount of the holder’s prior

income inclusions on the bond. If any

of the excess bond premium is not

deductible under section 171(a)(1), this

amount is carried forward to the next

accrual period and is treated as bond

premium allocable to that period.

Bonds Subject to Certain Contingencies

If a bond provides for one or more

alternative payment schedules, the yield

of the bond cannot be determined

without making assumptions about the

actual payment schedule. The OID

regulations provide rules for making

these assumptions. For example, the

rules assume that an issuer will exercise

a call option if doing so would

minimize the yield of the debt

instrument and that a holder will

exercise a put option if doing so would

maximize the yield of the debt

instrument.

The proposed regulations under

section 171 generally use similar

assumptions to determine the holder’s

yield on a bond that provides for

alternative payment schedules.

However, in the case of an issuer’s

option on a taxable bond, the proposed

regulations reverse the assumption in

the OID regulations by assuming that

the issuer will exercise the option only

if doing so would increase the yield on

the bond. See section 171(b)(1)(B)(ii).

Thus, under the proposed regulations, a

holder generally must amortize bond

premium on a taxable bond by reference

to the stated maturity date, even if it

appears likely the bond will be called.

In this case, if the bond is actually

called, the proposed regulations provide

that the holder may deduct the

unamortized premium. If the bond is

partially called and the partial call is

not a pro-rata prepayment, the proposed

regulations do not allow the holder to

deduct a portion of the unamortized

premium. Instead, the holder must

recompute the yield of the bond on the

date of the partial call and amortize the

remaining premium by reference to the

recomputed yield.

In general, the final regulations adopt

the rules of the proposed regulations. In

response to a comment, the final

regulations limit the issuer rule for

taxable bonds to call options.

Bond Issuance Premium

Under existing § 1.61–12(c), a

corporate issuer treats premium

received upon issuance of a bond as a

separate item of income. Over the term

of the bond, the premium is taken into

income, and the full amount of the

stated interest is deducted. The

proposed regulations revise the

treatment of bond issuance premium.

Under the proposed regulations, bond

issuance premium is amortized as an

offset to the issuer’s otherwise allowable

interest deduction, not as a separate

item of income. The amount of bond

issuance premium amortized in any

period is based on a constant yield. In

addition, the proposed regulations

apply to all issuers, not just corporate

issuers.

In general, the final regulations adopt

the rules in the proposed regulations for

bond issuance premium. However, the

final regulations contain several
Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68175

important changes from the proposed

regulations. First, in response to

comments, the final regulations clarify

the treatment of a debt instrument

subject to an alternative payment

schedule by explicitly cross-referencing

§ 1.1272–1(c). Second, the final

regulations provide that, in the case of

a debt instrument subject to a

mandatory sinking fund provision, the

issuer must determine the payment

schedule by assuming that a pro rata

portion of the debt instrument will be

called under the sinking fund provision.

This rule produces more economic

interest accruals than the accruals

determined by ignoring the sinking fund

provision as under the proposed

regulations. Third, the final regulations

adopt rules for excess bond issuance

premium allocable to an accrual period.

These rules are similar to the rules for

excess bond premium described above.

Aggregation Rules

Although the proposed regulations do

not provide for an aggregate method of

accounting for premium, comments

were requested on the need for an

aggregate method. Because no

comments were received, the final

regulations do not provide rules for an

aggregate method of accounting for

premium.

Bonds Not Subject to the Final

Regulations

The final regulations generally apply

to bonds acquired or issued at a

premium. Certain bonds, however, are

excluded from the application of the

final regulations. For example, the final

regulations exclude debt instruments

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

(regular interests in a REMIC, qualified

mortgages held by a REMIC, and certain

other debt instruments, or pools of debt

instruments, with payments subject to

acceleration). No inference is intended

regarding the treatment of debt

instruments described in section

1272(a)(6)(C).

Effective Dates

The final regulations relating to bond

premium are effective for bonds

acquired on or after March 2, 1998.

However, if a holder makes the election

to amortize bond premium for the

taxable year containing March 2, 1998,

or any subsequent taxable year, the

regulations apply to bonds held on or

after the first day of the taxable year in

which the election is made.

The final regulations relating to bond

issuance premium apply to debt

instruments issued on or after March 2,

1998.

The final regulations also provide

automatic consent for a taxpayer to

change its method of accounting for

premium in certain circumstances.

Because the change is made on a cut-off

basis, no items of income or deduction

are omitted or duplicated. Therefore, no

adjustment under section 481 is

allowed.

Special Analyses

It is hereby certified that these

regulations do not have significant

economic impact on a substantial

number of small entities. This

certification is based upon the fact that

the regulations merely require a

taxpayer to attach to the taxpayer’s

return a statement that indicates

whether the taxpayer is making an

election under section 171 or is

changing its accounting method for

bond premium or bond issuance

premium. Therefore, a Regulatory

Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) is not required.

It has been determined that this

Treasury Decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory

assessment is not required. It has also

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) does not apply to these

regulations. Pursuant to section 7805(f)

of the Internal Revenue Code, the notice

of proposed rulemaking was submitted

to the Chief Counsel for Advocacy of the

Small Business Administration for

comment on its impact on small

business.

Drafting Information

Several persons from the Office of

Assistant Chief Counsel (Financial

Institutions and Products) and the

Treasury Department participated in the

development of these regulations.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping

requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by adding entries

in numerical order to read as follows:

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

Section 1.171–2 also issued under 26

U.S.C. 171(e).

Section 1.171–3 also issued under 26

U.S.C. 171(e).

Section 1.171–4 also issued under 26

U.S.C. 171(c). * * *

Par. 2. Section 1.61–12 is amended by

revising paragraph (c) to read as follows:

§ 1.61–12 Income from discharge of

indebtedness.

* * * * *

(c) Issuance and repurchase of debt

instruments—(1) Issuance. An issuer

does not realize gain or loss upon the

issuance of a debt instrument. For rules

relating to an issuer’s interest deduction

for a debt instrument issued with bond

issuance premium, see § 1.163–13.

(2) Repurchase—(i) In general. An

issuer does not realize gain or loss upon

the repurchase of a debt instrument.

However, if a debt instrument provides

for payments denominated in, or

determined by reference to, a

nonfunctional currency, an issuer may

realize a currency gain or loss upon the

repurchase of the instrument. See

section 988 and the regulations

thereunder. For purposes of this

paragraph (c)(2), the term repurchase

includes the retirement of a debt

instrument, the conversion of a debt

instrument into stock of the issuer, and

the exchange (including an exchange

under section 1001) of a newly issued

debt instrument for an existing debt

instrument.

(ii) Repurchase at a discount. An

issuer realizes income from the

discharge of indebtedness upon the

repurchase of a debt instrument for an

amount less than its adjusted issue price

(within the meaning of § 1.1275–1(b)).

The amount of discharge of

indebtedness income is equal to the

excess of the adjusted issue price over

the repurchase price. See section 108

and the regulations thereunder for

additional rules relating to income from

discharge of indebtedness. For example,

to determine the repurchase price of a

debt instrument that is repurchased

through the issuance of a new debt

instrument, see section 108(e)(10).

(iii) Repurchase at a premium. An

issuer may be entitled to a repurchase

premium deduction upon the

repurchase of a debt instrument for an

amount greater than its adjusted issue

price (within the meaning of § 1.1275–

1(b)). See § 1.163–7(c) for the treatment

of repurchase premium.

(iv) Effective date. This paragraph

(c)(2) applies to debt instruments

repurchased on or after March 2, 1998.

* * * * *
68176 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations

Par. 3. Section 1.163–13 is added to

read as follows:

§ 1.163–13 Treatment of bond issuance

premium.

(a) General rule. If a debt instrument

is issued with bond issuance premium,

this section limits the amount of the

issuer’s interest deduction otherwise

allowable under section 163(a). In

general, the issuer determines its

interest deduction by offsetting the

interest allocable to an accrual period

with the bond issuance premium

allocable to that period. Bond issuance

premium is allocable to an accrual

period based on a constant yield. The

use of a constant yield to amortize bond

issuance premium is intended to

generally conform the treatment of debt

instruments having bond issuance

premium with those having original

issue discount. Unless otherwise

provided, the terms used in this section

have the same meaning as those terms

in section 163(e), sections 1271 through

1275, and the corresponding

regulations. Moreover, unless otherwise

provided, the provisions of this section

apply in a manner consistent with those

of section 163(e), sections 1271 through

1275, and the corresponding

regulations. In addition, the anti-abuse

rule in § 1.1275–2(g) applies for

purposes of this section. For rules

dealing with the treatment of bond

premium by a holder, see §§ 1.171–1

through 1.171–5.

(b) Exceptions. This section does not

apply to—

(1) A debt instrument described in

section 1272(a)(6)(C) (regular interests

in a REMIC, qualified mortgages held by

a REMIC, and certain other debt

instruments, or pools of debt

instruments, with payments subject to

acceleration); or

(2) A debt instrument to which

§ 1.1275–4 applies (relating to certain

debt instruments that provide for

contingent payments).

(c) Bond issuance premium. Bond

issuance premium is the excess, if any,

of the issue price of a debt instrument

over its stated redemption price at

maturity. For purposes of this section,

the issue price of a convertible bond (as

defined in § 1.171–1(e)(1)(iii)(C)) does

not include an amount equal to the

value of the conversion option (as

determined under

§ 1.171–1(e)(1)(iii)(A)).

(d) Offsetting qualified stated interest

with bond issuance premium—(1) In

general. An issuer amortizes bond

issuance premium by offsetting the

qualified stated interest allocable to an

accrual period with the bond issuance

premium allocable to the accrual period.

This offset occurs when the issuer takes

the qualified stated interest into account

under its regular method of accounting.

(2) Qualified stated interest allocable

to an accrual period. See § 1.446–2(b) to

determine the accrual period to which

qualified stated interest is allocable and

to determine the accrual of qualified

stated interest within an accrual period.

(3) Bond issuance premium allocable

to an accrual period. The bond issuance

premium allocable to an accrual period

is determined under this paragraph

(d)(3). Within an accrual period, the

bond issuance premium allocable to the

period accrues ratably.

(i) Step one: Determine the debt

instrument’s yield to maturity. The yield

to maturity of a debt instrument is

determined under the rules of § 1.1272–

1(b)(1)(i).

(ii) Step two: Determine the accrual

periods. The accrual periods are

determined under the rules of § 1.1272–

1(b)(1)(ii).

(iii) Step three: Determine the bond

issuance premium allocable to the

accrual period. The bond issuance

premium allocable to an accrual period

is the excess of the qualified stated

interest allocable to the accrual period

over the product of the adjusted issue

price at the beginning of the accrual

period and the yield. In performing this

calculation, the yield must be stated

appropriately taking into account the

length of the particular accrual period.

Principles similar to those in § 1.1272–

1(b)(4) apply in determining the bond

issuance premium allocable to an

accrual period.

(4) Bond issuance premium in excess

of qualified stated interest—(i) Ordinary

income. If the bond issuance premium

allocable to an accrual period exceeds

the qualified stated interest allocable to

the accrual period, the excess is treated

as ordinary income by the issuer for the

accrual period. However, the amount

treated as ordinary income is limited to

the amount by which the issuer’s total

interest deductions on the debt

instrument in prior accrual periods

exceed the total amount treated by the

issuer as ordinary income on the debt

instrument in prior accrual periods.

(ii) Carryforward. If the bond issuance

premium allocable to an accrual period

exceeds the sum of the qualified stated

interest allocable to the accrual period

and the amount treated as ordinary

income for the accrual period under

paragraph (d)(4)(i) of this section, the

excess is carried forward to the next

accrual period and is treated as bond

issuance premium allocable to that

period. If a carryforward exists on the

date the debt instrument is retired, the

carryforward is treated as ordinary

income on that date.

(e) Special rules—(1) Variable rate

debt instruments. An issuer determines

bond issuance premium on a variable

rate debt instrument by reference to the

stated redemption price at maturity of

the equivalent fixed rate debt

instrument constructed for the variable

rate debt instrument. The issuer also

allocates any bond issuance premium

among the accrual periods by reference

to the equivalent fixed rate debt

instrument. The issuer constructs the

equivalent fixed rate debt instrument, as

of the issue date, by using the principles

of § 1.1275–5(e).

(2) Inflation-indexed debt

instruments. An issuer determines bond

issuance premium on an inflationindexed debt instrument by assuming

that there will be no inflation or

deflation over the term of the

instrument. The issuer also allocates

any bond issuance premium among the

accrual periods by assuming that there

will be no inflation or deflation over the

term of the instrument. The bond

issuance premium allocable to an

accrual period offsets qualified stated

interest allocable to the period.

Notwithstanding paragraph (d)(4) of this

section, if the bond issuance premium

allocable to an accrual period exceeds

the qualified stated interest allocable to

the period, the excess is treated as a

deflation adjustment under § 1.1275–

7T(f)(1)(ii). See § 1.1275–7T for other

rules relating to inflation-indexed debt

instruments.

(3) Certain debt instruments subject to

contingencies—(i) In general. Except as

provided in paragraph (e)(3)(ii) of this

section, the rules of § 1.1272–1(c) apply

to determine a debt instrument’s

payment schedule for purposes of this

section. For example, an issuer uses the

payment schedule determined under

§ 1.1272–1(c) to determine the amount,

if any, of bond issuance premium on the

debt instrument, the yield and maturity

of the debt instrument, and the

allocation of bond issuance premium to

an accrual period.

(ii) Mandatory sinking fund provision.

Notwithstanding paragraph (e)(3)(i) of

this section, if a debt instrument is

subject to a mandatory sinking fund

provision described in § 1.1272–1(c)(3),

the issuer must determine the payment

schedule by assuming that a pro rata

portion of the debt instrument will be

called under the sinking fund provision.

(4) Remote and incidental

contingencies. For purposes of

determining the amount of bond

issuance premium and allocating bond

issuance premium among accrual

periods, if a bond provides for a
Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68177

contingency that is remote or incidental

(within the meaning of § 1.1275–2(h)),

the issuer takes the contingency into

account under the rules for remote and

incidental contingencies in § 1.1275–

2(h).

(f) Example. The following example

illustrates the rules of this section:

Example—(i) Facts. On February 1, 1999,

X issues for $110,000 a debt instrument

maturing on February 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The debt instrument provides for

unconditional payments of interest of

$10,000, payable on February 1 of each year.

X uses the calendar year as its taxable year,

X uses the cash receipts and disbursements

method of accounting, and X decides to use

annual accrual periods ending on February 1

of each year. X’s calculations assume a 30-

day month and 360-day year.

(ii) Amount of bond issuance premium.

The issue price of the debt instrument is

$110,000. Because the interest payments on

the debt instrument are qualified stated

interest, the stated redemption price at

maturity of the debt instrument is $100,000.

Therefore, the amount of bond issuance

premium is $10,000 ($110,000¥$100,000).

(iii) Bond issuance premium allocable to

the first accrual period. Based on the

payment schedule and the issue price of the

debt instrument, the yield of the debt

instrument is 8.07 percent, compounded

annually. (Although, for purposes of

simplicity, the yield as stated is rounded to

two decimal places, the computations do not

reflect this rounding convention.) The bond

issuance premium allocable to the accrual

period ending on February 1, 2000, is the

excess of the qualified stated interest

allocable to the period ($10,000) over the

product of the adjusted issue price at the

beginning of the period ($110,000) and the

yield (8.07 percent, compounded annually).

Therefore, the bond issuance premium

allocable to the accrual period is $1,118.17

($10,000¥$8,881.83).

(iv) Premium used to offset interest.

Although X makes an interest payment of

$10,000 on February 1, 2000, X only deducts

interest of $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with the bond issuance premium

allocable to the period ($1,118.17).

(g) Effective date. This section applies to

debt instruments issued on or after March 2,

1998.

(h) Accounting method changes—(1)

Consent to change. An issuer required

to change its method of accounting for

bond issuance premium to comply with

this section must secure the consent of

the Commissioner in accordance with

the requirements of § 1.446–1(e).

Paragraph (h)(2) of this section provides

the Commissioner’s automatic consent

for certain changes.

(2) Automatic consent. The

Commissioner grants consent for an

issuer to change its method of

accounting for bond issuance premium

on debt instruments issued on or after

March 2, 1998. Because this change is

made on a cut-off basis, no items of

income or deduction are omitted or

duplicated and, therefore, no

adjustment under section 481 is

allowed. The consent granted by this

paragraph (h)(2) applies provided—

(i) The change is made to comply with

this section;

(ii) The change is made for the first

taxable year for which the issuer must

account for a debt instrument under this

section; and

(iii) The issuer attaches to its federal

income tax return for the taxable year

containing the change a statement that

it has changed its method of accounting

under this section.

PAR. 4. Sections 1.171–1 through

1.171–4 are revised to read as follows:

§ 1.171–1 Bond premium.

(a) Overview—(1) In general. This

section and §§ 1.171–2 through 1.171–5

provide rules for the determination and

amortization of bond premium by a

holder. In general, a holder amortizes

bond premium by offsetting the interest

allocable to an accrual period with the

premium allocable to that period. Bond

premium is allocable to an accrual

period based on a constant yield. The

use of a constant yield to amortize bond

premium is intended to generally

conform the treatment of bond premium

to the treatment of original issue

discount under sections 1271 through

1275. Unless otherwise provided, the

terms used in this section and §§ 1.171–

2 through 1.171–5 have the same

meaning as those terms in sections 1271

through 1275 and the corresponding

regulations. Moreover, unless otherwise

provided, the provisions of this section

and §§ 1.171–2 through 1.171–5 apply

in a manner consistent with those of

sections 1271 through 1275 and the

corresponding regulations. In addition,

the anti-abuse rule in § 1.1275–2(g)

applies for purposes of this section and

§§ 1.171–2 through 1.171–5.

(2) Cross-references. For rules dealing

with the adjustments to a holder’s basis

to reflect the amortization of bond

premium, see § 1.1016–5(b). For rules

dealing with the treatment of bond

issuance premium by an issuer, see

§ 1.163–13.

(b) Scope—(1) In general. Except as

provided in paragraph (b)(2) of this

section and § 1.171–5, this section and

§§ 1.171–2 through 1.171–4 apply to any

bond that, upon its acquisition by the

holder, is held with bond premium. For

purposes of this section and §§ 1.171–2

through 1.171–5, the term bond has the

same meaning as the term debt

instrument in § 1.1275–1(d).

(2) Exceptions. This section and

§§ 1.171–2 through 1.171–5 do not

apply to—

(i) A bond described in section

1272(a)(6)(C) (regular interests in a

REMIC, qualified mortgages held by a

REMIC, and certain other debt

instruments, or pools of debt

instruments, with payments subject to

acceleration);

(ii) A bond to which § 1.1275–4

applies (relating to certain debt

instruments that provide for contingent

payments);

(iii) A bond held by a holder that has

made a § 1.1272–3 election with respect

to the bond;

(iv) A bond that is stock in trade of

the holder, a bond of a kind that would

properly be included in the inventory of

the holder if on hand at the close of the

taxable year, or a bond held primarily

for sale to customers in the ordinary

course of the holder’s trade or business;

or

(v) A bond issued before September

28, 1985, unless the bond bears interest

and was issued by a corporation or by

a government or political subdivision

thereof.

(c) General rule—(1) Tax-exempt

obligations. A holder must amortize

bond premium on a bond that is a taxexempt obligation. See § 1.171–2(c)

Example 4.

(2) Taxable bonds. A holder may elect

to amortize bond premium on a taxable

bond. Except as provided in paragraph

(c)(3) of this section, a taxable bond is

any bond other than a tax-exempt

obligation. See § 1.171–4 for rules

relating to the election to amortize bond

premium on a taxable bond.

(3) Bonds the interest on which is

partially excludable. For purposes of

this section and §§ 1.171–2 through

1.171–5, a bond the interest on which is

partially excludable from gross income

is treated as two instruments, a taxexempt obligation and a taxable bond.

The holder’s basis in the bond and each

payment on the bond are allocated

between the two instruments based on

a reasonable method.

(d) Determination of bond premium—

(1) In general. A holder acquires a bond

at a premium if the holder’s basis in the

bond immediately after its acquisition

by the holder exceeds the sum of all

amounts payable on the bond after the

acquisition date (other than payments of

qualified stated interest). This excess is

bond premium, which is amortizable

under § 1.171–2.

(2) Additional rules for amounts

payable on certain bonds. Additional

rules apply to determine the amounts

payable on a variable rate debt

instrument, an inflation-indexed debt
68178 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations

instrument, a bond that provides for

certain alternative payment schedules,

and a bond that provides for remote or

incidental contingencies. See § 1.171–3.

(e) Basis. A holder determines its

basis in a bond under this paragraph (e).

This determination of basis applies only

for purposes of this section and

§§ 1.171–2 through 1.171–5. Because of

the application of this paragraph (e), the

holder’s basis in the bond for purposes

of these sections may differ from the

holder’s basis for determining gain or

loss on the sale or exchange of the bond.

(1) Determination of basis—(i) In

general. In general, the holder’s basis in

the bond is the holder’s basis for

determining loss on the sale or exchange

of the bond.

(ii) Bonds acquired in certain

exchanges. If the holder acquired the

bond in exchange for other property

(other than in a reorganization defined

in section 368) and the holder’s basis in

the bond is determined in whole or in

part by reference to the holder’s basis in

the other property, the holder’s basis in

the bond may not exceed its fair market

value immediately after the exchange.

See paragraph (f) Example 1 of this

section. If the bond is acquired in a

reorganization, see section 171(b)(4)(B).

(iii) Convertible bonds—(A) General

rule. If the bond is a convertible bond,

the holder’s basis in the bond is reduced

by an amount equal to the value of the

conversion option. The value of the

conversion option may be determined

under any reasonable method. For

example, the holder may determine the

value of the conversion option by

comparing the market price of the

convertible bond to the market prices of

similar bonds that do not have

conversion options. See paragraph (f)

Example 2 of this section.

(B) Convertible bonds acquired in

certain exchanges. If the bond is a

convertible bond acquired in a

transaction described in paragraph

(e)(1)(ii) of this section, the holder’s

basis in the bond may not exceed its fair

market value immediately after the

exchange reduced by the value of the

conversion option.

(C) Definition of convertible bond. A

convertible bond is a bond that provides

the holder with an option to convert the

bond into stock of the issuer, stock or

debt of a related party (within the

meaning of section 267(b) or 707(b)(1)),

or into cash or other property in an

amount equal to the approximate value

of such stock or debt.

(2) Basis in bonds held by certain

transferees. Notwithstanding paragraph

(e)(1) of this section, if the bond is

transferred basis property (as defined in

section 7701(a)(43)) and the transferor

had acquired the bond at a premium,

the holder’s basis in the bond is—

(i) The holder’s basis for determining

loss on the sale or exchange of the bond;

reduced by

(ii) Any amounts that the transferor

could not have amortized under this

paragraph (e) or under § 1.171–4(c),

except to the extent that the holder’s

basis already reflects a reduction

attributable to such nonamortizable

amounts.

(f) Examples. The following examples

illustrate the rules of this section:

Example 1. Bond received in liquidation of

a partnership interest—(i) Facts. PR is a

partner in partnership PRS. PRS does not

have any unrealized receivables or inventory

items as defined in section 751. On January

1, 1998, PRS distributes to PR a taxable bond,

issued by an unrelated corporation, in

liquidation of PR’s partnership interest. At

that time, the fair market value of PR’s

partnership interest is $40,000 and the basis

is $100,000. The fair market value of the

bond is $40,000.

(ii) Determination of basis. Under section

732(b), PR’s basis in the bond is equal to PR’s

basis in the partnership interest. Therefore,

PR’s basis for determining loss on the sale or

exchange of the bond is $100,000. However,

because the distribution is treated as an

exchange for purposes of section 171(b)(4),

PR’s basis in the bond is $40,000 for

purposes of this section and §§ 1.171–2

through 1.171–5. See paragraph (e)(1)(ii) of

this section.

Example 2. Convertible bond—(i) Facts. On

January 11, 1998, A purchases for $1,100 B

corporation’s bond maturing on January 1,

2001, with a stated principal amount of

$1,000, payable at maturity. The bond

provides for unconditional payments of

interest of $30 on January 1 and July 1 of

each year. In addition, the bond is

convertible into 15 shares of B corporation

stock at the option of the holder. On January

1, 1998, B corporation’s nonconvertible,

publicly-traded, three-year debt with a

similar credit rating trades at a price that

reflects a yield of 6.75 percent, compounded

semiannually.

(ii) Determination of basis. A’s basis for

determining loss on the sale or exchange of

the bond is $1,100. As of January 1, 1998,

discounting the remaining payments on the

bond at the yield at which B’s similar

nonconvertible bonds trade (6.75 percent,

compounded semiannually) results in a

present value of $980. Thus, the value of the

conversion option is $120. Under paragraph

(e)(1)(iii)(A) of this section, A’s basis is $980

($1,100¥$120) for purposes of this section

and §§ 1.171–2 through 1.171–5. The sum of

all amounts payable on the bond other than

qualified stated interest is $1,000. Because

A’s basis (as determined under paragraph

(e)(1)(iii)(A) of this section) does not exceed

$1,000, A does not acquire the bond at a

premium.

§ 1.171–2 Amortization of bond premium.

(a) Offsetting qualified stated interest

with premium—(1) In general. A holder

amortizes bond premium by offsetting

the qualified stated interest allocable to

an accrual period with the bond

premium allocable to the accrual period.

This offset occurs when the holder takes

the qualified stated interest into account

under the holder’s regular method of

accounting.

(2) Qualified stated interest allocable

to an accrual period. See § 1.446–2(b) to

determine the accrual period to which

qualified stated interest is allocable and

to determine the accrual of qualified

stated interest within an accrual period.

(3) Bond premium allocable to an

accrual period. The bond premium

allocable to an accrual period is

determined under this paragraph (a)(3).

Within an accrual period, the bond

premium allocable to the period accrues

ratably.

(i) Step one: Determine the holder’s

yield. The holder’s yield is the discount

rate that, when used in computing the

present value of all remaining payments

to be made on the bond (including

payments of qualified stated interest),

produces an amount equal to the

holder’s basis in the bond as determined

under § 1.171–1(e). For this purpose, the

remaining payments include only

payments to be made after the date the

holder acquires the bond. The yield is

calculated as of the date the holder

acquires the bond, must be constant

over the term of the bond, and must be

calculated to at least two decimal places

when expressed as a percentage.

(ii) Step two: Determine the accrual

periods. A holder determines the

accrual periods for the bond under the

rules of § 1.1272–1(b)(1)(ii).

(iii) Step three: Determine the bond

premium allocable to the accrual

period. The bond premium allocable to

an accrual period is the excess of the

qualified stated interest allocable to the

accrual period over the product of the

holder’s adjusted acquisition price (as

defined in paragraph (b) of this section)

at the beginning of the accrual period

and the holder’s yield. In performing

this calculation, the yield must be stated

appropriately taking into account the

length of the particular accrual period.

Principles similar to those in § 1.1272–

1(b)(4) apply in determining the bond

premium allocable to an accrual period.

(4) Bond premium in excess of

qualified stated interest—(i) Taxable

bonds—(A) Bond premium deduction.

In the case of a taxable bond, if the bond

premium allocable to an accrual period

exceeds the qualified stated interest

allocable to the accrual period, the

excess is treated by the holder as a bond

premium deduction under section

171(a)(1) for the accrual period.

However, the amount treated as a bond
Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68179

premium deduction is limited to the

amount by which the holder’s total

interest inclusions on the bond in prior

accrual periods exceed the total amount

treated by the holder as a bond premium

deduction on the bond in prior accrual

periods. A deduction determined under

this paragraph (a)(4)(i)(A) is not subject

to section 67 (the 2-percent floor on

miscellaneous itemized deductions).

See Example 1 of § 1.171–3(e).

(B) Carryforward. If the bond

premium allocable to an accrual period

exceeds the sum of the qualified stated

interest allocable to the accrual period

and the amount treated as a deduction

for the accrual period under paragraph

(a)(4)(i)(A) of this section, the excess is

carried forward to the next accrual

period and is treated as bond premium

allocable to that period.

(ii) Tax-exempt obligations. In the

case of a tax-exempt obligation, if the

bond premium allocable to an accrual

period exceeds the qualified stated

interest allocable to the accrual period,

the excess is a nondeductible loss. If a

regulated investment company (RIC)

within the meaning of section 851 has

excess bond premium for an accrual

period that would be a nondeductible

loss under the prior sentence, the RIC

must use this excess bond premium to

reduce its tax-exempt interest income

on other tax-exempt obligations held

during the accrual period.

(5) Additional rules for certain bonds.

Additional rules apply to determine the

amortization of bond premium on a

variable rate debt instrument, an

inflation-indexed debt instrument, a

bond that provides for certain

alternative payment schedules, and a

bond that provides for remote or

incidental contingencies. See § 1.171–3.

(b) Adjusted acquisition price. The

adjusted acquisition price of a bond at

the beginning of the first accrual period

is the holder’s basis as determined

under § 1.171–1(e). Thereafter, the

adjusted acquisition price is the holder’s

basis in the bond decreased by—

(1) The amount of bond premium

previously allocable under paragraph

(a)(3) of this section; and

(2) The amount of any payment

previously made on the bond other than

a payment of qualified stated interest.

(c) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the

calendar year as its taxable year and has

elected to amortize bond premium,

effective for all relevant taxable years. In

addition, each example assumes a 30-

day month and 360-day year. Although,

for purposes of simplicity, the yield as

stated is rounded to two decimal places,

the computations do not reflect this

rounding convention. The examples are

as follows:

Example 1. Taxable bond—(i) Facts. On

February 1, 1999, A purchases for $110,000

a taxable bond maturing on February 1, 2006,

with a stated principal amount of $100,000,

payable at maturity. The bond provides for

unconditional payments of interest of

$10,000, payable on February 1 of each year.

A uses the cash receipts and disbursements

method of accounting, and A decides to use

annual accrual periods ending on February 1

of each year.

(ii) Amount of bond premium. The interest

payments on the bond are qualified stated

interest. Therefore, the sum of all amounts

payable on the bond (other than the interest

payments) is $100,000. Under § 1.171–1, the

amount of bond premium is $10,000

($110,000¥$100,000).

(iii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the bond and A’s basis

in the bond, A’s yield is 8.07 percent,

compounded annually. The bond premium

allocable to the accrual period ending on

February 1, 2000, is the excess of the

qualified stated interest allocable to the

period ($10,000) over the product of the

adjusted acquisition price at the beginning of

the period ($110,000) and A’s yield (8.07

percent, compounded annually). Therefore,

the bond premium allocable to the accrual

period is $1,118.17 ($10,000¥$8,881.83).

(iv) Premium used to offset interest.

Although A receives an interest payment of

$10,000 on February 1, 2000, A only includes

in income $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

period ($1,118.17). Under § 1.1016–5(b), A’s

basis in the bond is reduced by $1,118.17 on

February 1, 2000.

Example 2. Alternative accrual periods—(i)

Facts. The facts are the same as in Example

1 of this paragraph (c) except that A decides

to use semiannual accrual periods ending on

February 1 and August 1 of each year.

(ii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the bond and A’s basis

in the bond, A’s yield is 7.92 percent,

compounded semiannually. The bond

premium allocable to the accrual period

ending on August 1, 1999, is the excess of the

qualified stated interest allocable to the

period ($5,000) over the product of the

adjusted acquisition price at the beginning of

the period ($110,000) and A’s yield, stated

appropriately taking into account the length

of the accrual period (7.92 percent/2).

Therefore, the bond premium allocable to the

accrual period is $645.29

($5,000¥$4,354.71). Although the accrual

period ends on August 1, 1999, the qualified

stated interest of $5,000 is not taken into

income until February 1, 2000, the date it is

received. Likewise, the bond premium of

$645.29 is not taken into account until

February 1, 2000. The adjusted acquisition

price of the bond on August 1, 1999, is

$109,354.71 (the adjusted acquisition price at

the beginning of the period ($110,000) less

the bond premium allocable to the period

($645.29)).

(iii) Bond premium allocable to the second

accrual period. Because the interval between

payments of qualified stated interest contains

more than one accrual period, the adjusted

acquisition price at the beginning of the

second accrual period must be adjusted for

the accrued but unpaid qualified stated

interest. See paragraph (a)(3)(iii) of this

section and § 1.1272–1(b)(4)(i)(B). Therefore,

the adjusted acquisition price on August 1,

1999, is $114,354.71 ($109,354.71 + $5,000).

The bond premium allocable to the accrual

period ending on February 1, 2000, is the

excess of the qualified stated interest

allocable to the period ($5,000) over the

product of the adjusted acquisition price at

the beginning of the period ($114,354.71) and

A’s yield, stated appropriately taking into

account the length of the accrual period (7.92

percent/2). Therefore, the bond premium

allocable to the accrual period is $472.88

($5,000¥$4,527.12).

(iv) Premium used to offset interest.

Although A receives an interest payment of

$10,000 on February 1, 2000, A only includes

in income $8,881.83, the qualified stated

interest of $10,000 ($5,000 allocable to the

accrual period ending on August 1, 1999, and

$5,000 allocable to the accrual period ending

on February 1, 2000) offset with bond

premium of $1,118.17 ($645.29 allocable to

the accrual period ending on August 1, 1999,

and $472.88 allocable to the accrual period

ending on February 1, 2000). As indicated in

Example 1 of this paragraph (c), this same

amount would be taken into income at the

same time had A used annual accrual

periods.

Example 3. Holder uses accrual method of

accounting—(i) Facts. The facts are the same

as in Example 1 of this paragraph (c) except

that A uses an accrual method of accounting.

Thus, for the accrual period ending on

February 1, 2000, the qualified stated interest

allocable to the period is $10,000, and the

bond premium allocable to the period is

$1,118.17. Because the accrual period

extends beyond the end of A’s taxable year,

A must allocate these amounts between the

two taxable years.

(ii) Amounts allocable to the first taxable

year. The qualified stated interest allocable to

the first taxable year is $9,166.67 ($10,000 × 11⁄12). The bond premium allocable to the

first taxable year is $1,024.99 ($1,118.17 x

11⁄12).

(iii) Premium used to offset interest. For

1999, A includes in income $8,141.68, the

qualified stated interest allocable to the

period ($9,166.67) offset with bond premium

allocable to the period ($1,024.99). Under

§ 1.1016–5(b), A’s basis in the bond is

reduced by $1,024.99 in 1999.

(iv) Amounts allocable to the next taxable

year. The remaining amounts of qualified

stated interest and bond premium allocable

to the accrual period ending on February 1,

2000, are taken into account for the taxable

year ending on December 31, 2000.

Example 4. Tax-exempt obligation—(i)

Facts. On January 15, 1999, C purchases for

$120,000 a tax-exempt obligation maturing

on January 15, 2006, with a stated principal

amount of $100,000, payable at maturity. The

obligation provides for unconditional

payments of interest of $9,000, payable on
68180 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations

January 15 of each year. C uses the cash

receipts and disbursements method of

accounting, and C decides to use annual

accrual periods ending on January 15 of each

year.

(ii) Amount of bond premium. The interest

payments on the obligation are qualified

stated interest. Therefore, the sum of all

amounts payable on the obligation (other

than the interest payments) is $100,000.

Under § 1.171–1, the amount of bond

premium is $20,000 ($120,000—$100,000).

(iii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the obligation and C’s

basis in the obligation, C’s yield is 5.48

percent, compounded annually. The bond

premium allocable to the accrual period

ending on January 15, 2000, is the excess of

the qualified stated interest allocable to the

period ($9,000) over the product of the

adjusted acquisition price at the beginning of

the period ($120,000) and C’s yield (5.48

percent, compounded annually). Therefore,

the bond premium allocable to the accrual

period is $2,420.55 ($9,000¥$6,579.45).

(iv) Premium used to offset interest.

Although C receives an interest payment of

$9,000 on January 15, 2000, C only receives

tax-exempt interest income of $6,579.45, the

qualified stated interest allocable to the

period ($9,000) offset with bond premium

allocable to the period ($2,420.55). Under

§ 1.1016–5(b), C’s basis in the obligation is

reduced by $2,420.55 on January 15, 2000.

§ 1.171–3 Special rules for certain bonds.

(a) Variable rate debt instruments. A

holder determines bond premium on a

variable rate debt instrument by

reference to the stated redemption price

at maturity of the equivalent fixed rate

debt instrument constructed for the

variable rate debt instrument. The

holder also allocates any bond premium

among the accrual periods by reference

to the equivalent fixed rate debt

instrument. The holder constructs the

equivalent fixed rate debt instrument, as

of the date the holder acquires the

variable rate debt instrument, by using

the principles of § 1.1275–5(e). See

paragraph (e) Example 1 of this section.

(b) Inflation-indexed debt

instruments. A holder determines bond

premium on an inflation-indexed debt

instrument by assuming that there will

be no inflation or deflation over the

remaining term of the instrument. The

holder also allocates any bond premium

among the accrual periods by assuming

that there will be no inflation or

deflation over the remaining term of the

instrument. The bond premium

allocable to an accrual period offsets

qualified stated interest allocable to the

period. Notwithstanding § 1.171–2(a)(4),

if the bond premium allocable to an

accrual period exceeds the qualified

stated interest allocable to the period,

the excess is treated as a deflation

adjustment under § 1.1275–7T(f)(1)(i).

See § 1.1275–7T for other rules relating

to inflation-indexed debt instruments.

(c) Yield and remaining payment

schedule of certain bonds subject to

contingencies—(1) Applicability. This

paragraph (c) provides rules that apply

in determining the yield and remaining

payment schedule of certain bonds that

provide for an alternative payment

schedule (or schedules) applicable upon

the occurrence of a contingency (or

contingencies). This paragraph (c)

applies, however, only if the timing and

amounts of the payments that comprise

each payment schedule are known as of

the date the holder acquires the bond

(the acquisition date) and the bond is

subject to paragraph (c)(2), (3), or (4) of

this section. A bond does not provide

for an alternative payment schedule

merely because there is a possibility of

impairment of a payment (or payments)

by insolvency, default, or similar

circumstances. See § 1.1275–4 for the

treatment of a bond that provides for a

contingency that is not described in this

paragraph (c).

(2) Remaining payment schedule that

is significantly more likely than not to

occur. If, based on all the facts and

circumstances as of the acquisition date,

a single remaining payment schedule for

a bond is significantly more likely than

not to occur, this remaining payment

schedule is used to determine and

amortize bond premium under

§§ 1.171–1 and 1.171–2.

(3) Mandatory sinking fund provision.

Notwithstanding paragraph (c)(2) of this

section, if a bond is subject to a

mandatory sinking fund provision

described in § 1.1272–1(c)(3), the

provision is ignored for purposes of

determining and amortizing bond

premium under §§ 1.171–1 and 1.171–2.

(4) Treatment of certain options—(i)

Applicability. Notwithstanding

paragraphs (c)(2) and (3) of this section,

the rules of this paragraph (c)(4)

determine the remaining payment

schedule of a bond that provides the

holder or issuer with an unconditional

option or options, exercisable on one or

more dates during the remaining term of

the bond, to alter the bond’s remaining

payment schedule.

(ii) Operating rules. A holder

determines the remaining payment

schedule of a bond by assuming that

each option will (or will not) be

exercised under the following rules:

(A) Issuer options. In general, the

issuer is deemed to exercise or not

exercise an option or combination of

options in the manner that minimizes

the holder’s yield on the obligation.

However, the issuer of a taxable bond is

deemed to exercise or not exercise a call

option or combination of call options in

the manner that maximizes the holder’s

yield on the bond.

(B) Holder options. A holder is

deemed to exercise or not exercise an

option or combination of options in the

manner that maximizes the holder’s

yield on the bond.

(C) Multiple options. If both the issuer

and the holder have options, the rules

of paragraphs (c)(4)(ii)(A) and (B) of this

section are applied to the options in the

order that they may be exercised. Thus,

the deemed exercise of one option may

eliminate other options that are later in

time.

(5) Subsequent adjustments—(i) In

general. Except as provided in

paragraph (c)(5)(ii) of this section, if a

contingency described in this paragraph

(c) (including the exercise of an option

described in paragraph (c)(4) of this

section) actually occurs or does not

occur, contrary to the assumption made

pursuant to paragraph (c) of this section

(a change in circumstances), then solely

for purposes of section 171, the bond is

treated as retired and reacquired by the

holder on the date of the change in

circumstances for an amount equal to

the adjusted acquisition price of the

bond as of that date. If, however, the

change in circumstances results in a

substantially contemporaneous pro-rata

prepayment as defined in § 1.1275–

2(f)(2), the pro-rata prepayment is

treated as a payment in retirement of a

portion of the bond. See paragraph (e)

Example 2 of this section.

(ii) Bond premium deduction on the

issuer’s call of a taxable bond. If a

change in circumstances results from an

issuer’s call of a taxable bond or a

partial call that is a pro-rata

prepayment, the holder may deduct as

bond premium an amount equal to the

excess, if any, of the holder’s adjusted

acquisition price of the bond over the

greater of—

(A) The amount received on

redemption; and

(B) The amounts that would have

been payable under the bond (other than

payments of qualified stated interest) if

no change in circumstances had

occurred.

(d) Remote and incidental

contingencies. For purposes of

determining and amortizing bond

premium, if a bond provides for a

contingency that is remote or incidental

(within the meaning of § 1.1275–2(h)),

the holder takes the contingency into

account under the rules for remote and

incidental contingencies in § 1.1275–

2(h).

(e) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the

calendar year as its taxable year and has
Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68181

elected to amortize bond premium,

effective for all relevant taxable years. In

addition, each example assumes a 30-

day month and 360-day year. Although,

for purposes of simplicity, the yield as

stated is rounded to two decimal places,

the computations do not reflect this

rounding convention. The examples are

as follows:

Example 1. Variable rate debt instrument—

(i) Facts. On March 1, 1999, E purchases for

$110,000 a taxable bond maturing on March

1, 2007, with a stated principal amount of

$100,000, payable at maturity. The bond

provides for unconditional payments of

interest on March 1 of each year based on the

percentage appreciation of a nationallyknown commodity index. On March 1, 1999,

it is reasonably expected that the bond will

yield 12 percent, compounded annually. E

uses the cash receipts and disbursements

method of accounting, and E decides to use

annual accrual periods ending on March 1 of

each year. Assume that the bond is a variable

rate debt instrument under § 1.1275–5.

(ii) Amount of bond premium. Because the

bond is a variable rate debt instrument, E

determines and amortizes its bond premium

by reference to the equivalent fixed rate debt

instrument constructed for the bond as of

March 1, 1999. Because the bond provides for

interest at a single objective rate that is

reasonably expected to yield 12 percent,

compounded annually, the equivalent fixed

rate debt instrument for the bond is an eightyear bond with a principal amount of

$100,000, payable at maturity. It provides for

annual payments of interest of $12,000. E’s

basis in the equivalent fixed rate debt

instrument is $110,000. The sum of all

amounts payable on the equivalent fixed rate

debt instrument (other than payments of

qualified stated interest) is $100,000. Under

§ 1.171–1, the amount of bond premium is

$10,000 ($110,000 ¥$100,000).

(iii) Bond premium allocable to each

accrual period. E allocates bond premium to

the remaining accrual periods by reference to

the payment schedule on the equivalent fixed

rate debt instrument. Based on the payment

schedule of the equivalent fixed rate debt

instrument and E’s basis in the bond, E’s

yield is 10.12 percent, compounded

annually. The bond premium allocable to the

accrual period ending on March 1, 2000, is

the excess of the qualified stated interest

allocable to the period for the equivalent

fixed rate debt instrument ($12,000) over the

product of the adjusted acquisition price at

the beginning of the period ($110,000) and

E’s yield (10.12 percent, compounded

annually). Therefore, the bond premium

allocable to the accrual period is $870.71

($12,000¥$11,129.29). The bond premium

allocable to all the accrual periods is listed

in the following schedule:

Accrual period

ending

Adjusted acquisition price

at beginning of

accrual period

Premium allocable to

accrual

period

3/1/00 ............ $110,000.00 $870.71

3/1/01 ............ 109,129.29 958.81

3/1/02 ............ 108,170.48 1,055.82

3/1/03 ............ 107,114.66 1,162.64

3/1/04 ............ 105,952.02 1,280.27

3/1/05 ............ 104,671.75 1,409.80

3/1/06 ............ 103,261.95 1,552.44

3/1/07 ............ 101,709.51 1,709.51

10,000.00

(iv) Qualified stated interest for each

accrual period. Assume the bond actually

pays the following amounts of qualified

stated interest:

Accrual period ending

Qualified

stated

interest

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

3/1/01 ........................................ 0.00

3/1/02 ........................................ 0.00

3/1/03 ........................................ 10,000.00

3/1/04 ........................................ 8,000.00

3/1/05 ........................................ 12,000.00

Accrual period ending

Qualified

stated

interest

3/1/06 ........................................ 15,000.00

3/1/07 ........................................ 8,500.00

(v) Premium used to offset interest. E’s

interest income for each accrual period is

determined by offsetting the qualified stated

interest allocable to the period with the bond

premium allocable to the period. For the

accrual period ending on March 1, 2000, E

includes in income $1,129.29, the qualified

stated interest allocable to the period ($2,000)

offset with the bond premium allocable to the

period ($870.71). For the accrual period

ending on March 1, 2001, the bond premium

allocable to the accrual period ($958.81)

exceeds the qualified stated interest allocable

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

have interest income for this accrual period.

However, under § 1.171–2(a)(4)(i)(A), E may

deduct as bond premium $958.81, the excess

of the bond premium allocable to the accrual

period ($958.81) over the qualified stated

interest allocable to the accrual period ($0).

For the accrual period ending on March 1,

2002, the bond premium allocable to the

accrual period ($1,055.82) exceeds the

qualified stated interest allocable to the

accrual period ($0) and, therefore, E does not

have interest income for the accrual period.

Under § 1.171–2(a)(4)(i)(A), E’s deduction for

bond premium for the accrual period is

limited to $170.48, the excess of E’s total

interest inclusions on the bond in prior

accrual periods ($1,129.29) over the total

amount treated by E as a bond premium

deduction in prior accrual periods ($958.81).

Under § 1.171–2(a)(4)(i)(B), E must carry

forward the remaining $885.34 of bond

premium allocable to the period ending

March 1, 2002, and treat it as bond premium

allocable to the period ending March 1, 2003.

The amount E includes in income for each

accrual period is shown in the following

schedule:

Accrual period ending

Qualified

stated

interest

Premium allocable

to accrual

period

Interest

income

Premium

deduction

Premium

carryforward

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

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

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

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

3/1/04 ........................................................................................................ 8,000.00 1,280.27 6,719.73 .................... ....................

3/1/05 ........................................................................................................ 12,000.00 1,409.80 10,590.20 .................... ....................

3/1/06 ........................................................................................................ 15,000.00 1,552.44 13,447.56 .................... ....................

3/1/07 ........................................................................................................ 8,500.00 1,709.51 6,790.49

.................... 10,000.00 .................... .................... ....................

Example 2. Partial call that results in a

pro-rata prepayment—(i) Facts. On April 1,

1999, M purchases for $110,000 N’s taxable

bond maturing on April 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The bond provides for

unconditional payments of interest of

$10,000, payable on April 1 of each year. N

has the option to call all or part of the bond

on April 1, 2001, at a 5 percent premium over

the principal amount. M uses the cash

receipts and disbursements method of

accounting.

(ii) Determination of yield and the

remaining payment schedule. M’s yield

determined without regard to the call option

is 8.07 percent, compounded annually. M’s

yield determined by assuming N exercises its

call option is 6.89 percent, compounded

annually. Under paragraph (c)(4)(ii)(A) of this

section, it is assumed N will not exercise the

call option because exercising the option

would minimize M’s yield. Thus, for

purposes of determining and amortizing
68182 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations

bond premium, the bond is assumed to be a

seven-year bond with a single principal

payment at maturity of $100,000.

(iii) Amount of bond premium. The interest

payments on the bond are qualified stated

interest. Therefore, the sum of all amounts

payable on the bond (other than the interest

payments) is $100,000. Under § 1.171–1, the

amount of bond premium is $10,000

($110,000¥$100,000).

(iv) Bond premium allocable to the first

two accrual periods. For the accrual period

ending on April 1, 2000, M includes in

income $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

period ($1,118.17). The adjusted acquisition

price on April 1, 2000, is $108,881.83

($110,000¥$1,118.17). For the accrual period

ending on April 1, 2001, M includes in

income $8,791.54, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

period ($1,208.46). The adjusted acquisition

price on April 1, 2001, is $107,673.37

($108,881.83¥$1,208.46).

(v) Partial call. Assume N calls one-half of

M’s bond for $52,500 on April 1, 2001.

Because it was assumed the call would not

be exercised, the call is a change in

circumstances. However, the partial call is

also a pro-rata prepayment within the

meaning of § 1.1275–2(f)(2). As a result, the

call is treated as a retirement of one-half of

the bond. Under paragraph (c)(5)(ii) of this

section, M may deduct $1,336.68, the excess

of its adjusted acquisition price in the retired

portion of the bond ($107,673.37/2, or

$53,836.68) over the amount received on

redemption ($52,500). M’s adjusted basis in

the portion of the bond that remains

outstanding is $53,836.68

($107,673.37¥$53,836.68).

§ 1.171–4 Election to amortize bond

premium on taxable bonds.

(a) Time and manner of making the

election—(1) In general. A holder makes

the election to amortize bond premium

by offsetting interest income with bond

premium in the holder’s timely filed

federal income tax return for the first

taxable year to which the holder desires

the election to apply. The holder should

attach to the return a statement that the

holder is making the election under this

section.

(2) Coordination with OID election. If

a holder makes an election under

§ 1.1272–3 for a bond with bond

premium, the holder is deemed to have

made the election under this section.

(b) Scope of election. The election

under this section applies to all taxable

bonds held during or after the taxable

year for which the election is made.

(c) Election to amortize made in a

subsequent taxable year—(1) In general.

If a holder elects to amortize bond

premium and holds a taxable bond

acquired before the taxable year for

which the election is made, the holder

may not amortize amounts that would

have been amortized in prior taxable

years had an election been in effect for

those prior years.

(2) Example. The following example

illustrates the rule of this paragraph (c):

Example—(i) Facts. On May 1, 1999, C

purchases for $130,000 a taxable bond

maturing on May 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The bond provides for

unconditional payments of interest of

$15,000, payable on May 1 of each year. C

uses the cash receipts and disbursements

method of accounting and the calendar year

as its taxable year. C has not previously

elected to amortize bond premium, but does

so for 2002.

(ii) Amount to amortize. C’s basis for

determining loss on the sale or exchange of

the bond is $130,000. Thus, under § 1.171–

1, the amount of bond premium is $30,000.

Under § 1.171–2, if a bond premium election

were in effect for the prior taxable years, C

would have amortized $3,257.44 of bond

premium on May 1, 2000, and $3,551.68 of

bond premium on May 1, 2001, based on

annual accrual periods ending on May 1.

Thus, for 2002 and future years to which the

election applies, C may amortize only

$23,190.88 ($30,000¥$3,257.44¥$3,551.68).

(d) Revocation of election. The

election under this section may not be

revoked unless approved by the

Commissioner. Because a revocation of

the election is a change in accounting

method, a taxpayer must follow the

rules under § 1.446–1(e)(3)(i) to request

the Commissioner’s consent to revoke

the election. A revocation of the election

applies to all taxable bonds held during

or after the taxable year for which the

revocation is effective. The holder may

not amortize any remaining bond

premium on bonds held at the

beginning of the taxable year for which

the revocation is effective. Therefore, no

adjustment under section 481 is allowed

upon the revocation of the election

because no items of income or

deduction are omitted or duplicated.

Par. 5. Section 1.171–5 is added to

read as follows:

§ 1.171–5 Effective date and transition

rules.

(a) Effective date—(1) In general.

Sections 1.171–1 through 1.171–4 apply

to bonds acquired on or after March 2,

1998. However, if a holder makes the

election under § 1.171–4 for the taxable

year containing March 2, 1998, or any

subsequent taxable year, §§ 1.171–1

through 1.171–4 apply to bonds held on

or after the first day of the taxable year

in which the election is made.

(2) Transition rule for use of constant

yield. Notwithstanding paragraph (a)(1)

of this section, § 1.171–2(a)(3)

(providing that the bond premium

allocable to an accrual period is

determined with reference to a constant

yield) does not apply to a bond issued

before September 28, 1985.

(b) Coordination with existing

election. A holder is deemed to have

made the election under § 1.171–4 for

the taxable year containing March 2,

1998, if the holder elected to amortize

bond premium under section 171 and

that election is effective on March 2,

1998. If the holder is deemed to have

made the election under § 1.171–4 for

the taxable year containing March 2,

1998, §§ 1.171–1 through 1.171–4 apply

to bonds acquired on or after the first

day of that taxable year. See § 1.171–

4(d) for rules relating to a revocation of

an election under section 171.

(c) Accounting method changes—(1)

Consent to change. A holder required to

change its method of accounting for

bond premium to comply with

§§ 1.171–1 through 1.171–3 must secure

the consent of the Commissioner in

accordance with the requirements of

§ 1.446–1(e). Paragraph (c)(2) of this

section provides the Commissioner’s

automatic consent for certain changes. A

holder making the election under

§ 1.171–4 does not need the

Commissioner’s consent to make the

election.

(2) Automatic consent. The

Commissioner grants consent for a

holder to change its method of

accounting for bond premium with

respect to taxable bonds to which

§§ 1.171–1 through 1.171–3 apply.

Because this change is made on a cutoff basis, no items of income or

deduction are omitted or duplicated

and, therefore, no adjustment under

section 481 is allowed. The consent

granted by this paragraph (c)(2) applies

provided—

(i) The holder elected to amortize

bond premium under section 171 for a

taxable year prior to the taxable year

containing March 2, 1998, and that

election has not been revoked;

(ii) The change is made for the first

taxable year for which the holder must

account for a bond under §§ 1.171–1

through 1.171–3; and

(iii) The holder attaches to its return

for the taxable year containing the

change a statement that it has changed

its method of accounting under this

section.

Par. 6. Section 1.249–1 is amended by

revising paragraph (c) and the first

sentence of paragraph (d)(2) to read as

follows:

§ 1.249–1 Limitation on deduction of bond

premium on repurchase.

* * * * *

(c) Repurchase premium. For

purposes of this section, the term

repurchase premium means the excess
Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68183

of the repurchase price paid or incurred

to repurchase the obligation over its

adjusted issue price (within the

meaning of § 1.1275–1(b)) as of the

repurchase date. For the general rules

applicable to the deductibility of

repurchase premium, see § 1.163–7(c).

This paragraph (c) applies to convertible

obligations repurchased on or after

March 2, 1998.

(d) * * *

(2) * * * For a convertible obligation

repurchased on or after March 2, 1998,

a call premium specified in dollars

under the terms of the obligation is

considered to be a normal call premium

on a nonconvertible obligation if the call

premium applicable when the

obligation is repurchased does not

exceed an amount equal to the interest

(including original issue discount) that

otherwise would be deductible for the

taxable year of repurchase (determined

as if the obligation were not

repurchased). * * *

* * * * *

Par. 7. Section 1.1016–5 is amended

by revising paragraph (b) to read as

follows:

§ 1.1016–5 Miscellaneous adjustments to

basis.

* * * * *

(b) Amortizable bond premium—(1)

In general. A holder’s basis in a bond is

reduced by the amount of bond

premium used to offset qualified stated

interest income under § 1.171–2. This

reduction occurs when the holder takes

the qualified stated interest into account

under the holder’s regular method of

accounting.

(2) Special rules for taxable bonds. A

holder’s basis in a taxable bond is

reduced by the amount of bond

premium allowed as a deduction under

§ 1.171–3(c)(5)(ii) (relating to the

issuer’s call of a taxable bond) or under

§ 1.171–2(a)(4)(i)(A) (relating to excess

bond premium).

(3) Special rule for tax-exempt

obligations. A holder’s basis in a taxexempt obligation is reduced by the

amount of excess bond premium that is

treated as a nondeductible loss under

§ 1.171–2(a)(4)(ii).

* * * * *

§ 1.1016–9 [Removed]

Par. 8. Section 1.1016–9 is removed.

Par. 9. Section 1.1275–1 is amended

by:

1. Redesignating paragraph (b)(2) as

paragraph (b)(3).

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

The addition reads as follows:

§ 1.1275–1 Definitions.

* * * * *

(b) * * *

(2) Bond issuance premium. If a debt

instrument is issued with bond issuance

premium (as defined in § 1.163–13(c)),

for purposes of determining the issuer’s

adjusted issue price, the adjusted issue

price determined under paragraph (b)(1)

of this section is also decreased by the

amount of bond issuance premium

previously allocable under § 1.163–

13(d)(3).

* * * * *

PART 602—OMB CONTROL NUMBERS

UNDER THE PAPERWORK

REDUCTION ACT

Par. 10. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 11. Section 602.101, paragraph

(c) is amended by:

1. Removing the following entry from

the table:

§ 602.101 OMB Control numbers.

* * * * *

(c) * * *

CFR part or section where

identified and described

Current

OMB control No.

* * * * *

1.171–3 ..................................... 1545–0172

* * * * *

2. Adding entries in numerical order

to the table to read as follows:

§ 602.101 OMB Control numbers.

* * * * *

(c) * * *

CFR part or section where

identified and described

Current

OMB control No.

* * * * *

1.163–13 ................................... 1545–1491

* * * * *

1.171–4 ..................................... 1545–1491

1.171–5 ..................................... 1545–1491

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Approved: December 15, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

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

BILLING CODE 4830–01–P

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 20 and 25

[TD 8744]

RIN 1545–AR52

Disclaimer of Interests and Powers

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the treatment of

disclaimers for estate and gift tax

purposes. The regulations clarify certain

provisions governing the disclaimer of

property interests and powers and, in

addition, conform the regulations to

court decisions holding the current

regulation invalid with respect to the

disclaimer of joint property interests.

The final regulations will affect persons

who disclaim property interests,

powers, or interests in jointly owned

property.

DATES: Effective date:

The final regulations are effective

December 31, 1997.

Applicability dates: The amendments

to §§ 25.2518–1(a) and 25.2518–2(c)(3)

(substituting the statutory language in

section 2518(b)(2)(A) ‘‘transfer creating

the interest,’’ for ‘‘taxable transfer’’) and

conforming changes to §§ 20.2041–

3(d)(6)(i), 20.2046–1, 20.2056(d)–2(a)

and (b), 25.2511–1(c)(1), 25.2514–

3(c)(5), are applicable for transfers

creating the interest or power to be

disclaimed made on or after December

31, 1997. The amendments to

§ 25.2518–2(c)(4) (relating to the

disclaimer of joint property and bank

accounts) are applicable for disclaimers

made on or after December 31, 1997.

FOR FURTHER INFORMATION CONTACT:

James F. Hogan (202) 622–3090 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On August 21, 1996, the IRS

published in the Federal Register (61

FR 43197) a notice of proposed

rulemaking (REG–208216–91) amending

the regulations under section 2518. The

IRS received comments on the proposed

regulations; however, no request for a

public hearing was received so no

public hearing was held. This document

adopts final regulations with respect to

this notice of proposed rulemaking.

The proposed regulations substituted

the statutory language of section

2518(b)(2)(A), ‘‘transfer creating the

interest,’’ for ‘‘taxable transfer’’ as the