33396 Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules

Business Administration for comment

on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

written comments (a signed original and

eight (8) copies) that are submitted

timely to the IRS. All comments will be

available for public inspection and

copying.

A public hearing has been scheduled

for Thursday, October 17, 1996, at 10

a.m. in the NYU Classroom, Room 2615,

Internal Revenue Building, 1111

Constitution Avenue NW., Washington,

DC. Because of access restrictions,

visitors will not be admitted beyond the

building lobby more than 15 minutes

before the hearing starts.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

written comments by September 25,

1996 and submit an outline of the topics

to be discussed and the time to be

devoted to each topic (signed original

and eight (8) copies) by Thursday,

September 26, 1996.

A period of 10 minutes will be

allotted to each person for making

comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

Drafting information: The principal author

of the temporary regulations is David B.

Friedel of the Office of Assistant Chief

Counsel (Corporate), IRS. Other personnel

from the IRS and Treasury participated in

their development.

Withdrawal of Notice of Proposed

Rulemaking

Accordingly, under the authority of

26 U.S.C. 7805, the notice of proposed

rulemaking that was published on

February 4, 1991 (56 FR 4194) is

withdrawn.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding entries in

numerical order to read as follows:

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

Section 1.1502–91 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–92 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–93 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–94 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–95 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–96 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–98 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502.

Section 1.1502–99 also issued under 26

U.S.C. 382(m) and 26 U.S.C. 1502. * * *

Par. 2. Sections 1.1502–90 through

1.1502–99 are added to read as follows:

§ 1.1502–90 Table of contents.

§ 1.1502–91 Application of section 382 with

respect to a consolidated group.

§ 1.1502–92 Ownership change of a loan

group of a loss subgroup.

§ 1.1502–93 Consolidated section 382

limitation (or subgroup section 382

limitation).

§ 1.1502–94 Coordination with section 382

and the regulations thereunder when a

corporation becomes a member of a

consolidated group.

§ 1.1502–95 Rules on ceasing to be a

member of a consolidated group (or loss

subgroup).

§ 1.1502–96 Miscellaneous rules.

§ 1.1502–97 Special rules under section 382

for members under the jurisdiction of a

court in a title 11 or similar case.

[Reserved]

§ 1.1502–98 Coordination with section 383.

§ 1.1502–99 Effective dates.

[The text of the above proposed sections

is the same as the text of §§ 1.1502–90T

through 1.1502–99T published

elsewhere in this issue of the Federal

Register.]

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96–15827 Filed 6–26–96; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Part 1

[FI–48–95]

RIN 1545–AU09

Amortizable Bond Premium

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations relating to the

federal income tax treatment of bond

premium and bond issuance premium.

The proposed regulations reflect

changes to the law made by the Tax

Reform Act of 1986 and the Technical

and Miscellaneous Revenue Act of 1988.

The proposed regulations in this

document would provide needed

guidance to holders and issuers of debt

instruments. This document also

provides a notice of a public hearing on

the proposed regulations.

DATES: Written comments must be

received by September 25, 1996.

Requests to appear and outlines of

topics to be discussed at the public

hearing scheduled for October 23, 1996,

at 10 a.m. must be received by October

2, 1996.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (FI–48–95), room

5226, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative,

submissions may be hand delivered

between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:R (FI–48–95),

Courier’s Desk, Internal Revenue

Service, 1111 Constitution Avenue NW,

Washington, DC. A public hearing will

be held in the Commissioner’s

Conference Room, Internal Revenue

Building, 1111 Constitution Avenue

NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, William P.

Cejudo, (202) 622–4016, or Jeffrey W.

Maddrey, (202) 622–3940; concerning

submissions and the hearing, Christina

Vasquez, (202) 622–7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in this notice of proposed

rulemaking have been submitted to the

Office of Management and Budget for

review in accordance with the

Paperwork Reduction Act of 1995 (44

U.S.C. 3507).

Comments on the collections of

information should be sent to the Office

of Management and Budget, Attn: Desk

Officer for the Department of Treasury,

Office of Information and Regulatory

Affairs, Washington, DC 20503, with

copies to the Internal Revenue Service,

Attn: IRS Reports Clearance Officer,

T:FP, Washington, DC 20224. Comments

on the collections of information should

be received by August 26, 1996.

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 collections of information are in

proposed §§ 1.163–13(h)(3), 1.171–

4(a)(1), and 1.171–5(c)(2)(iii). This

information is required by the IRS to

monitor compliance with the federal tax

rules for amortizing bond premium and

bond issuance premium. The likely

respondents are taxpayers who either
Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules 33397

acquire a bond at a premium or issue a

bond at a premium. Responses to this

collection of information are required to

determine whether a holder of a bond

has elected to amortize bond premium

and to determine whether an issuer or

a holder has changed its method of

accounting for premium.

Books or records relating to a

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Estimated total annual reporting

burden: 50,000 hours. The estimated

annual burden per respondent varies

from 0.25 hours to 0.75 hours,

depending on individual circumstances,

with an estimated average of 0.5 hours.

Estimated number of respondents:

100,000.

Estimated annual frequency of

responses: One time per respondent.

Background

Sections 1.171–1 through 1.171–4 of

the Income Tax Regulations were

promulgated in 1957 and last amended

in 1968. In the Tax Reform Act of 1986,

section 171(b) was amended to require

that bond premium be amortized by

reference to a constant yield. In the

Technical and Miscellaneous Revenue

Act of 1988, section 171(e) was

amended to require that bond premium

be amortized as an offset to interest

income. The proposed regulations

would substantially revise the existing

regulations to reflect these amendments.

In addition, the proposed regulations

would revise existing guidance

addressing the issuer’s treatment of

bond issuance premium.

Explanation of Provisions

In general, bond premium arises when

a holder acquires a bond for more than

the principal amount of the bond.

Similarly, bond issuance premium

arises when an issuer issues a bond for

more than the principal amount of the

bond. A holder will purchase, and an

issuer will issue, a bond for more than

its principal amount when the stated

interest rate on the bond is higher than

the current market yield for the bond.

The holder’s treatment of bond

premium is addressed in proposed

regulations under section 171. The

issuer’s treatment of bond issuance

premium is addressed in proposed

regulations under section 163. In each

case, the amortization of premium is

based on constant yield principles. For

this reason, the proposed regulations

use concepts and definitions from the

original issue discount (OID) regulations

(§§ 1.1271–0 through 1.1275–6).

Determination of Bond Premium

Under the proposed regulations, bond

premium is defined as the excess of a

holder’s basis in a bond over the sum of

the remaining amounts payable on the

bond other than payments of qualified

stated interest. The holder generally

determines the amount of bond

premium as of the date the holder

acquires the bond.

The proposed regulations provide

special rules that limit a holder’s basis

solely for purposes of determining bond

premium. For example, if a bond is

convertible into stock of the issuer at the

holder’s option, for purposes of

determining bond premium, the holder

must reduce its basis in the bond by the

value of the conversion option. This

reduction prevents the holder from

inappropriately amortizing the cost of

the embedded conversion option.

Amortization of Bond Premium

Under section 171, the holder of a

taxable bond acquired at a premium

may elect to amortize bond premium.

The holder of a tax-exempt bond

acquired at a premium must amortize

the premium. As premium is amortized,

the holder’s basis in the bond is reduced

by a corresponding amount under

section 1016(a)(5).

Under the proposed regulations, a

holder amortizes bond premium by

offsetting qualified stated interest

income with bond premium. An offset

is calculated for each accrual period

using constant yield principles.

However, the offset for an accrual

period is only taken into account when

the holder takes qualified stated interest

into account under the holder’s regular

method of accounting. Thus, a holder

using the cash receipts and

disbursements method of accounting

does not take bond premium into

account until a qualified stated interest

payment is received.

For certain bonds (e.g., bonds that pay

a variable rate of interest or that provide

for an interest holiday), the amount of

bond premium allocable to an accrual

period could exceed the amount of

qualified stated interest allocable to that

period. The proposed regulations

address this situation by providing that

the excess bond premium is not allowed

as a deduction but is carried forward to

future accrual periods.

Variable Rate Debt Instruments

Because a variable rate debt

instrument (VRDI) provides for variable

interest payments, the yield and

payment schedule of a VRDI cannot be

determined without making

assumptions about the amount of the

variable payments. Under the OID

regulations, OID on a VRDI is

determined and allocated among accrual

periods by reference to an equivalent

fixed rate debt instrument constructed

as of the issue date of the VRDI. The

proposed regulations provide that bond

premium on a VRDI is determined and

allocated in a similar manner. Under the

proposed regulations, bond premium on

a VRDI is determined and allocated by

reference to an equivalent fixed rate

debt instrument. However, the

equivalent fixed rate debt instrument is

constructed as of the date the holder

acquires the VRDI rather than the issue

date.

Bonds Subject to Certain Contingencies

If a bond provides for one or more

alternative payment schedules, the yield

of the bond cannot be determined

without making assumptions about the

actual payment schedule. The OID

regulations provide three rules for

making these assumptions. First, if one

payment schedule is significantly more

likely than not to occur, the yield of the

debt instrument is determined by

reference to this payment schedule.

Second, if the debt instrument is subject

to a mandatory sinking fund provision,

the yield is determined without regard

to the mandatory sinking fund

provision. Third, notwithstanding the

first two rules, if the debt instrument

provides for an unconditional option or

options to alter the payment schedule,

the yield is determined by assuming

that the issuer will exercise its options

in the manner that minimizes the yield

of the debt instrument and that the

holder will exercise its options in the

manner that maximizes the yield of the

debt instrument.

The proposed regulations generally

use similar assumptions to determine

the holder’s yield on a bond that

provides for alternative payment

schedules. However, in the case of an

issuer’s option on a taxable bond, the

proposed regulations reverse the

assumption by assuming that the issuer

will exercise the option only if doing so

would increase the yield on the bond.

See section 171(b)(1)(B)(ii). As a result

of this rule, a holder generally must

amortize bond premium on a taxable

bond by reference to the stated maturity

date, even if it appears likely the bond

will be called. In this case, if the bond

is actually called, the proposed

regulations provide that the holder may

deduct the unamortized premium. If the

bond is partially called and the partial

call is not a pro-rata prepayment, the

proposed regulations do not allow the
33398 Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules

holder to deduct a portion of the

unamortized premium. Instead, the

holder must recompute the yield of the

bond on the date of the partial call and

amortize the remaining premium by

reference to the recomputed yield.

Treasury and IRS request comments

on the application of the alternative

payment schedule rules. Specifically,

comments are requested on whether the

‘‘significantly more likely than not to

occur’’ standard is appropriate for

taxable bonds, whether ignoring

mandatory sinking fund provisions is

appropriate for tax-exempt bonds, and

whether the distinction between prorata and non-pro-rata calls is

appropriate.

Bond Issuance Premium

Under existing § 1.61–12(c), a

corporate issuer treats premium

received upon issuance of a bond as a

separate item of income. Over the term

of the bond, the premium is taken into

income, and the full amount of the

stated interest is deducted. The

proposed regulations would revise the

treatment of bond issuance premium.

Under the proposed regulations, bond

issuance premium is amortized as an

offset to the issuer’s otherwise allowable

interest deduction, not as a separate

item of income. The amount of bond

issuance premium amortized in any

period is based on a constant yield. In

addition, the proposed regulations

would apply to all issuers, not just

corporate issuers.

De Minimis Rules and Aggregate Rules

The proposed regulations do not

provide rules for de minimis amounts of

premium or for aggregate methods of

accounting for premium. Treasury and

IRS request comments on whether de

minimis rules or aggregate rules are

necessary or appropriate.

Bonds Not Subject to the Proposed

Regulations

The proposed regulations generally

apply to bonds acquired or issued at a

premium. Certain bonds, however, are

excluded from the application of the

proposed regulations. For example, the

proposed regulations exclude debt

instruments subject to section 1272(a)(6)

(relating to certain prepayable debt

instruments). No inference is intended

regarding the treatment of these debt

instruments.

Proposed Effective Dates

The proposed regulations relating to

bond premium provide that the final

regulations generally will apply to

bonds acquired on or after the date 60

days after the date final regulations are

published in the Federal Register.

However, if a holder makes the election

to amortize bond premium for the

taxable year containing the date 60 days

after the date final regulations are

published, the regulations apply to

bonds held on or after the first day of

that taxable year.

The proposed regulations relating to

bond issuance premium provide that the

final regulations will apply to debt

instruments issued on or after the date

60 days after the date final regulations

are published in the Federal Register.

The proposed regulations also would

provide automatic consent for a

taxpayer to change its method of

accounting for premium in certain

circumstances. Because the change is

made on a cut-off basis, no items of

income or deduction are omitted or

duplicated. Therefore, no adjustment

under section 481 is allowed.

Special Analyses

It has been determined that this notice

of proposed rulemaking 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, this notice of proposed

rulemaking will be submitted to the

Chief Counsel for Advocacy of the Small

Business Administration for comment

on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

written comments (a signed original and

eight (8) copies) that are submitted

timely to the IRS. All comments will be

available for public inspection and

copying.

A public hearing has been scheduled

for October 23, 1996, at 10 a.m. in the

Commissioner’s Conference Room,

Internal Revenue Building, 1111

Constitution Avenue NW, Washington,

DC. Because of access restrictions,

visitors will not be admitted beyond the

building lobby more than 15 minutes

before the hearing starts.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

written comments by September 25,

1996. and submit an outline of the

topics to be discussed and the time to

be devoted to each topic (signed original

and eight (8) copies) by October 2, 1996.

A period of 10 minutes will be

allotted to each person for making

comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

Drafting Information

The principal authors of these

regulations are William P. Cejudo and

Jeffrey W. Maddrey of the Office of

Assistant Chief Counsel (Financial

Institutions and Products). However,

other personnel from the IRS and

Treasury Department participated in

their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by adding entries

in numerical order to read as follows:

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

Section 1.171–2 also issued under 26

U.S.C. 171(e).

Section 1.171–3 also issued under 26

U.S.C. 171(e).

Section 1.171–4 also issued under 26

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

Par. 2. Section 1.61–12 is amended by

revising paragraph (c) to read as follows:

§ 1.61–12 Income from discharge of

indebtedness.

* * * * *

(c) Issuance and repurchase of debt

instruments—(1) Issuance. An issuer

does not realize gain or loss upon the

issuance of a debt instrument (as

defined in § 1.1275–1(d)).

(2) Repurchase—(i) In general. An

issuer does not realize gain or loss upon

the repurchase of a debt instrument. For

purposes of this paragraph (c)(2), the

term repurchase includes the retirement

of a debt instrument, the conversion of

a debt instrument into stock of the

issuer, and the exchange (including an

exchange under section 1001) of a

newly issued debt instrument for an

existing debt instrument.

(ii) Repurchase at a discount. An

issuer realizes income from the

discharge of indebtedness upon the

repurchase of a debt instrument for an

amount less than its adjusted issue price

(as defined in § 1.163–13(d)(5)). The
Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules 33399

amount of discharge of indebtedness

income is equal to the excess of the

adjusted issue price over the repurchase

price. To determine the repurchase

price of a debt instrument that is

repurchased through the issuance of a

new debt instrument, see section

108(e)(10). See § 1.108–2 for rules

relating to the realization of discharge of

indebtedness income upon the

acquisition of a debt instrument by a

person related to the issuer.

(iii) Repurchase at a premium. An

issuer may be entitled to a repurchase

premium deduction upon the

repurchase of a debt instrument for an

amount greater than its adjusted issue

price (as defined in § 1.163–13(d)(5)).

See § 1.163–7(c) for the treatment of

repurchase premium.

(3) Bond issuance premium. For rules

relating to an issuer’s interest deduction

for a debt instrument issued with bond

issuance premium, see § 1.163–13.

(4) Effective date. This paragraph (c)

applies to debt instruments issued on or

after the date that is 60 days after the

date final regulations are published in

the Federal Register.

* * * * *

Par. 3. Section 1.163–7 is amended by

revising the first sentence of paragraph

(c) to read as follows:

§ 1.163–7 Deduction for OID on certain

debt instruments.

* * * * *

(c) Deduction upon repurchase.

Except to the extent disallowed by any

other section of the Internal Revenue

Code (e.g., section 249) or this

paragraph (c), if a debt instrument is

repurchased by the issuer for a price in

excess of its adjusted issue price (as

defined in § 1.163–13(d)(5)), the excess

(repurchase premium) is deductible as

interest for the taxable year in which the

repurchase occurs. * * *

* * * * *

Par. 4. Section 1.163–13 is added to

read as follows:

§ 1.163–13 Treatment of bond issuance

premium.

(a) General rule. If a debt instrument

is issued with bond issuance premium,

this section limits the amount of the

issuer’s interest deduction otherwise

allowable under section 163(a). In

general, the issuer determines its

interest deduction by offsetting the

interest allocable to an accrual period

with the bond issuance premium

allocable to that period. Bond issuance

premium is allocable to an accrual

period based on a constant yield. The

use of a constant yield to amortize bond

issuance premium is intended to

conform the treatment of debt

instruments having bond issuance

premium with those having original

issue discount. Unless otherwise

provided, the terms used in this section

have the same meaning as those terms

in section 163(e), sections 1271 through

1275, and the corresponding

regulations. Moreover, the provisions of

this section apply in a manner

consistent with those of section 163(e),

sections 1271 through 1275, and the

corresponding regulations. In addition,

the anti- abuse rule in § 1.1275–2(g)

applies for purposes of this section. For

rules dealing with the treatment of bond

premium by a holder, see §§ 1.171–1

through 1.171–5.

(b) Exceptions. This section does not

apply to—

(1) A debt instrument to which

section 1272(a)(6) applies (relating to

certain interests in or mortgages held by

a REMIC, and certain other debt

instruments with payments subject to

acceleration); or

(2) A debt instrument to which

§ 1.1275–4 applies (relating to certain

debt instruments that provide for

contingent payments).

(c) Bond issuance premium. Bond

issuance premium is the excess, if any,

of the issue price of a debt instrument

over its stated redemption price at

maturity. For purposes of this section,

the issue price of a convertible bond (as

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

not include an amount equal to the

value of the conversion option.

(d) Offsetting qualified stated interest

with bond issuance premium—(1) In

general. An issuer amortizes bond

issuance premium by offsetting the

qualified stated interest allocable to an

accrual period with the bond issuance

premium allocable to the accrual period.

This offset occurs when the issuer takes

the qualified stated interest into account

under its regular method of accounting.

(2) Qualified stated interest allocable

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

determine the accrual period to which

qualified stated interest is allocable and

to determine the accrual of qualified

stated interest within an accrual period.

(3) Bond issuance premium allocable

to an accrual period. The bond issuance

premium allocable to an accrual period

is determined under this paragraph

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

bond issuance premium allocable to the

period accrues ratably.

(i) Step one: Determine the debt

instrument’s yield to maturity. The yield

to maturity of a debt instrument is

determined under the rules of § 1.1272–

1(b)(1)(i).

(ii) Step two: Determine the accrual

periods. The accrual periods are

determined under the rules of § 1.1272–

1(b)(1)(ii).

(iii) Step three: Determine the bond

issuance premium allocable to the

accrual period. The bond issuance

premium allocable to an accrual period

is the excess of the qualified stated

interest allocable to the accrual period

over the product of the adjusted issue

price at the beginning of the accrual

period and the yield. In performing this

calculation, the yield must be stated

appropriately taking into account the

length of the particular accrual period.

Principles similar to those in § 1.1272–

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

issuance premium allocable to an

accrual period.

(4) Bond issuance premium in excess

of qualified stated interest. If the bond

issuance premium allocable to an

accrual period exceeds the qualified

stated interest allocable to the accrual

period for a debt instrument, the excess

is carried forward to the next accrual

period and offsets qualified stated

interest in that accrual period to the

extent of the disallowed amount. If the

amount carried forward to an accrual

period exceeds the qualified stated

interest for that period, the excess is

carried forward to subsequent accrual

periods, beginning with the next accrual

period, and is used to offset qualified

stated interest in those accrual periods

to the extent of the excess. If an excess

amount exists on the date the debt

instrument is retired, the issuer takes

this amount into account as ordinary

income.

(5) Adjusted issue price. In general,

the adjusted issue price of a debt

instrument is determined under the

rules of § 1.1275–1(b). In addition, the

adjusted issue price of the debt

instrument is decreased by the amount

of bond issuance premium previously

allocable under paragraph (d)(3) of this

section.

(e) Special rules—(1) Variable rate

debt instruments issued with bond

issuance premium. Bond issuance

premium on a variable rate debt

instrument is determined by reference

to the stated redemption price at

maturity of the equivalent fixed rate

debt instrument constructed as of the

issue date. In addition, the issuer

allocates bond issuance premium on a

variable rate debt instrument among the

accrual periods by reference to the

equivalent fixed rate debt instrument.

The equivalent fixed rate debt

instrument is determined using the

principles of § 1.1275–5(e).

(2) Remote and incidental

contingencies. For purposes of

determining and amortizing bond

issuance premium, if a bond provides
33400 Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules

for a contingency that is remote or

incidental (within the meaning of

§ 1.1275–2(h)), the contingency is taken

into account under the rules for remote

and incidental contingencies in

§ 1.1275–2(h).

(f) Example. The following example

illustrates the rules of this section.

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

X issues for $110,000 a debt instrument

maturing on February 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The debt instrument provides for

unconditional payments of interest of

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

X uses the calendar year as its taxable year,

X uses the cash receipts and disbursements

method of accounting, and X decides to use

annual accrual periods ending on February 1

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

day month and 360-day year.

(ii) Amount of bond issuance premium.

The issue price of the debt instrument is

$110,000. Because the interest payments on

the debt instrument are qualified stated

interest, the stated redemption price at

maturity of the debt instrument is $100,000.

Therefore, the amount of bond issuance

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

(iii) Bond issuance premium allocable to

the first accrual period. Based on the

payment schedule and the issue price of the

debt instrument, the yield of the debt

instrument is 8.07 percent, compounded

annually. (Although, for purposes of

simplicity, the yield as stated is rounded to

two decimal places, the computations do not

reflect this rounding convention.) The bond

issuance premium allocable to the accrual

period ending on February 1, 2000, is the

excess of the qualified stated interest

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

product of the adjusted issue price at the

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

yield (8.07 percent, compounded annually).

Therefore, the bond issuance premium

allocable to the accrual period is $1,118.17

($10,000 ¥ $8,881.83).

(iv) Premium used to offset interest.

Although X makes an interest payment of

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

interest of $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with bond issuance premium allocable

to the period ($1,118.17).

(g) Effective date. This section applies

to debt instruments issued on or after

the date that is 60 days after the date

final regulations are published in the

Federal Register.

(h) Consent to change method of

accounting. The Commissioner grants

consent for an issuer to change its

method of accounting for bond issuance

premium on debt instruments issued on

or after the date that is 60 days after the

date final regulations are published in

the Federal Register. However, this

consent is granted only if—

(1) The change is made to comply

with this section;

(2) The change is made for the first

taxable year for which the issuer must

account for a debt instrument under this

section; and

(3) The issuer attaches to its federal

income tax return for the taxable year

containing the change a statement that

it has changed its method of accounting

under this section.

Par. 5. Sections 1.171–1 through

1.171–4 are revised to read as follows:

§ 1.171–1 Bond premium.

(a) Overview—(1) In general. This

section and §§ 1.171–2 through 1.171–5

provide rules for the determination and

amortization of bond premium by a

holder. In general, a holder amortizes

bond premium by offsetting the interest

allocable to an accrual period with the

premium allocable to that period. Bond

premium is allocable to an accrual

period based on a constant yield. The

use of a constant yield to amortize bond

premium is intended generally to

conform the treatment of bond premium

to the treatment of original issue

discount under sections 1271 through

1275. Unless otherwise provided, the

terms used in this section and §§ 1.171–

2 through 1.171–5 have the same

meaning as those terms in sections 1271

through 1275 and the corresponding

regulations. Moreover, the provisions of

this section and §§ 1.171–2 through

1.171–5 apply in a manner consistent

with those of sections 1271 through

1275 and the corresponding regulations.

In addition, the anti-abuse rule in

§ 1.1275–2(g) applies for purposes of

this section and §§ 1.171–2 through

1.171–5.

(2) Cross-references. For rules dealing

with the adjustments to a holder’s basis

to reflect the amortization of bond

premium, see § 1.1016–5(b). For rules

dealing with the treatment of bond

issuance premium by an issuer, see

§ 1.163–13.

(b) Scope—(1) In general. Except as

provided in paragraph (b)(2) of this

section, this section and §§ 1.171–2

through 1.171–5 apply to any bond that,

upon its acquisition by the holder, is

held with bond premium. For purposes

of this section and §§ 1.171–2 through

1.171–5, the term bond has the same

meaning as the term debt instrument in

§ 1.1275–1(d).

(2) Exceptions. This section and

§§ 1.171–2 through 1.171–5 do not

apply to—

(i) A bond to which section 1272(a)(6)

applies (relating to certain interests in or

mortgages held by a REMIC, and certain

other debt instruments with payments

subject to acceleration);

(ii) A bond to which § 1.1275–4

applies (relating to certain debt

instruments that provide for contingent

payments);

(iii) A bond held by a holder that has

made a § 1.1272–3 election with respect

to the bond;

(iv) A bond that is stock in trade of

the holder, a bond of a kind that would

properly be included in the inventory of

the holder if on hand at the close of the

taxable year, or a bond held primarily

for sale to customers in the ordinary

course of the holder’s trade or business;

or

(v) A bond issued before September

28, 1985, unless the bond bears interest

and was issued by a corporation or by

a government or political subdivision

thereof.

(c) General rule—(1) Tax-exempt

obligations. A holder must amortize

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

Example 4.

(2) Taxable bonds. A holder may elect

to amortize bond premium on a taxable

bond. Except as provided in paragraph

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

any bond other than a tax-exempt

obligation. See § 1.171–4 for rules

relating to the election to amortize bond

premium on a taxable bond.

(3) Bonds the interest on which is

partially excludable. For purposes of

this section and §§ 1.171–2 through

1.171–5, a bond the interest on which is

partially excludable from gross income

(e.g., a securities acquisition loan under

section 133) is treated as two

instruments, a tax-exempt obligation

and a taxable bond. The holder’s basis

in the bond and each payment on the

bond are allocated between the two

instruments based on the ratio of the

interest excludable to the total interest

payable on the bond.

(d) Determination of bond premium—

(1) In general. A holder acquires a bond

at a premium if the holder’s basis in the

bond immediately after its acquisition

by the holder exceeds the sum of all

amounts payable on the bond after the

acquisition date (other than payments of

qualified stated interest). This excess is

bond premium, which is amortizable

under § 1.171–2.

(2) Additional rules for amounts

payable on certain bonds. Additional

rules apply to determine the amounts

payable on a variable rate debt

instrument and on a bond that provides

for certain alternative payment

schedules. See § 1.171–3.

(e) Basis. A holder determines its

basis in a bond under this paragraph (e).

This determination of basis applies only

for purposes of this section and

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

the application of this paragraph (e), the

holder’s basis in the bond for purposes

of these sections may differ from the
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holder’s basis for determining gain or

loss on the sale or exchange of the bond.

(1) Determination of basis—(i) In

general. In general, the holder’s basis in

the bond is the holder’s basis for

determining loss on the sale or exchange

of the bond.

(ii) Bonds acquired in certain

exchanges. If the holder acquired the

bond in exchange for other property

(other than in a reorganization defined

in section 368) and the holder’s basis in

the bond is determined in whole or in

part by reference to the holder’s basis in

the other property, the holder’s basis in

the bond may not exceed its fair market

value immediately after the exchange.

See paragraph (f) Example 1 of this

section. If the bond is acquired in a

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

(iii) Convertible bonds—(A) General

rule. If the bond is a convertible bond,

the holder’s basis in the bond is reduced

by an amount equal to the value of the

conversion option. The value of the

conversion option may be determined

under any reasonable method. For

example, the holder may determine the

value of the conversion option by

comparing the market price of the

convertible bond to the market prices of

similar bonds that do not have

conversion options. See paragraph (f)

Example 2 of this section.

(B) Convertible bonds acquired in

certain exchanges. If the bond is a

convertible bond acquired in a

transaction described in paragraph

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

basis in the bond may not exceed its fair

market value immediately after the

exchange reduced by the value of the

conversion option.

(C) Definition of convertible bond. A

convertible bond is a bond that provides

the holder with an option to convert the

bond into stock of the issuer, stock or

debt of a related party (within the

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

or into cash or other property in an

amount equal to the approximate value

of that stock or debt.

(2) Basis in bonds held by certain

transferees. Notwithstanding paragraph

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

transferred basis property (as defined in

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

had acquired the bond at a premium,

the holder’s basis in the bond is—

(i) The holder’s basis for determining

loss on the sale or exchange of the bond;

reduced by

(ii) Any amounts that the transferor

could not have amortized under this

paragraph (e) or under § 1.171–4(c).

(f) Examples. The following examples

illustrate the rules of this section.

Example 1. Bond received in liquidation of

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

partner in partnership PRS. PRS does not

have any unrealized receivables or

substantially appreciated inventory items as

defined in section 751. On January 1, 1997,

PRS distributes to PR a taxable bond, issued

by an unrelated corporation, in liquidation of

PR’s partnership interest. At that time, the

fair market value of PR’s partnership interest

is $40,000 and the basis is $100,000. The fair

market value of the bond is $40,000.

(ii) Determination of basis. Under section

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

basis in the partnership interest. Therefore,

PR’s basis for determining loss on the sale or

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

under paragraph (e)(1)(ii) of this section, PR’s

basis in the bond is $40,000 for purposes of

this section and §§ 1.171–2 through 1.171–5.

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

January 1, 1997, A purchases for $1,100 B

corporation’s bond maturing on January 1,

2000, with a stated principal amount of

$1,000, payable at maturity. The bond

provides for unconditional payments of

interest of $30 on January 1 and July 1 of

each year. In addition, the bond is

convertible into 15 shares of B corporation

stock at the option of the holder. On January

1, 1997, B corporation’s nonconvertible,

publicly-traded, three-year debt with similar

credit rating trades at a price that reflects a

yield of 6.75 percent, compounded

semiannually.

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

determining loss on the sale or exchange of

the bond is $1,100. As of January 1, 1997,

discounting the remaining payments on the

bond at the yield at which B’s similar

nonconvertible bonds trade (6.75 percent,

compounded semiannually) results in a

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

conversion option is $120. Under paragraph

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

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

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

all amounts payable on the bond other than

qualified stated interest is $1,000. Because

A’s basis (as determined under paragraph

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

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

premium.

§ 1.171–2 Amortization of bond premium.

(a) Offsetting qualified stated interest

with premium—(1) In general. A holder

amortizes bond premium by offsetting

the qualified stated interest allocable to

an accrual period with the bond

premium allocable to the accrual period.

This offset occurs when the holder takes

the qualified stated interest into account

under the holder’s regular method of

accounting.

(2) Qualified stated interest allocable

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

determine the accrual period to which

qualified stated interest is allocable and

to determine the accrual of qualified

stated interest within an accrual period.

(3) Bond premium allocable to an

accrual period. The bond premium

allocable to an accrual period is

determined under this paragraph (a)(3).

Within an accrual period, the bond

premium allocable to the period accrues

ratably.

(i) Step one: Determine the holder’s

yield. The holder’s yield is the discount

rate that, when used in computing the

present value of all remaining payments

to be made on the bond (including

payments of qualified stated interest),

produces an amount equal to the

holder’s basis in the bond as determined

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

remaining payments include only

payments to be made after the date the

holder acquires the bond. The yield is

calculated as of the date the holder

acquires the bond, must be constant

over the term of the bond, and must be

calculated to at least two decimal places

when expressed as a percentage.

(ii) Step two: Determine the accrual

periods. A holder determines the

accrual periods for the bond under the

rules of § 1.1272–1(b)(1)(ii).

(iii) Step three: Determine the bond

premium allocable to the accrual

period. The bond premium allocable to

an accrual period is the excess of the

qualified stated interest allocable to the

accrual period over the product of the

holder’s adjusted acquisition price (as

defined in paragraph (b) of this section)

at the beginning of the accrual period

and the holder’s yield. In performing

this calculation, the yield must be stated

appropriately taking into account the

length of the particular accrual period.

Principles similar to those in § 1.1272–

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

premium allocable to an accrual period.

(4) Bond premium in excess of

qualified stated interest. If the bond

premium allocable to an accrual period

exceeds the qualified stated interest

allocable to the accrual period for that

bond, the excess is carried forward to

the next accrual period and offsets

qualified stated interest in that accrual

period to the extent of the disallowed

amount. If the bond premium carried

forward to an accrual period exceeds the

qualified stated interest for that period,

the excess is carried forward to

subsequent accrual periods, beginning

with the next accrual period, and is

used to offset qualified stated interest in

those accrual periods to the extent of the

excess.

(5) Additional rules for certain bonds.

Additional rules apply to determine the

amortization of bond premium on a

variable rate debt instrument and on a

bond that provides for certain

alternative payment schedules. See

§ 1.171–3.

(b) Adjusted acquisition price. The

adjusted acquisition price of a bond at

the beginning of the first accrual period

is the holder’s basis as determined

under § 1.171–1(e). Thereafter, the
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adjusted acquisition price is the holder’s

basis in the bond decreased by—

(1) The amount of bond premium

previously allocable under paragraph

(a)(3) of this section; and

(2) The amount of any payment

previously made on the bond other than

a payment of qualified stated interest.

(c) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the

calendar year as its taxable year and has

elected to amortize bond premium,

effective for all relevant taxable years. In

addition, each example assumes a 30-

day month and 360-day year. Although,

for purposes of simplicity, the yield as

stated is rounded to two decimal places,

the computations do not reflect this

rounding convention.

Example 1. Taxable bond—(i) Facts. On

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

a taxable bond maturing on February 1, 2006,

with a stated principal amount of $100,000,

payable at maturity. The bond provides for

unconditional payments of interest of

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

A uses the cash receipts and disbursements

method of accounting, and A decides to use

annual accrual periods ending on February 1

of each year.

(ii) Amount of bond premium. The interest

payments on the bond are qualified stated

interest. Therefore, the sum of all amounts

payable on the bond (other than the interest

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

amount of bond premium is $10,000

($110,000–$100,000).

(iii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the bond and A’s basis

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

compounded annually. The bond premium

allocable to the accrual period ending on

February 1, 2000, is the excess of the

qualified stated interest allocable to the

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

adjusted acquisition price at the beginning of

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

percent, compounded annually). Therefore,

the bond premium allocable to the accrual

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

(iv) Premium used to offset interest.

Although A receives an interest payment of

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

in income $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

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

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

February 1, 2000.

Example 2. Alternative accrual periods—(i)

Facts. The facts are the same as in Example

1 of this paragraph (c) except that A decides

to use semiannual accrual periods ending on

February 1 and August 1 of each year.

(ii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the bond and A’s basis

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

compounded semiannually. The bond

premium allocable to the accrual period

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

qualified stated interest allocable to the

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

adjusted acquisition price at the beginning of

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

appropriately taking into account the length

of the accrual period (7.92 percent/2).

Therefore, the bond premium allocable to the

accrual period is $645.29

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

period ends on August 1, 1999, the qualified

stated interest of $5,000 is not taken into

income until February 1, 2000, the date it is

received. Likewise, the bond premium of

$645.29 is not taken into account until

February 1, 2000. The adjusted acquisition

price of the bond on August 1, 1999, is

$109,354.71 (the adjusted acquisition price at

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

the bond premium allocable to the period

($645.29)).

(iii) Bond premium allocable to the second

accrual period. Because the interval between

payments of qualified stated interest contains

more than one accrual period, the adjusted

acquisition price at the beginning of the

second accrual period must be adjusted for

the accrued but unpaid qualified stated

interest. Therefore, the adjusted acquisition

price on August 1, 1999, is $114,354.71

($109,354.71+$5,000). The bond premium

allocable to the accrual period ending on

February 1, 2000, is the excess of the

qualified stated interest allocable to the

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

adjusted acquisition price at the beginning of

the period ($114,354.71) and A’s yield, stated

appropriately taking into account the length

of the accrual period (7.92 percent/2).

Therefore, the bond premium allocable to the

accrual period is $472.88

($5,000¥$4,527.12).

(iv) Premium used to offset interest.

Although A receives an interest payment of

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

in income $8,881.83, the qualified stated

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

accrual period ending on August 1, 1999, and

$5,000 allocable to the accrual period ending

on February 1, 2000) offset with bond

premium of $1,118.17 ($645.29 allocable to

the accrual period ending on August 1, 1999,

and $472.88 allocable to the accrual period

ending on February 1, 2000). As indicated in

Example 1 of this paragraph (c), this same

amount would be taken into income at the

same time had A used annual accrual

periods.

Example 3. Holder uses accrual method of

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

as in Example 1 of this paragraph (c) except

that A uses the accrual method of accounting.

Thus, for the accrual period ending on

February 1, 2000, the qualified stated interest

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

bond premium allocable to the period is

$1,118.17. Because the accrual period

extends beyond the end of A’s taxable year,

A must allocate these amounts between the

two taxable years.

(ii) Amounts allocable to the first taxable

year. The qualified stated interest allocable to

the first taxable year is $9,166.67 ($10,000 ×

11/12). The bond premium allocable to the

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

11/12).

(iii) Premium used to offset interest. For

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

qualified stated interest allocable to the

period ($9,166.67) offset with bond premium

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

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

reduced by $1,024.99 in 1999.

(iv) Amounts allocable to the next taxable

year. The remaining amounts of qualified

stated interest and bond premium allocable

to the accrual period ending on February 1,

2000, are taken into account for the taxable

year ending on December 31, 2000.

Example 4. Tax-exempt obligation—(i)

Facts. On January 15, 1999, C purchases for

$120,000 a tax-exempt obligation maturing

on January 15, 2006, with a stated principal

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

obligation provides for unconditional

payments of interest of $9,000, payable on

January 15 of each year. C uses the cash

receipts and disbursements method of

accounting, and C decides to use annual

accrual periods ending on January 15 of each

year.

(ii) Amount of bond premium. The interest

payments on the obligation are qualified

stated interest. Therefore, the sum of all

amounts payable on the obligation (other

than the interest payments) is $100,000.

Under § 1.171–1, the amount of bond

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

(iii) Bond premium allocable to the first

accrual period. Based on the remaining

payment schedule of the obligation and C’s

basis in the obligation, C’s yield is 5.48

percent, compounded annually. The bond

premium allocable to the accrual period

ending on January 15, 2000, is the excess of

the qualified stated interest allocable to the

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

adjusted acquisition price at the beginning of

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

percent, compounded annually). Therefore,

the bond premium allocable to the accrual

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

(iv) Premium used to offset interest.

Although C receives an interest payment of

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

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

qualified stated interest allocable to the

period ($9,000) offset with bond premium

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

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

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

§ 1.171–3 Special rules for certain bonds.

(a) Variable rate debt instruments.

Bond premium on a variable rate debt

instrument is determined by reference

to the stated redemption price at

maturity of the equivalent fixed rate

debt instrument constructed for the

variable rate debt instrument. In

addition, a holder allocates bond

premium on a variable rate debt

instrument among the accrual periods

by reference to the equivalent fixed rate

debt instrument. The equivalent fixed

rate debt instrument is determined as of

the date the variable rate debt

instrument is acquired by the holder

and is constructed using the principles

of § 1.1275–5(e). See paragraph (d)

Example 1 of this section.

(b) Yield and remaining payment

schedule of certain bonds subject to
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contingencies—(1) Applicability. This

paragraph (b) provides rules that apply

in determining the yield and remaining

payment schedule of certain bonds that

provide for an alternative payment

schedule (or schedules) applicable upon

the occurrence of a contingency (or

contingencies). This paragraph (b)

applies, however, only if the timing and

amounts of the payments that comprise

each payment schedule are known as of

the date the holder acquires the bond

(the acquisition date) and the bond is

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

this section. A bond does not provide

for an alternative payment schedule

merely because there is a possibility of

impairment of a payment (or payments)

by insolvency, default, or similar

circumstances. See § 1.1275–4 for the

treatment of a bond that provides for a

contingency that is not described in this

paragraph (b).

(2) Remaining payment schedule that

is significantly more likely than not to

occur. If, based on all the facts and

circumstances as of the acquisition date,

a single remaining payment schedule for

a bond is significantly more likely than

not to occur, this remaining payment

schedule is used to determine and

amortize bond premium under

§§ 1.171–1 and 1.171–2.

(3) Mandatory sinking fund provision.

Notwithstanding paragraph (b)(2) of this

section, if a bond is subject to a

mandatory sinking fund provision

described in § 1.1272–1(c)(3) and the

use and terms of the provision meet

reasonable commercial standards, the

provision is ignored for purposes of

determining and amortizing bond

premium under §§ 1.171–1 and 1.171–2.

(4) Treatment of certain options—(i)

Applicability. Notwithstanding

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

the rules of this paragraph (b)(4)

determine the remaining payment

schedule of a bond that provides the

holder or issuer with an unconditional

option or options, exercisable on one or

more dates during the remaining term of

the bond, to alter the bond’s remaining

payment schedule.

(ii) Operating rules. A holder

determines the remaining payment

schedule of a bond by assuming that

each option will (or will not) be

exercised under the following rules:

(A) Issuer options. The issuer of a taxexempt obligation is deemed to exercise

or not exercise an option or combination

of options in the manner that minimizes

the holder’s yield on the obligation. The

issuer of a taxable bond is deemed to

exercise or not exercise an option or

combination of options in the manner

that maximizes the holder’s yield on the

bond.

(B) Holder options. A holder is

deemed to exercise or not exercise an

option or combination of options in the

manner that maximizes the holder’s

yield on the bond.

(C) Multiple options. If both the issuer

and the holder have options, the rules

of paragraphs (b)(4)(ii) (A) and (B) of

this section are applied to the options in

the order that they may be exercised.

Thus, the deemed exercise of one option

may eliminate other options that are

later in time.

(5) Subsequent adjustments—(i) In

general. Except as provided in

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

contingency described in this paragraph

(b) (including the exercise of an option

described in paragraph (b)(4) of this

section) actually occurs or does not

occur, contrary to the assumption made

pursuant to this paragraph (b) (a change

in circumstances), then solely for

purposes of section 171, the bond is

treated as retired and reacquired by the

holder on the date of the change in

circumstances for an amount equal to

the adjusted acquisition price of the

bond as of that date. If, however, the

change in circumstances results in a

substantially contemporaneous pro-rata

prepayment as defined in § 1.1275–

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

treated as a payment in retirement of a

portion of the bond. See paragraph (d)

Example 2 of this section. (ii) Bond

premium deduction on the issuer’s call

of a taxable bond. If a change in

circumstances results from an issuer’s

call of a taxable bond or a partial call

that is a pro-rata prepayment, the holder

may deduct as bond premium an

amount equal to the excess, if any, of

the adjusted acquisition price of the

bond over the greater of the amount

received on redemption or the amount

payable on maturity.

(c) Remote and incidental

contingencies. For purposes of

determining and amortizing bond

premium, if a bond provides for a

contingency that is remote or incidental

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

the contingency is taken into account

under the rules for remote and

incidental contingencies in § 1.1275–

2(h).

(d) Examples. The following examples

illustrate the rules of this section. Each

example assumes the holder uses the

calendar year as its taxable year and,

except as otherwise stated, has elected

to amortize bond premium, effective for

all relevant taxable years. In addition,

each example assumes a 30-day month

and 360-day year. Although, for

purposes of simplicity, the yield as

stated is rounded to two decimal places,

the computations do not reflect this

rounding convention.

Example 1. Variable rate debt instrument—

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

$110,000 a taxable bond maturing on March

1, 2007, with a stated principal amount of

$100,000, payable at maturity. The bond

provides for unconditional payments of

interest on March 1 of each year based on the

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

it is reasonably expected that the bond will

yield 12 percent, compounded annually. E

uses the cash receipts and disbursements

method of accounting, and E decides to use

annual accrual periods ending on March 1 of

each year. Assume that the bond is a variable

rate debt instrument under § 1.1275–5.

(ii) Amount of bond premium. Because the

bond is a variable rate debt instrument, E

determines and amortizes its bond premium

by reference to the equivalent fixed rate debt

instrument constructed for the bond as of

March 1, 1999. Because the bond provides for

interest at a single objective rate that is

reasonably expected to yield 12 percent,

compounded annually, the equivalent fixed

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

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

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

basis in the equivalent fixed rate debt

instrument is $110,000. The sum of all

amounts payable on the equivalent fixed rate

debt instrument (other than payments of

qualified stated interest) is $100,000. Under

§ 1.171–1, the amount of bond premium is

$10,000 ($110,000–$100,000).

(iii) Bond premium allocable to each

accrual period. E allocates bond premium to

the remaining accrual periods by reference to

the payment schedule on the equivalent fixed

rate debt instrument. Based on the payment

schedule of the equivalent fixed rate debt

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

yield is 10.12 percent, compounded

annually. The bond premium allocable to the

accrual period ending on March 1, 2000, is

the excess of the qualified stated interest

allocable to the period for the equivalent

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

product of the adjusted acquisition price at

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

E’s yield (10.12 percent, compounded

annually). Therefore, the bond premium

allocable to the accrual period is $870.71

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

allocable to all the accrual periods is listed

in the following schedule:

Accrual period

ending

Adjusted acquisition price

at beginning of

accrual period

Premium allocable to

accrual period

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

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

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

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

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

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

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

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

10,000.00
33404 Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules

(iv) Qualified stated interest for each

accrual period. Assume the bond actually

pays the following amounts of qualified

stated interest:

Accrual period ending Qualified stated interest

3/1/00 .................................... $15,000.00

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

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

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

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

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

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

Accrual period ending Qualified stated interest

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

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

interest income for each accrual period is

determined by offsetting the qualified stated

interest allocable to the period with the bond

premium allocable to the period. For the

accrual period ending on March 1, 2000, E

includes in income $14,129.29, the qualified

stated interest allocable to the period

($15,000) offset with the bond premium

allocable to the period ($870.71). For the

accrual period ending on March 1, 2001, the

bond premium allocable to the period

($958.81) exceeds the qualified stated interest

allocable to the period ($0). Therefore, the

excess of $958.81 ($958.81¥$0) is carried

forward to the next accrual period. For the

next accrual period, the qualified stated

interest for the period is insufficient to offset

the bond premium allocable to the period

($1,055.82) and the amount carried forward

from the prior period ($958.81). Thus,

$2,014.63 ($1,055.82 + $958.81) is carried

forward to the accrual period ending on

March 1, 2003, and offsets qualified stated

interest allocable to that period. The amount

E includes in income for each accrual period

is shown in the following schedule:

Accrual period ending Qualified stated interest

Premium allocable to accrual period

Interest income

Premium

carry forward

3/1/00 .................................................................................................................... $15,000.00 $870.71 $14,129.29 ....................

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

3/1/02 .................................................................................................................... 0.00 1,055.82 0.00 2,014.63

3/1/03 .................................................................................................................... 10,000.00 1,162.64 6,822.73 ....................

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

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

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

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

10,000.00

Example 2. Partial call that results in a

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

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

bond maturing on April 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The bond provides for

unconditional payments of interest of

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

has the option to call all or part of the bond

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

the principal amount. M uses the cash

receipts and disbursements method of

accounting.

(ii) Determination of yield and the

remaining payment schedule. M’s yield

determined without regard to the call option

is 8.07 percent, compounded annually. M’s

yield determined by assuming N exercises its

call option is 6.89 percent, compounded

annually. Under paragraph (b)(4)(ii)(A) of

this section, it is assumed N will not exercise

the call option because exercising the option

would minimize M’s yield. Thus, for

purposes of determining and amortizing

bond premium, the bond is assumed to be a

seven-year bond with a single principal

payment at maturity of $100,000.

(iii) Amount of bond premium. The interest

payments on the bond are qualified stated

interest. Therefore, the sum of all amounts

payable on the bond (other than the interest

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

amount of bond premium is $10,000

($110,000–$100,000).

(iv) Bond premium allocable to the first

two accrual periods. For the accrual period

ending on April 1, 2000, M includes in

income $8,881.83, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

period ($1,118.17). The adjusted acquisition

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

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

ending on April 1, 2001, M includes in

income $8,791.54, the qualified stated

interest allocable to the period ($10,000)

offset with bond premium allocable to the

period ($1,208.46). The adjusted acquisition

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

($108,881.83–$1,208.46).

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

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

Because it was assumed the call would not

be exercised, the call is a change in

circumstances. However, the partial call is

also a pro-rata prepayment within the

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

call is treated as a retirement of one-half of

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

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

of its adjusted acquisition price in the retired

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

$53,836.68) over the amount received on

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

the portion of the bond that remains

outstanding is $53,836.68

($107,673.37¥$53,836.68).

§ 1.171–4 Election to amortize bond

premium on taxable bonds.

(a) Time and manner of making the

election—(1) In general. A holder makes

the election to amortize bond premium

by offsetting interest income with bond

premium in the holder’s timely filed

federal income tax return for the first

taxable year to which the holder desires

the election to apply. The holder should

attach to the return a statement that the

holder is making the election under this

section.

(2) Coordination with OID election. If

a holder makes an election under

§ 1.1272–3 for a bond with bond

premium, the holder is deemed to have

made the election under this section.

(b) Scope of election. The election

under this section applies to all taxable

bonds held during or after the taxable

year for which the election is made.

(c) Election to amortize made in a

subsequent taxable year—(1) In general.

If a holder elects to amortize bond

premium and holds a taxable bond

acquired before the taxable year for

which the election is made, the holder

may not amortize amounts that would

have been amortized in prior taxable

years had an election been in effect for

those prior years.

(2) Example. The following example

illustrates the rule of this paragraph (c).

Example—(i) Facts. On May 1, 1999, C

purchases for $130,000 a taxable bond

maturing on May 1, 2006, with a stated

principal amount of $100,000, payable at

maturity. The bond provides for

unconditional payments of interest of

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

uses the cash receipts and disbursements

method of accounting and the calendar year

as its taxable year. C has not previously

elected to amortize bond premium, but does

so for 2002.

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

determining loss on the sale or exchange of

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

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

Under § 1.171–2, if a bond premium election

were in effect for the prior taxable years, C

would have amortized $3,257.44 of bond

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

bond premium on May 1, 2001, based on

annual accrual periods ending on May 1.
Federal Register / Vol. 61, No. 125 / Thursday, June 27, 1996 / Proposed Rules 33405

Thus, for 2002 and future years to which the

election applies, C may amortize only

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

(d) Revocation of election. The

election under this section may not be

revoked unless approved by the

Commissioner.

Par. 6. Section 1.171–5 is added to

read as follows:

§ 1.171–5 Effective date and transition

rules.

(a) Effective date—(1) In general. This

section and §§ 1.171–1 through 1.171–4

apply to bonds acquired on or after the

date 60 days after the date final

regulations are published in the Federal

Register. However, if a holder makes the

election under § 1.171–4 for the taxable

year containing the date 60 days after

the date final regulations are published

in the Federal Register, this section and

§§ 1.171–1 through 1.171–4 apply to

bonds held on or after the first day of

that taxable year.

(2) Transition rule for use of constant

yield. Notwithstanding paragraph (a)(1)

of this section, § 1.171–2(a)(3)

(providing that the bond premium

allocable to an accrual period is

determined with reference to a constant

yield) does not apply to a bond issued

before September 28, 1985.

(b) Coordination with existing

election. A holder is deemed to have

made the election under § 1.171–4 if the

holder elected to amortize bond

premium under section 171 and that

election is effective on the date 60 days

after the date final regulations are

published in the Federal Register.

(c) Accounting method changes—(1)

Consent to change. A holder required to

change its method of accounting for

bond premium to comply with

§§ 1.171–1 through 1.171–3 must secure

the consent of the Commissioner in

accordance with the requirements of

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

section provides the Commissioner’s

automatic consent for certain changes. A

holder making the election does not

need the Commissioner’s consent.

(2) Automatic consent. The

Commissioner grants consent for a

holder to change its method of

accounting for bond premium with

respect to bonds to which §§ 1.171–1

through 1.171–3 apply. The consent

granted by this paragraph (c)(2) applies

provided—

(i) The holder elected to amortize

bond premium under section 171 for a

taxable year prior to the taxable year

containing the date 60 days after the

date final regulations are published in

the Federal Register and that election

has not been revoked;

(ii) The change is made for the first

taxable year for which the holder must

account for a bond under §§ 1.171–1

through 1.171–3; and

(iii) The holder attaches to its return

for the taxable year containing the

change a statement that it has changed

its method of accounting under this

section.

Par. 7. Section 1.1016–5 is amended

by revising paragraph (b) to read as

follows:

§ 1.1016–5 Miscellaneous adjustments to

basis.

* * * * *

(b) Amortizable bond premium. A

holder’s basis in a bond is reduced by

the amount of bond premium used to

offset qualified stated interest income

under § 1.171–2. This reduction occurs

when the holder takes the qualified

stated interest into account under the

holder’s regular method of accounting.

In addition, a holder’s basis in a taxable

bond is reduced by the amount of bond

premium allowed as a deduction under

§ 1.171–3(b)(5)(ii) (relating to the

issuer’s call of a taxable bond).

* * * * *

§ 1.1016–9 [Removed]

Par. 8. Section 1.1016–9 is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96–16350 Filed 6–26–96; 8:45 am]

BILLING CODE 4830–01–P

26 CFR Part 1

[FI–28–96]

RIN 1545–AU39

Arbitrage Restrictions on Tax-Exempt

Bonds

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations on the arbitrage

restrictions applicable to tax-exempt

bonds issued by state and local

governments. Changes to applicable law

were made by the Tax Reform Act of

1986. These proposed regulations affect

issuers of tax-exempt bonds and would

provide guidance for complying with

the arbitrage regulations.

DATES: Written comments must be

received by September 25, 1996.

Requests to speak (with outlines of oral

comments) at a public hearing

scheduled for Thursday, October 24,

1996, at 10 a.m. must be received by

October 3, 1996.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (FI–28–96), room

5226, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. In the alternative,

submissions may be hand delivered

between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:R (FI–28–96),

Courier’s Desk, Internal Revenue

Service, 1111 Constitution Avenue NW.,

Washington, DC. The public hearing

will be held in the Commissioner’s

Conference Room, Internal Revenue

Building, 1111 Constitution Avenue,

NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations,

Loretta J. Finger, (202) 622–3980;

concerning submissions and the

hearing, Michael Slaughter, (202) 622–

7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in this notice of proposed

rulemaking have been submitted to the

Office of Management and Budget for

review in accordance with the

Paperwork Reduction Act of 1995 (44

U.S.C. 3507).

Comments on the collections of

information should be sent to the Office

of Management and Budget, Attn: Desk

Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503, with copies to the Internal

Revenue Service, Attn: IRS Reports

Clearance Officer, T:FP, Washington, DC

20224. Comments on the collections of

information should be received by

August 26, 1996.

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 collections of information are in

proposed § 1.148–5(d)(6) (v), (vi), and

(vii). This information is required by the

IRS to verify compliance with section

148. This information will be used to

establish a rebuttable presumption that

a Treasury obligation is purchased at

fair market value. The likely

respondents and/or recordkeepers are

state or local governments. Responses to

this collection of information are

required to establish a rebuttable

presumption that a Treasury obligation

is purchased at fair market value.

Books or records relating to a

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information