Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30133

DEPARTMENT OF HEALTH AND

HUMAN SERVICES

Food and Drug Administration

21 CFR Part 558

New Animal Drugs For Use In Animal

Feeds; Virginiamycin

AGENCY: Food and Drug Administration,

HHS.

ACTION: Final rule.

SUMMARY: The Food and Drug

Administration (FDA) is amending the

animal drug regulations to reflect

approval of a supplemental new animal

drug application (NADA) filed by Pfizer

Inc. The supplement provides for use of

a 30% virginiamycin formulation of a

Type A medicated article to be used for

the manufacture of Type C medicated

feeds for cattle fed in confinement for

slaughter.

EFFECTIVE DATE: June 14, 1996.

FOR FURTHER INFORMATION CONTACT:

Russell G. Arnold, Center for Veterinary

Medicine (HFV–142), Food and Drug

Administration, 7500 Standish Pl.,

Rockville, MD 20855, 301–594–1674.

SUPPLEMENTARY INFORMATION: Pfizer Inc.,

235 East 42d St., New York, NY 10017,

filed a supplement to NADA 140–998

which provided for use of a 30%

virginiamycin Type A medicated article

formulation to be used in a microingredient production process for the

preparation of Type C medicated feeds

for cattle fed in confinement for

slaughter. The Type C medicated feed is

fed at 11 to 16 grams per ton (g/t) for

improved feed efficiency, 13.5 to 16 g/

t for reduction of incidence of liver

abscesses, and 16 to 22.5 g/t for

increased rate of weight gain. The feed

is not for animals intended for breeding.

The supplement is approved as of May

3, 1996, and the regulations are

amended in 21 CFR 558.635(b) to reflect

the approval.

Approval of this supplement does not

require submission of new safety or

effectiveness data. The supplement

provides for use of an additional level

of Type A medicated article to make a

Type C medicated feed fed at previously

approved levels and for previously

approved conditions of use.

The agency has determined under 21

CFR 25.24(d)(1)(iii) that this action is of

a type that does not individually or

cumulatively have a significant effect on

the human environment. Therefore,

neither an environmental assessment

nor an environmental impact statement

is required.

Under section 512(c)(2)(F)(iii) of the

Federal Food, Drug, and Cosmetic Act

(21 U.S.C. 360b(c)(2)(F)(iii)), this

approval does not qualify for marketing

exclusivity because reports of new

clinical or field investigations (other

than bioequivalence or residue studies)

and, in the case of food producing

animals, human food safety studies

(other than bioequivalence or residue

studies) essential to the approval and

conducted or sponsored by the

applicant were not required.

List of Subjects in 21 CFR Part 558

Animal drugs, Animal feeds.

Therefore, under the Federal Food,

Drug, and Cosmetic Act and under

authority delegated to the Commissioner

of Food and Drugs and redelegated to

the Center for Veterinary Medicine, 21

CFR part 558 is amended as follows:

PART 558—NEW ANIMAL DRUGS FOR

USE IN ANIMAL FEEDS

1. The authority citation for 21 CFR

part 558 continues to read as follows:

Authority: Secs. 512, 701 of the Federal

Food, Drug, and Cosmetic Act (21 U.S.C.

360b, 371).

§ 558.635 [Amended]

2. Section 558.635 Virginiamycin is

amended in paragraph (b)(1) by

removing ‘‘to 000069’’ and by adding in

its place ‘‘used as in paragraph (f) of this

section; and 30 percent activity (136.2

grams per pound) for the manufacture of

Type C medicated feed for cattle used as

in paragraph (f)(3); to 000069’’.

Dated: June 7, 1996.

Andrew J. Beaulieau,

Deputy Director, Office of New Animal Drug

Evaluation, Center for Veterinary Medicine.

[FR Doc. 96–15202 Filed 6–13–96; 8:45 am]

BILLING CODE 4160–01–F

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8674]

RIN 1545–AQ86; 1545–AS35

Debt Instruments With Original Issue

Discount; Contingent Payments; AntiAbuse Rule

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the tax treatment

of debt instruments that provide for one

or more contingent payments. This

document also contains final regulations

that treat a debt instrument and a

related hedge as an integrated

transaction. In addition, this document

contains amendments to the original

issue discount regulations, and finalizes

the anti-abuse rule relating to those

regulations. The final regulations in this

document provide needed guidance to

holders and issuers of contingent

payment debt instruments.

DATES: Except as noted below, the

regulations are effective August 13,

1996. The amendments to § 1.1275–5

are effective June 14, 1996, except for

paragraphs (a)(6), (b)(2), and (c)(1),

which are effective August 13, 1996.

The removal of § 1.483–2T is effective

June 14, 1996. The removal of § 1.1275–

2T is effective August 13, 1996.

For dates of applicability of these

regulations, see Effective Dates under

SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations (other than

§ 1.1275–6), William E. Blanchard, (202)

622–3950, or Jeffrey W. Maddrey, (202)

622–3940; or concerning § 1.1275–6,

Michael S. Novey, (202) 622–3900 (not

toll-free numbers).

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 Paperwork

Reduction Act (44 U.S.C. 3507) under

control number 1545–1450. Responses

to these collections of information are

required to determine a taxpayer’s

interest income or deductions on a

contingent payment debt instrument.

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/recordkeeper varies from .3

hours to .5 hours, depending on

individual circumstances, with an

estimated average of .47 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 the

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
30134 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Background

Section 1275(d) of the Internal

Revenue Code (Code) grants the

Secretary the authority to prescribe

regulations under the original issue

discount (OID) provisions of the Code

(sections 163(e) and 1271 through 1275),

including regulations relating to debt

instruments that provide for contingent

payments. On February 2, 1994, the IRS

published final OID regulations in the

Federal Register (59 FR 4799). However,

the final OID regulations did not contain

rules for contingent payment debt

instruments.

On December 16, 1994, the IRS

published a notice of proposed

rulemaking in the Federal Register (59

FR 62884) relating to the tax treatment

of debt instruments that provide for one

or more contingent payments. The

notice also contained proposed

amendments to the regulations under

sections 483 (relating to unstated

interest), 1001 (relating to the amount

realized on a sale, exchange, or other

disposition of property), 1272 (relating

to the accrual of OID), 1274 (relating to

debt instruments issued for nonpublicly

traded property), and 1275(c) (relating

to OID information reporting

requirements), and to § 1.1275–5

(relating to variable rate debt

instruments). In addition, the notice

contained proposed regulations relating

to the integration of a contingent

payment or variable rate debt

instrument with a related hedge. The

notice withdrew the proposed

regulations relating to contingent

payment debt instruments that were

previously published in the Federal

Register on April 8, 1986 (51 FR 12087),

and February 28, 1991 (56 FR 8308).

On March 16, 1995, the IRS held a

public hearing on the proposed

regulations. In addition, the IRS

received a number of written comments

on the proposed regulations. The

proposed regulations, with certain

changes to respond to comments, are

adopted as final regulations. In addition,

certain clarifying and conforming

amendments are made to the OID

regulations that were published in the

Federal Register on February 2, 1994.

The comments and significant changes

are discussed below.

Explanation of Provisions

Section 1.1275–4 Contingent Payment

Debt Instruments

A. Noncontingent Bond Method

Under the noncontingent bond

method in the proposed regulations, a

taxpayer computes interest accruals on

a contingent payment debt instrument

by setting a payment schedule as of the

issue date and applying the OID rules to

the payment schedule. The payment

schedule consists of all fixed payments

on the debt instrument and a projected

amount for each contingent payment.

For market-based contingencies (i.e.,

contingencies for which price quotes are

readily available), the projected amount

is the forward price of the contingency.

For other contingencies, the issuer first

determines a reasonable yield for the

debt instrument and then sets projected

amounts equal to the relative expected

payments on the contingencies so that

the payment schedule produces the

reasonable yield. These rules were

designed to produce a yield similar to

the yield the issuer would obtain on a

fixed rate debt instrument.

Commentators suggested that the

regulations could be simplified if they

used the same basic methodology for

both market-based and non-marketbased contingencies. In addition,

commentators suggested that forward

price quotes would be variable or

manipulable and that taxpayers will set

more appropriate payment schedules if

they first determine yield and then set

the payment schedule to fit the yield.

The final regulations adopt these

suggestions and generally conform the

treatment of debt instruments that

provide for either market-based or nonmarket-based contingent payments.

Thus, for any contingent payment debt

instrument subject to the noncontingent

bond method, a taxpayer first

determines the yield on the instrument

and then sets the payment schedule to

fit the yield. The yield is determined by

the yield at which the issuer would

issue a fixed rate debt instrument with

terms and conditions similar to the

contingent payment debt instrument

(the comparable yield). Relevant terms

and conditions include the level of

subordination, term, timing of

payments, and general market

conditions. For example, if a hedge is

available such that the issuer or holder

could integrate the debt instrument and

the hedge into a synthetic fixed-rate

debt instrument under the rules of

§ 1.1275–6, the comparable yield is the

yield that the synthetic fixed-rate debt

instrument would have. If a § 1.1275–6

hedge (or the substantial equivalent) is

not available, but similar fixed rate debt

instruments of the issuer trade at a price

that reflects a spread above a benchmark

rate, the comparable yield is the sum of

the value of the benchmark rate on the

issue date and the spread. In all cases,

the yield must be a reasonable yield for

the issuer and may not be less than the

applicable Federal rate (AFR).

Once the comparable yield is

determined, the payment schedule is set

to produce the comparable yield. The

final regulations retain the general

approach of the proposed regulations in

determining the payment schedule.

Thus, for market-based payments, the

projected payment is the forward price

of the payment. For non-market-based

payments, the projected payment is the

expected amount of the payment as of

the issue date.

Commentators were concerned that a

taxpayer could overstate the yield on a

contingent payment debt instrument

and, therefore, claim excess interest

deductions during the term of the

instrument. They were particularly

concerned about a long-term debt

instrument that has non-market-based

payments because the taxpayer’s

determination would be hard to verify

and any excess interest deductions

would not be recaptured for a long time.

The final regulations address this

concern by providing that the

comparable yield for a debt instrument

is presumed to be the AFR if the

instrument provides for a non-marketbased payment and is part of an issue

that is marketed or sold in substantial

part to tax-exempt investors or other

investors for whom the treatment of the

debt instrument is not expected to have

a substantial effect on their U.S. tax

liability. A taxpayer may overcome this

presumption only with clear and

convincing evidence that the

comparable yield for the debt

instrument should be a specific yield

that is higher than the AFR. Appraisals

and other valuations of nonpublicly

traded property cannot be used to

overcome the presumption, nor can

references to general market rates. An

issuer may, for example, overcome the

presumption by showing that recently

issued similar debt instruments of the

issuer trade at a price that reflects a

specific yield.

One commentator suggested that the

use of the term projected payment

schedule caused securities law

problems because the issuer could be

seen as making representations to the

holder about the expected payments.

The comparable yield and projected

payment schedule determined under

these regulations are for tax purposes

only and are not assurances by the
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30135

issuer with respect to the payments. The

final regulations retain the term

projected payment schedule, but an

issuer may use a different term to

describe the payment schedule (e.g.,

payment schedule determined under

§ 1.1275–4) if the language used by the

issuer is clear.

Under the proposed regulations,

projected payments rather than actual

payments are used to determine the

adjusted issue price of a debt

instrument, the holder’s basis in a debt

instrument, and the amount of any

contingent payment treated as made on

the scheduled retirement of a debt

instrument. One commentator

questioned the use of projected

payments to make these determinations.

The approach in the proposed

regulations is appropriate, however,

because a positive or negative

adjustment is used to take into account

the difference between the actual

amount and the projected amount of a

contingent payment. This difference

would be counted twice if the adjusted

issue price, the holder’s basis, and the

amount deemed paid on retirement

were based on the actual amount rather

than the projected amount of a

contingent payment. Thus, the approach

used in the proposed regulations is

retained in the final regulations.

B. Tax-Exempt Obligations

In response to comments, the rules

contained in § 1.1275–4(d) relating to

tax-exempt contingent payment

obligations have been revised. Under

the proposed regulations, tax-exempt

obligations are generally subject to the

noncontingent bond method, with the

following modifications: (1) The yield

on which interest accruals are based

may not exceed the greater of the yield

on the obligation, determined without

regard to the non-market-based

contingent payments, and the taxexempt AFR that applies to the

obligation; (2) Positive adjustments are

treated as gain from the sale or exchange

of the obligation rather than as interest;

and (3) Negative adjustments reduce the

amount of tax-exempt interest, and,

therefore, are generally not taken into

account as deductible losses. These

modifications to the noncontingent

bond method for tax-exempt obligations

were added because the IRS and

Treasury believe that when a property

right is embedded in a tax-exempt

obligation it is generally inappropriate

to treat payments on the right as interest

on an obligation of a state or political

subdivision.

Several commentators suggested that

the proposed regulations relating to taxexempt obligations are overly

restrictive. These commentators

questioned the reason for limiting the

rate of accrual to the tax-exempt AFR

and characterizing positive adjustments

as taxable gain rather than interest. They

also questioned the fairness of treating

negative adjustments as nondeductible

adjustments to tax-exempt interest when

positive adjustments are treated as

taxable gain. Some of the commentators

suggested that, at a minimum, the

interest limitations should not apply to

contingent obligations that pay interest

based on interest rate formulas that

reflect the cost of funds rather than

changes in the value of embedded

property rights. Finally, commentators

noted that programs involving

municipal refinancings of real estate

projects (for example, low-income

multi-family housing projects) would be

jeopardized by the proposed regulations

because payments on tax-exempt

obligations issued to finance these

projects are in certain cases contingent

in part on the revenues or appreciation

in value of the project.

The IRS and Treasury continue to

believe that gain from a property right

should not be recharacterized as taxexempt interest merely because the

property right is embedded in a taxexempt obligation. The IRS and

Treasury nevertheless recognize that

certain types of traditional tax-exempt

financings should not be subject to the

interest limitations of the proposed

regulations (e.g., financings on which

interest is computed in a manner that

relates to the cost of funds).

Accordingly, § 1.1275–4(d) has been

revised to include a category of taxexempt obligations that will be subject

to the noncontingent bond method

without the tax-exempt interest

limitations contained in the proposed

regulations. This category of tax-exempt

obligations includes (1) obligations that

would qualify as variable rate debt

instruments (VRDIs) except for the

failure to meet certain of the technical

requirements of the VRDI definition

(such as the cap and floor limitations, or

the requirement that interest be paid or

compounded at least annually), and (2)

certain obligations issued to refinance

an obligation, the proceeds of which

were used to finance a project.

For other tax-exempt obligations, the

interest restrictions of the proposed

regulations are adopted in final form.

Section 1.1275–4(d) has been revised,

however, to provide that a negative

adjustment is treated as a taxable loss

from the sale or exchange of the

obligation, rather than as a

nondeductible adjustment to tax-exempt

interest.

C. Prepaid Tuition Plans

A number of commentators asked

whether contracts issued under statesponsored prepaid tuition plans are

subject to § 1.1275–4. Although the

terms of the contracts vary, the contracts

generally are issued pursuant to a plan

created by a state to enable the

participants in the plan to save for postsecondary education for themselves or

other designated beneficiaries. In

addition, the plans generally provide

protection against increases in the costs

of higher education or otherwise

subsidize these costs, often by providing

for contingent payments that are linked

to the future costs of post-secondary

education.

The commentators argue that

§ 1.1275–4 does not apply to the

contracts because the contracts are not

debt instruments for federal income tax

purposes. In addition, the commentators

argue that, even if the contracts are debt

instruments, the noncontingent bond

method would be unduly burdensome

and inappropriate for contracts of this

type.

The final regulations under § 1.1275–

4 do not affect the treatment of contracts

issued pursuant to state-sponsored

prepaid tuition plans, whether or not

the contracts are debt instruments. The

final regulations, like the proposed

regulations, only apply to debt

instruments. Thus, the final regulations

do not apply to contracts issued

pursuant to a plan created by a state to

enable participants to save for postsecondary education if the contracts are

not debt instruments. In addition, the

final regulations provide an exception

for any debt instrument issued pursuant

to a state-sponsored prepaid tuition

plan.

This exception applies to a contract

issued pursuant to a plan or

arrangement if: The plan or arrangement

is created by a state statute; the plan or

arrangement has a primary objective of

enabling the participants to pay for the

costs of post-secondary education for

themselves or their designated

beneficiaries; and the contingencies

under the contract are related to such

purpose. These characteristics are

intended to describe all existing statesponsored prepaid tuition plans.

Therefore, the final regulations do not

change the tax treatment of a contract

issued pursuant to these plans. As a

result, if the contract is a debt

instrument, the contingent payments on

the contract are not taken into account

by an individual until the payments are

made.

The exception in the final regulations

is intended to apply only to the existing
30136 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

state-sponsored prepaid tuition plans

and to any future plans that are

substantially similar to the existing

plans. In addition, no inference is

intended as to whether contracts issued

by any state-sponsored prepaid tuition

plan are debt instruments.

D. Debt Instruments Subject to Section

1274

The proposed regulations provide a

method for contingent payment debt

instruments not subject to the

noncontingent bond method (i.e., a

nonpublicly traded debt instrument

issued in a sale or exchange of

nonpublicly traded property). Under the

method, a debt instrument’s

noncontingent payments are treated as a

separate debt instrument, which is

generally taxed under the rules for

noncontingent debt instruments. The

debt instrument’s contingent payments

are taken into account when made. A

portion of each contingent payment is

treated as principal, based on the

amount determined by discounting the

payment at the AFR from the payment

date to the issue date, and the remainder

is treated as interest. Special rules are

provided if a contingent payment

becomes fixed more than 6 months

before it is due.

The final regulations generally adopt

the method in the proposed regulations.

In addition, the final regulations contain

rules for a holder whose basis in a debt

instrument is different from the

instrument’s adjusted issue price (e.g., a

subsequent holder).

E. Inflation-Indexed Bonds

The Treasury recently announced that

it was considering issuing bonds

indexed to inflation (61 FR 25164).

Depending on their ultimate structure,

the noncontingent bond method might

be inappropriate for these bonds. If the

Treasury issues these bonds, the

Treasury and IRS may issue regulations

to provide a simplified tax treatment for

the bonds. The treatment would require

current accrual of the inflation

component.

Other Amendments to the OID

Regulations

A. Alternative Payment Schedules

Under § 1.1272–1(c)

Section 1.1272–1(c) provides rules to

determine the yield and maturity of

certain debt instruments that provide for

one or more alternative payment

schedules applicable upon the

occurrence of a contingency (or

contingencies), provided that the timing

and amounts of the payments that

comprise each payment schedule are

known as of the issue date. Under these

rules, the yield and maturity of a debt

instrument are generally determined by

assuming that the payments will be

made under the payment schedule most

likely to occur (based on all the facts

and circumstances as of the issue date).

Special rules are provided for

unconditional options and mandatory

sinking funds.

The general rules in § 1.1272–1(c)

produce a reasonable result when a debt

instrument has one stated payment

schedule that is very likely to occur and

one or more alternative payment

schedules that are unlikely to occur. In

this case, adherence to the stated

payment schedule will result in accruals

on the debt instrument that reasonably

reflect the expected return on the

instrument. The rules can lead to

unreasonable results, however, if a debt

instrument provides for a stated

payment schedule and one or more

alternative payment schedules that

differ significantly and that have a

comparable likelihood of occurring. In

this case, the accruals based on the

payment schedule identified as most

likely to occur could differ significantly

from the expected return on the debt

instrument, which would reflect all the

payment schedules and their relative

probabilities of occurrence.

Because the general rules of § 1.1272–

1(c) could produce unreasonable results,

these rules have been modified. Under

the final regulations, if a single payment

schedule is significantly more likely

than not to occur, the yield and maturity

of the debt instrument are calculated

based on that payment schedule. As a

result, any other debt instrument that

provides for an alternative payment

schedule (other than because of an

unconditional option or mandatory

sinking fund) will generally be subject

to the rules in § 1.1275–4 for contingent

payment debt instruments. The final

regulations generally retain the rules for

mandatory sinking funds and

unconditional options.

B. Remote and Incidental Contingencies

The proposed regulations provide that

a payment subject to a remote or

incidental contingency is not

considered a contingent payment for

purposes of § 1.1275–4. In response to a

comment, the rule relating to remote

and incidental contingencies has been

broadened, through the addition of new

§ 1.1275–2(h), to provide that remote

and incidental contingencies are

generally ignored for purposes of

sections 163(e) (other than section

163(e)(5)) and 1271 through 1275 and

the regulations thereunder. Thus, for

example, if an otherwise fixed payment

debt instrument provides for an

additional payment that will be made

upon the occurrence of a contingency

and there is a remote likelihood that the

contingency will occur, the contingent

payment is ignored for purposes of

computing OID accruals on the

instrument. If the contingency occurs,

however, then, solely for purposes of

sections 1272 and 1273, the debt

instrument is treated as reissued.

Therefore, OID on the debt instrument

is redetermined.

C. Definition of Qualified Stated Interest

The addition of the rules for remote

or incidental contingencies and the

changes to the rules for alternative

payment schedules allow simplification

of the definition of qualified stated

interest. Under § 1.1273–1(c), as

published in the Federal Register on

February 2, 1994, qualified stated

interest must be unconditionally

payable in cash or property at least

annually at a single fixed rate. Interest

is unconditionally payable only if late

payment (other than a late payment that

occurs within a reasonable grace period)

or nonpayment is expected to be

penalized or reasonable remedies exist

to compel payment.

This definition of unconditionally

payable can be read to conflict with the

alternative payment schedule rules. For

example, if a debt instrument has two

alternative payment schedules, one

schedule can be stated as the required

payment schedule and the other

schedule can be stated as a penalty if

the required payments are not made.

The required payments might then be

treated as unconditionally payable and,

therefore, as being qualified stated

interest even if they would not be

qualified stated interest if treated under

the alternative payment schedule rules.

Under this treatment, if a payment is not

made, the reissuance rules of the

alternative payment schedule regime do

not apply. Holders can thus argue that

no OID would accrue with respect to the

debt instrument even though OID would

accrue if the instrument were treated as

having an alternative payment schedule

and holders fully expect any unmade

payment to be made in the future.

The remote or incidental rules in

§ 1.1275–2(h) provide a better

mechanism for determining whether a

payment is qualified stated interest and

determining the treatment if no payment

is made. Thus, the final regulations

modify the definition of unconditionally

payable so that interest is

unconditionally payable only if

reasonable legal remedies exist to

compel payment or the debt instrument

otherwise provides terms and
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30137

conditions that make the likelihood of

late payment (other than a late payment

that occurs within a reasonable grace

period) or nonpayment remote. If the

payment is not made (other than

because of insolvency, default, or

similar circumstances), the final

regulations require a deemed reissuance

for OID purposes, which ensures that

OID will accrue. This approach should

simplify the treatment of many debt

instruments and yet ensure that OID

accrues in appropriate circumstances.

D. OID Anti-Abuse Rule

On February 2, 1994, the IRS

published in the Federal Register

temporary and proposed regulations

that contained an anti-abuse rule for

purposes of the OID regulations

(§ 1.1275–2T (59 FR 4831); § 1.1275–2(g)

(59 FR 4878)). Under the anti-abuse

rule, the Commissioner can apply or

depart from the regulations under

section 163(e) or sections 1271 through

1275 as necessary to achieve a

reasonable result if a principal purpose

in structuring a debt instrument or

engaging in a transaction is to achieve

a result under the regulations that is

unreasonable in light of the applicable

statutes. This rule is adopted as a final

regulation with some clarifying changes

and the addition of an example to

illustrate its application to certain

contingent payment debt instruments.

E. Determination of Issue Price Under

Section 1274

Under the proposed regulations, the

issue price of a contingent payment debt

instrument that is subject to section

1274 (i.e., a debt instrument issued in

exchange for nonpublicly traded

property) is determined without taking

into account the instrument’s contingent

payments. Thus, the issue price of the

debt instrument (and the buyer’s initial

basis in the property) is limited to an

amount determined by taking into

account only the noncontingent

payments. The buyer’s basis in the

property, however, is increased by the

amount of a contingent payment treated

as principal. This approach was adopted

primarily because it is inappropriate to

allow a buyer a basis in property that

reflects anticipated contingent payments

that are uncertain in amount. In

addition, this approach limits the ability

of the buyer to overstate interest

deductions over the term of the debt

instrument. The approach of the

proposed regulations has been adopted

in the final regulations for taxable debt

instruments subject to section 1274. See

§ 1.1274–2(g).

It is not appropriate, however, to

apply this approach to tax-exempt

contingent payment obligations subject

to section 1274. Because the present

value of projected contingent payments

generally is not included in the issue

price of a taxable debt instrument

subject to section 1274, the instrument

is accounted for under § 1.1275–4(c).

This regime is not appropriate for taxexempt obligations because it does not

distinguish between tax-exempt interest

and gain attributable to an embedded

property right. Thus, in order to permit

tax-exempt obligations to be subject to

the noncontingent bond method under

§ 1.1275–4(b), the final regulations

provide special rules to determine the

issue price of a tax-exempt contingent

payment obligation subject to section

1274.

Under these rules, the issue price of

a tax-exempt contingent payment

obligation subject to section 1274 is

equal to the fair market value of the

obligation on the issue date (or, in the

case of an obligation that provides for

interest-based or revenue-based

payments, the greater of the obligation’s

fair market value or stated principal

amount). In addition, the obligation is

subject to the rules of § 1.1275–4(d) (the

noncontingent bond method for taxexempt contingent payment obligations)

rather than § 1.1275–4(c). However, to

ensure that the buyer’s basis is the same

as if the buyer had issued a taxable debt

instrument, the final regulations limit

the buyer’s basis to the present value of

the fixed payments.

Section 1.1275–6 Integration Rules

Commentators generally approved of

the integration rules in the proposed

regulations, and those rules are adopted

with only two significant changes.

First, the final regulations allow (but

do not require) the integration of a

hedge with a fixed rate debt instrument.

For example, a taxpayer may integrate a

fixed rate debt instrument and a swap

into a VRDI. Although the hedging

transaction regulations (§ 1.446–4) cover

many of these transactions, the

integration rules provide more certain

treatment. The final regulations,

however, do not allow the

Commissioner to integrate a hedge with

either a fixed rate debt instrument or a

VRDI that provides for interest at a

qualified floating rate. In these cases,

treating the hedge and the debt

instrument separately is a longstanding

rule that generally clearly reflects

income.

Second, in limited circumstances, the

final regulations allow a hedge to be

entered into prior to the date the

taxpayer issues or acquires the debt

instrument. In these circumstances,

however, the taxpayer must identify the

hedge as part of an integrated

transaction on the day the hedge is

entered into by the taxpayer. Under the

final regulations, if the hedging

transaction has not yet had any cash

flows (including amounts paid to enter

into or purchase the hedge), the

integration rules work appropriately so

that any built-in gain or loss on the

hedge at the time of integration is

included over the term of the synthetic

debt instrument. Thus, the final

regulations put no restriction on the

time the hedging transaction has to be

entered into in this case. If there have

been cash flows on the hedge, the final

regulations require the hedge to be

entered into no earlier than a date that

is substantially contemporaneous with

the date on which the debt instrument

is acquired. This approach should allow

commercially reasonable transactions to

be integrated without the need to create

complex rules to determine the

treatment of prior cash flows on the

hedging transaction.

The rules for remote and incidental

contingencies in § 1.1275–2(h) apply for

purposes of the integration rules. Thus,

if there is an incidental mismatch

between a § 1.1275–6 hedge and a

qualifying debt instrument, a taxpayer

may still integrate the hedge and the

instrument. The mismatch is dealt with

according to the rules for incidental

contingencies.

The final regulations also clarify the

timing of income, deductions, gains,

and losses from a hedge of a contingent

payment debt instrument not subject to

integration. Under § 1.446–4, the

income, deductions, gains, and losses

must match the income, deductions,

gains, and losses from the debt

instrument. The final regulations clarify

that gain or loss realized on a

transaction that hedges a contingent

payment on a debt instrument subject to

§ 1.1275–4(c) is taken into account

when the contingent payment is taken

into account under § 1.1275–4(c). This

treatment does not allow the taxpayer to

change the timing of the income,

deductions, gains, and losses from the

debt instrument.

Effective Dates

In general, the final regulations apply

to debt instruments issued on or after

August 13, 1996. Section 1.1275–6

applies to a qualifying debt instrument

issued on or after August 13, 1996.

Section 1.1275–6 also applies to a

qualifying debt instrument acquired by

the taxpayer on or after August 13, 1996,

if the qualifying debt instrument is a

fixed rate debt instrument or a VRDI or

if the qualifying debt instrument and the

§ 1.1275–6 hedge are acquired by the
30138 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

taxpayer substantially

contemporaneously. Except as

otherwise provided in the regulations,

the changes to § 1.1275–5 apply to debt

instruments issued on or after April 4,

1994.

Debt Instruments Issued Before the

Effective Date of the Final Regulations

For a contingent payment debt

instrument issued before August 13,

1996, a taxpayer may use any reasonable

method to account for the debt

instrument, including a method that

would have been required under the

proposed regulations when the debt

instrument was issued. However, unless

§ 1.1275–6 applies to the debt

instrument, integration is not a

reasonable method to account for the

instrument.

Consent To Change Accounting Method

The Commissioner grants consent for

a taxpayer to change its method of

accounting to follow the final

regulations in this document. This

consent is granted, however, only for a

change for the first taxable year in

which the taxpayer must account for a

debt instrument under the final

regulations. The change is made on a

cut-off basis (i.e., the new method only

applies to debt instruments issued on or

after August 13, 1996. Therefore, no

items of income or deduction are

omitted or duplicated, and no

adjustment under section 481 is

allowed.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory

assessment is not required. It also has

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and,

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these regulations was

submitted to the Small Business

Administration for comment on its

impact on small business.

Drafting Information

Several persons from the Office of

Chief Counsel and the Treasury

Department, including Andrew C.

Kittler, formerly of the Office of the

Assistant Chief Counsel (Financial

Institutions and Products), participated

in developing 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 removing the

entry for § 1.1275–2T and adding two

entries in numerical order to read as

follows:

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

Section 1.483–4 also issued under 26 U.S.C.

483(f). * * *

Section 1.1275–6 also issued under 26 U.S.C.

1275(d). * * *

Par. 2. Section 1.163–7 is amended by

adding a sentence at the end of

paragraph (a) to read as follows:

§ 1.163–7 Deduction for OID on certain

debt instruments.

(a) * * * To determine the amount of

interest (OID) that is deductible each

year on a debt instrument that provides

for contingent payments, see § 1.1275–4.

* * * * *

Par. 3. Section 1.446–4 is amended

by:

1. Redesignating paragraphs (a)(2)(ii)

and (a)(2)(iii) as paragraphs (a)(2)(iii)

and (a)(2)(iv), respectively.

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

3. Adding a sentence at the end of

paragraph (e)(4).

The additions read as follows:

§ 1.446–4 Hedging transactions.

(a) * * *

(2) * * *

(ii) An integrated transaction subject

to § 1.1275–6;

* * * * *

(e) * * *

(4) * * * Similarly, gain or loss

realized on a transaction that hedges a

contingent payment on a debt

instrument subject to § 1.1275–4(c) (a

contingent payment debt instrument

issued for nonpublicly traded property)

is taken into account when the

contingent payment is taken into

account under § 1.1275–4(c).

* * * * *

§ 1.483–2T [Removed]

Par. 4. Section 1.483–2T is removed

effective June 14, 1996.

Par. 5. Section 1.483–4 is added to

read as follows:

§ 1.483–4 Contingent payments.

(a) In general. This section applies to

a contract for the sale or exchange of

property (the overall contract) if the

contract provides for one or more

contingent payments and the contract is

subject to section 483. This section

applies even if the contract provides for

adequate stated interest under § 1.483–

2. If this section applies to a contract,

interest under the contract is generally

computed and accounted for using rules

similar to those that would apply if the

contract were a debt instrument subject

to § 1.1275–4(c). Consequently, all

noncontingent payments under the

overall contract are treated as if made

under a separate contract, and interest

accruals on this separate contract are

computed under rules similar to those

contained in § 1.1275–4(c)(3). Each

contingent payment under the overall

contract is characterized as principal

and interest under rules similar to those

contained in § 1.1275–4(c)(4). However,

any interest, or amount treated as

interest, on a contract subject to this

section is taken into account by a

taxpayer under the taxpayer’s regular

method of accounting (e.g., an accrual

method or the cash receipts and

disbursements method).

(b) Examples. The following examples

illustrate the provisions of paragraph (a)

of this section:

Example 1. Deferred payment sale with

contingent interest—(i) Facts. On December

31, 1996, A sells depreciable personal

property to B. As consideration for the sale,

B issues to A a debt instrument with a

maturity date of December 31, 2001. The debt

instrument provides for a principal payment

of $200,000 on the maturity date, and a

payment of interest on December 31 of each

year, beginning in 1997, equal to a percentage

of the total gross income derived from the

property in that year. However, the total

interest payable on the debt instrument over

its entire term is limited to a maximum of

$50,000. Assume that on December 31, 1996,

the short-term applicable Federal rate is 4

percent, compounded annually, and the midterm applicable Federal rate is 5 percent,

compounded annually.

(ii) Treatment of noncontingent payment

as separate contract. Each payment of

interest is a contingent payment.

Accordingly, under paragraph (a) of this

section, for purposes of applying section 483

to the debt instrument, the right to the

noncontingent payment of $200,000 is

treated as a separate contract. The amount of

unstated interest on this separate contract is

equal to $43,295, which is the amount by

which the payment ($200,000) exceeds the

present value of the payment ($156,705),

calculated using the test rate of 5 percent,

compounded annually. The $200,000

payment is thus treated as consisting of a
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30139

payment of interest of $43,295 and a payment

of principal of $156,705. The interest is

includible in A’s gross income, and

deductible by B, under their respective

methods of accounting.

(iii) Treatment of contingent payments.

Assume that the amount of the contingent

payment that is paid on December 31, 1997,

is $20,000. Under paragraph (a) of this

section, the $20,000 payment is treated as a

payment of principal of $19,231 (the present

value, as of the date of sale, of the $20,000

payment, calculated using a test rate equal to

4 percent, compounded annually) and a

payment of interest of $769. The $769

interest payment is includible in A’s gross

income, and deductible by B, in their

respective taxable years in which the

payment occurs. The amount treated as

principal gives B additional basis in the

property on December 31, 1997. The

remaining contingent payments on the debt

instrument are accounted for similarly, using

a test rate of 4 percent, compounded

annually, for the payments made on

December 31, 1998, and December 31, 1999,

and a test rate of 5 percent, compounded

annually, for the payments made on

December 31, 2000, and December 31, 2001.

Example 2. Contingent stock payout—(i)

Facts. M Corporation and N Corporation each

owns one-half of the stock of O Corporation.

On December 31, 1996, pursuant to a

reorganization qualifying under section

368(a)(1)(B), M acquires the one-half interest

of O held by N in exchange for 30,000 shares

of M voting stock and a non-assignable right

to receive up to 10,000 additional shares of

M’s voting stock during the next 3 years,

provided the net profits of O exceed certain

amounts specified in the contract. No interest

is provided for in the contract. No additional

shares are received in 1997 or in 1998. In

1999, the annual earnings of O exceed the

specified amount, and, on December 31,

1999, an additional 3,000 M voting shares are

transferred to N. The fair market value of the

3,000 shares on December 31, 1999, is

$300,000. Assume that on December 31,

1996, the short-term applicable Federal rate

is 4 percent, compounded annually. M and

N are calendar year taxpayers.

(ii) Allocation of interest. Section 1274

does not apply to the right to receive the

additional shares because the right is not a

debt instrument for federal income tax

purposes. As a result, the transfer of the

3,000 M voting shares to N is a deferred

payment subject to section 483 and a portion

of the shares is treated as unstated interest

under that section. The amount of interest

allocable to the shares is equal to the excess

of $300,000 (the fair market value of the

shares on December 31, 1999) over $266,699

(the present value of $300,000, determined

by discounting the payment at the test rate

of 4 percent, compounded annually, from

December 31, 1999, to December 31, 1996).

As a result, the amount of interest allocable

to the payment of the shares is $33,301

($300,000–$266,699). Both M and N take the

interest into account in 1999.

(c) Effective date. This section applies

to sales and exchanges that occur on or

after August 13, 1996.

Par. 6. Section 1.1001–1 is amended

by revising paragraph (g) to read as

follows:

§ 1.1001–1 Computation of gain or loss.

* * * * *

(g) Debt instruments issued in

exchange for property—(1) In general. If

a debt instrument is issued in exchange

for property, the amount realized

attributable to the debt instrument is the

issue price of the debt instrument as

determined under § 1.1273–2 or

§ 1.1274–2, whichever is applicable. If,

however, the issue price of the debt

instrument is determined under section

1273(b)(4), the amount realized

attributable to the debt instrument is its

stated principal amount reduced by any

unstated interest (as determined under

section 483).

(2) Certain debt instruments that

provide for contingent payments—(i) In

general. Paragraph (g)(1) of this section

does not apply to a debt instrument

subject to either § 1.483–4 or § 1.1275–

4(c) (certain contingent payment debt

instruments issued for nonpublicly

traded property).

(ii) Special rule to determine amount

realized. If a debt instrument subject to

§ 1.1275–4(c) is issued in exchange for

property, and the income from the

exchange is not reported under the

installment method of section 453, the

amount realized attributable to the debt

instrument is the issue price of the debt

instrument as determined under

§ 1.1274–2(g), increased by the fair

market value of the contingent

payments payable on the debt

instrument. If a debt instrument subject

to § 1.483–4 is issued in exchange for

property, and the income from the

exchange is not reported under the

installment method of section 453, the

amount realized attributable to the debt

instrument is its stated principal

amount, reduced by any unstated

interest (as determined under section

483), and increased by the fair market

value of the contingent payments

payable on the debt instrument. This

paragraph (g)(2)(ii), however, does not

apply to a debt instrument if the fair

market value of the contingent

payments is not reasonably

ascertainable. Only in rare and

extraordinary cases will the fair market

value of the contingent payments be

treated as not reasonably ascertainable.

(3) Coordination with section 453. If a

debt instrument is issued in exchange

for property, and the income from the

exchange is not reported under the

installment method of section 453, this

paragraph (g) applies rather than

§ 15a.453–1(d)(2) to determine the

taxpayer’s amount realized attributable

to the debt instrument.

(4) Effective date. This paragraph (g)

applies to sales or exchanges that occur

on or after August 13, 1996.

Par. 7. Section 1.1012–1 is amended

by revising paragraph (g) to read as

follows:

§ 1.1012–1 Basis of property.

* * * * *

(g) Debt instruments issued in

exchange for property—(1) In general.

For purposes of paragraph (a) of this

section, if a debt instrument is issued in

exchange for property, the cost of the

property that is attributable to the debt

instrument is the issue price of the debt

instrument as determined under

§ 1.1273–2 or § 1.1274–2, whichever is

applicable. If, however, the issue price

of the debt instrument is determined

under section 1273(b)(4), the cost of the

property attributable to the debt

instrument is its stated principal

amount reduced by any unstated

interest (as determined under section

483).

(2) Certain tax-exempt obligations.

This paragraph (g)(2) applies to a taxexempt obligation (as defined in section

1275(a)(3)) that is issued in exchange for

property and that has an issue price

determined under § 1.1274–2(j)

(concerning tax-exempt contingent

payment obligations and certain taxexempt variable rate debt instruments

subject to section 1274).

Notwithstanding paragraph (g)(1) of this

section, if this paragraph (g)(2) applies

to a tax-exempt obligation, for purposes

of paragraph (a) of this section, the cost

of the property that is attributable to the

obligation is the sum of the present

values of the noncontingent payments

(as determined under § 1.1274–2(c)).

(3) Effective date. This paragraph (g)

applies to sales or exchanges that occur

on or after August 13, 1996.

Par. 8. Section 1.1271–0(b) is

amended by:

1. Revising the entries for paragraphs

(c)(2), (c)(3), (c)(4), and (d) of § 1.1272–

1.

2. Adding an entry for paragraph

(c)(7) of § 1.1272–1.

3. Revising the entry for paragraph (g)

and adding entries for paragraphs (i)

and (j) of § 1.1274–2.

4. Revising the entry for paragraph (g)

and adding entries for paragraphs (g),

(h), (i), and (j) of § 1.1275–2.

5. Removing the entries for § 1.1275–

2T.

6. Adding entries for § 1.1275–4.

7. Adding entries for paragraphs (a)(5)

and (a)(6) of § 1.1275–5.

8. Revising the entries for paragraphs

(c)(1) and (c)(5) of § 1.1275–5.
30140 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

9. Adding entries for § 1.1275–6.

The revisions and additions read as

follows:

§ 1.1271–0 Original issue discount;

effective date; table of contents.

* * * * *

(b) * * *

* * * * *

§ 1.1272–1 Current Inclusion of OID in

Income

* * * * *

(c) * * *

(2) Payment schedule that is significantly

more likely than not to occur.

(3) Mandatory sinking fund provision.

(4) Consistency rule. [Reserved]

* * * * *

(7) Effective date.

(d) Certain debt instruments that provide

for a fixed yield.

* * * * *

§ 1.1274–2 Issue Price of Debt Instruments

to Which Section 1274 Applies

* * * * *

(g) Treatment of contingent payment debt

instrument.

* * * * *

(i) [Reserved]

(j) Special rules for tax-exempt obligations.

(1) Certain variable rate debt instruments.

(2) Contingent payment debt instruments.

(3) Effective date.

* * * * *

§ 1.1275–2 Special Rules Relating to Debt

Instruments

* * * * *

(g) Anti-abuse rule.

(1) In general.

(2) Unreasonable result.

(3) Examples.

(4) Effective date.

(h) Remote and incidental contingencies.

(1) In general.

(2) Remote contingencies.

(3) Incidental contingencies.

(4) Aggregation rule.

(5) Consistency rule.

(6) Subsequent adjustments.

(7) Effective date.

(i) [Reserved]

(j) Treatment of certain modifications.

* * * * *

§ 1.1275–4 Contingent Payment Debt

Instruments

(a) Applicability.

(1) In general.

(2) Exceptions.

(3) Insolvency and default.

(4) Convertible debt instruments.

(5) Remote and incidental contingencies.

(b) Noncontingent bond method.

(1) Applicability.

(2) In general.

(3) Description of method.

(4) Comparable yield and projected

payment schedule.

(5) Qualified stated interest.

(6) Adjustments.

(7) Adjusted issue price, adjusted basis,

and retirement.

(8) Character on sale, exchange, or

retirement.

(9) Operating rules.

(c) Method for debt instruments not subject

to the noncontingent bond method.

(1) Applicability.

(2) Separation into components.

(3) Treatment of noncontingent payments.

(4) Treatment of contingent payments.

(5) Basis different from adjusted issue

price.

(6) Treatment of a holder on sale,

exchange, or retirement.

(7) Examples.

(d) Rules for tax-exempt obligations.

(1) In general.

(2) Certain tax-exempt obligations with

interest-based or revenue-based payments

(3) All other tax-exempt obligations.

(4) Basis different from adjusted issue

price.

(e) Amounts treated as interest under this

section.

(f) Effective date.

§ 1.1275–5 Variable Rate Debt Instruments

(a) * * *

(5) No contingent principal payments.

(6) Special rule for debt instruments issued

for nonpublicly traded property.

* * * * *

(c) * * *

(1) Definition.

* * * * *

(5) Tax-exempt obligations.

* * * * *

§ 1.1275–6 Integration of Qualifying Debt

Instruments

(a) In general.

(b) Definitions.

(1) Qualifying debt instrument.

(2) Section 1.1275–6 hedge.

(3) Financial instrument.

(4) Synthetic debt instrument.

(c) Integrated transaction.

(1) Integration by taxpayer.

(2) Integration by Commissioner.

(d) Special rules for legging into and

legging out of an integrated transaction.

(1) Legging into.

(2) Legging out.

(e) Identification requirements.

(f) Taxation of integrated transactions.

(1) General rule.

(2) Issue date.

(3) Term.

(4) Issue price.

(5) Adjusted issue price.

(6) Qualified stated interest.

(7) Stated redemption price at maturity.

(8) Source of interest income and

allocation of expense.

(9) Effectively connected income.

(10) Not a short-term obligation.

(11) Special rules in the event of

integration by the Commissioner.

(12) Retention of separate transaction rules

for certain purposes.

(13) Coordination with consolidated return

rules.

(g) Predecessors and successors.

(h) Examples.

(i) [Reserved]

(j) Effective date.

Par. 9. Section 1.1272–1 is amended

by:

1. Revising paragraphs (b)(2)(ii), (c),

and (d).

2. Adding a sentence at the end of

paragraph (f)(2).

3. Removing the language

‘‘determining yield and maturity’’ from

the first sentence of paragraph (j)

Example 5 (iii) and adding the language

‘‘sections 1272 and 1273’’ in its place.

4. Removing the language

‘‘determining yield and maturity’’ from

the second sentence of paragraph (j)

Example 7 (v) and adding the language

‘‘sections 1272 and 1273’’ in its place.

The revisions and addition read as

follows:

§ 1.1272–1 Current inclusion of OID in

income.

* * * * *

(b) * * *

(2) * * *

(ii) A debt instrument that provides

for contingent payments, other than a

debt instrument described in paragraph

(c) or (d) of this section or except as

provided in § 1.1275–4; or

* * * * *

(c) Yield and maturity of certain debt

instruments subject to contingencies—

(1) Applicability. This paragraph (c)

provides rules to determine the yield

and maturity of certain debt instruments

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 issue date and the debt instrument

is subject to paragraph (c) (2), (3), or (5)

of this section. A debt instrument 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 debt instrument

that provides for a contingency that is

not described in this paragraph (c). See

§ 1.1273–1(c) to determine whether

stated interest on a debt instrument

subject to this paragraph (c) is qualified

stated interest.

(2) Payment schedule that is

significantly more likely than not to

occur. If, based on all the facts and

circumstances as of the issue date, a

single payment schedule for a debt

instrument, including the stated

payment schedule, is significantly more

likely than not to occur, the yield and

maturity of the debt instrument are

computed based on this payment

schedule.
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30141

(3) Mandatory sinking fund provision.

Notwithstanding paragraph (c)(2) of this

section, if a debt instrument is subject

to a mandatory sinking fund provision,

the provision is ignored for purposes of

computing the yield and maturity of the

debt instrument if the use and terms of

the provision meet reasonable

commercial standards. For purposes of

the preceding sentence, a mandatory

sinking fund provision is a provision

that meets the following requirements:

(i) The provision requires the issuer to

redeem a certain amount of debt

instruments in an issue prior to

maturity.

(ii) The debt instruments actually

redeemed are chosen by lot or

purchased by the issuer either in the

open market or pursuant to an offer

made to all holders (with any proration

determined by lot).

(iii) On the issue date, the specific

debt instruments that will be redeemed

on any date prior to maturity cannot be

identified.

(4) Consistency rule. [Reserved]

(5) Treatment of certain options.

Notwithstanding paragraphs (c) (2) and

(3) of this section, the rules of this

paragraph (c)(5) determine the yield and

maturity of a debt instrument that

provides the holder or issuer with an

unconditional option or options,

exercisable on one or more dates during

the term of the debt instrument, that, if

exercised, require payments to be made

on the debt instrument under an

alternative payment schedule or

schedules (e.g., an option to extend or

an option to call a debt instrument at a

fixed premium). Under this paragraph

(c)(5), an issuer is deemed to exercise or

not exercise an option or combination of

options in a manner that minimizes the

yield on the debt instrument, and a

holder is deemed to exercise or not

exercise an option or combination of

options in a manner that maximizes the

yield on the debt instrument. If both the

issuer and the holder have options, the

rules of this paragraph (c)(5) are applied

to the options in the order that they may

be exercised. See paragraph (j) Example

5 through Example 8 of this section.

(6) Subsequent adjustments. If a

contingency described in this paragraph

(c) (including the exercise of an option

described in paragraph (c)(5) of this

section) actually occurs or does not

occur, contrary to the assumption made

pursuant to this paragraph (c) (a change

in circumstances), then, solely for

purposes of sections 1272 and 1273, the

debt instrument is treated as retired and

then reissued on the date of the change

in circumstances for an amount equal to

its adjusted issue price on that date. See

paragraph (j) Example 5 and Example 7

of this section. 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 debt instrument, which

may result in gain or loss to the holder.

See paragraph (j) Example 6 and

Example 8 of this section.

(7) Effective date. This paragraph (c)

applies to debt instruments issued on or

after August 13, 1996.

(d) Certain debt instruments that

provide for a fixed yield. If a debt

instrument provides for one or more

contingent payments but all possible

payment schedules under the terms of

the instrument result in the same fixed

yield, the yield of the debt instrument

is the fixed yield. For example, the yield

of a debt instrument with principal

payments that are fixed in total amount

but that are uncertain as to time (such

as a demand loan) is the stated interest

rate if the issue price of the instrument

is equal to the stated principal amount

and interest is paid or compounded at

a fixed rate over the entire term of the

instrument. This paragraph (d) applies

to debt instruments issued on or after

August 13, 1996.

* * * * *

(f) * * *

(2) * * * For purposes of the

preceding sentence, the last possible

date that the debt instrument could be

outstanding is determined without

regard to § 1.1275–2(h) (relating to

payments subject to remote or

incidental contingencies).

* * * * *

Par. 10. Section 1.1273–1 is amended

by:

1. Removing the language ‘‘principal

payments uncertain as to time’’ in the

fourth sentence of paragraph (a) and

adding the language ‘‘a fixed yield’’ in

its place.

2. Revising paragraph (c)(1)(ii).

3. Revising paragraph (f) Example 4.

The revisions read as follows:

§ 1.1273–1 Definition of OID.

* * * * *

(c) * * * (1) * * *

(ii) Unconditionally payable. Interest

is unconditionally payable only if

reasonable legal remedies exist to

compel timely payment or the debt

instrument otherwise provides terms

and conditions that make the likelihood

of late payment (other than a late

payment that occurs within a reasonable

grace period) or nonpayment a remote

contingency (within the meaning of

§ 1.1275–2(h)). For purposes of the

preceding sentence, remedies or other

terms and conditions are not taken into

account if the lending transaction does

not reflect arm’s length dealing and the

holder does not intend to enforce the

remedies or other terms and conditions.

For purposes of determining whether

interest is unconditionally payable, the

possibility of nonpayment due to

default, insolvency, or similar

circumstances, or due to the exercise of

a conversion option described in

§ 1.1272–1(e) is ignored. This paragraph

(c)(1)(ii) applies to debt instruments

issued on or after August 13, 1996.

* * * * *

(f) * * *

Example 4. Qualified stated interest on a

debt instrument that is subject to an option—

(i) Facts. On January 1, 1997, A issues, for

$100,000, a 10-year debt instrument that

provides for a $100,000 principal payment at

maturity and for annual interest payments of

$10,000. Under the terms of the debt

instrument, A has the option, exercisable on

January 1, 2002, to lower the annual interest

payments to $8,000. In addition, the debt

instrument gives the holder an unconditional

right to put the debt instrument back to A,

exercisable on January 1, 2002, in return for

$100,000.

(ii) Amount of qualified stated interest.

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

debt instrument provides for qualified stated

interest to the extent of the lowest fixed rate

at which qualified stated interest would be

payable under any payment schedule. If the

payment schedule determined by assuming

that the issuer’s option will be exercised and

the put option will not be exercised were

treated as the debt instrument’s sole payment

schedule, only $8,000 of each annual interest

payment would be qualified stated interest.

Under any other payment schedule, the debt

instrument would provide for annual

qualified stated interest payments of $10,000.

Accordingly, only $8,000 of each annual

interest payment is qualified stated interest.

Any excess of each annual interest payment

over $8,000 is included in the debt

instrument’s stated redemption price at

maturity.

* * * * *

Par. 11. Section 1.1274–2 is amended

by:

1. Removing the language ‘‘§ 1.1272–

1(c)(3)(ii)’’ from paragraph (e) and

adding the language ‘‘§ 1.1272–1(c)(3)’’

in its place.

2. Revising paragraph (g).

3. Adding and reserving paragraph (i)

and adding paragraph (j).

The revisions and additions read as

follows:

§ 1.1274–2 Issue price of debt instruments

to which section 1274 applies.

* * * * *

(g) Treatment of contingent payment

debt instruments. Notwithstanding

paragraph (b) of this section, if a debt

instrument subject to section 1274

provides for one or more contingent
30142 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

payments, the issue price of the debt

instrument is the lesser of the

instrument’s noncontingent principal

payments and the sum of the present

values of the noncontingent payments

(as determined under paragraph (c) of

this section). However, if the debt

instrument is issued in a potentially

abusive situation, the issue price of the

debt instrument is the fair market value

of the noncontingent payments. For

additional rules relating to a debt

instrument that provides for one or

more contingent payments, see

§ 1.1275–4. This paragraph (g) applies to

debt instruments issued on or after

August 13, 1996.

* * * * *

(i) [Reserved]

(j) Special rules for tax-exempt

obligations—(1) Certain variable rate

debt instruments. Notwithstanding

paragraph (b) of this section, if a taxexempt obligation (as defined in section

1275(a)(3)) is a variable rate debt

instrument (within the meaning of

§ 1.1275–5) that pays interest at an

objective rate and is subject to section

1274, the issue price of the obligation is

the greater of the obligation’s fair market

value and its stated principal amount.

(2) Contingent payment debt

instruments. Notwithstanding

paragraphs (b) and (g) of this section, if

a tax-exempt obligation (as defined in

section 1275(a)(3)) is subject to section

1274 and § 1.1275–4, the issue price of

the obligation is the fair market value of

the obligation. However, in the case of

a tax-exempt obligation that is subject to

§ 1.1275–4(d)(2) (an obligation that

provides for interest-based or revenuebased payments), the issue price of the

obligation is the greater of the

obligation’s fair market value and its

stated principal amount.

(3) Effective date. This paragraph (j)

applies to debt instruments issued on or

after August 13, 1996.

Par. 12. Section 1.1275–2 is amended

by adding the text of paragraph (g), and

adding paragraph (h), adding and

reserving paragraph (i), and adding

paragraph (j) to read as follows:

§ 1.1275–2 Special rules relating to debt

instruments.

* * * * *

(g) Anti-abuse rule—(1) In general. If

a principal purpose in structuring a debt

instrument or engaging in a transaction

is to achieve a result that is

unreasonable in light of the purposes of

section 163(e), sections 1271 through

1275, or any related section of the Code,

the Commissioner can apply or depart

from the regulations under the

applicable sections as necessary or

appropriate to achieve a reasonable

result. For example, if this paragraph (g)

applies to a debt instrument that

provides for a contingent payment, the

Commissioner can treat the contingency

as if it were a separate position.

(2) Unreasonable result. Whether a

result is unreasonable is determined

based on all the facts and

circumstances. In making this

determination, a significant fact is

whether the treatment of the debt

instrument is expected to have a

substantial effect on the issuer’s or a

holder’s U.S. tax liability. In the case of

a contingent payment debt instrument,

another significant fact is whether the

result is obtainable without the

application of § 1.1275–4 and any

related provisions (e.g., if the debt

instrument and the contingency were

entered into separately). A result will

not be considered unreasonable,

however, in the absence of an expected

substantial effect on the present value of

a taxpayer’s tax liability.

(3) Examples. The following examples

illustrate the provisions of this

paragraph (g):

Example 1. A issues a current-pay,

increasing-rate note that provides for an early

call option. Although the option is deemed

exercised on the call date under § 1.1272–

1(c)(5), the option is not expected to be

exercised by A. In addition, a principal

purpose of including the option in the terms

of the note is to limit the amount of interest

income includible by the holder in the period

prior to the call date by virtue of the option

rules in § 1.1272–1(c)(5). Moreover, the

application of the option rules is expected to

substantially reduce the present value of the

holder’s tax liability. Based on these facts,

the application of § 1.1272–1(c)(5) produces

an unreasonable result. Therefore, under this

paragraph (g), the Commissioner can apply

the regulations (in whole or in part) to the

note without regard to § 1.1272–1(c)(5).

Example 2. C, a foreign corporation not

subject to U.S. taxation, issues to a U.S.

holder a debt instrument that provides for a

contingent payment. The debt instrument is

issued for cash and is subject to the

noncontingent bond method in § 1.1275–4(b).

Six months after issuance, C and the holder

modify the debt instrument so that there is

a deemed reissuance of the instrument under

section 1001. The new debt instrument is

subject to the rules of § 1.1275–4(c) rather

than § 1.1275–4(b). The application of

§ 1.1275–4(c) is expected to substantially

reduce the present value of the holder’s tax

liability as compared to the application of

§ 1.1275–4(b). In addition, a principal

purpose of the modification is to

substantially reduce the present value of the

holder’s tax liability through the application

of § 1.1275–4(c). Based on these facts, the

application of § 1.1275–4(c) produces an

unreasonable result. Therefore, under this

paragraph (g), the Commissioner can apply

the noncontingent bond method to the

modified debt instrument.

Example 3. D issues a convertible debt

instrument rather than an economically

equivalent investment unit consisting of a

debt instrument and a warrant. The

convertible debt instrument is issued at par

and provides for annual payments of interest.

D issues the convertible debt instrument

rather than the investment unit so that the

debt instrument would not have OID. See

§ 1.1273–2(j). In general, this is a reasonable

result in light of the purposes of the

applicable statutes. Therefore, the

Commissioner generally will not use the

authority under this paragraph (g) to depart

from the application of § 1.1273–2(j) in this

case.

(4) Effective date. This paragraph (g)

applies to debt instruments issued on or

after August 13, 1996.

(h) Remote and incidental

contingencies—(1) In general. This

paragraph (h) applies to a debt

instrument if one or more payments on

the instrument are subject to either a

remote or incidental contingency.

Whether a contingency is remote or

incidental is determined as of the issue

date of the debt instrument, including

any date there is a deemed reissuance of

the debt instrument under paragraph

(h)(6) (ii) or (j) of this section or

§ 1.1272–1(c)(6). Except as otherwise

provided, the treatment of the

contingency under this paragraph (h)

applies for all purposes of sections

163(e) (other than sections 163(e)(5))

and 1271 through 1275 and the

regulations thereunder. For purposes of

this paragraph (h), the possibility of

impairment of a payment by insolvency,

default, or similar circumstances is not

a contingency.

(2) Remote contingencies. A

contingency is remote if there is a

remote likelihood either that the

contingency will occur or that the

contingency will not occur. If there is a

remote likelihood that the contingency

will occur, it is assumed that the

contingency will not occur. If there is a

remote likelihood that the contingency

will not occur, it is assumed that the

contingency will occur.

(3) Incidental contingencies—(i)

Contingency relating to amount. A

contingency relating to the amount of a

payment is incidental if, under all

reasonably expected market conditions,

the potential amount of the payment is

insignificant relative to the total

expected amount of the remaining

payments on the debt instrument. If a

payment on a debt instrument is subject

to an incidental contingency described

in this paragraph (h)(3)(i), the payment

is ignored until the payment is made.

However, see paragraph (h)(6)(i)(B) of

this section for the treatment of the debt

instrument if a change in circumstances
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30143

occurs prior to the date the payment is

made.

(ii) Contingency relating to time. A

contingency relating to the timing of a

payment is incidental if, under all

reasonably expected market conditions,

the potential difference in the timing of

the payment (from the earliest date to

the latest date) is insignificant. If a

payment on a debt instrument is subject

to an incidental contingency described

in this paragraph (h)(3)(ii), the payment

is treated as made on the earliest date

that the payment could be made

pursuant to the contingency. If the

payment is not made on this date, a

taxpayer makes appropriate adjustments

to take into account the delay in

payment. However, see paragraph

(h)(6)(i)(C) of this section for the

treatment of the debt instrument if the

delay is not insignificant.

(4) Aggregation rule. For purposes of

paragraph (h)(2) of this section, if a debt

instrument provides for multiple

contingencies each of which has a

remote likelihood of occurring but,

when all of the contingencies are

considered together, there is a greater

than remote likelihood that at least one

of the contingencies will occur, none of

the contingencies is treated as a remote

contingency. For purposes of paragraph

(h)(3)(i) of this section, if a debt

instrument provides for multiple

contingencies each of which is

incidental but the potential total amount

of all of the payments subject to the

contingencies is not, under reasonably

expected market conditions,

insignificant relative to the total

expected amount of the remaining

payments on the debt instrument, none

of the contingencies is treated as

incidental.

(5) Consistency rule. For purposes of

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

the issuer’s determination that a

contingency is either remote or

incidental is binding on all holders.

However, the issuer’s determination is

not binding on a holder that explicitly

discloses that its determination is

different from the issuer’s

determination. Unless otherwise

prescribed by the Commissioner, the

disclosure must be made 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 debt instrument. See § 1.1275–

2(e) for rules relating to the issuer’s

obligation to disclose certain

information to holders.

(6) Subsequent adjustments—(i)

Applicability. This paragraph (h)(6)

applies to a debt instrument when there

is a change in circumstances. For

purposes of the preceding sentence,

there is a change in circumstances if—

(A) A remote contingency actually

occurs or does not occur, contrary to the

assumption made in paragraph (h)(2) of

this section;

(B) A payment subject to an incidental

contingency described in paragraph

(h)(3)(i) of this section becomes fixed in

an amount that is not insignificant

relative to the total expected amount of

the remaining payments on the debt

instrument; or

(C) A payment subject to an incidental

contingency described in paragraph

(h)(3)(ii) of this section becomes fixed

such that the difference between the

assumed payment date and the due date

of the payment is not insignificant.

(ii) In general. If a change in

circumstances occurs, solely for

purposes of sections 1272 and 1273, the

debt instrument is treated as retired and

then reissued on the date of the change

in circumstances for an amount equal to

the instrument’s adjusted issue price on

that date.

(iii) Contingent payment debt

instruments. Notwithstanding paragraph

(h)(6)(ii) of this section, in the case of a

contingent payment debt instrument

subject to § 1.1275–4, if a change in

circumstances occurs, no retirement or

reissuance is treated as occurring, but

any payment that is fixed as a result of

the change in circumstances is governed

by the rules in § 1.1275–4 that apply

when the amount of a contingent

payment becomes fixed.

(7) Effective date. This paragraph (h)

applies to debt instruments issued on or

after August 13, 1996.

(i) [Reserved]

(j) Treatment of certain modifications.

If the terms of a debt instrument are

modified to defer one or more

payments, and the modification does

not cause an exchange under section

1001, then, solely for purposes of

sections 1272 and 1273, the debt

instrument is treated as retired and then

reissued on the date of the modification

for an amount equal to the instrument’s

adjusted issue price on that date. This

paragraph (j) applies to debt instruments

issued on or after August 13, 1996.

§ 1.1275–2T [Removed]

Par. 13. Section 1.1275–2T is

removed effective August 13, 1996.

Par. 14. In § 1.1275–3, paragraph

(b)(1)(i) is revised to read as follows:

§ 1.1275–3 OID information reporting

requirements.

* * * * *

(b) * * * (1) * * *

(i) Set forth on the face of the debt

instrument the issue price, the amount

of OID, the issue date, the yield to

maturity, and, in the case of a debt

instrument subject to the rules of

§ 1.1275–4(b), the comparable yield and

projected payment schedule; or

* * * * *

Par. 15. Section 1.1275–4 is added to

read as follows:

§ 1.1275–4 Contingent payment debt

instruments.

(a) Applicability—(1) In general.

Except as provided in paragraph (a)(2)

of this section, this section applies to

any debt instrument that provides for

one or more contingent payments. In

general, paragraph (b) of this section

applies to a contingent payment debt

instrument that is issued for money or

publicly traded property and paragraph

(c) of this section applies to a contingent

payment debt instrument that is issued

for nonpublicly traded property.

Paragraph (d) of this section provides

special rules for tax-exempt obligations.

See § 1.1275–6 for a taxpayer’s

treatment of a contingent payment debt

instrument and a hedge.

(2) Exceptions. This section does not

apply to—

(i) A debt instrument that has an issue

price determined under section

1273(b)(4) (e.g., a debt instrument

subject to section 483);

(ii) A variable rate debt instrument (as

defined in § 1.1275–5);

(iii) A debt instrument subject to

§ 1.1272–1(c) (a debt instrument that

provides for certain contingencies) or

§ 1.1272–1(d) (a debt instrument that

provides for a fixed yield);

(iv) A debt instrument subject to

section 988 (except as provided in

section 988 and the regulations

thereunder);

(v) A debt instrument to which

section 1272(a)(6) applies (certain

interests in or mortgages held by a

REMIC, and certain other debt

instruments with payments subject to

acceleration);

(vi) A debt instrument (other than a

tax-exempt obligation) described in

section 1272(a)(2) (e.g., U.S. savings

bonds, certain loans between natural

persons, and short-term taxable

obligations); or

(vii) A debt instrument issued

pursuant to a plan or arrangement if—

(A) The plan or arrangement is

created by a state statute;

(B) A primary objective of the plan or

arrangement is to enable the

participants to pay for the costs of postsecondary education for themselves or

their designated beneficiaries; and

(C) Contingent payments on the debt

instrument are related to such objective.
30144 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

(3) Insolvency and default. A payment

is not contingent merely because of the

possibility of impairment by insolvency,

default, or similar circumstances.

(4) Convertible debt instruments. A

debt instrument does not provide for

contingent payments merely because it

provides for an option to convert the

debt instrument into the stock of the

issuer, into the 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.

(5) Remote and incidental

contingencies. A payment is not a

contingent payment merely because of a

contingency that, as of the issue date, is

either remote or incidental. See

§ 1.1275–2(h) for the treatment of

remote and incidental contingencies.

(b) Noncontingent bond method—(1)

Applicability. The noncontingent bond

method described in this paragraph (b)

applies to a contingent payment debt

instrument that has an issue price

determined under § 1.1273–2 (e.g., a

contingent payment debt instrument

that is issued for money or publicly

traded property).

(2) In general. Under the

noncontingent bond method, interest on

a debt instrument must be taken into

account whether or not the amount of

any payment is fixed or determinable in

the taxable year. The amount of interest

that is taken into account for each

accrual period is determined by

constructing a projected payment

schedule for the debt instrument and

applying rules similar to those for

accruing OID on a noncontingent debt

instrument. If the actual amount of a

contingent payment is not equal to the

projected amount, appropriate

adjustments are made to reflect the

difference.

(3) Description of method. The

following steps describe how to

compute the amount of income,

deductions, gain, and loss under the

noncontingent bond method:

(i) Step one: Determine the

comparable yield. Determine the

comparable yield for the debt

instrument under the rules of paragraph

(b)(4) of this section. The comparable

yield is determined as of the debt

instrument’s issue date.

(ii) Step two: Determine the projected

payment schedule. Determine the

projected payment schedule for the debt

instrument under the rules of paragraph

(b)(4) of this section. The projected

payment schedule is determined as of

the issue date and remains fixed

throughout the term of the debt

instrument (except under paragraph

(b)(9)(ii) of this section, which applies

to a payment that is fixed more than 6

months before it is due).

(iii) Step three: Determine the daily

portions of interest. Determine the daily

portions of interest on the debt

instrument for a taxable year as follows.

The amount of interest that accrues in

each accrual period is the product of the

comparable yield of the debt instrument

(properly adjusted for the length of the

accrual period) and the debt

instrument’s adjusted issue price at the

beginning of the accrual period. See

paragraph (b)(7)(ii) of this section to

determine the adjusted issue price of the

debt instrument. The daily portions of

interest are determined by allocating to

each day in the accrual period the

ratable portion of the interest that

accrues in the accrual period. Except as

modified by paragraph (b)(3)(iv) of this

section, the daily portions of interest are

includible in income by a holder for

each day in the holder’s taxable year on

which the holder held the debt

instrument and are deductible by the

issuer for each day during the issuer’s

taxable year on which the issuer was

primarily liable on the debt instrument.

(iv) Step four: Adjust the amount of

income or deductions for differences

between projected and actual contingent

payments. Make appropriate

adjustments to the amount of income or

deductions attributable to the debt

instrument in a taxable year for any

differences between projected and

actual contingent payments. See

paragraph (b)(6) of this section to

determine the amount of an adjustment

and the treatment of the adjustment.

(4) Comparable yield and projected

payment schedule. This paragraph (b)(4)

provides rules for determining the

comparable yield and projected

payment schedule for a debt instrument.

The comparable yield and projected

payment schedule must be supported by

contemporaneous documentation

showing that both are reasonable, are

based on reliable, complete, and

accurate data, and are made in good

faith.

(i) Comparable yield—(A) In general.

Except as provided in paragraph

(b)(4)(i)(B) of this section, the

comparable yield for a debt instrument

is the yield at which the issuer would

issue a fixed rate debt instrument with

terms and conditions similar to those of

the contingent payment debt instrument

(the comparable fixed rate debt

instrument), including the level of

subordination, term, timing of

payments, and general market

conditions. For example, if a § 1.1275–

6 hedge (or the substantial equivalent) is

available, the comparable yield is the

yield on the synthetic fixed rate debt

instrument that would result if the

issuer entered into the § 1.1275–6

hedge. If a § 1.1275–6 hedge (or the

substantial equivalent) is not available,

but similar fixed rate debt instruments

of the issuer trade at a price that reflects

a spread above a benchmark rate, the

comparable yield is the sum of the value

of the benchmark rate on the issue date

and the spread. In determining the

comparable yield, no adjustments are

made for the riskiness of the

contingencies or the liquidity of the

debt instrument. The comparable yield

must be a reasonable yield for the issuer

and must not be less than the applicable

Federal rate (based on the overall

maturity of the debt instrument).

(B) Presumption for certain debt

instruments. This paragraph (b)(4)(i)(B)

applies to a debt instrument if the

instrument provides for one or more

contingent payments not based on

market information and the instrument

is part of an issue that is marketed or

sold in substantial part to persons for

whom the inclusion of interest under

this paragraph (b) is not expected to

have a substantial effect on their U.S.

tax liability. If this paragraph (b)(4)(i)(B)

applies to a debt instrument, the

instrument’s comparable yield is

presumed to be the applicable Federal

rate (based on the overall maturity of the

debt instrument). A taxpayer may

overcome this presumption only with

clear and convincing evidence that the

comparable yield for the debt

instrument should be a specific yield

(determined using the principles in

paragraph (b)(4)(i)(A) of this section)

that is higher than the applicable

Federal rate. The presumption may not

be overcome with appraisals or other

valuations of nonpublicly traded

property. Evidence used to overcome

the presumption must be specific to the

issuer and must not be based on

comparable issuers or general market

conditions.

(ii) Projected payment schedule. The

projected payment schedule for a debt

instrument includes each noncontingent

payment and an amount for each

contingent payment determined as

follows:

(A) Market-based payments. If a

contingent payment is based on market

information (a market-based payment),

the amount of the projected payment is

the forward price of the contingent

payment. The forward price of a

contingent payment is the amount one

party would agree, as of the issue date,

to pay an unrelated party for the right

to the contingent payment on the

settlement date (e.g., the date the

contingent payment is made). For

example, if the right to a contingent
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30145

payment is substantially similar to an

exchange-traded option, the forward

price is the spot price of the option (the

option premium) compounded at the

applicable Federal rate from the issue

date to the date the contingent payment

is due.

(B) Other payments. If a contingent

payment is not based on market

information (a non-market-based

payment), the amount of the projected

payment is the expected value of the

contingent payment as of the issue date.

(C) Adjustments to the projected

payment schedule. The projected

payment schedule must produce the

comparable yield. If the projected

payment schedule does not produce the

comparable yield, the schedule must be

adjusted consistent with the principles

of this paragraph (b)(4) to produce the

comparable yield. For example, the

adjusted amounts of non-market-based

payments must reasonably reflect the

relative expected values of the payments

and must not be set to accelerate or

defer income or deductions. If the debt

instrument contains both market-based

and non-market-based payments,

adjustments are generally made first to

the non-market-based payments because

more objective information is available

for the market-based payments.

(iii) Market information. For purposes

of this paragraph (b), market

information is any information on

which an objective rate can be based

under § 1.1275–5(c)(1) or (2).

(iv) Issuer/holder consistency. The

issuer’s projected payment schedule is

used to determine the holder’s interest

accruals and adjustments. The issuer

must provide the projected payment

schedule to the holder in a manner

consistent with the issuer disclosure

rules of § 1.1275–2(e). If the issuer does

not create a projected payment schedule

for a debt instrument or the issuer’s

projected payment schedule is

unreasonable, the holder of the debt

instrument must determine the

comparable yield and projected

payment schedule for the debt

instrument under the rules of this

paragraph (b)(4). A holder that

determines its own projected payment

schedule must explicitly disclose this

fact and the reason why the holder set

its own schedule (e.g., why the issuer’s

projected payment schedule is

unreasonable). Unless otherwise

prescribed by the Commissioner, the

disclosure must be made 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 debt instrument.

(v) Issuer’s determination respected—

(A) In general. If the issuer maintains

the contemporaneous documentation

required by this paragraph (b)(4), the

issuer’s determination of the

comparable yield and projected

payment schedule will be respected

unless either is unreasonable.

(B) Unreasonable determination. For

purposes of paragraph (b)(4)(v)(A) of

this section, a comparable yield or

projected payment schedule generally

will be considered unreasonable if it is

set with a purpose to overstate,

understate, accelerate, or defer interest

accruals on the debt instrument. In a

determination of whether a comparable

yield or projected payment schedule is

unreasonable, consideration will be

given to whether the treatment of the

debt instrument under this section is

expected to have a substantial effect on

the issuer’s or holder’s U.S. tax liability.

For example, if a taxable issuer markets

a debt instrument to a holder not subject

to U.S. taxation, the comparable yield

will be given close scrutiny and will not

be respected unless contemporaneous

documentation shows that the yield is

not too high.

(C) Exception. Paragraph (b)(4)(v)(A)

of this section does not apply to a debt

instrument subject to paragraph

(b)(4)(i)(B) of this section (concerning a

yield presumption for certain debt

instruments that provide for nonmarket-based payments).

(vi) Examples. The following

examples illustrate the provisions of

this paragraph (b)(4). 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.

Example 1. Market-based payment—(i)

Facts. On December 31, 1996, X corporation

issues for $1,000,000 a debt instrument that

matures on December 31, 2006. The debt

instrument provides for annual payments of

interest, beginning in 1997, at the rate of 6

percent and for a payment at maturity equal

to $1,000,000 plus the excess, if any, of the

price of 10,000 shares of publicly traded

stock in an unrelated corporation on the

maturity date over $350,000, or less the

excess, if any, of $350,000 over the price of

10,000 shares of the stock on the maturity

date. On the issue date, the forward price to

purchase 10,000 shares of the stock on

December 31, 2006, is $350,000.

(ii) Comparable yield. Under paragraph

(b)(4)(i) of this section, the debt instrument’s

comparable yield is the yield on the synthetic

debt instrument that would result if X

corporation entered into a § 1.1275–6 hedge.

A § 1.1275–6 hedge in this case is a forward

contract to purchase 10,000 shares of the

stock on December 31, 2006. If X corporation

entered into this hedge, the resulting

synthetic debt instrument would yield 6

percent, compounded annually. Thus, the

comparable yield on the debt instrument is

6 percent, compounded annually.

(iii) Projected payment schedule. Under

paragraph (b)(4)(ii) of this section, the

projected payment schedule for the debt

instrument consists of 10 annual payments of

$60,000 and a projected amount for the

contingent payment at maturity. Because the

right to the contingent payment is based on

market information, the projected amount of

the contingent payment is the forward price

of the payment. The right to the contingent

payment is substantially similar to a right to

a payment of $1,000,000 combined with a

cash-settled forward contract for the

purchase of 10,000 shares of the stock for

$350,000 on December 31, 2006. Because the

forward price to purchase 10,000 shares of

the stock on December 31, 2006, is $350,000,

the amount to be received or paid under the

forward contract is projected to be zero. As

a result, the projected amount of the

contingent payment at maturity is

$1,000,000, consisting of the $1,000,000 base

amount and no additional amount to be

received or paid under the forward contract.

(A) Assume, alternatively, that on the issue

date the forward price to purchase 10,000

shares of the stock on December 31, 2006, is

$370,000. If X corporation entered into a

§ 1.1275–6 hedge (a forward contract to

purchase the shares for $370,000), the

resulting synthetic debt instrument would

yield 6.15 percent, compounded annually.

Thus, the comparable yield on the debt

instrument is 6.15 percent, compounded

annually. The projected payment schedule

for the debt instrument consists of 10 annual

payments of $60,000 and a projected amount

for the contingent payment at maturity. The

projected amount of the contingent payment

is $1,020,000, consisting of the $1,000,000

base amount plus the excess $20,000 of the

forward price of the stock over the purchase

price of the stock under the forward contract.

(B) Assume, alternatively, that on the issue

date the forward price to purchase 10,000

shares of the stock on December 31, 2006, is

$330,000. If X corporation entered into a

§ 1.1275–6 hedge, the resulting synthetic debt

instrument would yield 5.85 percent,

compounded annually. Thus, the comparable

yield on the debt instrument is 5.85 percent,

compounded annually. The projected

payment schedule for the debt instrument

consists of 10 annual payments of $60,000

and a projected amount for the contingent

payment at maturity. The projected amount

of the contingent payment is $980,000,

consisting of the $1,000,000 base amount

minus the excess $20,000 of the purchase

price of the stock under the forward contract

over the forward price of the stock.

Example 2. Non-market-based payments—

(i) Facts. On December 31, 1996, Y issues to

Z for $1,000,000 a debt instrument that

matures on December 31, 2000. The debt

instrument has a stated principal amount of

$1,000,000, payable at maturity, and provides

for payments on December 31 of each year,

beginning in 1997, of $20,000 plus 1 percent

of Y’s gross receipts, if any, for the year. On

the issue date, Y has outstanding fixed rate

debt instruments with maturities of 2 to 10

years that trade at a price that reflects an

average of 100 basis points over Treasury
30146 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

bonds. These debt instruments have terms

and conditions similar to those of the debt

instrument. Assume that on December 31,

1996, 4-year Treasury bonds have a yield of

6.5 percent, compounded annually, and that

no § 1.1275–6 hedge is available for the debt

instrument. In addition, assume that the

interest inclusions attributable to the debt

instrument are expected to have a substantial

effect on Z’s U.S. tax liability.

(ii) Comparable yield. The comparable

yield for the debt instrument is equal to the

value of the benchmark rate (i.e., the yield on

4-year Treasury bonds) on the issue date plus

the spread. Thus, the debt instrument’s

comparable yield is 7.5 percent, compounded

annually.

(iii) Projected payment schedule. Y

anticipates that it will have no gross receipts

in 1997, but that it will have gross receipts

in later years, and those gross receipts will

grow each year for the next three years. Based

on its business projections, Y believes that it

is not unreasonable to expect that its gross

receipts in 1999 and each year thereafter will

grow by between 6 percent and 13 percent

over the prior year. Thus, Y must take these

expectations into account in establishing a

projected payment schedule for the debt

instrument that results in a yield of 7.5

percent, compounded annually. Accordingly,

Y could reasonably set the following

projected payment schedule for the debt

instrument:

Date

Noncontingent paymentContingent payment

12/31/1997 ............ $20,000 0

12/31/1998 ............ 20,000 70,000

12/31/1999 ............ 20,000 75,600

12/31/2000 ............ 1,020,000 83,850

(5) Qualified stated interest. No

amounts payable on a debt instrument

to which this paragraph (b) applies are

qualified stated interest within the

meaning of § 1.1273–1(c).

(6) Adjustments. This paragraph (b)(6)

provides rules for the treatment of

positive and negative adjustments under

the noncontingent bond method. A

taxpayer takes into account only those

adjustments that occur during a taxable

year while the debt instrument is held

by the taxpayer or while the taxpayer is

primarily liable on the debt instrument.

(i) Determination of positive and

negative adjustments. If the amount of

a contingent payment is more than the

projected amount of the contingent

payment, the difference is a positive

adjustment on the date of the payment.

If the amount of a contingent payment

is less than the projected amount of the

contingent payment, the difference is a

negative adjustment on the date of the

payment (or on the scheduled date of

the payment if the amount of the

payment is zero).

(ii) Treatment of net positive

adjustments. The amount, if any, by

which total positive adjustments on a

debt instrument in a taxable year exceed

the total negative adjustments on the

debt instrument in the taxable year is a

net positive adjustment. A net positive

adjustment is treated as additional

interest for the taxable year.

(iii) Treatment of net negative

adjustments. The amount, if any, by

which total negative adjustments on a

debt instrument in a taxable year exceed

the total positive adjustments on the

debt instrument in the taxable year is a

net negative adjustment. A taxpayer’s

net negative adjustment on a debt

instrument for a taxable year is treated

as follows:

(A) Reduction of interest accruals. A

net negative adjustment first reduces

interest for the taxable year that the

taxpayer would otherwise account for

on the debt instrument under paragraph

(b)(3)(iii) of this section.

(B) Ordinary income or loss. If the net

negative adjustment exceeds the interest

for the taxable year that the taxpayer

would otherwise account for on the debt

instrument under paragraph (b)(3)(iii) of

this section, the excess is treated as

ordinary loss by a holder and ordinary

income by an issuer. However, the

amount treated as ordinary loss by a

holder is limited to the amount by

which the holder’s total interest

inclusions on the debt instrument

exceed the total amount of the holder’s

net negative adjustments treated as

ordinary loss on the debt instrument in

prior taxable years. The amount treated

as ordinary income by an issuer is

limited to the amount by which the

issuer’s total interest deductions on the

debt instrument exceed the total amount

of the issuer’s net negative adjustments

treated as ordinary income on the debt

instrument in prior taxable years.

(C) Carryforward. If the net negative

adjustment exceeds the sum of the

amounts treated by the taxpayer as a

reduction of interest and as ordinary

income or loss (as the case may be) on

the debt instrument for the taxable year,

the excess is a negative adjustment

carryforward for the taxable year. In

general, a taxpayer treats a negative

adjustment carryforward for a taxable

year as a negative adjustment on the

debt instrument on the first day of the

succeeding taxable year. However, if a

holder of a debt instrument has a

negative adjustment carryforward on the

debt instrument in a taxable year in

which the debt instrument is sold,

exchanged, or retired, the negative

adjustment carryforward reduces the

holder’s amount realized on the sale,

exchange, or retirement. If an issuer of

a debt instrument has a negative

adjustment carryforward on the debt

instrument for a taxable year in which

the debt instrument is retired, the issuer

takes the negative adjustment

carryforward into account as ordinary

income.

(D) Treatment under section 67. A net

negative adjustment is not subject to

section 67 (the 2-percent floor on

miscellaneous itemized deductions).

(iv) Cross-references. If a holder has a

basis in a debt instrument that is

different from the debt instrument’s

adjusted issue price, the holder may

have additional positive or negative

adjustments under paragraph (b)(9)(i) of

this section. If the amount of a

contingent payment is fixed more than

6 months before the date it is due, the

amount and timing of the adjustment

are determined under paragraph

(b)(9)(ii) of this section.

(7) Adjusted issue price, adjusted

basis, and retirement—(i) In general. If

a debt instrument is subject to the

noncontingent bond method, this

paragraph (b)(7) provides rules to

determine the adjusted issue price of the

debt instrument, the holder’s basis in

the debt instrument, and the treatment

of any scheduled or unscheduled

retirements. In general, because any

difference between the actual amount of

a contingent payment and the projected

amount of the payment is taken into

account as an adjustment to income or

deduction, the projected payments are

treated as the actual payments for

purposes of making adjustments to issue

price and basis and determining the

amount of any contingent payment

made on a scheduled retirement.

(ii) Definition of adjusted issue price.

The adjusted issue price of a debt

instrument is equal to the debt

instrument’s issue price, increased by

the interest previously accrued on the

debt instrument under paragraph

(b)(3)(iii) of this section (determined

without regard to any adjustments taken

into account under paragraph (b)(3)(iv)

of this section), and decreased by the

amount of any noncontingent payment

and the projected amount of any

contingent payment previously made on

the debt instrument. See paragraph

(b)(9)(ii) of this section for special rules

that apply when a contingent payment

is fixed more than 6 months before it is

due.

(iii) Adjustments to basis. A holder’s

basis in a debt instrument is increased

by the interest previously accrued by

the holder on the debt instrument under

paragraph (b)(3)(iii) of this section

(determined without regard to any

adjustments taken into account under

paragraph (b)(3)(iv) of this section), and

decreased by the amount of any

noncontingent payment and the
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30147

projected amount of any contingent

payment previously made on the debt

instrument to the holder. See paragraph

(b)(9)(i) of this section for special rules

that apply when basis is different from

adjusted issue price and paragraph

(b)(9)(ii) of this section for special rules

that apply when a contingent payment

is fixed more than 6 months before it is

due.

(iv) Scheduled retirements. For

purposes of determining the amount

realized by a holder and the repurchase

price paid by the issuer on the

scheduled retirement of a debt

instrument, a holder is treated as

receiving, and the issuer is treated as

paying, the projected amount of any

contingent payment due at maturity. If

the amount paid or received is different

from the projected amount, see

paragraph (b)(6) of this section for the

treatment of the difference by the

taxpayer. Under paragraph (b)(6)(iii)(C)

of this section, the amount realized by

a holder on the retirement of a debt

instrument is reduced by any negative

adjustment carryforward determined in

the taxable year of the retirement.

(v) Unscheduled retirements. An

unscheduled retirement of a debt

instrument (or the receipt of a pro-rata

prepayment that is treated as a

retirement of a portion of a debt

instrument under § 1.1275–2(f)) is

treated as a repurchase of the debt

instrument (or a pro-rata portion of the

debt instrument) by the issuer from the

holder for the amount paid by the issuer

to the holder.

(vi) Examples. The following

examples illustrate the provisions of

paragraphs (b) (6) and (7) of this section.

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.

Example 1. Treatment of positive and

negative adjustments—(i) Facts. On

December 31, 1996, Z, a calendar year

taxpayer, purchases a debt instrument subject

to this paragraph (b) at original issue for

$1,000. The debt instrument’s comparable

yield is 10 percent, compounded annually,

and the projected payment schedule provides

for payments of $500 on December 31, 1997

(consisting of a noncontingent payment of

$375 and a projected amount of $125) and

$660 on December 31, 1998 (consisting of a

noncontingent payment of $600 and a

projected amount of $60). The debt

instrument is a capital asset in the hands of

Z.

(ii) Adjustment in 1997. Based on the

projected payment schedule, Z’s total daily

portions of interest on the debt instrument

are $100 for 1997 (issue price of $1,000 x 10

percent). Assume that the payment actually

made on December 31, 1997, is $375, rather

than the projected $500. Under paragraph

(b)(6)(i) of this section, Z has a negative

adjustment of $125 on December 31, 1997,

attributable to the difference between the

amount of the actual payment and the

amount of the projected payment. Because Z

has no positive adjustments for 1997, Z has

a net negative adjustment of $125 on the debt

instrument for 1997. This net negative

adjustment reduces to zero the $100 total

daily portions of interest Z would otherwise

include in income in 1997. Accordingly, Z

has no interest income on the debt

instrument for 1997. Because Z had no

interest inclusions on the debt instrument for

prior taxable years, the remaining $25 of the

net negative adjustment is a negative

adjustment carryforward for 1997 that results

in a negative adjustment of $25 on January

1, 1998.

(iii) Adjustment to issue price and basis.

Z’s total daily portions of interest on the debt

instrument are $100 for 1997. The adjusted

issue price of the debt instrument and Z’s

adjusted basis in the debt instrument are

increased by this amount, despite the fact

that Z does not include this amount in

income because of the net negative

adjustment for 1997. In addition, the adjusted

issue price of the debt instrument and Z’s

adjusted basis in the debt instrument are

decreased on December 31, 1997, by the

projected amount of the payment on that date

($500). Thus, on January 1, 1998, Z’s adjusted

basis in the debt instrument and the adjusted

issue price of the debt instrument are $600.

(iv) Adjustments in 1998. Based on the

projected payment schedule, Z’s total daily

portions of interest are $60 for 1998 (adjusted

issue price of $600 x 10 percent). Assume

that the payment actually made on December

31, 1998, is $700, rather than the projected

$660. Under paragraph (b)(6)(i) of this

section, Z has a positive adjustment of $40

on December 31, 1998, attributable to the

difference between the amount of the actual

payment and the amount of the projected

payment. Because Z also has a negative

adjustment of $25 on January 1, 1998, Z has

a net positive adjustment of $15 on the debt

instrument for 1998 (the excess of the $40

positive adjustment over the $25 negative

adjustment). As a result, Z has $75 of interest

income on the debt instrument for 1998 (the

$15 net positive adjustment plus the $60 total

daily portions of interest that are taken into

account by Z in that year).

(v) Retirement. Based on the projected

payment schedule, Z’s adjusted basis in the

debt instrument immediately before the

payment at maturity is $660 ($600 plus $60

total daily portions of interest for 1998). Even

though Z receives $700 at maturity, for

purposes of determining the amount realized

by Z on retirement of the debt instrument, Z

is treated as receiving the projected amount

of the contingent payment on December 31,

1998. Therefore, Z is treated as receiving

$660 on December 31, 1998. Because Z’s

adjusted basis in the debt instrument

immediately before its retirement is $660, Z

recognizes no gain or loss on the retirement.

Example 2. Negative adjustment

carryforward for year of sale—(i) Facts.

Assume the same facts as in Example 1 of

this paragraph (b)(7)(vi), except that Z sells

the debt instrument on January 1, 1998, for

$630.

(ii) Gain on sale. On the date the debt

instrument is sold, Z’s adjusted basis in the

debt instrument is $600. Because Z has a

negative adjustment of $25 on the debt

instrument on January 1, 1998, and has no

positive adjustments on the debt instrument

in 1998, Z has a net negative adjustment for

1998 of $25. Because Z has not included in

income any interest on the debt instrument,

the entire $25 net negative adjustment is a

negative adjustment carryforward for the

taxable year of the sale. Under paragraph

(b)(6)(iii)(C) of this section, the $25 negative

adjustment carryforward reduces the amount

realized by Z on the sale of the debt

instrument from $630 to $605. Thus, Z has

a gain on the sale of $5 ($605¥$600). Under

paragraph (b)(8)(i) of this section, the gain is

treated as interest income.

Example 3. Negative adjustment

carryforward for year of retirement—(i) Facts.

Assume the same facts as in Example 1 of

this paragraph (b)(7)(vi), except that the

payment actually made on December 31,

1998, is $615, rather than the projected $660.

(ii) Adjustments in 1998. Under paragraph

(b)(6)(i) of this section, Z has a negative

adjustment of $45 on December 31, 1998,

attributable to the difference between the

amount of the actual payment and the

amount of the projected payment. In

addition, Z has a negative adjustment of $25

on January 1, 1998. See Example 1(ii) of this

paragraph (b)(7)(vi). Because Z has no

positive adjustments in 1998, Z has a net

negative adjustment of $70 for 1998. This net

negative adjustment reduces to zero the $60

total daily portions of interest Z would

otherwise include in income for 1998.

Therefore, Z has no interest income on the

debt instrument for 1998. Because Z had no

interest inclusions on the debt instrument for

1997, the remaining $10 of the net negative

adjustment is a negative adjustment

carryforward for 1998 that reduces the

amount realized by Z on retirement of the

debt instrument.

(iii) Loss on retirement. Immediately before

the payment at maturity, Z’s adjusted basis

in the debt instrument is $660. Under

paragraph (b)(7)(iv) of this section, Z is

treated as receiving the projected amount of

the contingent payment, or $660, as the

payment at maturity. Under paragraph

(b)(6)(iii)(C) of this section, however, this

amount is reduced by any negative

adjustment carryforward determined for the

taxable year of retirement to calculate the

amount Z realizes on retirement of the debt

instrument. Thus, Z has a loss of $10 on the

retirement of the debt instrument, equal to

the amount by which Z’s adjusted basis in

the debt instrument ($660) exceeds the

amount Z realizes on the retirement of the

debt instrument ($660 minus the $10

negative adjustment carryforward). Under

paragraph (b)(8)(ii) of this section, the loss is

a capital loss.

(8) Character on sale, exchange, or

retirement—(i) Gain. Any gain

recognized by a holder on the sale,
30148 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

exchange, or retirement of a debt

instrument subject to this paragraph (b)

is interest income.

(ii) Loss. Any loss recognized by a

holder on the sale, exchange, or

retirement of a debt instrument subject

to this paragraph (b) is ordinary loss to

the extent that the holder’s total interest

inclusions on the debt instrument

exceed the total net negative

adjustments on the debt instrument the

holder took into account as ordinary

loss. Any additional loss is treated as

loss from the sale, exchange, or

retirement of the debt instrument.

However, any loss that would otherwise

be ordinary under this paragraph

(b)(8)(ii) and that is attributable to the

holder’s basis that could not be

amortized under section 171(b)(4) is loss

from the sale, exchange, or retirement of

the debt instrument.

(iii) Special rule if there are no

remaining contingent payments on the

debt instrument—(A) In general.

Notwithstanding paragraphs (b)(8) (i)

and (ii) of this section, if, at the time of

the sale, exchange, or retirement of the

debt instrument, there are no remaining

contingent payments due on the debt

instrument under the projected payment

schedule, any gain or loss recognized by

the holder is gain or loss from the sale,

exchange, or retirement of the debt

instrument. See paragraph (b)(9)(ii) of

this section to determine whether there

are no remaining contingent payments

on a debt instrument that provides for

fixed but deferred contingent payments.

(B) Exception for certain positive

adjustments. Notwithstanding

paragraph (b)(8)(iii)(A) of this section, if

a positive adjustment on a debt

instrument is spread under paragraph

(b)(9)(ii) (F) or (G) of this section, any

gain recognized by the holder on the

sale, exchange, or retirement of the

instrument is treated as interest income

to the extent of the positive adjustment

that has not yet been accrued and

included in income by the holder.

(iv) Examples. The following

examples illustrate the provisions of

this paragraph (b)(8). 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.

Example 1. Gain on sale—(i) Facts. On

January 1, 1998, D, a calendar year taxpayer,

sells a debt instrument that is subject to

paragraph (b) of this section for $1,350. The

projected payment schedule for the debt

instrument provides for contingent payments

after January 1, 1998. On January 1, 1998, D

has an adjusted basis in the debt instrument

of $1,200. In addition, D has a negative

adjustment carryforward of $50 for 1997 that,

under paragraph (b)(6)(iii)(C) of this section,

results in a negative adjustment of $50 on

January 1, 1998. D has no positive

adjustments on the debt instrument on

January 1, 1998.

(ii) Character of gain. Under paragraph

(b)(6) of this section, the $50 negative

adjustment on January 1, 1998, results in a

negative adjustment carryforward for 1998,

the taxable year of the sale of the debt

instrument. Under paragraph (b)(6)(iii)(C) of

this section, the negative adjustment

carryforward reduces the amount realized by

D on the sale of the debt instrument from

$1,350 to $1,300. As a result, D realizes a

$100 gain on the sale of the debt instrument,

equal to the $1,300 amount realized minus

D’s $1,200 adjusted basis in the debt

instrument. Under paragraph (b)(8)(i) of this

section, the gain is interest income to D.

Example 2. Loss on sale—(i) Facts. On

December 31, 1996, E, a calendar year

taxpayer, purchases a debt instrument at

original issue for $1,000. The debt instrument

is a capital asset in the hands of E. The debt

instrument provides for a single payment on

December 31, 1998 (the maturity date of the

instrument), of $1,000 plus an amount based

on the increase, if any, in the price of a

specified commodity over the term of the

instrument. The comparable yield for the

debt instrument is 9.54 percent, compounded

annually, and the projected payment

schedule provides for a payment of $1,200 on

December 31, 1998. Based on the projected

payment schedule, the total daily portions of

interest are $95 for 1997 and $105 for 1998.

(ii) Ordinary loss. Assume that E sells the

debt instrument for $1,050 on December 31,

1997. On that date, E has an adjusted basis

in the debt instrument of $1,095 ($1,000

original basis, plus total daily portions of $95

for 1997). Therefore, E realizes a $45 loss on

the sale of the debt instrument ($1,050–

$1,095). The loss is ordinary to the extent E’s

total interest inclusions on the debt

instrument ($95) exceed the total net negative

adjustments on the instrument that E took

into account as an ordinary loss. Because E

has not had any net negative adjustments on

the debt instrument, the $45 loss is an

ordinary loss.

(iii) Capital loss. Alternatively, assume that

E sells the debt instrument for $990 on

December 31, 1997. E realizes a $105 loss on

the sale of the debt instrument ($990 ¥

$1,095). The loss is ordinary to the extent E’s

total interest inclusions on the debt

instrument ($95) exceed the total net negative

adjustments on the instrument that E took

into account as an ordinary loss. Because E

has not had any net negative adjustments on

the debt instrument, $95 of the $105 loss is

an ordinary loss. The remaining $10 of the

$105 loss is a capital loss.

(9) Operating rules. The rules of this

paragraph (b)(9) apply to a debt

instrument subject to the noncontingent

bond method notwithstanding any other

rule of this paragraph (b).

(i) Basis different from adjusted issue

price. This paragraph (b)(9)(i) provides

rules for a holder whose basis in a debt

instrument is different from the adjusted

issue price of the debt instrument (e.g.,

a subsequent holder that purchases the

debt instrument for more or less than

the instrument’s adjusted issue price).

(A) General rule. The holder accrues

interest under paragraph (b)(3)(iii) of

this section and makes adjustments

under paragraph (b)(3)(iv) of this section

based on the projected payment

schedule determined as of the issue date

of the debt instrument. However, upon

acquiring the debt instrument, the

holder must reasonably allocate any

difference between the adjusted issue

price and the basis to daily portions of

interest or projected payments over the

remaining term of the debt instrument.

Allocations are taken into account

under paragraphs (b)(9)(i) (B) and (C) of

this section.

(B) Basis greater than adjusted issue

price. If the holder’s basis in the debt

instrument exceeds the debt

instrument’s adjusted issue price, the

amount of the difference allocated to a

daily portion of interest or to a projected

payment is treated as a negative

adjustment on the date the daily portion

accrues or the payment is made. On the

date of the adjustment, the holder’s

adjusted basis in the debt instrument is

reduced by the amount the holder treats

as a negative adjustment under this

paragraph (b)(9)(i)(B). See paragraph

(b)(9)(ii)(E) of this section for a special

rule that applies when a contingent

payment is fixed more than 6 months

before it is due.

(C) Basis less than adjusted issue

price. If the holder’s basis in the debt

instrument is less than the debt

instrument’s adjusted issue price, the

amount of the difference allocated to a

daily portion of interest or to a projected

payment is treated as a positive

adjustment on the date the daily portion

accrues or the payment is made. On the

date of the adjustment, the holder’s

adjusted basis in the debt instrument is

increased by the amount the holder

treats as a positive adjustment under

this paragraph (b)(9)(i)(C). See

paragraph (b)(9)(ii)(E) of this section for

a special rule that applies when a

contingent payment is fixed more than

6 months before it is due.

(D) Premium and discount rules do

not apply. The rules for accruing

premium and discount in sections 171,

1272(a)(7), 1276, and 1281 do not apply.

Other rules of those sections, such as

section 171(b)(4), continue to apply to

the extent relevant.

(E) Safe harbor for exchange listed

debt instruments. If the debt instrument

is exchange listed property (within the

meaning of § 1.1273–2(f)(2)), it is

reasonable for the holder to allocate any

difference between the holder’s basis
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30149

and the adjusted issue price of the debt

instrument pro-rata to daily portions of

interest (as determined under paragraph

(b)(3)(iii) of this section) over the

remaining term of the debt instrument.

A pro-rata allocation is not reasonable,

however, to the extent the holder’s yield

on the debt instrument, determined after

taking into account the amounts

allocated under this paragraph

(b)(9)(i)(E), is less than the applicable

Federal rate for the instrument. For

purposes of the preceding sentence, the

applicable Federal rate for the debt

instrument is determined as if the

purchase date were the issue date and

the remaining term of the instrument

were the term of the instrument.

(F) Examples. The following examples

illustrate the provisions of this

paragraph (b)(9)(i). 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. In addition, assume that

each instrument is not exchange listed

property.

Example 1. Basis greater than adjusted

issue price—(i) Facts. On July 1, 1998, Z

purchases for $1,405 a debt instrument that

matures on December 31, 1999, and promises

to pay on the maturity date $1,000 plus the

increase, if any, in the price of a specified

amount of a commodity from the issue date

to the maturity date. The debt instrument

was originally issued on December 31, 1996,

for an issue price of $1,000. The comparable

yield for the debt instrument is 10.25

percent, compounded semiannually, and the

projected payment schedule for the debt

instrument (determined as of the issue date)

provides for a single payment at maturity of

$1,350. At the time of the purchase, the debt

instrument has an adjusted issue price of

$1,162, assuming semiannual accrual periods

ending on December 31 and June 30 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 and not to a decrease

in market interest rates. The debt instrument

is a capital asset in the hands of Z. Z is a

calendar year taxpayer.

(ii) Allocation of the difference between

basis and adjusted issue price. Z’s basis in

the debt instrument on July 1, 1998, is

$1,405. Under paragraph (b)(9)(i)(A) of this

section, Z allocates the $243 difference

between basis ($1,405) and adjusted issue

price ($1,162) to the contingent payment at

maturity. Z’s allocation of the difference

between basis and adjusted issue price is

reasonable because 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.

(iii) Treatment of debt instrument for 1998.

Based on the projected payment schedule,

$60 of interest accrues on the debt

instrument from July 1, 1998 to December 31,

1998 (the product of the debt instrument’s

adjusted issue price on July 1, 1998 ($1,162)

and the comparable yield properly adjusted

for the length of the accrual period (10.25

percent/2)). Z has no net negative or positive

adjustments for 1998. Thus, Z includes in

income $60 of total daily portions of interest

for 1998. On December 31, 1998, Z’s adjusted

basis in the debt instrument is $1,465 ($1,405

original basis, plus total daily portions of $60

for 1998).

(iv) Effect of allocation to contingent

payment at maturity. Assume that the

payment actually made on December 31,

1999, is $1,400, rather than the projected

$1,350. Thus, under paragraph (b)(6)(i) of this

section, Z has a positive adjustment of $50

on December 31, 1999. In addition, under

paragraph (b)(9)(i)(B) of this section, Z has a

negative adjustment of $243 on December 31,

1999, which is attributable to the difference

between Z’s basis in the debt instrument on

July 1, 1998, and the instrument’s adjusted

issue price on that date. As a result, Z has

a net negative adjustment of $193 for 1999.

This net negative adjustment reduces to zero

the $128 total daily portions of interest Z

would otherwise include in income in 1999.

Accordingly, Z has no interest income on the

debt instrument for 1999. Because Z had $60

of interest inclusions for 1998, $60 of the

remaining $65 net negative adjustment is

treated by Z as an ordinary loss for 1999. The

remaining $5 of the net negative adjustment

is a negative adjustment carryforward for

1999 that reduces the amount realized by Z

on the retirement of the debt instrument from

$1,350 to $1,345.

(v) Loss at maturity. On December 31,

1999, Z’s basis in the debt instrument is

$1,350 ($1,405 original basis, plus total daily

portions of $60 for 1998 and $128 for 1999,

minus the negative adjustment of $243). As

a result, Z realizes a loss of $5 on the

retirement of the debt instrument (the

difference between the amount realized on

the retirement ($1,345) and Z’s adjusted basis

in the debt instrument ($1,350)). Under

paragraph (b)(8)(ii) of this section, the $5 loss

is treated as loss from the retirement of the

debt instrument. Consequently, Z realizes a

total loss of $65 on the debt instrument for

1999 (a $60 ordinary loss and a $5 capital

loss).

Example 2. Basis less than adjusted issue

price—(i) Facts. On January 1, 1999, Y

purchases for $910 a debt instrument that

pays 7 percent interest semiannually on June

30 and December 31 of each year, and that

promises to pay on December 31, 2001,

$1,000 plus or minus $10 times the positive

or negative difference, if any, between a

specified amount and the value of an index

on December 31, 2001. However, the

payment on December 31, 2001, may not be

less than $650. The debt instrument was

originally issued on December 31, 1996, for

an issue price of $1,000. The comparable

yield for the debt instrument is 9.80 percent,

compounded semiannually, and the

projected payment schedule for the debt

instrument (determined as of the issue date)

provides for semiannual payments of $35 and

a contingent payment at maturity of $1,175.

On January 1, 1999, the debt instrument has

an adjusted issue price of $1,060, assuming

semiannual accrual periods ending on

December 31 and June 30 of each year. Y is

a calendar year taxpayer.

(ii) Allocation of the difference between

basis and adjusted issue price. Y’s basis in

the debt instrument on January 1, 1999, is

$910. Under paragraph (b)(9)(i)(A) of this

section, Y must allocate the $150 difference

between basis ($910) and adjusted issue price

($1,060) to daily portions of interest or to

projected payments. These amounts will be

positive adjustments taken into account at

the time the daily portions accrue or the

payments are made.

(A) Assume that, because of a decrease in

the relevant index, the expected value of the

payment at maturity has declined by about 9

percent. Based on forward prices on January

1, 1999, Y determines that approximately

$105 of the difference between basis and

adjusted issue price is allocable to the

contingent payment. Y allocates the

remaining $45 to daily portions of interest on

a pro-rata basis (i.e., the amount allocated to

an accrual period equals the product of $45

and a fraction, the numerator of which is the

total daily portions for the accrual period and

the denominator of which is the total daily

portions remaining on the debt instrument on

January 1, 1999). This allocation is

reasonable.

(B) Assume alternatively that, based on

yields of comparable debt instruments and its

purchase price for the debt instrument, Y

determines that an appropriate yield for the

debt instrument is 13 percent, compounded

semiannually. Based on this determination, Y

allocates $55.75 of the difference between

basis and adjusted issue price to daily

portions of interest as follows: $15.19 to the

daily portions of interest for the taxable year

ending December 31, 1999; $18.40 to the

daily portions of interest for the taxable year

ending December 31, 2000; and $22.16 to the

daily portions of interest for the taxable year

ending December 31, 2001. Y allocates the

remaining $94.25 to the contingent payment

at maturity. This allocation is reasonable.

(ii) Fixed but deferred contingent

payments. This paragraph (b)(9)(ii)

provides rules that apply when the

amount of a contingent payment

becomes fixed before the payment is

due. For purposes of paragraph (b) of

this section, if a contingent payment

becomes fixed within the 6-month

period ending on the due date of the

payment, the payment is treated as a

contingent payment even after the

payment is fixed. If a contingent

payment becomes fixed more than 6

months before the payment is due, the

following rules apply to the debt

instrument.

(A) Determining adjustments. The

amount of the adjustment attributable to

the contingent payment is equal to the

difference between the present value of

the amount that is fixed and the present

value of the projected amount of the

contingent payment. The present value

of each amount is determined by

discounting the amount from the date

the payment is due to the date the
30150 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

payment becomes fixed, using a

discount rate equal to the comparable

yield on the debt instrument. The

adjustment is treated as a positive or

negative adjustment, as appropriate, on

the date the contingent payment

becomes fixed. See paragraph

(b)(9)(ii)(G) of this section to determine

the timing of the adjustment if all

remaining contingent payments on the

debt instrument become fixed

substantially contemporaneously.

(B) Payment schedule. The contingent

payment is no longer treated as a

contingent payment after the date the

amount of the payment becomes fixed.

On the date the contingent payment

becomes fixed, the projected payment

schedule for the debt instrument is

modified prospectively to reflect the

fixed amount of the payment. Therefore,

no adjustment is made under paragraph

(b)(3)(iv) of this section when the

contingent payment is actually made.

(C) Accrual period. Notwithstanding

the determination under § 1.1272–

1(b)(1)(ii) of accrual periods for the debt

instrument, an accrual period ends on

the day the contingent payment

becomes fixed, and a new accrual

period begins on the day after the day

the contingent payment becomes fixed.

(D) Adjustments to basis and adjusted

issue price. The amount of any positive

adjustment on a debt instrument

determined under paragraph (b)(9)(ii)(A)

of this section increases the adjusted

issue price of the instrument and the

holder’s adjusted basis in the

instrument. Similarly, the amount of

any negative adjustment on a debt

instrument determined under paragraph

(b)(9)(ii)(A) of this section decreases the

adjusted issue price of the instrument

and the holder’s adjusted basis in the

instrument.

(E) Basis different from adjusted issue

price. If a holder’s basis in a debt

instrument exceeds the debt

instrument’s adjusted issue price, the

amount allocated to a projected

payment under paragraph (b)(9)(i) of

this section is treated as a negative

adjustment on the date the payment

becomes fixed. If a holder’s basis in a

debt instrument is less than the debt

instrument’s adjusted issue price, the

amount allocated to a projected

payment under paragraph (b)(9)(i) of

this section is treated as a positive

adjustment on the date the payment

becomes fixed.

(F) Special rule for certain contingent

interest payments. Notwithstanding

paragraph (b)(9)(ii)(A) of this section,

this paragraph (b)(9)(ii)(F) applies to

contingent stated interest payments that

are adjusted to compensate for

contingencies regarding the

reasonableness of the debt instrument’s

stated rate of interest. For example, this

paragraph (b)(9)(ii)(F) applies to a debt

instrument that provides for an increase

in the stated rate of interest if the credit

quality of the issuer or liquidity of the

debt instrument deteriorates. Contingent

stated interest payments of this type are

recognized over the period to which

they relate in a reasonable manner.

(G) Special rule when all contingent

payments become fixed.

Notwithstanding paragraph (b)(9)(ii)(A)

of this section, if all the remaining

contingent payments on a debt

instrument become fixed substantially

contemporaneously, any positive or

negative adjustments on the instrument

are taken into account in a reasonable

manner over the period to which they

relate. For purposes of the preceding

sentence, a payment is treated as a fixed

payment if all remaining contingencies

with respect to the payment are remote

or incidental (within the meaning of

§ 1.1275–2(h)).

(H) Example. The following example

illustrates the provisions of this

paragraph (b)(9)(ii). In this 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.

Example. Fixed but deferred payments—(i)

Facts. On December 31, 1996, B, a calendar

year taxpayer, purchases a debt instrument at

original issue for $1,000. The debt instrument

matures on December 31, 2002, and provides

for a payment of $1,000 at maturity. In

addition, on December 31, 1999, and

December 31, 2002, the debt instrument

provides for payments equal to the excess of

the average daily value of an index for the

6-month period ending on September 30 of

the preceding year over a specified amount.

The debt instrument’s comparable yield is 10

percent, compounded annually, and the

instrument’s projected payment schedule

consists of a payment of $250 on December

31, 1999, and a payment of $1,439 on

December 31, 2002. B uses annual accrual

periods.

(ii) Interest accrual for 1997. Based on the

projected payment schedule, B includes a

total of $100 of daily portions of interest in

income in 1997. B’s adjusted basis in the debt

instrument and the debt instrument’s

adjusted issue price on December 31, 1997,

is $1,100.

(iii) Interest accrual for 1998—(A)

Adjustment. Based on the projected payment

schedule, B would include $110 of total daily

portions of interest in income in 1998.

However, assume that on September 30,

1998, the payment due on December 31,

1999, fixes at $300, rather than the projected

$250. Thus, on September 30, 1998, B has an

adjustment equal to the difference between

the present value of the $300 fixed amount

and the present value of the $250 projected

amount of the contingent payment. The

present values of the two payments are

determined by discounting each payment

from the date the payment is due (December

31, 1999) to the date the payment becomes

fixed (September 30, 1998), using a discount

rate equal to 10 percent, compounded

annually. The present value of the fixed

payment is $266.30 and the present value of

the projected amount of the contingent

payment is $221.91. Thus, on September 30,

1998, B has a positive adjustment of $44.39

($266.30–$221.91).

(B) Effect of adjustment. Under paragraph

(b)(9)(ii)(C) of this section, B’s accrual period

ends on September 30, 1998. The daily

portions of interest on the debt instrument

for the period from January 1, 1998 to

September 30, 1998 total $81.51. The

adjusted issue price of the debt instrument

and B’s adjusted basis in the debt instrument

are thus increased over this period by

$125.90 (the sum of the daily portions of

interest of $81.51 and the positive adjustment

of $44.39 made at the end of the period) to

$1,225.90. For purposes of all future accrual

periods, including the new accrual period

from October 1, 1998, to December 31, 1998,

the debt instrument’s projected payment

schedule is modified to reflect a fixed

payment of $300 on December 31, 1999.

Based on the new adjusted issue price of the

debt instrument and the new projected

payment schedule, the yield on the debt

instrument does not change.

(C) Interest accrual for 1998. Based on the

modified projected payment schedule, $29.56

of interest accrues during the accrual period

that ends on December 31, 1998. Because B

has no other adjustments during 1998, the

$44.39 positive adjustment on September 30,

1998, results in a net positive adjustment for

1998, which is additional interest for that

year. Thus, B includes $155.46

($81.51+$29.56+$44.39) of interest in income

in 1998. B’s adjusted basis in the debt

instrument and the debt instrument’s

adjusted issue price on December 31, 1998,

is $1,255.46 ($1,225.90 from the end of the

prior accrual period plus $29.56 total daily

portions for the current accrual period).

(iii) Timing contingencies. This

paragraph (b)(9)(iii) provides rules for

debt instruments that have payments

that are contingent as to time.

(A) Treatment of certain options. If a

taxpayer has an unconditional option to

put or call the debt instrument, to

exchange the debt instrument for other

property, or to extend the maturity date

of the debt instrument, the projected

payment schedule is determined by

using the principles of § 1.1272–1(c)(5).

(B) Other timing contingencies.

[Reserved]

(iv) Cross-border transactions—(A)

Allocation of deductions. For purposes

of § 1.861–8, the holder of a debt

instrument shall treat any deduction or

loss treated as an ordinary loss under

paragraph (b)(6)(iii)(B) or (b)(8)(ii) of

this section as a deduction that is

definitely related to the class of gross
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30151

income to which income from such debt

instrument belongs. Accordingly, if a

U.S. person holds a debt instrument

issued by a related controlled foreign

corporation and, pursuant to section

904(d)(3) and the regulations

thereunder, any interest accrued by

such U.S. person with respect to such

debt instrument would be treated as

foreign source general limitation

income, any deductions relating to a net

negative adjustment will reduce the U.S.

person’s foreign source general

limitation income. The holder shall

apply the general rules relating to

allocation and apportionment of

deductions to any other deduction or

loss realized by the holder with respect

to the debt instrument.

(B) Investments in United States real

property. Notwithstanding paragraph

(b)(8)(i) of this section, gain on the sale,

exchange, or retirement of a debt

instrument that is a United States real

property interest is treated as gain for

purposes of sections 897, 1445, and

6039C.

(v) Coordination with subchapter M

and related provisions. For purposes of

sections 852(c)(2) and 4982 and § 1.852–

11, any positive adjustment, negative

adjustment, income, or loss on a debt

instrument that occurs after October 31

of a taxable year is treated in the same

manner as foreign currency gain or loss

that is attributable to a section 988

transaction.

(vi) Coordination with section 1092. A

holder treats a negative adjustment and

an issuer treats a positive adjustment as

a loss with respect to a position in a

straddle if the debt instrument is a

position in a straddle and the

contingency (or any portion of the

contingency) to which the adjustment

relates would be part of the straddle if

entered into as a separate position.

(c) Method for debt instruments not

subject to the noncontingent bond

method—(1) Applicability. This

paragraph (c) applies to a contingent

payment debt instrument (other than a

tax-exempt obligation) that has an issue

price determined under § 1.1274–2. For

example, this paragraph (c) generally

applies to a contingent payment debt

instrument that is issued for

nonpublicly traded property.

(2) Separation into components. If

paragraph (c) of this section applies to

a debt instrument (the overall debt

instrument), the noncontingent

payments are subject to the rules in

paragraph (c)(3) of this section, and the

contingent payments are accounted for

separately under the rules in paragraph

(c)(4) of this section.

(3) Treatment of noncontingent

payments. The noncontingent payments

are treated as a separate debt

instrument. The issue price of the

separate debt instrument is the issue

price of the overall debt instrument,

determined under § 1.1274–2(g). 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.

(4) Treatment of contingent

payments—(i) In general. Except as

provided in paragraph (c)(4)(iii) of this

section, the portion of a contingent

payment treated as interest under

paragraph (c)(4)(ii) of this section is

includible in gross income by the holder

and deductible from gross income by

the issuer in their respective taxable

years in which the payment is made.

(ii) Characterization of contingent

payments as principal and interest—(A)

General rule. A contingent payment is

treated as a payment of principal in an

amount equal to the present value of the

payment, determined by discounting the

payment at the test rate from the date

the payment is made to the issue date.

The amount of the payment in excess of

the amount treated as principal under

the preceding sentence is treated as a

payment of interest.

(B) Test rate. The test rate used for

purposes of paragraph (c)(4)(ii)(A) of

this section is the rate that would be the

test rate for the overall debt instrument

under § 1.1274–4 if the term of the

overall debt instrument began on the

issue date of the overall debt instrument

and ended on the date the contingent

payment is made. However, in the case

of a contingent payment that consists of

a payment of stated principal

accompanied by a payment of stated

interest at a rate that exceeds the test

rate determined under the preceding

sentence, the test rate is the stated

interest rate.

(iii) Certain delayed contingent

payments—(A) General rule.

Notwithstanding paragraph (c)(4)(ii) of

this section, if a contingent payment

becomes fixed more than 6 months

before the payment is due, the issuer

and holder are treated as if the issuer

had issued a separate debt instrument

on the date the payment becomes fixed,

maturing on the date the payment is

due. This separate debt instrument is

treated as a debt instrument to which

section 1274 applies. The stated

principal amount of this separate debt

instrument is the amount of the

payment that becomes fixed. An amount

equal to the issue price of this debt

instrument is characterized as interest

or principal under the rules of

paragraph (c)(4)(ii) of this section and

accounted for as if this amount had been

paid by the issuer to the holder on the

date that the amount of the payment

becomes fixed. To determine the issue

price of the separate debt instrument,

the payment is discounted at the test

rate from the maturity date of the

separate debt instrument to the date that

the amount of the payment becomes

fixed.

(B) Test rate. The test rate used for

purposes of paragraph (c)(4)(iii)(A) of

this section is determined in the same

manner as the test rate under paragraph

(c)(4)(ii)(B) of this section is determined

except that the date the contingent

payment is due is used rather than the

date the contingent payment is made.

(5) Basis different from adjusted issue

price. This paragraph (c)(5) provides

rules for a holder whose basis in a debt

instrument is different from the

instrument’s adjusted issue price (e.g., a

subsequent holder). This paragraph

(c)(5), however, does not apply if the

holder is reporting income under the

installment method of section 453.

(i) Allocation of basis. The holder

must allocate basis to the noncontingent

component (i.e., the right to the

noncontingent payments) and to any

separate debt instruments described in

paragraph (c)(4)(iii) of this section in an

amount up to the total of the adjusted

issue price of the noncontingent

component and the adjusted issue

prices of the separate debt instruments.

The holder must allocate the remaining

basis, if any, to the contingent

component (i.e., the right to the

contingent payments).

(ii) Noncontingent component. Any

difference between the holder’s basis in

the noncontingent component and the

adjusted issue price of the

noncontingent component, and any

difference between the holder’s basis in

a separate debt instrument and the

adjusted issue price of the separate debt

instrument, is taken into account under

the rules for market discount, premium,

and acquisition premium that apply to

a noncontingent debt instrument.

(iii) Contingent component. Amounts

received by the holder that are treated

as principal payments under paragraph

(c)(4)(ii) of this section reduce the

holder’s basis in the contingent

component. If the holder’s basis in the

contingent component is reduced to

zero, any additional principal payments

on the contingent component are treated

as gain from the sale or exchange of the

debt instrument. Any basis remaining

on the contingent component on the

date the final contingent payment is

made increases the holder’s adjusted

basis in the noncontingent component
30152 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

(or, if there are no remaining

noncontingent payments, is treated as

loss from the sale or exchange of the

debt instrument).

(6) Treatment of a holder on sale,

exchange, or retirement. This paragraph

(c)(6) provides rules for the treatment of

a holder on the sale, exchange, or

retirement of a debt instrument subject

to this paragraph (c). Under this

paragraph (c)(6), the holder must

allocate the amount received from the

sale, exchange, or retirement of a debt

instrument first to the noncontingent

component and to any separate debt

instruments described in paragraph

(c)(4)(iii) of this section in an amount up

to the total of the adjusted issue price

of the noncontingent component and

the adjusted issue prices of the separate

debt instruments. The holder must

allocate the remaining amount received,

if any, to the contingent component.

(i) Amount allocated to the

noncontingent component. The amount

allocated to the noncontingent

component and any separate debt

instruments is treated as an amount

realized from the sale, exchange, or

retirement of the noncontingent

component or separate debt instrument.

(ii) Amount allocated to the

contingent component. The amount

allocated to the contingent component

is treated as a contingent payment that

is made on the date of the sale,

exchange, or retirement and is

characterized as interest and principal

under the rules of paragraph (c)(4)(ii) of

this section.

(7) Examples. The following examples

illustrate the provisions of this

paragraph (c). 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.

Example 1. Contingent interest payments—

(i) Facts. A owns Blackacre, unencumbered

depreciable real estate. On January 1, 1997,

A sells Blackacre to B. As consideration for

the sale, B makes a downpayment of

$1,000,000 and issues to A a debt instrument

that matures on December 31, 2001. The debt

instrument provides for a payment of

principal at maturity of $5,000,000 and a

contingent payment of interest on December

31 of each year equal to a fixed percentage

of the gross rents B receives from Blackacre

in that year. Assume that the debt instrument

is not issued in a potentially abusive

situation. Assume also that on January 1,

1997, the short-term applicable Federal rate

is 5 percent, compounded annually, and the

mid-term applicable Federal rate is 6 percent,

compounded annually.

(ii) Determination of issue price. Under

§ 1.1274–2(g), the issue price of the debt

instrument is $3,736,291, which is the

present value, as of the issue date, of the

$5,000,000 noncontingent payment due at

maturity, calculated using a discount rate

equal to the mid-term applicable Federal rate.

Under § 1.1012–1(g)(1), B’s basis in Blackacre

on January 1, 1997, is $4,736,291 ($1,000,000

down payment plus the $3,736,291 issue

price of the debt instrument).

(iii) Noncontingent payment treated as

separate debt instrument. Under paragraph

(c)(3) of this section, the right to the

noncontingent payment of principal at

maturity is treated as a separate debt

instrument. The issue price of this separate

debt instrument is $3,736,291 (the issue price

of the overall debt instrument). The separate

debt instrument has a stated redemption

price at maturity of $5,000,000 and,

therefore, OID of $1,263,709.

(iv) Treatment of contingent payments.

Assume that the amount of contingent

interest that is fixed and paid on December

31, 1997, is $200,000. Under paragraph

(c)(4)(ii) of this section, this payment is

treated as consisting of a payment of

principal of $190,476, which is the present

value of the payment, determined by

discounting the payment at the test rate of 5

percent, compounded annually, from the

date the payment is made to the issue date.

The remainder of the $200,000 payment

($9,524) is treated as interest. The additional

amount treated as principal gives B

additional basis in Blackacre on December

31, 1997. The portion of the payment treated

as interest is includible in gross income by

A and deductible by B in their respective

taxable years in which December 31, 1997

occurs. The remaining contingent payments

on the debt instrument are accounted for

similarly, using a test rate of 5 percent,

compounded annually, for the contingent

payments due on December 31, 1998, and

December 31, 1999, and a test rate of 6

percent, compounded annually, for the

contingent payments due on December 31,

2000, and December 31, 2001.

Example 2. Fixed but deferred payment—

(i) Facts. The facts are the same as in

paragraph (c)(7) Example 1 of this section,

except that the contingent payment of

interest that is fixed on December 31, 1997,

is not payable until December 31, 2001, the

maturity date.

(ii) Treatment of deferred contingent

payment. Assume that the amount of the

payment that becomes fixed on December 31,

1997, is $200,000. Because this amount is not

payable until December 31, 2001, under

paragraph (c)(4)(iii) of this section, a separate

debt instrument to which section 1274

applies is treated as issued by B on December

31, 1997 (the date the payment is fixed). The

maturity date of this separate debt instrument

is December 31, 2001 (the date on which the

payment is due). The stated principal amount

of this separate debt instrument is $200,000,

the amount of the payment that becomes

fixed. The imputed principal amount of the

separate debt instrument is $158,419, which

is the present value, as of December 31, 1997,

of the $200,000 payment, computed using a

discount rate equal to the test rate of the

overall debt instrument (6 percent,

compounded annually). An amount equal to

the issue price of the separate debt

instrument is treated as an amount paid on

December 31, 1997, and characterized as

interest and principal under the rules of

paragraph (c)(4)(ii) of this section. The

amount of the deemed payment characterized

as principal is equal to $150,875, which is

the present value, as of January 1, 1997 (the

issue date of the overall debt instrument), of

the deemed payment, computed using a

discount rate of 5 percent, compounded

annually. The amount of the deemed

payment characterized as interest is $7,544

($158,419 ¥$150,875), which is includible in

gross income by A and deductible by B in

their respective taxable years in which

December 31, 1997 occurs.

(d) Rules for tax-exempt obligations—

(1) In general. Except as modified by

this paragraph (d), the noncontingent

bond method described in paragraph (b)

of this section applies to a tax-exempt

obligation (as defined in section

1275(a)(3)) to which this section

applies. Paragraph (d)(2) of this section

applies to certain tax-exempt obligations

that provide for interest-based payments

or revenue-based payments and

paragraph (d)(3) of this section applies

to all other obligations. Paragraph (d)(4)

of this section provides rules for a

holder whose basis in a tax-exempt

obligation is different from the adjusted

issue price of the obligation.

(2) Certain tax-exempt obligations

with interest-based or revenue-based

payments—(i) Applicability. This

paragraph (d)(2) applies to a tax-exempt

obligation that provides for interestbased payments or revenue-based

payments.

(ii) Interest-based payments. A taxexempt obligation provides for interestbased payments if the obligation would

otherwise qualify as a variable rate debt

instrument under § 1.1275–5 except

that—

(A) The obligation provides for more

than one fixed rate;

(B) The obligation provides for one or

more caps, floors, or governors (or

similar restrictions) that are fixed as of

the issue date;

(C) The interest on the obligation is

not compounded or paid at least

annually; or (D) The obligation provides for

interest at one or more rates equal to the

product of a qualified floating rate and

a fixed multiple greater than zero and

less than .65, or at one or more rates

equal to the product of a qualified

floating rate and a fixed multiple greater

than zero and less than .65, increased or

decreased by a fixed rate. (iii) Revenue-based payments. A taxexempt obligation provides for revenuebased payments if the obligation—

(A) Is issued to refinance (including a

series of refinancings) an obligation (in

a series of refinancings, the original
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30153

obligation), the proceeds of which were

used to finance a project or enterprise;

and

(B) Would otherwise qualify as a

variable rate debt instrument under

§ 1.1275–5 except that it provides for

stated interest payments at least

annually based on a single fixed

percentage of the revenue, value, change

in value, or other similar measure of the

performance of the refinanced project or

enterprise.

(iv) Modifications to the

noncontingent bond method. If a taxexempt obligation is subject to this

paragraph (d)(2), the following

modifications to the noncontingent

bond method described in paragraph (b)

of this section apply to the obligation.

(A) Daily portions and net positive

adjustments. The daily portions of

interest determined under paragraph

(b)(3)(iii) of this section and any net

positive adjustment on the obligation

are interest for purposes of section 103.

(B) Net negative adjustments. A net

negative adjustment for a taxable year

reduces the amount of tax-exempt

interest the holder would otherwise

account for on the obligation for the

taxable year under paragraph (b)(3)(iii)

of this section. If the net negative

adjustment exceeds this amount, the

excess is a nondeductible,

noncapitalizable loss. If a regulated

investment company (RIC) within the

meaning of section 851 has a net

negative adjustment in a taxable year

that would be a nondeductible,

noncapitalizable loss under the prior

sentence, the RIC must use this loss to

reduce its tax-exempt interest income

on other tax-exempt obligations held

during the taxable year.

(C) Gains. Any gain recognized on the

sale, exchange, or retirement of the

obligation is gain from the sale or

exchange of the obligation.

(D) Losses. Any loss recognized on the

sale, exchange, or retirement of the

obligation is treated the same as a net

negative adjustment under paragraph

(d)(2)(iv)(B) of this section.

(E) Special rule for losses and net

negative adjustments. Notwithstanding

paragraphs (d)(2)(iv) (B) and (D) of this

section, on the sale, exchange, or

retirement of the obligation, the holder

may claim a loss from the sale or

exchange of the obligation to the extent

the holder has not received in cash or

property the sum of its original

investment in the obligation and any

amounts included in income under

paragraph (d)(4)(ii) of this section.

(3) All other tax-exempt obligations—

(i) Applicability. This paragraph (d)(3)

applies to a tax-exempt obligation that

is not subject to paragraph (d)(2) of this

section.

(ii) Modifications to the

noncontingent bond method. If a taxexempt obligation is subject to this

paragraph (d)(3), the following

modifications to the noncontingent

bond method described in paragraph (b)

of this section apply to the obligation.

(A) Modification to projected payment

schedule. The comparable yield for the

obligation is the greater of the

obligation’s yield, determined without

regard to the contingent payments, and

the tax-exempt applicable Federal rate

that applies to the obligation. The

Internal Revenue Service publishes the

tax-exempt applicable Federal rate for

each month in the Internal Revenue

Bulletin (see § 601.601(d)(2)(ii) of this

chapter).

(B) Daily portions. The daily portions

of interest determined under paragraph

(b)(3)(iii) of this section are interest for

purposes of section 103.

(C) Adjustments. A net positive

adjustment on the obligation is treated

as gain to the holder from the sale or

exchange of the obligation in the taxable

year of the adjustment. A net negative

adjustment on the obligation is treated

as a loss to the holder from the sale or

exchange of the obligation in the taxable

year of the adjustment.

(D) Gains and losses. Any gain or loss

recognized on the sale, exchange, or

retirement of the obligation is gain or

loss from the sale or exchange of the

obligation.

(4) Basis different from adjusted issue

price. This paragraph (d)(4) provides

rules for a holder whose basis in a taxexempt obligation is different from the

adjusted issue price of the obligation.

The rules of paragraph (b)(9)(i) of this

section do not apply to tax-exempt

obligations.

(i) Basis greater than adjusted issue

price. If the holder’s basis in the

obligation exceeds the obligation’s

adjusted issue price, the holder, upon

acquiring the obligation, must allocate

this difference to daily portions of

interest on a yield to maturity basis over

the remaining term of the obligation.

The amount allocated to a daily portion

of interest is not deductible by the

holder. However, the holder’s basis in

the obligation is reduced by the amount

allocated to a daily portion of interest

on the date the daily portion accrues.

(ii) Basis less than adjusted issue

price. If the holder’s basis in the

obligation is less than the obligation’s

adjusted issue price, the holder, upon

acquiring the obligation, must allocate

this difference to daily portions of

interest on a yield to maturity basis over

the remaining term of the obligation.

The amount allocated to a daily portion

of interest is includible in income by the

holder as ordinary income on the date

the daily portion accrues. The holder’s

adjusted basis in the obligation is

increased by the amount includible in

income by the holder under this

paragraph (d)(4)(ii) on the date the daily

portion accrues.

(iii) Premium and discount rules do

not apply. The rules for accruing

premium and discount in sections 171,

1276, and 1288 do not apply. Other

rules of those sections continue to apply

to the extent relevant.

(e) Amounts treated as interest under

this section. Amounts treated as interest

under this section are treated as OID for

all purposes of the Internal Revenue

Code.

(f) Effective date. This section applies

to debt instruments issued on or after

August 13, 1996.

Par. 16. Section 1.1275–5 is amended

by:

1. Revising paragraph (a)(1).

2. Removing the language ‘‘The debt

instrument must provide for stated

interest’’ from the introductory language

of paragraph (a)(3)(i) and adding the

language ‘‘The debt instrument must not

provide for any stated interest other

than stated interest’’ in its place.

3. Removing the language ‘‘less than

1 year’’ from the first sentence of

paragraph (a)(3)(ii) and adding the

language ‘‘1 year or less’’ in its place.

4. Adding paragraphs (a)(5) and (a)(6).

5. Revising paragraph (b)(2).

6. Revising paragraphs (c)(1) and

(c)(5).

7. Removing the language ‘‘cost of

newly borrowed funds’’ from paragraph

(c)(3)(ii) and adding the language

‘‘qualified floating rate’’ in its place.

8. Revising paragraph (d) introductory

text; revising Examples 4 through 9; and

adding Example 10.

9. Revising paragraph (e)(2).

10. Revising paragraph (e)(3)(v)

introductory text; revising Example 3

(ii); and removing Example 3 (iii).

The revisions and additions read as

follows:

§ 1.1275–5 Variable rate debt instruments.

(a) Applicability—(1) In general. This

section provides rules for variable rate

debt instruments. Except as provided in

paragraph (a)(6) of this section, a

variable rate debt instrument is a debt

instrument that meets the conditions

described in paragraphs (a)(2), (3), (4),

and (5) of this section. If a debt

instrument that provides for a variable

rate of interest does not qualify as a

variable rate debt instrument, the debt

instrument is a contingent payment debt

instrument. See § 1.1275–4 for the
30154 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

treatment of a contingent payment debt

instrument. See § 1.1275–6 for a

taxpayer’s treatment of a variable rate

debt instrument and a hedge.

* * * * *

(5) No contingent principal payments.

Except as provided in paragraph (a)(2)

of this section, the debt instrument must

not provide for any principal payments

that are contingent (within the meaning

of § 1.1275–4(a)).

(6) Special rule for debt instruments

issued for nonpublicly traded property.

A debt instrument (other than a taxexempt obligation) that would otherwise

qualify as a variable rate debt

instrument under this section is not a

variable rate debt instrument if section

1274 applies to the instrument and any

stated interest payments on the

instrument are treated as contingent

payments under § 1.1274–2. This

paragraph (a)(6) applies to debt

instruments issued on or after August

13, 1996.

(b) * * *

(2) Certain rates based on a qualified

floating rate. For a debt instrument

issued on or after August 13, 1996, a

variable rate is a qualified floating rate

if it is equal to either—

(i) The product of a qualified floating

rate described in paragraph (b)(1) of this

section and a fixed multiple that is

greater than .65 but not more than 1.35;

or

(ii) The product of a qualified floating

rate described in paragraph (b)(1) of this

section and a fixed multiple that is

greater than .65 but not more than 1.35,

increased or decreased by a fixed rate.

* * * * *

(c) Objective rate—(1) Definition—(i)

In general. For debt instruments issued

on or after August 13, 1996, an objective

rate is a rate (other than a qualified

floating rate) that is determined using a

single fixed formula and that is based on

objective financial or economic

information. For example, an objective

rate generally includes a rate that is

based on one or more qualified floating

rates or on the yield of actively traded

personal property (within the meaning

of section 1092(d)(1)).

(ii) Exception. For purposes of

paragraph (c)(1)(i) of this section, an

objective rate does not include a rate

based on information that is within the

control of the issuer (or a related party

within the meaning of section 267(b) or

707(b)(1)) or that is unique to the

circumstances of the issuer (or a related

party within the meaning of section

267(b) or 707(b)(1)), such as dividends,

profits, or the value of the issuer’s stock.

However, a rate does not fail to be an

objective rate merely because it is based

on the credit quality of the issuer.

* * * * *

(5) Tax-exempt obligations.

Notwithstanding paragraph (c)(1) of this

section, in the case of a tax-exempt

obligation (within the meaning of

section 1275(a)(3)), a variable rate is an

objective rate only if it is a qualified

inverse floating rate or a qualified

inflation rate. A rate is a qualified

inflation rate if the rate measures

contemporaneous changes in inflation

based on a general inflation index.

(d) Examples. The following examples

illustrate the rules of paragraphs (b) and

(c) of this section. For purposes of these

examples, assume that the debt

instrument is not a tax-exempt

obligation. In addition, unless otherwise

provided, assume that the rate is not

reasonably expected to result in a

significant front-loading or back-loading

of interest and that the rate is not based

on objective financial or economic

information that is within the control of

the issuer (or a related party) or that is

unique to the circumstances of the

issuer (or a related party).

* * * * *

Example 4. Rate based on changes in the

value of a commodity index. On January 1,

1997, X issues a debt instrument that

provides for annual interest payments at the

end of each year at a rate equal to the

percentage increase, if any, in the value of an

index for the year immediately preceding the

payment. The index is based on the prices of

several actively traded commodities.

Variations in the value of this interest rate

cannot reasonably be expected to measure

contemporaneous variations in the cost of

newly borrowed funds. Accordingly, the rate

is not a qualified floating rate. However,

because the rate is based on objective

financial information using a single fixed

formula, the rate is an objective rate.

Example 5. Rate based on a percentage of

S&P 500 Index. On January 1, 1997, X issues

a debt instrument that provides for annual

interest payments at the end of each year

based on a fixed percentage of the value of

the S&P 500 Index. Variations in the value of

this interest rate cannot reasonably be

expected to measure contemporaneous

variations in the cost of newly borrowed

funds and, therefore, the rate is not a

qualified floating rate. Although the rate is

described in paragraph (c)(1)(i) of this

section, the rate is not an objective rate

because, based on historical data, it is

reasonably expected that the average value of

the rate during the first half of the

instrument’s term will be significantly less

than the average value of the rate during the

final half of the instrument’s term.

Example 6. Rate based on issuer’s profits.

On January 1, 1997, Z issues a debt

instrument that provides for annual interest

payments equal to 1 percent of Z’s gross

profits earned during the year immediately

preceding the payment. Variations in the

value of this interest rate cannot reasonably

be expected to measure contemporaneous

variations in the cost of newly borrowed

funds. Accordingly, the rate is not a qualified

floating rate. In addition, because the rate is

based on information that is unique to the

issuer’s circumstances, the rate is not an

objective rate.

Example 7. Rate based on a multiple of an

interest index. On January 1, 1997, Z issues

a debt instrument with annual interest

payments at a rate equal to two times the

value of 1-year LIBOR as of the payment date.

Because the rate is a multiple greater than

1.35 times a qualified floating rate, the rate

is not a qualified floating rate. However,

because the rate is based on objective

financial information using a single fixed

formula, the rate is an objective rate.

Example 8. Variable rate based on the cost

of borrowed funds in a foreign currency. On

January 1, 1997, Y issues a 5-year dollar

denominated debt instrument that provides

for annual interest payments at a rate equal

to the value of 1-year French franc LIBOR as

of the payment date. Variations in the value

of French franc LIBOR do not measure

contemporaneous changes in the cost of

newly borrowed funds in dollars. As a result,

the rate is not a qualified floating rate for an

instrument denominated in dollars. However,

because the rate is based on objective

financial information using a single fixed

formula, the rate is an objective rate.

Example 9. Qualified inverse floating rate.

On January 1, 1997, X issues a debt

instrument that provides for annual interest

payments at the end of each year at a rate

equal to 12 percent minus the value of 1-year

LIBOR as of the payment date. On the issue

date, the value of 1-year LIBOR is 6 percent.

Because the rate can reasonably be expected

to inversely reflect contemporaneous

variations in 1-year LIBOR, it is a qualified

inverse floating rate. However, if the value of

1-year LIBOR on the issue date were 11

percent rather than 6 percent, the rate would

not be a qualified inverse floating rate

because the rate could not reasonably be

expected to inversely reflect

contemporaneous variations in 1-year LIBOR.

Example 10. Rate based on an inflation

index. On January 1, 1997, X issues a debt

instrument that provides for annual interest

payments at the end of each year at a rate

equal to 400 basis points (4 percent) plus the

annual percentage change in a general

inflation index (e.g., the Consumer Price

Index, U.S. City Average, All Items, for all

Urban Consumers, seasonally unadjusted).

The rate, however, may not be less than zero.

Variations in the value of this interest rate

cannot reasonably be expected to measure

contemporaneous variations in the cost of

newly borrowed funds. Accordingly, the rate

is not a qualified floating rate. However,

because the rate is based on objective

economic information using a single fixed

formula, the rate is an objective rate.

(e) * * *

(2) Variable rate debt instrument that

provides for annual payments of interest

at a single variable rate. If a variable rate

debt instrument provides for stated

interest at a single qualified floating rate
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30155

or objective rate and the interest is

unconditionally payable in cash or in

property (other than debt instruments of

the issuer), or will be constructively

received under section 451, at least

annually, the following rules apply to

the instrument:

(i) All stated interest with respect to

the debt instrument is qualified stated

interest.

(ii) The amount of qualified stated

interest and the amount of OID, if any,

that accrues during an accrual period is

determined under the rules applicable

to fixed rate debt instruments by

assuming that the variable rate is a fixed

rate equal to—

(A) In the case of a qualified floating

rate or qualified inverse floating rate,

the value, as of the issue date, of the

qualified floating rate or qualified

inverse floating rate; or

(B) In the case of an objective rate

(other than a qualified inverse floating

rate), a fixed rate that reflects the yield

that is reasonably expected for the debt

instrument.

(iii) The qualified stated interest

allocable to an accrual period is

increased (or decreased) if the interest

actually paid during an accrual period

exceeds (or is less than) the interest

assumed to be paid during the accrual

period under paragraph (e)(2)(ii) of this

section.

(3) * * *

(v) Examples. The following examples

illustrate the rules in paragraphs (e) (2)

and (3) of this section:

* * * * *

Example 3. * * *

(ii) Accrual of OID and qualified stated

interest. Under paragraph (e)(2) of this

section, the variable rate debt instrument is

treated as a 2-year debt instrument that has

an issue price of $90,000, a stated principal

amount of $100,000, and interest payments of

$5,000 at the end of each year. The debt

instrument has $10,000 of OID and the

annual interest payments of $5,000 are

qualified stated interest payments. Under

§ 1.1272–1, the debt instrument has a yield

of 10.82 percent, compounded annually. The

amount of OID allocable to the first annual

accrual period (assuming Z uses annual

accrual periods) is $4,743.25

(($90,000×.1082)¥ $5,000), and the amount

of OID allocable to the second annual accrual

period is $5,256.75 ($100,000¥$94,743.25).

Under paragraph (e)(2)(iii) of this section, the

$2,000 difference between the $7,000 interest

payment actually made at maturity and the

$5,000 interest payment assumed to be made

at maturity under the equivalent fixed rate

debt instrument is treated as additional

qualified stated interest for the period.

* * * * *

Par. 17. Section 1.1275–6 is added to

read as follows:

§ 1.1275–6 Integration of qualifying debt

instruments.

(a) In general. This section generally

provides for the integration of a

qualifying debt instrument with a hedge

or combination of hedges if the

combined cash flows of the components

are substantially equivalent to the cash

flows on a fixed or variable rate debt

instrument. The integrated transaction

is generally subject to the rules of this

section rather than the rules to which

each component of the transaction

would be subject on a separate basis.

The purpose of this section is to permit

a more appropriate determination of the

character and timing of income,

deductions, gains, or losses than would

be permitted by separate treatment of

the components. The rules of this

section affect only the taxpayer who

holds (or issues) the qualifying debt

instrument and enters into the hedge.

(b) Definitions—(1) Qualifying debt

instrument. A qualifying debt

instrument is any debt instrument

(including an integrated transaction as

defined in paragraph (c) of this section)

other than—

(i) A tax-exempt obligation as defined

in section 1275(a)(3);

(ii) A debt instrument to which

section 1272(a)(6) applies (certain

interests in or mortgages held by a

REMIC, and certain other debt

instruments with payments subject to

acceleration); or

(iii) A debt instrument that is subject

to § 1.483–4 or § 1.1275–4(c) (certain

contingent payment debt instruments

issued for nonpublicly traded property).

(2) Section 1.1275–6 hedge—(i) In

general. A § 1.1275–6 hedge is any

financial instrument (as defined in

paragraph (b)(3) of this section) if the

combined cash flows of the financial

instrument and the qualifying debt

instrument permit the calculation of a

yield to maturity (under the principles

of section 1272), or the right to the

combined cash flows would qualify

under § 1.1275–5 as a variable rate debt

instrument that pays interest at a

qualified floating rate or rates (except

for the requirement that the interest

payments be stated as interest). A

financial instrument is not a § 1.1275–

6 hedge, however, if the resulting

synthetic debt instrument does not have

the same term as the remaining term of

the qualifying debt instrument. A

financial instrument that hedges

currency risk is not a § 1.1275–6 hedge.

(ii) Limitations—(A) A debt

instrument issued by a taxpayer and a

debt instrument held by the taxpayer

cannot be part of the same integrated

transaction.

(B) A debt instrument can be a

§ 1.1275–6 hedge only if it is issued

substantially contemporaneously with,

and has the same maturity (including

rights to accelerate or delay payments)

as, the qualifying debt instrument.

(3) Financial instrument. For

purposes of this section, a financial

instrument is a spot, forward, or futures

contract, an option, a notional principal

contract, a debt instrument, or a similar

instrument, or combination or series of

financial instruments. Stock is not a

financial instrument for purposes of this

section.

(4) Synthetic debt instrument. The

synthetic debt instrument is the

hypothetical debt instrument with the

same cash flows as the combined cash

flows of the qualifying debt instrument

and the § 1.1275–6 hedge.

(c) Integrated transaction—(1)

Integration by taxpayer. Except as

otherwise provided in this section, a

qualifying debt instrument and a

§ 1.1275–6 hedge are an integrated

transaction if all of the following

requirements are satisfied:

(i) The taxpayer satisfies the

identification requirements of paragraph

(e) of this section on or before the date

the taxpayer enters into the § 1.1275–6

hedge.

(ii) None of the parties to the

§ 1.1275–6 hedge are related within the

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

or, if the parties are related, the party

providing the hedge uses, for federal

income tax purposes, a mark-to-market

method of accounting for the hedge and

all similar or related transactions.

(iii) Both the qualifying debt

instrument and the § 1.1275–6 hedge are

entered into by the same individual,

partnership, trust, estate, or corporation

(regardless of whether the corporation is

a member of an affiliated group of

corporations that files a consolidated

return).

(iv) If the taxpayer is a foreign person

engaged in a U.S. trade or business and

the taxpayer issues or acquires a

qualifying debt instrument, or enters

into a § 1.1275–6 hedge, through the

trade or business, all items of income

and expense associated with the

qualifying debt instrument and the

§ 1.1275–6 hedge (other than interest

expense that is subject to § 1.882–5)

would have been effectively connected

with the U.S. trade or business

throughout the term of the qualifying

debt instrument had this section not

applied.

(v) Neither the qualifying debt

instrument, nor any other debt

instrument that is part of the same issue

as the qualifying debt instrument, nor

the § 1.1275–6 hedge was, with respect
30156 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

to the taxpayer, part of an integrated

transaction that was terminated or

otherwise legged out of within the 30

days immediately preceding the date

that would be the issue date of the

synthetic debt instrument.

(vi) The qualifying debt instrument is

issued or acquired by the taxpayer on or

before the date of the first payment on

the § 1.1275–6 hedge, whether made or

received by the taxpayer (including a

payment made to purchase the hedge).

If the qualifying debt instrument is

issued or acquired by the taxpayer after,

but substantially contemporaneously

with, the date of the first payment on

the § 1.1275–6 hedge, the qualifying

debt instrument is treated, solely for

purposes of this paragraph (c)(1)(vi), as

meeting the requirements of the

preceding sentence.

(vii) Neither the § 1.1275–6 hedge nor

the qualifying debt instrument was,

with respect to the taxpayer, part of a

straddle (as defined in section 1092(c))

prior to the issue date of the synthetic

debt instrument.

(2) Integration by Commissioner. The

Commissioner may treat a qualifying

debt instrument and a financial

instrument (whether entered into by the

taxpayer or by a related party) as an

integrated transaction if the combined

cash flows on the qualifying debt

instrument and financial instrument are

substantially the same as the combined

cash flows required for the financial

instrument to be a § 1.1275–6 hedge.

The Commissioner, however, may not

integrate a transaction unless the

qualifying debt instrument either is

subject to § 1.1275–4 or is subject to

§ 1.1275–5 and pays interest at an

objective rate. The circumstances under

which the Commissioner may require

integration include, but are not limited

to, the following:

(i) A taxpayer fails to identify a

qualifying debt instrument and the

§ 1.1275–6 hedge under paragraph (e) of

this section.

(ii) A taxpayer issues or acquires a

qualifying debt instrument and a related

party (within the meaning of section

267(b) or 707(b)(1)) enters into the

§ 1.1275–6 hedge.

(iii) A taxpayer issues or acquires a

qualifying debt instrument and enters

into the § 1.1275–6 hedge with a related

party (within the meaning of section

267(b) or 707(b)(1)).

(iv) The taxpayer legs out of an

integrated transaction and within 30

days enters into a new § 1.1275–6 hedge

with respect to the same qualifying debt

instrument or another debt instrument

that is part of the same issue.

(d) Special rules for legging into and

legging out of an integrated

transaction—(1) Legging into—(i)

Definition. Legging into an integrated

transaction under this section means

that a § 1.1275–6 hedge is entered into

after the date the qualifying debt

instrument is issued or acquired by the

taxpayer, and the requirements of

paragraph (c)(1) of this section are

satisfied on the date the § 1.1275–6

hedge is entered into (the leg-in date).

(ii) Treatment. If a taxpayer legs into

an integrated transaction, the taxpayer

treats the qualifying debt instrument

under the applicable rules for taking

interest and OID into account up to the

leg-in date, except that the day before

the leg-in date is treated as the end of

an accrual period. As of the leg-in date,

the qualifying debt instrument is subject

to the rules of paragraph (f) of this

section.

(iii) Anti-abuse rule. If a taxpayer legs

into an integrated transaction with a

principal purpose of deferring or

accelerating income or deductions on

the qualifying debt instrument, the

Commissioner may—

(A) Treat the qualifying debt

instrument as sold for its fair market

value on the leg-in date; or

(B) Refuse to allow the taxpayer to

integrate the qualifying debt instrument

and the § 1.1275–6 hedge.

(2) Legging out—(i) Definition—(A)

Legging out if the taxpayer has

integrated. If a taxpayer has integrated a

qualifying debt instrument and a

§ 1.1275–6 hedge under paragraph (c)(1)

of this section, legging out means that,

prior to the maturity of the synthetic

debt instrument, the § 1.1275–6 hedge

ceases to meet the requirements for a

§ 1.1275–6 hedge, the taxpayer fails to

meet any requirement of paragraph

(c)(1) of this section, or the taxpayer

disposes of or otherwise terminates all

or a part of the qualifying debt

instrument or § 1.1275–6 hedge. If the

taxpayer fails to meet the requirements

of paragraph (c)(1) of this section but

meets the requirements of paragraph

(c)(2) of this section, the Commissioner

may treat the taxpayer as not legging

out.

(B) Legging out if the Commissioner

has integrated. If the Commissioner has

integrated a qualifying debt instrument

and a financial instrument under

paragraph (c)(2) of this section, legging

out means that, prior to the maturity of

the synthetic debt instrument, the

requirements for Commissioner

integration under paragraph (c)(2) of

this section are not met or the taxpayer

fails to meet the requirements for

taxpayer integration under paragraph

(c)(1) of this section and the

Commissioner agrees to allow the

taxpayer to be treated as legging out.

(C) Exception for certain

nonrecognition transactions. If, in a

single nonrecognition transaction, a

taxpayer disposes of, or ceases to be

primarily liable on, the qualifying debt

instrument and the § 1.1275–6 hedge,

the taxpayer is not treated as legging

out. Instead, the integrated transaction

is treated under the rules governing the

nonrecognition transaction. For

example, if a holder of an integrated

transaction is acquired in a

reorganization under section

368(a)(1)(A), the holder is treated as

disposing of the synthetic debt

instrument in the reorganization rather

than legging out. If the successor holder

is not eligible for integrated treatment,

the successor is treated as legging out.

(ii) Operating rules. If a taxpayer legs

out (or is treated as legging out) of an

integrated transaction, the following

rules apply:

(A) The transaction is treated as an

integrated transaction during the time

the requirements of paragraph (c)(1) or

(2) of this section, as appropriate, are

satisfied.

(B) Immediately before the taxpayer

legs out, the taxpayer is treated as

selling or otherwise terminating the

synthetic debt instrument for its fair

market value and, except as provided in

paragraph (d)(2)(ii)(D) of this section,

any income, deduction, gain, or loss is

realized and recognized at that time.

(C) If, immediately after the taxpayer

legs out, the taxpayer holds or remains

primarily liable on the qualifying debt

instrument, adjustments are made to

reflect any difference between the fair

market value of the qualifying debt

instrument and the adjusted issue price

of the qualifying debt instrument. If,

immediately after the taxpayer legs out,

the taxpayer is a party to a § 1.1275–6

hedge, the § 1.1275–6 hedge is treated as

entered into at its fair market value.

(D) If a taxpayer legs out of an

integrated transaction by disposing of or

otherwise terminating a § 1.1275–6

hedge within 30 days of legging into the

integrated transaction, then any loss or

deduction determined under paragraph

(d)(2)(ii)(B) of this section is not

allowed. Appropriate adjustments are

made to the qualifying debt instrument

for any disallowed loss. The

adjustments are taken into account on a

yield to maturity basis over the

remaining term of the qualifying debt

instrument.

(E) If a holder of a debt instrument

subject to § 1.1275–4 legs into an

integrated transaction with respect to

the instrument and subsequently legs

out of the integrated transaction, any

gain recognized under paragraph

(d)(2)(ii)(B) or (C) of this section is
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30157

treated as interest income to the extent

determined under the principles of

§ 1.1275–4(b)(8)(iii)(B) (rules for

determining the character of gain on the

sale of a debt instrument all of the

payments on which have been fixed). If

the synthetic debt instrument would

qualify as a variable rate debt

instrument, the equivalent fixed rate

debt instrument determined under

§ 1.1275–5(e) is used for this purpose.

(e) Identification requirements. For

each integrated transaction, a taxpayer

must enter and retain as part of its books

and records the following information—

(1) The date the qualifying debt

instrument was issued or acquired (or is

expected to be issued or acquired) by

the taxpayer and the date the § 1.1275–

6 hedge was entered into by the

taxpayer;

(2) A description of the qualifying

debt instrument and the § 1.1275–6

hedge; and

(3) A summary of the cash flows and

accruals resulting from treating the

qualifying debt instrument and the

§ 1.1275–6 hedge as an integrated

transaction (i.e., the cash flows and

accruals on the synthetic debt

instrument).

(f) Taxation of integrated

transactions—(1) General rule. An

integrated transaction is generally

treated as a single transaction by the

taxpayer during the period that the

transaction qualifies as an integrated

transaction. Except as provided in

paragraph (f)(12) of this section, while a

qualifying debt instrument and a

§ 1.1275–6 hedge are part of an

integrated transaction, neither the

qualifying debt instrument nor the

§ 1.1275–6 hedge is subject to the rules

that would apply on a separate basis to

the debt instrument and the § 1.1275–6

hedge, including section 1092 or

§ 1.446–4. The rules that would govern

the treatment of the synthetic debt

instrument generally govern the

treatment of the integrated transaction.

For example, the integrated transaction

may be subject to section 263(g) or, if

the synthetic debt instrument would be

part of a straddle, section 1092.

Generally, the synthetic debt instrument

is subject to sections 163(e) and 1271

through 1275, with terms as set forth in

paragraphs (f)(2) through (13) of this

section.

(2) Issue date. The issue date of the

synthetic debt instrument is the first

date on which the taxpayer entered into

all of the components of the synthetic

debt instrument.

(3) Term. The term of the synthetic

debt instrument is the period beginning

on the issue date of the synthetic debt

instrument and ending on the maturity

date of the qualifying debt instrument.

(4) Issue price. The issue price of the

synthetic debt instrument is the

adjusted issue price of the qualifying

debt instrument on the issue date of the

synthetic debt instrument. If, as a result

of entering into the § 1.1275–6 hedge,

the taxpayer pays or receives one or

more payments that are substantially

contemporaneous with the issue date of

the synthetic debt instrument, the

payments reduce or increase the issue

price as appropriate.

(5) Adjusted issue price. In general,

the adjusted issue price of the synthetic

debt instrument is determined under the

principles of § 1.1275–1(b).

(6) Qualified stated interest. No

amounts payable on the synthetic debt

instrument are qualified stated interest

within the meaning of § 1.1273–1(c).

(7) Stated redemption price at

maturity—(i) Synthetic debt instruments

that are borrowings. In general, if the

synthetic debt instrument is a

borrowing, the instrument’s stated

redemption price at maturity is the sum

of all amounts paid or to be paid on the

qualifying debt instrument and the

§ 1.1275–6 hedge, reduced by any

amounts received or to be received on

the § 1.1275–6 hedge.

(ii) Synthetic debt instruments that

are held by the taxpayer. In general, if

the synthetic debt instrument is held by

the taxpayer, the instrument’s stated

redemption price at maturity is the sum

of all amounts received or to be received

by the taxpayer on the qualifying debt

instrument and the § 1.1275–6 hedge,

reduced by any amounts paid or to be

paid by the taxpayer on the § 1.1275–6

hedge.

(iii) Certain amounts ignored. For

purposes of this paragraph (f)(7), if an

amount paid or received on the

§ 1.1275–6 hedge is taken into account

under paragraph (f)(4) of this section to

determine the issue price of the

synthetic debt instrument, the amount is

not taken into account to determine the

synthetic debt instrument’s stated

redemption price at maturity.

(8) Source of interest income and

allocation of expense. The source of

interest income from the synthetic debt

instrument is determined by reference

to the source of income of the qualifying

debt instrument under sections 861(a)(1)

and 862(a)(1). For purposes of section

904, the character of interest from the

synthetic debt instrument is determined

by reference to the character of the

interest income from the qualifying debt

instrument. Interest expense is allocated

and apportioned under regulations

under section 861 or under § 1.882–5.

(9) Effectively connected income. If

the requirements of paragraph (c)(1)(iv)

of this section are satisfied, any interest

income resulting from the synthetic debt

instrument entered into by the foreign

person is treated as effectively

connected with a U.S. trade or business,

and any interest expense resulting from

the synthetic debt instrument entered

into by the foreign person is allocated

and apportioned under § 1.882–5.

(10) Not a short-term obligation. For

purposes of section 1272(a)(2)(C), a

synthetic debt instrument is not treated

as a short-term obligation.

(11) Special rules in the event of

integration by the Commissioner. If the

Commissioner requires integration,

appropriate adjustments are made to the

treatment of the synthetic debt

instrument, and, if necessary, the

qualifying debt instrument and financial

instrument. For example, the

Commissioner may treat a financial

instrument that is not a § 1.1275–6

hedge as a § 1.1275–6 hedge when

applying the rules of this section. The

issue date of the synthetic debt

instrument is the date determined

appropriate by the Commissioner to

require integration.

(12) Retention of separate transaction

rules for certain purposes. This

paragraph (f)(12) provides for the

retention of separate transaction rules

for certain purposes. In addition, by

publication in the Internal Revenue

Bulletin (see § 601.601(d)(2)(ii) of this

chapter), the Commissioner may require

use of separate transaction rules for any

aspect of an integrated transaction.

(i) Foreign persons that enter into

integrated transactions giving rise to

U.S. source income not effectively

connected with a U.S. trade or business.

If a foreign person enters into an

integrated transaction that gives rise to

U.S. source interest income (determined

under the source rules for the synthetic

debt instrument) not effectively

connected with a U.S. trade or business

of the foreign person, paragraph (f) of

this section does not apply for purposes

of sections 871(a), 881, 1441, 1442, and

6049. These sections of the Internal

Revenue Code are applied to the

qualifying debt instrument and the

§ 1.1275–6 hedge on a separate basis.

(ii) Relationship between taxpayer

and other persons. Because the rules of

this section affect only the taxpayer that

enters into an integrated transaction

(i.e., either the issuer or a particular

holder of a qualifying debt instrument),

any provisions of the Internal Revenue

Code or regulations that govern the

relationship between the taxpayer and

any other person are applied on a

separate basis. For example, taxpayers
30158 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

must comply with any reporting or

disclosure requirements on any

qualifying debt instrument as if it were

not part of an integrated transaction.

Thus, if required under § 1.1275–4(b)(4),

an issuer of a contingent payment debt

instrument subject to integrated

treatment must provide the projected

payment schedule to holders. Similarly,

if a U.S. corporation enters into an

integrated transaction that includes a

notional principal contract, the source

of any payment received by the

counterparty on the notional principal

contract is determined under § 1.863–7

as if the contract were not part of an

integrated transaction, and, if received

by a foreign person who is not engaged

in a U.S. trade or business, the payment

is non-U.S. source income that is not

subject to U.S. withholding tax.

(13) Coordination with consolidated

return rules. If a taxpayer enters into a

§ 1.1275–6 hedge with a member of the

same consolidated group (the

counterparty) and the § 1.1275–6 hedge

is part of an integrated transaction for

the taxpayer, the § 1.1275–6 hedge is not

treated as an intercompany transaction

for purposes of § 1.1502–13. If the

taxpayer legs out of integrated

treatment, the taxpayer and the

counterparty are each treated as

disposing of its position in the § 1.1275–

6 hedge under the principles of

paragraph (d)(2) of this section. If the

§ 1.1275–6 hedge remains in existence

after the leg-out date, the § 1.1275–6

hedge is treated under the rules that

would otherwise apply to the

transaction (including § 1.1502–13 if the

transaction is between members).

(g) Predecessors and successors. For

purposes of this section, any reference

to a taxpayer, holder, issuer, or person

includes, where appropriate, a reference

to a predecessor or successor. For

purposes of the preceding sentence, a

predecessor is a transferor of an asset or

liability (including an integrated

transaction) to a transferee (the

successor) in a nonrecognition

transaction. Appropriate adjustments, if

necessary, are made in the application

of this section to predecessors and

successors.

(h) Examples. The following examples

illustrate the provisions of this section.

In each example, assume that the

qualifying debt instrument is a debt

instrument for federal income tax

purposes. No inference is intended,

however, as to whether the debt

instrument is a debt instrument for

federal income tax purposes.

Example 1. Issuer hedge—(i) Facts. On

January 1, 1997, V, a domestic corporation,

issues a 5-year debt instrument for $1,000.

The debt instrument provides for annual

payments of interest at a rate equal to the

value of 1-year LIBOR and a principal

payment of $1,000 at maturity. On the same

day, V enters into a 5-year interest rate swap

agreement with an unrelated party. Under the

swap, V pays 6 percent and receives 1-year

LIBOR on a notional principal amount of

$1,000. The payments on the swap are fixed

and made on the same days as the payments

on the debt instrument. On January 1, 1997,

V identifies the debt instrument and the

swap as an integrated transaction in

accordance with the requirements of

paragraph (e) of this section.

(ii) Eligibility for integration. The debt

instrument is a qualifying debt instrument.

The swap is a § 1.1275–6 hedge because it is

a financial instrument and a yield to maturity

on the combined cash flows of the swap and

the debt instrument can be calculated. V has

met the identification requirements, and the

other requirements of paragraph (c)(1) of this

section are satisfied. Therefore, the

transaction is an integrated transaction under

this section.

(iii) Treatment of the synthetic debt

instrument. The synthetic debt instrument is

a 5-year debt instrument that has an issue

price of $1,000 and provides for annual

interest payments of $60 and a principal

payment of $1,000 at maturity. Under

paragraph (f)(6) of this section, no amounts

payable on the synthetic debt instrument are

qualified stated interest. Thus, under

paragraph (f)(7)(i) of this section, the

synthetic debt instrument has a stated

redemption price at maturity of $1,300 (the

sum of all amounts to be paid on the

qualifying debt instrument and the swap,

reduced by amounts to be received on the

swap). The synthetic debt instrument,

therefore, has $300 of OID.

Example 2. Issuer hedge with an option—

(i) Facts. On December 31, 1996, W, a

domestic corporation, issues for $1,000 a

debt instrument that matures on December

31, 1999. The debt instrument has a stated

principal amount of $1,000 payable at

maturity. The debt instrument also provides

for a payment at maturity equal to $10 times

the increase, if any, in the value of a

nationally known composite index of stocks

from December 31, 1996, to the maturity

date. On December 31, 1996, W purchases

from an unrelated party an option that pays

$10 times the increase, if any, in the stock

index from December 31, 1996, to December

31, 1999. W pays $250 for the option. On

December 31, 1996, W identifies the debt

instrument and option as an integrated

transaction in accordance with the

requirements of paragraph (e) of this section.

(ii) Eligibility for integration. The debt

instrument is a qualifying debt instrument.

The option is a § 1.1275–6 hedge because it

is a financial instrument and a yield to

maturity on the combined cash flows of the

option and the debt instrument can be

calculated. W has met the identification

requirements, and the other requirements of

paragraph (c)(1) of this section are satisfied.

Therefore, the transaction is an integrated

transaction under this section.

(iii) Treatment of the synthetic debt

instrument. Under paragraph (f)(4) of this

section, the issue price of the synthetic debt

instrument is equal to the issue price of the

debt instrument ($1,000) reduced by the

payment for the option ($250). As a result,

the synthetic debt instrument is a 3-year debt

instrument with an issue price of $750.

Under paragraph (f)(7) of this section, the

synthetic debt instrument has a stated

redemption price at maturity of $1,000 (the

$250 payment for the option is not taken into

account). The synthetic debt instrument,

therefore, has $250 of OID.

Example 3. Hedge with prepaid swap—(i)

Facts. On January 1, 1997, H purchases for

£1,000 a 5-year debt instrument that provides

for semiannual payments based on 6-month

pound LIBOR and a payment of the £1,000

principal at maturity. On the same day, H

enters into a swap with an unrelated third

party under which H receives semiannual

payments, in pounds, of 10 percent,

compounded semiannually, and makes

semiannual payments, in pounds, of 6-month

pound LIBOR on a notional principal amount

of £1,000. Payments on the swap are fixed

and made on the same dates as the payments

on the debt instrument. H also makes a £162

prepayment on the swap. On January 1, 1997,

H identifies the swap and the debt

instrument as an integrated transaction in

accordance with the requirements of

paragraph (e) of this section.

(ii) Eligibility for integration. The debt

instrument is a qualifying debt instrument.

The swap is a § 1.1275–6 hedge because it is

a financial instrument and a yield to maturity

on the combined cash flows of the swap and

the debt instrument can be calculated.

Although the debt instrument is

denominated in pounds, the swap hedges

only interest rate risk, not currency risk.

Therefore, the transaction is an integrated

transaction under this section. See § 1.988–

5(a) for the treatment of a debt instrument

and a swap if the swap hedges currency risk.

(iii) Treatment of the synthetic debt

instrument. Under paragraph (f)(4) of this

section, the issue price of the synthetic debt

instrument is equal to the issue price of the

debt instrument (£1,000) increased by the

prepayment on the swap (£162). As a result,

the synthetic debt instrument is a 5-year debt

instrument that has an issue price of £1,162

and provides for semiannual interest

payments of £50 and a principal payment of

£1,000 at maturity. Under paragraph (f)(6) of

this section, no amounts payable on the

synthetic debt instrument are qualified stated

interest. Thus, under paragraph (f)(7)(ii) of

this section, the synthetic debt instrument’s

stated redemption price at maturity is £1,500

(the sum of all amounts to be received on the

qualifying debt instrument and the § 1.1275–

6 hedge, reduced by all amounts to be paid

on the § 1.1275–6 hedge other than the £162

prepayment for the swap). The synthetic debt

instrument, therefore, has £338 of OID.

Example 4. Legging into an integrated

transaction by a holder—(i) Facts. On

December 31, 1996, X corporation purchases

for $1,000,000 a debt instrument that matures

on December 31, 2006. The debt instrument

provides for annual payments of interest at

the rate of 6 percent and for a payment at

maturity equal to $1,000,000, increased by

the excess, if any, of the price of 1,000 units

of a commodity on December 31, 2006, over
Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations 30159

$350,000, and decreased by the excess, if

any, of $350,000 over the price of 1,000 units

of the commodity on that date. The projected

amount of the payment at maturity

determined under § 1.1275–4(b)(4) is

$1,020,000. On December 31, 1999, X enters

into a cash-settled forward contract with an

unrelated party to sell 1,000 units of the

commodity on December 31, 2006, for

$450,000. On December 31, 1999, X also

identifies the debt instrument and the

forward contract as an integrated transaction

in accordance with the requirements of

paragraph (e) of this section.

(ii) Eligibility for integration. X meets the

requirements for integration as of December

31, 1999. Therefore, X legged into an

integrated transaction on that date. Prior to

that date, X treats the debt instrument under

the applicable rules of § 1.1275–4.

(iii) Treatment of the synthetic debt

instrument. As of December 31, 1999, the

debt instrument and the forward contract are

treated as an integrated transaction. The issue

price of the synthetic debt instrument is

equal to the adjusted issue price of the

qualifying debt instrument on the leg-in date,

$1,004,804 (assuming one year accrual

periods). The term of the synthetic debt

instrument is from December 31, 1999, to

December 31, 2006. The synthetic debt

instrument provides for annual interest

payments of $60,000 and a principal

payment at maturity of $1,100,000

($1,000,000 + $450,000 ¥ $350,000). Under

paragraph (f)(6) of this section, no amounts

payable on the synthetic debt instrument are

qualified stated interest. Thus, under

paragraph (f)(7)(ii) of this section, the

synthetic debt instrument’s stated

redemption price at maturity is $1,520,000

(the sum of all amounts to be received by X

on the qualifying debt instrument and the

§ 1.1275–6 hedge, reduced by all amounts to

be paid by X on the § 1.1275–6 hedge). The

synthetic debt instrument, therefore, has

$515,196 of OID.

Example 5. Abusive leg-in—(i) Facts. On

January 1, 1997, Y corporation purchases for

$1,000,000 a debt instrument that matures on

December 31, 2001. The debt instrument

provides for annual payments of interest at

the rate of 6 percent, a payment on December

31, 1999, of the increase, if any, in the price

of a commodity from January 1, 1997, to

December 31, 1999, and a payment at

maturity of $1,000,000 and the increase, if

any, in the price of the commodity from

December 31, 1999 to maturity. Because the

debt instrument is a contingent payment debt

instrument subject to § 1.1275–4, Y accrues

interest based on the projected payment

schedule.

(ii) Leg-in. By late 1999, the price of the

commodity has substantially increased, and

Y expects a positive adjustment on December

31, 1999. In late 1999, Y enters into an

agreement to exchange the two commodity

based payments on the debt instrument for

two payments on the same dates of $100,000

each. Y identifies the transaction as an

integrated transaction in accordance with the

requirements of paragraph (e) of this section.

Y disposes of the hedge in early 2000.

(iii) Treatment. The legging into an

integrated transaction has the effect of

deferring the positive adjustment from 1999

to 2000. Because Y legged into the integrated

transaction with a principal purpose to defer

the positive adjustment, the Commissioner

may treat the debt instrument as sold for its

fair market value on the leg-in date or refuse

to allow integration.

Example 6. Integration of offsetting debt

instruments—(i) Facts. On January 1, 1997, Z

issues two 10-year debt instruments. The

first, Issue 1, has an issue price of $1,000,

pays interest annually at 6 percent, and, at

maturity, pays $1,000, increased by $1 times

the increase, if any, in the value of the S&P

100 Index over the term of the instrument

and reduced by $1 times the decrease, if any,

in the value of the S&P 100 Index over the

term of the instrument. However, the amount

paid at maturity may not be less than $500

or more than $1,500. The second, Issue 2, has

an issue price of $1,000, pays interest

annually at 8 percent, and, at maturity, pays

$1,000, reduced by $1 times the increase, if

any, in the value of the S&P 100 Index over

the term of the instrument and increased by

$1 times the decrease, if any, in the value of

the S&P 100 Index over the term of the

instrument. The amount paid at maturity

may not be less than $500 or more than

$1,500. On January 1, 1997, Z identifies Issue

1 as the qualifying debt instrument, Issue 2

as a § 1.1275–6 hedge, and otherwise meets

the identification requirements of paragraph

(e) of this section.

(ii) Eligibility for integration. Both Issue 1

and Issue 2 are qualifying debt instruments.

Z has met the identification requirements by

identifying Issue 1 as the qualifying debt

instrument and Issue 2 as the § 1.1275–6

hedge. The other requirements of paragraph

(c)(1) of this section are satisfied. Therefore,

the transaction is an integrated transaction

under this section.

(iii) Treatment of the synthetic debt

instrument. The synthetic debt instrument

has an issue price of $2,000, provides for a

payment at maturity of $2,000, and, in

addition, provides for annual payments of

$140. Under paragraph (f)(6) of this section,

no amounts payable on the synthetic debt

instrument are qualified stated interest. Thus,

under paragraph (f)(7)(i) of this section, the

synthetic debt instrument’s stated

redemption price at maturity is $3,400 (the

sum of all amounts to be paid on the

qualifying debt instrument and the § 1.1275–

6 hedge, reduced by amounts to be received

on the § 1.1275–6 hedge other than the

$1,000 payment received on the issue date).

The synthetic debt instrument, therefore, has

$1,400 of OID.

Example 7. Integrated transaction entered

into by a foreign person—(i) Facts. X, a

foreign person, enters into an integrated

transaction by purchasing a qualifying debt

instrument that pays U.S. source interest and

entering into a notional principal contract

with a U.S. corporation. Neither the income

from the qualifying debt instrument nor the

income from the notional principal contract

is effectively connected with a U.S. trade or

business. The notional principal contract is

a § 1.1275–6 hedge.

(ii) Treatment of integrated transaction.

Under paragraph (f)(8) of this section, X will

receive U.S. source income from the

integrated transaction. However, under

paragraph (f)(12)(i) of this section, the

qualifying debt instrument and the notional

principal contract are treated as if they are

not part of an integrated transaction for

purposes of determining whether tax is due

and must be withheld on income.

Accordingly, because the § 1.1275–6 hedge

would produce foreign source income under

§ 1.863–7 to X if it were not part of an

integrated transaction, any income on the

§ 1.1275–6 hedge generally will not be

subject to tax under sections 871(a) and 881,

and the U.S. corporation that is the

counterparty will not be required to withhold

tax on payments under the § 1.1275–6 hedge

under sections 1441 and 1442.

(i) [Reserved]

(j) Effective date. This section applies

to a qualifying debt instrument issued

on or after August 13, 1996. This section

also applies to a qualifying debt

instrument acquired by the taxpayer on

or after August 13, 1996, if—

(1) The qualifying debt instrument is

a fixed rate debt instrument or a variable

rate debt instrument; or

(2) The qualifying debt instrument

and the § 1.1275–6 hedge are acquired

by the taxpayer substantially

contemporaneously.

PART 602—OMB CONTROL NUMBERS

UNDER THE PAPERWORK

REDUCTION ACT

Par. 18. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 19. Section 602.101, paragraph

(c) is amended by:

1. Removing the following entries

from the table:

§ 602.101 OMB Control numbers.

* * * * *

(c) * * *

CFR part or section where

identified and described

Current

OMB control No.

* * * * *

1.1272–1(c)(4) .......................... 1545–1353

* * * * *

1.1275–3(b) ............................... 1545–1353

1.1275–3(c) ............................... 1545–0887

* * * * *

2. Adding entries in numerical order

to the table to read as follows:

§ 602.101 OMB Control numbers.

* * * * *

(c) * * *
30160 Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations

CFR part or section where

identified and described

Current

OMB control No.

* * * * *

1.1275–2 ................................... 1545–1450

1.1275–3 ................................... 1545–0887

1545–1353

1545–1450

1.1275–4 ................................... 1545–1450

1.1275–6 ................................... 1545–1450

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: March 22, 1996.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 96–14918 Filed 6–11–96; 8:45 am]

BILLING CODE 4830–01–P

PENSION BENEFIT GUARANTY

CORPORATION

29 CFR Parts 2619 and 2676

Valuation of Plan Benefits in SingleEmployer Plans; Valuation of Plan

Benefits and Plan Assets Following

Mass Withdrawal; Amendments

Adopting Additional PBGC Rates

AGENCY: Pension Benefit Guaranty

Corporation.

ACTION: Final rule.

SUMMARY: This final rule amends the

Pension Benefit Guaranty Corporation’s

regulations on Valuation of Plan

Benefits in Single-Employer Plans and

Valuation of Plan Benefits and Plan

Assets Following Mass Withdrawal. The

former regulation contains the interest

assumptions that the PBGC uses to

value benefits under terminating singleemployer plans. The latter regulation

contains the interest assumptions for

valuations of multiemployer plans that

have undergone mass withdrawal. The

amendments set out in this final rule

adopt the interest assumptions

applicable to single-employer plans

with termination dates in July 1996, and

to multiemployer plans with valuation

dates in July 1996. The effect of these

amendments is to advise the public of

the adoption of these assumptions.

EFFECTIVE DATE: July 1, 1996.

FOR FURTHER INFORMATION CONTACT:

Harold J. Ashner, Assistant General

Counsel, Office of the General Counsel,

Pension Benefit Guaranty Corporation,

1200 K Street, NW., Washington, DC

20005, 202–326–4024 (202–326–4179

for TTY and TDD).

SUPPLEMENTARY INFORMATION: This rule

adopts the July 1996 interest

assumptions to be used under the

Pension Benefit Guaranty Corporation’s

regulations on Valuation of Plan

Benefits in Single-Employer Plans (29

CFR part 2619, the ‘‘single-employer

regulation’’) and Valuation of Plan

Benefits and Plan Assets Following

Mass Withdrawal (29 CFR part 2676, the

‘‘multiemployer regulation’’).

Part 2619 sets forth the methods for

valuing plan benefits of terminating

single-employer plans covered under

title IV of the Employee Retirement

Income Security Act of 1974, as

amended. Under ERISA section 4041(c),

all single-employer plans wishing to

terminate in a distress termination must

value guaranteed benefits and ‘‘benefit

liabilities,’’ i.e., all benefits provided

under the plan as of the plan

termination date, using the formulas set

forth in part 2619, subpart C. (Plans

terminating in a standard termination

may, for purposes of the Standard

Termination Notice filed with PBGC,

use these formulas to value benefit

liabilities, although this is not required.)

In addition, when the PBGC terminates

an underfunded plan involuntarily

pursuant to ERISA section 4042(a), it

uses the subpart C formulas to

determine the amount of the plan’s

underfunding. Part 2676 prescribes

rules for valuing benefits and certain

assets of multiemployer plans under

sections 4219(c)(1)(D) and 4281(b) of

ERISA.

Appendix B to part 2619 sets forth the

interest rates and factors under the

single-employer regulation. Appendix B

to part 2676 sets forth the interest rates

and factors under the multiemployer

regulation. Because these rates and

factors are intended to reflect current

conditions in the financial and annuity

markets, it is necessary to update the

rates and factors periodically.

The PBGC issues two sets of interest

rates and factors, one set to be used for

the valuation of benefits to be paid as

annuities and one set for the valuation

of benefits to be paid as lump sums. The

same assumptions apply to terminating

single-employer plans and to

multiemployer plans that have

undergone a mass withdrawal. This

amendment adds to appendix B to parts

2619 and 2676 sets of interest rates and

factors for valuing benefits in singleemployer plans that have termination

dates during July 1996 and

multiemployer plans that have

undergone mass withdrawal and have

valuation dates during July 1996.

For annuity benefits, the interest rates

will be 6.20% for the first 20 years

following the valuation date and 4.75%

thereafter. For benefits to be paid as

lump sums, the interest assumptions to

be used by the PBGC will be 5.00% for

the period during which benefits are in

pay status, 4.25% during the seven-year

period directly preceding the benefit’s

placement in pay status, and 4.0%

during any other years preceding the

benefit’s placement in pay status. These

annuity and lump sum interest

assumptions are unchanged from those

in effect for June 1996.

Generally, the interest rates and

factors under these regulations are in

effect for at least one month. However,

the PBGC publishes its interest

assumptions each month regardless of

whether they represent a change from

the previous month’s assumptions. The

assumptions normally will be published

in the Federal Register by the 15th of

the preceding month or as close to that

date as circumstances permit.

The PBGC has determined that notice

and public comment on these

amendments are impracticable and

contrary to the public interest. This

finding is based on the need to

determine and issue new interest rates

and factors promptly so that the rates

and factors can reflect, as accurately as

possible, current market conditions.

Because of the need to provide

immediate guidance for the valuation of

benefits in single-employer plans whose

termination dates fall during July 1996,

and in multiemployer plans that have

undergone mass withdrawal and have

valuation dates during July 1996, the

PBGC finds that good cause exists for

making the rates and factors set forth in

this amendment effective less than 30

days after publication.

The PBGC has determined that this

action is not a ‘‘significant regulatory

action’’ under the criteria set forth in

Executive Order 12866.

Because no general notice of proposed

rulemaking is required for this

amendment, the Regulatory Flexibility

Act of 1980 does not apply. See 5 U.S.C.

601(2).

List of Subjects

29 CFR Part 2619

Employee benefit plans, Pension

insurance, and Pensions.

29 CFR Part 2676

Employee benefit plans and Pensions.

In consideration of the foregoing,

parts 2619 and 2676 of chapter XXVI,

title 29, Code of Federal Regulations, are

hereby amended as follows:

PART 2619—[AMENDED]

1. The authority citation for part 2619

continues to read as follows:

Authority: 29 U.S.C. 1301(a), 1302(b)(3),

1341, 1344, 1362.