DEPARTMENT OF THE TREASURY

Treasury Decision 9157

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

2004-2 C.B. 545; T.D. 9157; 2004 IRB LEXIS 577; 2004-40 I.R.B. 545 

October 4, 2004

  [*1]  

SUBJECT MATTER: Section 988.-Treatment of Certain Foreign Currency Transactions

APPLICABLE SECTIONS: 
26 CFR 1.988-2: Recognition and computation of exchange gain or loss. Internal Revenue Service 26 CFR Parts 1 and 602

TEXT: 

AGENCY: 
Internal Revenue Service (IRS), Treasury.

ACTION: 
Final regulation.

SUMMARY: 
This document contains final regulations regarding the treatment of contingent payment debt instruments for which one or more payments are denominated in, or determined by reference to, a currency other than the taxpayer's functional currency. These regulations are necessary because current regulations do not provide guidance concerning the tax treatment of such instruments. The regulations affect issuers and holders of such instruments.

DATES: 
Effective Date: These regulations are effective August 30, 2004.
Applicability Date: These regulations apply to debt instruments issued on or after October 29, 2004.

FOR FURTHER INFORMATION CONTACT: 
Milton Cahn, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act 
The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507)   [*2]  under control number 1545-1831. Responses to these collections of information are mandatory.
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 assigned by the Office of Management and Budget.
The estimated annual burden per [respondent/recordkeeper] varies from 48 minutes to 1 hour 12 minutes, depending on individual circumstances, with an estimated average of 1 hour.
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, SE:W:CAR:MP:T:T:SP, 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 this collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Background 
This document contains amendments   [*3]  to 26 CFR part 1. On August 29, 2003, a notice of proposed rulemaking (REG-106486-98, 2003-42 I.R.B. 853) relating to the taxation of nonfunctional currency denominated contingent payment debt instruments was published in the Federal Register (68 FR 51944). No public hearing was requested or held. One written comment responding to the notice of proposed rulemaking was received. After consideration of this comment, the proposed regulations are adopted as amended by this Treasury decision. The revisions are discussed below.

Summary of Comments 
Treasury and the IRS received one comment letter in response to the notice of proposed rulemaking. The issues raised in that comment letter are addressed below.
1. Exceptions Described in §1.1275-4 (a) (2)
The comment letter notes that in describing instruments subject to §1.988-6 by reference to § 1.1275-4 (b) (1), it was unclear whether the exceptions set forth in §1.1275-4 (a) (2) applied to instruments described in §1.988-6 (a) (1).
It was intended to be implicit from the reference to §1.1275-4 (b) (1) that debt instruments excluded from the application of §1.1275-4 by reason of §1.1275-4 (a) (2) (other than by reason of being subject to section 988)   [*4]  are similarly excluded from § 1.988-6. Nevertheless, the final regulations have been revised to make explicit that § 1.988-6 applies only to debt instruments to which §1.1275-4 would otherwise apply (not taking into account the exclusion for debt instruments that are subject to section 988).
2. Multicurrency Debt Instruments With Related Hedges
The comment letter expresses concern that it may be possible to structure arrangements to avoid the original issue discount (OID) rules using a multicurrency debt instrument that has a nonfunctional currency as the predominant currency and partial hedges of that instrument. That is, it may be possible to closely replicate the economic attributes of a dollar denominated instrument with OID through a combination of a multicurrency instrument without OID and a partial hedge of that instrument. The comment letter suggests that §1.988-5 (a) would not apply in such a case, because the hedge would not be a complete hedge of all payments.
Treasury and the IRS believe that an anti-abuse rule is appropriate to prevent the potential abuse described above. Accordingly, an anti-abuse rule applicable to debt instruments subject to section 988 is included in §1.988-2 (b) (18).   [*5]  This anti-abuse rule is patterned after the anti-abuse rule contained in §1.1275-2 (g) and permits the Commissioner to apply or depart from the applicable regulations as necessary or appropriate to achieve a reasonable result. No inference is intended as to how the Commissioner may apply the anti-abuse rule contained in §1.1275-2 (g) to nonfunctional currency denominated debt instruments.
In addition, Treasury and the IRS believe that §1.988-2 (f) may be applied in the situation described. Furthermore, Treasury and the IRS note that under §1.988-5 (a) (8) (iii) the Commissioner can integrate a foreign currency denominated debt instrument with a partial hedge of that instrument.
3. Multicurrency Debt Instrument-Determination of Predominant Currency
The comment letter proposes the use of a special anti-abuse rule in the case where the net present value of all payments in, or determined with respect to, the predominant currency of a multicurrency instrument does not exceed 50 percent of the present value of all payments. The letter requests that, in such a case, the comparable yield be determined on a synthetic basis by reference to the weighted average of the comparable yields in each component   [*6]  currency rather than by reference to the predominant currency. There are two stated rationales for this request. First, the holder could avoid accrual of OID if a multicurrency contingent payment debt instrument's predominant currency is a currency with a low interest rate and the other currencies in which payments are denominated or with respect to which payments are determined are highly inflationary currencies (but not hyperinflationary currencies). Second, if the predominant low interest rate currency in such an instrument is the U.S. dollar and the issuer is foreign, a holder's gain upon disposition of the instrument would be characterized as foreign source interest income rather than as U.S. source foreign currency gain.
Treasury and the IRS agree that the letter has identified an issue to be addressed. However, Treasury and the IRS believe the proposed solution of creating a synthetic yield (and presumably a synthetic currency to measure currency gain or loss) is overly complex and would be difficult to administer. Instead, Treasury and the IRS have added a special rule that applies if there is no single currency for which the net present value in functional currency of all payments   [*7]  denominated in, or determined by reference to, that currency is greater than 50 percent of the total value of all payments. In such a case, if the discount rate attributable to the currency that would otherwise be the predominant currency differs by 10 percentage points or more from the discount rate attributable to any other currency in which payments are denominated or with respect to which payments are determined, the Commissioner can determine the predominant currency under any reasonable method.
4. Integrated Debt Instruments
The comment letter requests clarification that §1.988-6 does not apply to transactions that are composed of a nonfunctional currency contingent payment debt instrument (or a multicurrency debt instrument) and a qualified hedge and that are subject to the integration rules of §1.988-5. Treasury and the IRS believe that the proposed regulations are clear on this point, because §1.988-5 (a) (5) (i) provides that a taxpayer may treat a debt instrument and a hedge as an integrated economic transaction only if, among other things, all the contingent features of an instrument are fully hedged such that the synthetic debt instrument resulting from integration is not   [*8]  a contingent payment instrument. Accordingly, no change has been made in the final regulations regarding this issue.
5. Alternative Payment Schedule and Fixed Yield Rules
Section 1.1275-4 (a) (2) (iii) provides that the contingent payment debt instrument rules in §1.1275-4 do not apply to a debt instrument subject to §1.1272-1 (c) (a debt instrument that provides for certain alternative payment schedules) or §1.1272-1 (d) (a debt instrument that provides for a fixed yield). The comment letter requests that the final regulations clarify that, for purposes of applying §§1.1272-1 (c) and 1.1272-1 (d) to a nonfunctional currency denominated debt instrument, the yield of the instrument be determined in the instrument's denomination currency, rather than in the taxpayer's functional currency. Treasury and the IRS believe that it is clear under §1.988-2 (b) (2) (ii) (A) (determinations regarding OID in a nonfunctional currency denominated debt instrument are made in the currency of the debt instrument) that these provisions are applied by using the debt instrument's denomination currency. Accordingly, no change has been made in the final regulations regarding this issue.
6. Predominant Currency   [*9]  of a Multicurrency Debt Instrument is the Same as the Taxpayer's Functional Currency
The comment letter requests that the final regulations clarify that if the predominant currency of a multicurrency debt instrument is the taxpayer's functional currency, then section 988 does not apply to that instrument. Treasury and the IRS believe that §1.988-6 (d) (4) of the proposed regulations is clear on this point. Accordingly, no further clarification is made in the final regulations.
7. Other Regulatory Provisions
The comment letter requests that the final regulations clarify that debt instruments subject to §1.988-6 be treated for purposes of other regulations as if they were subject to §1.1275-4. Section 1.988-6 provides that the rules of §1.1275-4 apply to debt instruments subject to §1.988-6, except as otherwise provided in §1.988-6. Accordingly, a reference to a debt instrument subject to §1.1275-4 will also refer to a debt instrument subject to §1.988-6, unless otherwise provided in §1.988-6. Treasury and the IRS therefore believe that no further clarification is necessary.
8. Netting Currency Gain or Loss With Other Gain or Loss Upon a Disposition of the Instrument
In response to a request   [*10]  in the preamble to the proposed regulations for comments regarding netting, the comment letter proposes that foreign currency gain or loss be netted with other gain or loss on the disposition of a debt instrument. Treasury and the IRS are concerned about this type of netting in the context of foreign currency contingent payment debt instruments. Depending on the particular terms of such an instrument, a change in value due to a contingency may be recognized for tax purposes in a year prior to the recognition of foreign currency gain or loss upon disposition of the instrument or may be recognized concurrently with the recognition of foreign currency gain or loss upon disposition. Treasury and the IRS therefore have concluded that netting is not appropriate in the context of foreign currency contingent payment debt instruments.
9. Tax Exempt Foreign Currency Contingent Payment Debt Instruments
In response to a request in the preamble to the proposed regulations for comments regarding tax exempt foreign currency contingent payment debt instruments, the comment letter requests certain modifications to §1.1275-4 (d) (3) to take into account the policy considerations underlying §1.988-3 (c). Treasury and the IRS   [*11]  appreciate these comments but believe the matter deserves more careful study before any regulations specifically addressing tax exempt foreign currency contingent payment debt instruments can be issued.
10. Multicurrency Debt Instruments With no Non-Currency Contingencies
In response to the request for comments contained in the preamble to the proposed regulations, the comment letter requests that all gain or loss on a sale of a multicurrency debt instrument that has no non-currency contingencies be characterized wholly as foreign currency gain or loss. Treasury and the IRS are concerned that such treatment would differ inappropriately from the treatment of gain or loss in respect of a contingent payment debt instrument that has currency contingencies and non-currency contingencies. Accordingly, no change has been made in the final regulations regarding this issue.

Effect on Other Documents 
The following publications are obsolete with regard to debt instruments issued on or after October 29, 2004:
Announcement 99-76, 1999-2 C.B. 223.

Special Analyses 
It has been determined that this final regulation is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory   [*12]  assessment is not required. It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that few, if any, small entities issue or hold foreign currency denominated contingent payment debt instruments. Generally, it is expected that the only domestic holders of these instruments will likely be financial institutions, investment banking firms, investment funds, and other sophisticated investors, due to the foreign currency risk and other contingencies inherent in these instruments. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 26 U.S.C. 7805 (f), the notice of proposed rulemaking preceding these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information 
The principal author of these regulations is Milton Cahn of the Office of the Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.
* * *

Adoption of Amendments to the Regulations 
Accordingly,   [*13]  26 CFR parts 1 and 602 are amended as follows:

PART 1-INCOME TAXES 
Paragraph 1. The authority citation for part 1 continues to read, in part, as follows:

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

Par. 2. Section 1.988-0 is amended as follows:

	
1.  	The introductory text is revised.

2.  	Entries are added for §§1.988-2 (b) (18), 1.988-2 (h) and 1.988-6.
The revision and additions read as follows:

§1.988-0 Taxation of gain or loss from a section 988 transaction; Table of contents 
This section lists captioned paragraphs contained in §§1.988-1 through 1.988-6.
* * *

§1.988-2 Recognition and computation of exchange gain or loss. 
* * *
(b) * * *
(18) Interaction of section 988 and §1.1275-2 (g).
* * *
(h) Timing of income and deductions from notional principal contracts.
* * *

§1.988-6 Nonfunctional currency contingent payment debt instruments. 
(a) In general.
(1) Scope.
(2) Exception for hyperinflationary currencies.
(b) Instruments described in paragraph (a) (1) (i) of this section.
(1) In general.
(2) Application of noncontingent bond method.
(3) Treatment and translation of amounts determined under noncontingent bond method.
(4) Determination of gain or loss not attributable to foreign currency.
(5) Determination of foreign currency   [*14]  gain or loss.
(6) Source of gain or loss.
(7) Basis different from adjusted issue price.
(8) Fixed but deferred contingent payments.
(c) Examples.
(d) Multicurrency debt instruments.
(1) In general.
(2) Determination of denomination currency.
(3) Issuer/holder consistency.
(4) Treatment of payments in currencies other than the denomination currency.
(e) Instruments issued for nonpublicly traded property.
(1) Applicability.
(2) Separation into components.
(3) Treatment of components consisting of one or more noncontingent payments in the same currency.
(4) Treatment of components consisting of contingent payments.
(5) Basis different from adjusted issue price.
(6) Treatment of holder on sale, exchange, or retirement.
(f) Rules for nonfunctional currency tax exempt obligations described in §1.1275-4 (d).
(g) Effective date.

Par. 3. Section 1.988-2 is amended by:

	
1.  	Adding the text of paragraph (b) (2) (i) (B) (1).

2.  	Revising paragraph (b) (2) (i) (B) (2).

3.  	Adding the text of paragraph (b) (18).
The additions and revision read as follows:

§1.988-2 Recognition and computation of exchange gain or loss. 
* * *
(b) * * *
(2) * * *
(i) * * *
(B) * * * (1) Operative rules. See § 1.988-6 for rules applicable to contingent   [*15]  payment debt instruments for which one or more payments are denominated in, or determined by reference to, a nonfunctional currency.
(2) Certain instruments are not contingent payment debt instruments. For purposes of sections 163 (e) and 1271 through 1275 and the regulations thereunder, a debt instrument does not provide for contingent payments merely because the instrument is denominated in, or all payments of which are determined with reference to, a single nonfunctional currency. See § 1.988-6 for the treatment of nonfunctional currency contingent payment debt instruments.
* * *
(18) Interaction of section 988 and §1.1275-2 (g)-(i) In general. If a principal purpose of structuring a debt instrument subject to section 988 and any related hedges is to achieve a result that is unreasonable in light of the purposes of section 163 (e), section 988, sections 1271 through 1275, or any related section of the Internal Revenue 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 (b) (18) applies to a multicurrency debt instrument and a hedge or hedges, the Commissioner   [*16]  can wholly or partially integrate transactions or treat portions of the debt instrument as separate instruments where appropriate. See also §1.1275-2 (g).
(ii) 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. Another significant fact is whether the result is obtainable without the application of §1.988-6 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.
(iii) Effective date. This paragraph (b) (18) shall apply to debt instruments issued on or after October 29, 2004.
* * *

Par. 4. Section 1.988-6 is added to read as follows:

§1.988-6 Nonfunctional currency contingent payment debt instruments 
(a) In general-(1) Scope. This section determines the accrual of interest and the amount, timing, source, and character of any gain or loss on nonfunctional   [*17]  currency contingent payment debt instruments described in this paragraph (a) (1) and to which §1.1275-4 (a) would otherwise apply if the debt instrument were denominated in the taxpayer's functional currency. Except as provided by the rules in this section, the rules in §1.1275-4 (relating to contingent payment debt instruments) apply to the following instruments-

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

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

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

(iv)  	A debt instrument otherwise described in paragraph (a) (1) (i), (ii) or (iii) of this section, except that the debt instrument   [*18]  is described in §1.1275-4 (c) (1) rather than §1.1275-4 (b) (1) (e.g., the instrument is issued for non-publicly traded property).
(2) Exception for hyperinflationary currencies-(i) In general. Except as provided in paragraph (a) (2) (ii) of this section, this section shall not apply to an instrument described in paragraph (a) (1) of this section if any payment made under such instrument is determined by reference to a hyperinflationary currency, as defined in §1.985-1 (b) (2) (ii) (D). In such case, the amount, timing, source and character of interest, principal, foreign currency gain or loss, and gain or loss relating to a non-currency contingency shall be determined under the method that reflects the instrument's economic substance.
(ii) Discretion as to method. If a taxpayer does not account for an instrument described in paragraph (a) (2) (i) of this section in a manner that reflects the instrument's economic substance, the Commissioner may apply the rules of this section to such an instrument or apply the principles of § 1.988-2 (b) (15), reasonably taking into account the contingent feature or features of the instrument.
(b) Instruments described in paragraph (a) (1) (i) of this   [*19]  section-(1) In general. Paragraph (b) (2) of this section provides rules for applying the noncontingent bond method (as set forth in §1.1275-4 (b)) in the nonfunctional currency in which a debt instrument described in paragraph (a) (1) (i) of this section is denominated, or by reference to which its payments are determined (the denomination currency). Paragraph (b) (3) of this section describes how amounts determined in paragraph (b) (2) of this section shall be translated from the denomination currency of the instrument into the taxpayer's functional currency. Paragraph (b) (4) of this section describes how gain or loss (other than foreign currency gain or loss) shall be determined and characterized with respect to the instrument. Paragraph (b) (5) of this section describes how foreign currency gain or loss shall be determined with respect to accrued interest and principal on the instrument. Paragraph (b) (6) of this section provides rules for determining the source and character of any gain or loss with respect to the instrument. Paragraph (b) (7) of this section provides rules for subsequent holders of an instrument who purchase the instrument for an amount other than the adjusted   [*20]  issue price of the instrument. Paragraph (c) of this section provides examples of the application of paragraph (b) of this section. See paragraph (d) of this section for the determination of the denomination currency of an instrument described in paragraph (a) (1) (ii) or (iii) of this section. See paragraph (e) of this section for the treatment of an instrument described in paragraph (a) (1) (iv) of this section.
(2) Application of noncontingent bond method-(i) Accrued interest. Interest accruals on an instrument described in paragraph (a) (1) (i) of this section are initially determined in the denomination currency of the instrument by applying the noncontingent bond method, set forth in §1.1275-4 (b), to the instrument in its denomination currency. Accordingly, the comparable yield, projected payment schedule, and comparable fixed rate debt instrument, described in §1.1275-4 (b) (4), are determined in the denomination currency. For purposes of applying the noncontingent bond method to instruments described in this paragraph, the applicable Federal rate described in §1.1275-4 (b) (4) (i) shall be the rate described in §1.1274-4 (d) with respect to the denomination currency.
(ii) Net   [*21]  positive and negative adjustments. Positive and negative adjustments, and net positive and net negative adjustments, with respect to an instrument described in paragraph (a) (1) (i) of this section are determined by applying the rules of §1.1275-4 (b) (6) (and §1.1275-4 (b) (9) (i) and (ii), if applicable) in the denomination currency. Accordingly, a net positive adjustment is treated as additional interest (in the denomination currency) on the instrument. A net negative adjustment first reduces interest that otherwise would be accrued by the taxpayer during the current tax year in the denomination currency. If a net negative adjustment exceeds the interest that would otherwise be accrued by the taxpayer during the current tax year in the denomination currency, the excess is treated as ordinary loss (if the taxpayer is a holder of the instrument) or ordinary income (if the taxpayer is the issuer of the instrument). The amount treated as ordinary loss by a holder with respect to a net negative adjustment is limited, however, to the amount by which the holder's   [*22]  total interest inclusions on the debt instrument (determined in the denomination currency) exceed the total amount of the holder's net negative adjustments treated as ordinary loss on the debt instrument in prior taxable years (determined in the denomination currency). Similarly, the amount treated as ordinary income by an issuer with respect to a net negative adjustment is limited to the amount by which the issuer's total interest deductions on the debt instrument (determined in the denomination currency) exceed the total amount of the issuer's net negative adjustments treated as ordinary income on the debt instrument in prior taxable years (determined in the denomination currency). To the extent a net negative adjustment exceeds the current year's interest accrual and the amount treated as ordinary loss to a holder (or ordinary income to the issuer), the excess is treated as a negative adjustment carryforward, within the meaning of §1.1275-4 (b) (6) (iii) (C), in the denomination currency.
(iii) Adjusted issue price. The adjusted issue price of an instrument described in paragraph (a) (1) (i) of this section is determined by applying the rules of §1.1275-4 (b) (7) in the denomination   [*23]  currency. Accordingly, the adjusted issue price is equal to the debt instrument's issue price in the denomination currency, increased by the interest previously accrued on the debt instrument (determined without regard to any net positive or net negative adjustments on the instrument) and decreased by the amount of any noncontingent payment and the projected amount of any contingent payment previously made on the instrument. All adjustments to the adjusted issue price are calculated in the denomination currency.
(iv) Adjusted basis. The adjusted basis of an instrument described in paragraph (a) (1) (i) of this section is determined by applying the rules of §1.1275-4 (b) (7) in the taxpayer's functional currency. In accordance with those rules, a holder's basis in the debt instrument is increased by the interest previously accrued on the debt instrument (translated into functional currency), without regard to any net positive or net negative adjustments on the instrument (except as provided in paragraph (b) (7) or (8) of this section, if applicable), and decreased by the amount of any noncontingent payment and the projected amount of any contingent payment previously made on the instrument   [*24]  to the holder (translated into functional currency). See paragraph (b) (3) (iii) of this section for translation rules.
(v) Amount realized. The amount realized by a holder and the repurchase price paid by the issuer on the scheduled or unscheduled retirement of a debt instrument described in paragraph (a) (1) (i) of this section are determined by applying the rules of §1.1275-4 (b) (7) in the denomination currency. For example, with regard to a scheduled retirement at maturity, the holder is treated as receiving the projected amount of any contingent payment due at maturity, reduced by the amount of any negative adjustment carryforward. For purposes of translating the amount realized by the holder into functional currency, the rules of paragraph (b) (3) (iv) of this section shall apply.
(3) Treatment and translation of amounts determined under noncontingent bond method-(i) Accrued interest. The amount of accrued interest, determined under paragraph (b) (2) (i) of this section, is translated into the taxpayer's functional currency at the average exchange rate, as described in §1.988-2 (b) (2) (iii) (A), or, at the taxpayer's election, at the appropriate spot rate, as described in §1.988-2 (b) (2) (iii) (B).
(ii)   [*25]  Net positive and negative adjustments-(A) Net positive adjustments. A net positive adjustment, as referenced in paragraph (b) (2) (ii) of this section, is translated into the taxpayer's functional currency at the spot rate on the last day of the taxable year in which the adjustment is taken into account under §1.1275-4 (b) (6), or, if earlier, the date the instrument is disposed of or otherwise terminated.
(B) Net negative adjustments. A net negative adjustment is treated and, where necessary, is translated from the denomination currency into the taxpayer's functional currency under the following rules:

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

(2)  	The amount of a net negative adjustment treated as ordinary income or loss under §1.1275-4 (b) (6) (iii) (B) first is attributable to accrued but unpaid interest accrued in prior taxable years. For this purpose, the net negative adjustment shall be treated as attributable to   [*26]  any unpaid interest accrued in the immediately preceding taxable year, and thereafter to unpaid interest accrued in each preceding taxable year. The amount of the net negative adjustment applied to accrued but unpaid interest is translated into functional currency at the same rate used, in each of the respective prior taxable years, to translate the accrued interest.

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

(4)  	Any amount of the net negative adjustment remaining after application of paragraphs (b) (3) (ii) (B) (1), (2) and (3) of this section is a negative adjustment carryforward, within the meaning of §1.1275-4 (b) (6) (iii) (C). A negative adjustment carryforward is carried forward in the denomination currency and is applied to reduce interest accruals in subsequent years. In the year in which the instrument is sold, exchanged or retired,   [*27]  any negative adjustment carryforward not applied to interest reduces the holder's amount realized on the instrument (in the denomination currency). An issuer of a debt instrument described in paragraph (a) (1) (i) of this section who takes into income a negative adjustment carryforward (that is not applied to interest) in the year the instrument is retired, as described in §1.1275-4 (b) (6) (iii) (C), translates such income into functional currency at the spot rate on the date the instrument was issued.
(iii) Adjusted basis-(A) In general. Except as otherwise provided in this paragraph and paragraph (b) (7) or (8) of this section, a holder determines and maintains adjusted basis by translating the denomination currency amounts determined under §1.1275-4 (b) (7) (iii) into functional currency as follows:

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

(2)  	An increase in basis attributable to interest accrued on the instrument is translated at the rate applicable to such   [*28]  interest under paragraph (b) (3) (i) of this section.

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

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

(ii)  	Any amount remaining after the application of paragraph (b) (3) (iii) (A) (3) (i) of this section is attributable to principal. Such amounts are translated into functional currency at the spot rate on the date the instrument was issued or, if later, acquired.
	
(B) Exception for interest reduced by a negative adjustment carryforward. Solely for purposes of this § 1.988-6, any amounts of accrued interest income that are reduced as a result of a negative adjustment carryforward shall be treated as principal and translated at the spot rate on the date the instrument was issued or, if later, acquired.
(iv) Amount realized-(A) Instrument held to maturity-(1) In general. With respect to   [*29]  an instrument held to maturity, a holder translates the amount realized by separating such amount in the denomination currency into the component parts of interest and principal that make up adjusted basis prior to translation under paragraph (b) (3) (iii) of this section, and translating each of those component parts of the amount realized at the same rate used to translate the respective component parts of basis under paragraph (b) (3) (iii) of this section. The amount realized first shall be translated by reference to the component parts of basis consisting of accrued interest during the taxpayer's holding period as determined under paragraph (b) (3) (iii) of this section and ordering such amounts on a last in first out basis. Any remaining portion of the amount realized shall be translated by reference to the rate used to translate the component of basis consisting of principal as determined under paragraph (b) (3) (iii) of this section.
(2) Subsequent purchases at discount and fixed but deferred contingent payments. For purposes of this paragraph (b) (3) (iv) of this section, any amount which is required to be added to adjusted basis under paragraph (b) (7) or (8) of this section   [*30]  shall be treated as additional interest which was accrued on the date the amount was added to adjusted basis. To the extent included in amount realized, such amounts shall be translated into functional currency at the same rates at which they were translated for purposes of determining adjusted basis. See paragraphs (b) (7) (iv) and (b) (8) of this section for rules governing the rates at which the amounts are translated for purposes of determining adjusted basis.
(B) Sale, exchange, or unscheduled retirement-(1) Holder. In the case of a sale, exchange, or unscheduled retirement, application of the rule stated in paragraph (b) (3) (iv) (A) of this section shall be as follows. The holder's amount realized first shall be translated by reference to the principal component of basis as determined under paragraph (b) (3) (iii) of this section, and then to the component of basis consisting of accrued interest as determined under paragraph (b) (3) (iii) of this section and ordering such amounts on a first in first out basis. Any gain recognized by the holder (i.e., any excess of the sale price over the holder's basis, both expressed in the denomination currency) is translated into functional   [*31]  currency at the spot rate on the payment date.
(2) Issuer. In the case of an unscheduled retirement of the debt instrument, any excess of the adjusted issue price of the debt instrument over the amount paid by the issuer (expressed in denomination currency) shall first be attributable to accrued unpaid interest, to the extent the accrued unpaid interest had not been previously offset by a negative adjustment, on a last-in-first-out basis, and then to principal. The accrued unpaid interest shall be translated into functional currency at the rate at which the interest was accrued. The principal shall be translated at the spot rate on the date the debt instrument was issued.
(C) Effect of negative adjustment carryforward with respect to the issuer. Any amount of negative adjustment carryforward treated as ordinary income under §1.1275-4 (b) (6) (iii) (C) shall be translated at the exchange rate on the day the debt instrument was issued.
(4) Determination of gain or loss not attributable to foreign currency. A holder of a debt instrument described in paragraph (a) (1) (i) of this section shall recognize gain or loss upon sale, exchange, or retirement of the instrument equal to the difference   [*32]  between the amount realized with respect to the instrument, translated into functional currency as described in paragraph (b) (3) (iv) of this section, and the adjusted basis in the instrument, determined and maintained in functional currency as described in paragraph (b) (3) (iii) of this section. The amount of any gain or loss so determined is characterized as provided in §1.1275-4 (b) (8), and sourced as provided in paragraph (b) (6) of this section.
(5) Determination of foreign currency gain or loss-(i) In general. Other than in a taxable disposition of the debt instrument, foreign currency gain or loss is recognized with respect to a debt instrument described in paragraph (a) (1) (i) of this section only when payments are made or received. No foreign currency gain or loss is recognized with respect to a net positive or negative adjustment, as determined under paragraph (b) (2) (ii) of this section (except with respect to a positive adjustment described in paragraph (b) (8) of this section). As described in this paragraph (b) (5), foreign currency gain or loss is determined in accordance with the rules of §1.988-2 (b).
(ii) Foreign currency gain or loss attributable to accrued interest.   [*33]  The amount of foreign currency gain or loss recognized with respect to payments of interest previously accrued on the instrument is determined by translating the amount of interest paid or received into functional currency at the spot rate on the date of payment and subtracting from such amount the amount determined by translating the interest paid or received into functional currency at the rate at which such interest was accrued under the rules of paragraph (b) (3) (i) of this section. For purposes of this paragraph, the amount of any payment that is treated as accrued interest shall be reduced by the amount of any net negative adjustment treated as ordinary loss (to the holder) or ordinary income (to the issuer), as provided in paragraph (b) (2) (ii) of this section. For purposes of determining whether the payment consists of interest or principal, see the payment ordering rules in paragraph (b) (5) (iv) of this section.
(iii) Principal. The amount of foreign currency gain or loss recognized with respect to payment or receipt of principal is determined by translating the amount paid or received into functional currency at the spot rate on the date of payment or receipt and subtracting   [*34]  from such amount the amount determined by translating the principal into functional currency at the spot rate on the date the instrument was issued or, in case of the holder, if later, acquired. For purposes of determining whether the payment consists of interest or principal, see the payment ordering rules in paragraph (b) (5) (iv) of this section.
(iv) Payment ordering rules-(A) In general. Except as provided in paragraph (b) (5) (iv) (B) of this section, payments with respect to an instrument described in paragraph (a) (1) (i) of this section shall be treated as follows:

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

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

(3)  	Any amount remaining after applying paragraphs (b) (5) (iv) (A) (1) and (2) of this section shall be attributable to principal. Any interest paid   [*35]  in the current year that is reduced by a net negative adjustment shall be considered a payment of principal for purposes of determining foreign currency gain or loss.
(B) Special rule for sale or exchange or unscheduled retirement. Payments made or received upon a sale or exchange or unscheduled retirement shall first be applied against the principal of the debt instrument (or in the case of a subsequent purchaser, the purchase price of the instrument in denomination currency) and then against accrued unpaid interest (in the case of a holder, accrued while the holder held the instrument).
(C) Subsequent purchaser that has a positive adjustment allocated to a daily portion of interest. A positive adjustment that is allocated to a daily portion of interest pursuant to paragraph (b) (7) (iv) of this section shall be treated as interest for purposes of applying the payment ordering rule of this paragraph (b) (5) (iv).
(6) Source of gain or loss. The source of foreign currency gain or loss recognized with respect to an instrument described in paragraph (a) (1) (i) of this section shall be determined pursuant to §1.988-4. Consistent with the rules of §1.1275-4 (b) (8), all gain (other than   [*36]  foreign currency gain) on an instrument described in paragraph (a) (1) (i) of this section is treated as interest income for all purposes. The source of an ordinary loss (other than foreign currency loss) with respect to an instrument described in paragraph (a) (1) (i) of this section shall be determined pursuant to §1.1275-4 (b) (9) (iv). The source of a capital loss with respect to an instrument described in paragraph (a) (1) (i) of this section shall be determined pursuant to §1.865-1 (b) (2).
(7) Basis different from adjusted issue price-(i) In general. The rules of §1.1275-4 (b) (9) (i), except as set forth in this paragraph (b) (7), shall apply to an instrument described in paragraph (a) (1) (i) of this section purchased by a subsequent holder for more or less than the instrument's adjusted issue price.
(ii) Determination of basis. If an instrument described in paragraph (a) (1) (i) of this section is purchased by a subsequent holder, the subsequent holder's initial basis in the instrument shall equal the amount paid by the holder to acquire the instrument, translated into functional currency at the spot rate on the date of acquisition.
(iii) Purchase price greater than adjusted   [*37]  issue price. If the purchase price of the instrument (determined in the denomination currency) exceeds the adjusted issue price of the instrument, the holder shall, consistent with the rules of §1.1275-4 (b) (9) (i) (B), reasonably allocate such excess to the daily portions of interest accrued on the instrument or to a projected payment on the instrument. To the extent attributable to interest, the excess shall be reasonably allocated over the remaining term of the instrument to the daily portions of interest accrued and shall be a negative adjustment on the dates the daily portions accrue. On the date of such adjustment, the holder's adjusted basis in the instrument is reduced by the amount treated as a negative adjustment under this paragraph (b) (7) (iii), translated into functional currency at the rate used to translate the interest which is offset by the negative adjustment. To the extent related to a projected payment, such excess shall be treated as a negative adjustment on the date the payment is made. On the date of such adjustment, the holder's adjusted basis in the instrument is reduced by the amount treated as a negative adjustment under this paragraph (b) (7) (iii), translated   [*38]  into functional currency at the spot rate on the date the instrument was acquired.
(iv) Purchase price less than adjusted issue price. If the purchase price of the instrument (determined in the denomination currency) is less than the adjusted issue price of the instrument, the holder shall, consistent with the rules of §1.1275-4 (b) (9) (i) (C), reasonably allocate the difference to the daily portions of interest accrued on the instrument or to a projected payment on the instrument. To the extent attributable to interest, the difference shall be reasonably allocated over the remaining term of the instrument to the daily portions of interest accrued and shall be a positive adjustment on the dates the daily portions accrue. On the date of such adjustment, the holder's adjusted basis in the instrument is increased by the amount treated as a positive adjustment under this paragraph (b) (7) (iv), translated into functional currency at the rate used to translate the interest to which it relates. For purposes of determining adjusted basis under paragraph (b) (3) (iii) of this section, such increase in adjusted basis shall be treated as an additional accrual of interest during the period to   [*39]  which the positive adjustment relates. To the extent related to a projected payment, such difference shall be treated as a positive adjustment on the date the payment is made. On the date of such adjustment, the holder's adjusted basis in the instrument is increased by the amount treated as a positive adjustment under this paragraph (b) (7) (iv), translated into functional currency at the spot rate on the date the adjustment is taken into account. For purposes of determining the amount realized on the instrument in functional currency under paragraph (b) (3) (iv) of this section, amounts attributable to the excess of the adjusted issue price of the instrument over the purchase price of the instrument shall be translated into functional currency at the same rate at which the corresponding adjustments are taken into account under this paragraph (b) (7) (iv) for purposes of determining the adjusted basis of the instrument.
(8) Fixed but deferred contingent payments. In the case of an instrument with a contingent payment that becomes fixed as to amount before the payment is due, the rules of §1.1275-4 (b) (9) (ii) shall be applied in the denomination currency of the instrument. For this   [*40]  purpose, foreign currency gain or loss shall be recognized on the date payment is made or received with respect to the instrument under the principles of paragraph (b) (5) of this section. Any increase or decrease in basis required under §1.1275-4 (b) (9) (ii) (D) shall be taken into account at the same exchange rate as the corresponding net positive or negative adjustment is taken into account.
(c) Examples. The provisions of paragraph (b) of this section may be illustrated by the following examples. In each example, assume that the instrument described is a debt instrument for federal income tax purposes. No inference is intended, however, as to whether the instrument is a debt instrument for federal income tax purposes. The examples are as follows:

Example 1. Treatment of net positive adjustment-(i) Facts. On December 31, 2004, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases from a foreign corporation, at original issue, a zero-coupon debt instrument with a non-currency contingency for £1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional   [*41]  currency (the British pound). The debt instrument would be subject to §1.1275-4 (b) if it were denominated in dollars. The debt instrument's comparable yield, determined in British pounds under paragraph (b) (2) (i) of this section and § 1.1275-4 (b), is 10 percent, compounded annually, and the projected payment schedule, as constructed under the rules of §1.1275-4 (b), provides for a single payment of £1210 on December 31, 2006 (consisting of a non-contingent payment of £975 and a projected payment of £235). The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in §1.988-2 (b) (2) (iii) (B). The payment actually made on December 31, 2006, is £1300. The relevant pound/dollar spot rates over the term of the instrument are as follows:
Date	Spot rate (pounds to dollars)	
Dec. 31, 2004	£1.00 = $1.00	
Dec. 31, 2005	£1.00 = $1.10	
Dec. 31, 2006	£1.00 = $1.20	

Accrual period	Average rate (pounds to dollars)	
2005	£1.00 = $1.05	
2006	£1.00 = $1.15	
(ii) Treatment in 2005-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £100 of interest on the debt instrument for 2005 (issue   [*42]  price of £1000 × 10 percent). Under paragraph (b) (3) (i) of this section, Z translates the £100 at the average exchange rate for the accrual period ($1.05 × £100 = $105). Accordingly, Z has interest income in 2005 of $105.
(B) Adjusted issue price and basis. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued in 2005. Thus, on January 1, 2006, the adjusted issue price of the debt instrument is £1100. For purposes of determining Z's dollar basis in the debt instrument, the $ 1000 basis ($ 1.00 × £1000 original cost basis) is increased by the £100 of accrued interest, translated at the rate at which interest was accrued for 2005. See paragraph (b) (3) (iii) of this section. Accordingly, Z's adjusted basis in the debt instrument as of January 1, 2006, is $1105.
(iii) Treatment in 2006-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £110 of interest on the debt instrument for 2006 (adjusted issue price of £1100 × 10 percent). Under paragraph   [*43]  (b) (3) (i) of this section, Z translates the £110 at the average exchange rate for the accrual period ($1.15 × £110 = $126.50). Accordingly, Z has interest income in 2006 of $126.50.
(B) Effect of net positive adjustment. The payment actually made on December 31, 2006, is £1300, rather than the projected £1210. Under paragraph (b) (2) (ii) of this section, Z has a net positive adjustment of £90 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Under paragraph (b) (3) (ii) (A) of this section, the £90 net positive adjustment is treated as additional interest income and is translated into dollars at the spot rate on the last day of the year ($ 1.20 × £90 = $ 108). Accordingly, Z has a net positive adjustment of $ 108 resulting in a total interest inclusion for 2006 of $234.50 ($126.50+ $108 = $234.50).
(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is £1210 (£1100 plus £110 of accrued interest for 2006). Z's adjusted basis in dollars, based only on the noncontingent payment and the   [*44]  projected amount of the contingent payment to be received, is $ 1231.50 ($ 1105 plus $ 126.50 of accrued interest for 2006).
(D) Amount realized. Even though Z receives £1300 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b) (2) (v) of this section as receiving the projected amount of the contingent payment on December 31, 2006. Therefore, Z is treated as receiving £1210 on December 31, 2006. Under paragraph (b) (3) (iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its component parts. Accordingly, £100 of the £1210 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (£1 = $1.05), resulting in an amount realized of $105; £110 of the £1210 (representing the interest accrued in 2006) is translated into dollars at the rate at which it was accrued (£1 = $1.15), resulting in an amount realized of $126.50; and £1000 of the £1210 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (£1 = $1),   [*45]  resulting in an amount realized of $1000. Z's total amount realized is $1231.50, the same as its basis, and Z recognizes no gain or loss (before consideration of foreign currency gain or loss) on retirement of the instrument.
(E) Foreign currency gain or loss. Under paragraph (b) (5) of this section, Z recognizes foreign currency gain under section 988 on the instrument with respect to the consideration actually received at maturity (except for the net positive adjustment), £1210. The amount of recognized foreign currency gain is determined based on the difference between the spot rate on the date the instrument matures and the rates at which the principal and interest were taken into account. With respect to the portion of the payment attributable to interest accrued in 2005, the foreign currency gain is $15 [£100 × ($1.20 - $1.05)]. With respect to interest accrued in 2006, the foreign currency gain equals $5.50 [£110 × ($1.20 - $1.15)]. With respect to principal, the foreign currency gain is $200 [£1000 × ($1.20 - $1.00)]. Thus, Z recognizes a total foreign currency gain on December 31, 2006, of $220.50.
(F) Source. Z has interest income of $105 in 2005, interest income of $234.50   [*46]  in 2006 (attributable to £110 of accrued interest and the £90 net positive adjustment), and a foreign currency gain of $220.50 in 2006. Under paragraph (b) (6) of this section and section 862 (a) (1), the interest income is sourced by reference to the residence of the payor and is therefore from sources without the United States. Under paragraph (b) (6) of this section and § 1.988-4, Z's foreign currency gain of $220.50 is sourced by reference to Z's residence and is therefore from sources within the United States.
Example 2. Treatment of net negative adjustment-(i) Facts. Assume the same facts as in Example 1, except that Z receives £975 at maturity instead of £1300.
(ii) Treatment in 2005. The treatment of the debt instrument in 2005 is the same as in Example 1. Thus, Z has interest income in 2005 of $105. On January 1, 2006, the adjusted issue price of the debt instrument is £1100, and Z's adjusted basis in the instrument is $1105.
(iii) Treatment in 2006-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section and based on the comparable yield, Z's accrued interest for 2006 is £110 (adjusted issue price of £1100 × 10 percent). Under paragraph (b) (3) (i)   [*47]  of this section, the £110 of accrued interest is translated at the average exchange rate for the accrual period ($1.15 × £ 110 = $126.50).
(B) Effect of net negative adjustment. The payment actually made on December 31, 2006, is £975, rather than the projected £1210. Under paragraph (b) (2) (ii) of this section, Z has a net negative adjustment of £235 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of £110 in 2006 is reduced to zero by the net negative adjustment. Under paragraph (b) (3) (ii) (B) (1) of this section, the net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b) (2) (ii) of this section, Z treats the remaining £125 net negative adjustment as an ordinary loss to the extent of the £100 previously accrued interest in 2005. This £100 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b) (3) (ii) (B) (2) of this section, Z translates the loss into dollars at the average rate for such year (£1 = $1.05). Accordingly, Z has an ordinary   [*48]  loss of $105 in 2006. The remaining £25 of net negative adjustment is a negative adjustment carryforward under paragraph (b) (2) (ii) of this section.
(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is £1210 (£1100 plus £110 of accrued interest for 2006). Z's adjusted basis in dollars, based only on the noncontingent payments and the projected amount of the contingent payments to be received, is $1231.50 ($1105 plus $126.50 of accrued interest for 2006).
(D) Amount realized. Even though Z receives £975 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b) (2) (v) of this section as receiving the projected amount of the contingent payment on December 31, 2006, reduced by the amount of Z's negative adjustment carryforward of £25. Therefore, Z is treated as receiving £1185 (£1210 - £25) on December 31, 2006. Under paragraph (b) (3) (iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or loss) by breaking the amount realized into its   [*49]  component parts. Accordingly, £100 of the £1185 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (£1 = $1.05), resulting in an amount realized of $105; £110 of the £1185 (representing the interest accrued in 2006) is translated into dollars at the rate at which it was accrued (£1 = $1.15), resulting in an amount realized of $126.50; and £975 of the £1185 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (£1 = $1), resulting in an amount realized of $975. Z's amount realized is $1206.50 ($105 + $126.50 + $975 = $1206.50), and Z recognizes a capital loss (before consideration of foreign currency gain or loss) of $25 on retirement of the instrument ($1206.50-$1231.50 = -$25).
(E) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to the consideration actually received at maturity, £975. Under paragraph (b) (5) (ii) of this section, no foreign currency gain or loss is recognized with respect to unpaid accrued interest reduced to zero by the net negative adjustment resulting in 2006. In addition, no foreign currency gain or loss is recognized   [*50]  with respect to unpaid accrued interest from 2005, also reduced to zero by the ordinary loss. Accordingly, Z recognizes foreign currency gain with respect to principal only. Thus, Z recognizes a total foreign currency gain on December 31, 2006, of $195 [£975 x ($1.20-$1.00)].
(F) Source. In 2006, Z has an ordinary loss of $105, a capital loss of $25, and a foreign currency gain of $ 195. Under paragraph (b) (6) of this section and §1.1275-4 (b) (9) (iv), the $105 ordinary loss generally reduces Z's foreign source passive income under section 904 (d) and the regulations thereunder. Under paragraph (b) (6) of this section and §1.865-1 (b) (2), the $25 capital loss is sourced by reference to how interest income on the instrument would have been sourced. Therefore, the $25 capital loss generally reduces Z's foreign source passive income under section 904 (d) and the regulations thereunder. Under paragraph (b) (6) of this section and §1.988-4, Z's foreign currency gain of $195 is sourced by reference to Z's residence and is therefore from sources within the United States.
Example 3. Negative adjustment and periodic interest payments-(i) Facts. On December 31, 2004, Z, a calendar year U.S.   [*51]  resident taxpayer whose functional currency is the U.S. dollar, purchases from a foreign corporation, at original issue, a two-year debt instrument with a non-currency contingency for £1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to §1.1275-4 (b) if it were denominated in dollars. The debt instrument's comparable yield, determined in British pounds under §§1.988-2 (b) (2) and 1.1275-4 (b), is 10 percent, compounded semiannually. The debt instrument provides for semiannual interest payments of £30 payable each June 30, and December 31, and a contingent payment at maturity on December 31, 2006, which is projected to equal £1086.20 (consisting of a noncontingent payment of £980 and a projected payment of £106.20) in addition to the interest payable at maturity. The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in §1.988-2 (b) (2) (iii) (B). The payment actually made on December 31, 2006, is £981.00. The relevant pound/dollar spot rates over the term   [*52]  of the instrument are as follows:
Date	Spot rate (pounds to dollars)	
Dec. 31, 2004	£1.00 = $1.00	
June 30, 2005	£1.00 = $1.20	
Dec. 31, 2005	£1.00 = $1.40	
June 30, 2006	£1.00 = $1.60	
Dec. 31, 2006	£1.00 = $1.80	

Accrual period	Average rate (pounds to dollars)	
Jan. - June 2005	£1.00 = $1.10	
July - Dec. 2005	£1.00 = $1.30	
Jan. - June 2006	£1.00 = $1.50	
July - Dec. 2006	£1.00 = $1.70	
(ii) Treatment in 2005-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £50 of interest on the debt instrument for the January-June accrual period (issue price of £1000 × 10 percent/2). Under paragraph (b) (3) (i) of this section, Z translates the £50 at the average exchange rate for the accrual period ($1.10 × £50 = $55.00). Similarly, Z accrues £51 of interest in the July-December accrual period [(£1000 + £50 - &pound30) × 10 percent/2], which is translated at the average exchange rate for the accrual period ($1.30 × £51 = $66.30). Accordingly, Z accrues $121.30 of interest income in 2005.
(B) Adjusted issue price and basis-(1) January-June accrual period. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt   [*53]  instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the January-June accrual period. Thus, on July 1, 2005, the adjusted issue price of the debt instrument is £1020 (£1000 + £50 - £30 = £1020). For purposes of determining Z's dollar basis in the debt instrument, the $1000 basis is increased by the £50 of accrued interest, translated, under paragraph (b) (3) (iii) of this section, at the rate at which interest was accrued for the January-June accrual period ($ 1.10 × £50 = $55). The resulting amount is reduced by the £30 payment of interest made during the accrual period, translated, under paragraph (b) (3) (iii) of this section and § 1.988-2 (b) (7), at the rate applicable to accrued interest ($1.10 × £30 = $33). Accordingly, Z's adjusted basis as of July 1, 2005, is $1022 ($1000+ $55-$33).
(2) July-December accrual period. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by   [*54]  the interest payment made, in the July-December accrual period. Thus, on January 1, 2006, the adjusted issue price of the instrument is £1041 (£1020 + £51 &minus £30 = £1041). For purposes of determining Z's dollar basis in the debt instrument, the $1022 basis is increased by the £51 of accrued interest, translated, under paragraph (b) (3) (iii) of this section, at the rate at which interest was accrued for the July-December accrual period ($1.30 × £51 = $66.30). The resulting amount is reduced by the £30 payment of interest made during the accrual period, translated, under paragraph (b) (3) (iii) of this section and § 1.988-2 (b) (7), at the rate applicable to accrued interest ($1.30 × £30 = $39). Accordingly, Z's adjusted basis as of January 1, 2006, is $1049.30 ($1022+ $66.30-$39).
(C) Foreign currency gain or loss. Z will recognize foreign currency gain on the receipt of each £30 payment of interest actually received during 2005. The amount of foreign currency gain in each case is determined, under paragraph (b) (5) (ii) of this section, by reference to the difference between the spot rate on the date the £30 payment was made and the average exchange rate for the accrual period   [*55]  during which the interest accrued. Accordingly, Z recognizes $3 of foreign currency gain on the January-June interest payment [£30 × ($1.20 - $1.10)], and $3 of foreign currency gain on the July-December interest payment [£30 × ($1.40 - $1.30)]. Z recognizes in 2005 a total of $6 of foreign currency gain.
(D) Source. Z has interest income of $121.30 and a foreign currency gain of $6. Under paragraph (b) (6) of this section and section 862 (a) (1), the interest income is sourced by reference to the residence of the payor and is therefore from sources without the United States. Under paragraph (b) (6) of this section and §1.988-4, Z's foreign currency gain of $6 is sourced by reference to Z's residence and is therefore from sources within the United States.
(iii) Treatment in 2006-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z's accrued interest for the January-June accrual period is £52.05 (adjusted issue price of £1041 × 10 percent/2). Under paragraph (b) (3) (i) of this section, Z translates the £52.05 at the average exchange rate for the accrual period ($1.50 × £52.05 = $78.08). Similarly, Z accrues £53.15 of   [*56]  interest in the July-December accrual period [(£1041 + £52.05 - £30) × 10 percent/2], which is translated at the average exchange rate for the accrual period ($ 1.70 × £53.15 = $90.35). Accordingly, Z accrues £105.20, or $168.43, of interest income in 2006.
(B) Effect of net negative adjustment. The payment actually made on December 31, 2006, is £981.00, rather than the projected £1086.20. Under paragraph (b) (2) (ii) (B) of this section, Z has a net negative adjustment of £105.20 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of £105.20 in 2006 is reduced to zero by the net negative adjustment. Elimination of the 2006 accrued interest fully utilizes the net negative adjustment.
(C) Adjusted issue price and basis-(1) January-June accrual period. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the January-June accrual period. Thus, on July 1, 2006,   [*57]  the adjusted issue price of the debt instrument is £1063.05 (£1041 + £52.05 - £30 = £1063.05). For purposes of determining Z's dollar basis in the debt instrument, the $1049.30 adjusted basis is increased by the £52.05 of accrued interest, translated, under paragraph (b) (3) (iii) of this section, at the rate at which interest was accrued for the January-June accrual period ($1.50 × £52.05 = $78.08). The resulting amount is reduced by the £30 payment of interest made during the accrual period, translated, under paragraph (b) (3) (iii) of this section and §1.988-2 (b) (7), at the rate applicable to accrued interest ($1.50 × £30 = $45). Accordingly, Z's adjusted basis as of July 1, 2006, is $1082.38 ($1049.30 + $78.08 - $45).
(2) July-December accrual period. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued, and decreased by the interest payment made, in the July-December accrual period. Thus, immediately before maturity on December 31, 2006, the adjusted issue price of the instrument is £1086.20 (£1063.05   [*58]  + £53.15 - £30 = £1086.20). For purposes of determining Z's dollar basis in the debt instrument, the $1082.38 adjusted basis is increased by the £53.15 of accrued interest, translated, under paragraph (b) (3) (iii) of this section, at the rate at which interest was accrued for the July-December accrual period ($1.70 × £53.15 = $90.36). The resulting amount is reduced by the £30 payment of interest made during the accrual period, translated, under paragraph (b) (3) (iii) of this section and § 1.988-2 (b) (7), at the rate applicable to accrued interest ($1.70 × £30 = $51). Accordingly, Z's adjusted basis on December 31, 2006, immediately prior to maturity is $1121.74 ($1082.38+ $90.36-$51).
(D) Amount realized. Even though Z receives £981.00 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b) (2) (v) of this section as receiving the projected amount of the contingent payment on December 31, 2006. Therefore, Z is treated as receiving £1086.20 on December 31, 2006. Under paragraph (b) (3) (iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency gain or   [*59]  loss) by breaking the amount realized into its component parts. Accordingly, £20 of the £1086.20 (representing the interest accrued in the January-June 2005 accrual period, less £30 interest paid) is translated into dollars at the rate at which it was accrued (£1 = $1.10), resulting in an amount realized of $22; £21 of the £1086.20 (representing the interest accrued in the July-December 2005 accrual period, less £30 interest paid) is translated into dollars at the rate at which it was accrued (£1 = $1.30), resulting in an amount realized of $27.30; £22.05 of the £1086.20 (representing the interest accrued in the January-June 2006 accrual period, less £30 interest paid) is translated into dollars at the rate at which it was accrued (£1 = $1.50), resulting in an amount realized of $33.08; £23.15 of the £1086.20 (representing the interest accrued in the July 1-December 31, 2006, accrual period, less the £30 interest payment) is translated into dollars at the rate at which it was accrued (£1 = $1.70), resulting in an amount realized of $39.36; and £1000 (representing principal) is translated into dollars at the spot rate on the date the instrument was purchased (£1 = $1), resulting in   [*60]  an amount realized of $1000. Accordingly, Z's total amount realized is $ 1121.74 ($22 + $27.30 + $33.08 + $39.36 + $ 1000), the same as its basis, and Z recognizes no gain or loss (before consideration of foreign currency gain or loss) on retirement of the instrument.
(E) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to each £30 payment actually received during 2006. These payments, however, are treated as payments of principal for this purpose because all 2006 accrued interest is reduced to zero by the net negative adjustment. See paragraph (b) (5) (iv) (A) (3) of this section. The amount of foreign currency gain in each case is determined, under paragraph (b) (5) (iii) of this section, by reference to the difference between the spot rate on the date the £30 payment is made and the spot rate on the date the debt instrument was issued. Accordingly, Z recognizes $ 18 of foreign currency gain on the January-June 2006 interest payment [£30 × ($ 1.60 - $1.00)], and $24 of foreign currency gain on the July-December 2006 interest payment [£30 × ($1.80 - $1.00)]. Z separately recognizes foreign currency gain with respect to the consideration   [*61]  actually received at maturity, £981.00. The amount of such gain is determined based on the difference between the spot rate on the date the instrument matures and the rates at which the principal and interest were taken into account. With respect to the portion of the payment attributable to interest accrued in January-June 2005 (other than the £30 payments), the foreign currency gain is $14 [£20 × ($1.80 - $1.10)]. With respect to the portion of the payment attributable to interest accrued in July-December 2005 (other than the £30 payments), the foreign currency gain is $10.50 [£21 × ($1.80 - $1.30)]. With respect to the portion of the payment attributable to interest accrued in 2006 (other than the £30 payments), no foreign currency gain or loss is recognized under paragraph (b) (5) (ii) of this section because such interest was reduced to zero by the net negative adjustment. With respect to the portion of the payment attributable to principal, the foreign currency gain is $752 [£940 × ($1.80 - $1.00)]. Thus, Z recognizes a foreign currency gain of $42 on receipt of the two £30 payments in 2006, and $776.50 ($14 + $10.50 + $752) on receipt of the payment at maturity, for   [*62]  a total 2006 foreign currency gain of $818.50.
(F) Source. Under paragraph (b) (6) of this section and § 1.988-4, Z's foreign currency gain of $818.50 is sourced by reference to Z's residence and is therefore from sources within the United States.
Example 4. Purchase price greater than adjusted issue price-(i) Facts. On July 1, 2005, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases a debt instrument with a non-currency contingency for £1405. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to §1.1275-4 (b) if it were denominated in dollars. The debt instrument was originally issued by a foreign corporation on December 31, 2003, for an issue price of £1000, and matures on December 31, 2006. The debt instrument's comparable yield, determined in British pounds under §§1.988-2 (b) (2) and 1.1275-4 (b), is 10.25 percent, compounded semiannually, and the projected payment schedule for the debt instrument (determined as of the issue date under the rules of §1.1275-4 (b)) provides for   [*63]  a single payment at maturity of £1349.70 (consisting of a non-contingent payment of £1000 and a projected payment of £349.70). At the time of the purchase, the adjusted issue price of the debt instrument is £1161.76, assuming semiannual accrual periods ending on June 30 and December 31 of each year. The increase in the value of the debt instrument over its adjusted issue price is due to an increase in the expected amount of the contingent payment. The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in §1.988-2 (b) (2) (iii) (B). The payment actually made on December 31, 2006, is £1400. The relevant pound/dollar spot rates over the term of the instrument are as follows:
Date	Spot rate (pounds to dollars)	
July 1, 2005	£1.00 = $1.00	
Dec. 31, 2006	£1.00 = $2.00	

Accrual period	Average rate (pounds to dollars)	
July 1 -December 31, 2005	£1.00 = $1.50	
January 1 - June 30, 2006	£1.00 = $1.50	
July 1 - December 31, 2006	£1.00 = $1.50	
(ii) Initial basis. Under paragraph (b) (7) (ii) of this section, Z's initial basis in the debt instrument is $1405, Z's purchase price of £1405, translated into functional currency at the spot rate on the date the   [*64]  debt instrument was purchased (£1 = $1).
(iii) Allocation of purchase price differential. Z purchased the debt instrument for £1405 when its adjusted issue price was £1161.76. Under paragraph (b) (7) (iii) of this section, Z allocates the £243.24 excess of purchase price over adjusted issue price to the contingent payment at maturity. This allocation is reasonable because the excess is due to an increase in the expected amount of the contingent payment and not, for example, to a decrease in prevailing interest rates.
(iv) Treatment in 2005-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £59.54 of interest on the debt instrument for the July-December 2005 accrual period (issue price of £1161.76 × 10.25 percent/2). Under paragraph (b) (3) (i) of this section, Z translates the £59.54 of interest at the average exchange rate for the accrual period ($1.50 × £59.54 = $89.31). Accordingly, Z has interest income in 2005 of $89.31.
(B) Adjusted issue price and basis. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis   [*65]  in dollars in the debt instrument are increased by the interest accrued in July-December 2005. Thus, on January 1, 2006, the adjusted issue price of the debt instrument is £1221.30 (£1161.76 + £59.54). For purposes of determining Z's dollar basis in the debt instrument on January 1, 2006, the $1405 basis is increased by the 59.54 of accrued interest, translated at the rate at which interest was accrued for the July-December 2005 accrual period. Paragraph (b) (3) (iii) of this section. Accordingly, Z's adjusted basis in the instrument, as of January 1, 2006, is $1494.31 [$1405 + (£59.54 × $1.50)].
(v) Treatment in 2006-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £62.59 of interest on the debt instrument for the January-June 2006 accrual period (issue price of £1221.30 × 10.25 percent/2). Under paragraph (b) (3) (i) of this section, Z translates the £62.59 of accrued interest at the average exchange rate for the accrual period ($1.50 × £62.59 = $93.89). Similarly, Z accrues £65.80 of interest in the July-December 2006 accrual period [(£1221.30 + £62.59) × 10.25 percent/2], which is translated   [*66]  at the average exchange rate for the accrual period ($1.50 × £65.80 = $98.70). Accordingly, Z accrues £128.39, or $192.59, of interest income in 2006.
(B) Effect of positive and negative adjustments-(1) Offset of positive adjustment. The payment actually made on December 31, 2006, is £1400, rather than the projected £1349.70. Under paragraph (b) (2) (ii) of this section, Z has a positive adjustment of £50.30 on December 31, 2006, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Under paragraph (b) (7) (iii) of this section, however, Z also has a negative adjustment of £243.24, attributable to the excess of Z's purchase price for the debt instrument over its adjusted issue price. Accordingly, Z will have a net negative adjustment of £192.94 (£50.30 - £243.24 = -£192.94) for 2006.
(2) Offset of accrued interest. Z's accrued interest income of £128.39 in 2006 is reduced to zero by the net negative adjustment. The net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b) (2) (ii) of this section, Z treats the remaining £64.55 net negative adjustment as an   [*67]  ordinary loss to the extent of the £59.54 previously accrued interest in 2005. This £59.54 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b) (3) (ii) (B) (2) of this section, Z translates the loss into dollars at the average rate for such year (£1 = $1.50). Accordingly, Z has an ordinary loss of $89.31 in 2006. The remaining £5.01 of net negative adjustment is a negative adjustment carryforward under paragraph (b) (2) (ii) of this section.
(C) Adjusted issue price and basis-(1) January-June accrual period. Under paragraph (b) (2) (iii) of this section, the adjusted issue price of the debt instrument on July 1, 2006, is £1283.89 (£1221.30 + £62.59 = £1283.89). Under paragraphs (b) (2) (iv) and (b) (3) (iii) of this section, Z's adjusted basis as of July 1, 2006, is $1588.20 ($1494.31 + $93.89).
(2) July-December accrual period. Based on the projected payment schedule, the adjusted issue price of the debt instrument immediately before the payment at maturity is £1349.70 (£1283.89 + £65.80 accrued interest for July-December). Z's adjusted basis in dollars, based only on the noncontingent payments and the projected   [*68]  amount of the contingent payments to be received, is $1686.90 ($1588.20 plus $98.70 of accrued interest for July-December).
(3) Adjustment to basis upon contingent payment. Under paragraph (b) (7) (iii) of this section, Z's adjusted basis in the debt instrument is reduced at maturity by £243.24, the excess of Z's purchase price for the debt instrument over its adjusted issue price. For this purpose, the adjustment is translated into functional currency at the spot rate on the date the instrument was acquired (£1 = $1). Accordingly, Z's adjusted basis in the debt instrument at maturity is $1443.66 ($1686.90 - $243.24).
(D) Amount realized. Even though Z receives £1400 at maturity, for purposes of determining the amount realized, Z is treated under paragraph (b) (2) (v) of this section as receiving the projected amount of the contingent payment on December 31, 2006, reduced by the amount of Z's negative adjustment carryforward of £5.01. Therefore, Z is treated as receiving £1344.69 (£1349.70 - 5.01) on December 31, 2006. Under paragraph (b) (3) (iv) of this section, Z translates its amount realized into dollars and computes its gain or loss on the instrument (other than foreign currency   [*69]  gain or loss) by breaking the amount realized into its component parts. Accordingly, £59.54 of the £1344.69 (representing the interest accrued in 2005) is translated at the rate at which it was accrued (£1 = $1.50), resulting in an amount realized of $89.31; £62.59 of the £1344.69 (representing the interest accrued in January-June 2006) is translated into dollars at the rate at which it was accrued (£1 = $1.50), resulting in an amount realized of $93.89; £65.80 of the £1344.69 (representing the interest accrued in July-December 2006) is translated into dollars at the rate at which it was accrued (£1 = $1.50), resulting in an amount realized of $98.70; and £1156.76 of the £1344.69 (representing a return of principal) is translated into dollars at the spot rate on the date the instrument was purchased (£1 = $1), resulting in an amount realized of $1156.76. Z's amount realized is $1438.66 ($89.31 + $93.89 + $98.70 + $1156.76), and Z recognizes a capital loss (before consideration of foreign currency gain or loss) of $5 on retirement of the instrument ($1438.66-$1443.66 = -$5).
(E) Foreign currency gain or loss. Z recognizes foreign currency gain under section 988 on the   [*70]  instrument with respect to the entire consideration actually received at maturity, £1400. While foreign currency gain or loss ordinarily would not have arisen with respect to £50.30 of the £1400, which was initially treated as a positive adjustment in 2006, the larger negative adjustment in 2006 reduced this positive adjustment to zero. Accordingly, foreign currency gain or loss is recognized with respect to the entire £1400. Under paragraph (b) (5) (ii) of this section, however, no foreign currency gain or loss is recognized with respect to unpaid accrued interest reduced to zero by the net negative adjustment resulting in 2006, and no foreign currency gain or loss is recognized with respect to unpaid accrued interest from 2005, also reduced to zero by the ordinary loss. Therefore, the entire £1400 is treated as a return of principal for the purpose of determining foreign currency gain or loss, and Z recognizes a total foreign currency gain on December 31, 2001, of $1400 [£1400 × ($2.00 - $1.00)].
(F) Source. Z has an ordinary loss of $89.31, a capital loss of $5, and a foreign currency gain of $1400. Under paragraph (b) (6) of this section and §1.1275-4 (b) (9) (iv), the $89.31 ordinary   [*71]  loss generally reduces Z's foreign source passive income under section 904 (d) and the regulations thereunder. Under paragraph (b) (6) of this section and §1.865-1 (b) (2), the $5 capital loss is sourced by reference to how interest income on the instrument would have been sourced. Therefore, the $5 capital loss generally reduces Z's foreign source passive income under section 904 (d) and the regulations thereunder. Under paragraph (b) (6) of this section and § 1.988-4, Z's foreign currency gain of $1400 is sourced by reference to Z's residence and is therefore from sources within the United States.
Example 5. Sale of an instrument with a negative adjustment carryforward-(i) Facts. On December 31, 2003, Z, a calendar year U.S. resident taxpayer whose functional currency is the U.S. dollar, purchases at original issue a debt instrument with non-currency contingencies for £1000. All payments of principal and interest with respect to the instrument are denominated in, or determined by reference to, a single nonfunctional currency (the British pound). The debt instrument would be subject to §1.1275-4 (b) if it were denominated in dollars. The debt instrument's comparable yield, determined   [*72]  in British pounds under §§1.988-2 (b) (2) and 1.1275-4 (b), is 10 percent, compounded annually, and the projected payment schedule for the debt instrument provides for payments of £310 on December 31, 2005 (consisting of a noncontingent payment of £50 and a projected amount of £260) and £990 on December 31, 2006 (consisting of a noncontingent payment of £940 and a projected amount of £50). The debt instrument is a capital asset in the hands of Z. Z does not elect to use the spot-rate convention described in § 1.988-2 (b) (2) (iii) (B). The payment actually made on December 31, 2005, is £50. On December 30, 2006, Z sells the debt instrument for £940. The relevant pound/dollar spot rates over the term of the instrument are as follows:
Date	Spot rate (pounds to dollars)	
Dec. 31, 2003	£1.00 = $1.00	
Dec. 31, 2005	£1.00 = $2.00	
Dec. 30, 2006	£1.00 = $2.00	

Accrual period	Average rate (pounds to dollars)	
January 1 - December 31, 2004	£1.00 = $2.00	
January 1 - December 31, 2005	£1.00 = $2.00	
January 1 - December 31, 2006	£1.00 = $2.00	
(ii) Treatment in 2004-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £100 of interest on the   [*73]  debt instrument for 2004 (issue price of £1000 × 10 percent). Under paragraph (b) (3) (i) of this section, Z translates the £100 at the average exchange rate for the accrual period ($2.00 × £100 = $200). Accordingly, Z has interest income in 2004 of $200.
(B) Adjusted issue price and basis. Under paragraphs (b) (2) (iii) and (iv) of this section, the adjusted issue price of the debt instrument determined in pounds and Z's adjusted basis in dollars in the debt instrument are increased by the interest accrued in 2004. Thus, on January 1, 2005, the adjusted issue price of the debt instrument is £1100. For purposes of determining Z's dollar basis in the debt instrument, the $1000 basis ($1.00 × £1000 original cost basis) is increased by the £100 of accrued interest, translated at the rate at which interest was accrued for 2004. See paragraph (b) (3) (iii) of this section. Accordingly, Z's adjusted basis in the debt instrument as of January 1, 2005, is $1200 ($1000 + $200).
(iii) Treatment in 2005-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z's accrued interest for 2005 is £110 (adjusted issue price of £1100x   [*74]  10 percent). Under paragraph (b) (3) (i) of this section, the £110 of accrued interest is translated at the average exchange rate for the accrual period ($2.00 × £110 = $220).
(B) Effect of net negative adjustment. The payment actually made on December 31, 2005, is £50, rather than the projected £310. Under paragraph (b) (2) (ii) of this section, Z has a net negative adjustment of £260 on December 31, 2005, attributable to the difference between the amount of the actual payment and the amount of the projected payment. Z's accrued interest income of £110 in 2005 is reduced to zero by the net negative adjustment. Under paragraph (b) (3) (ii) (B) (1) of this section, the net negative adjustment which reduces the current year's interest is not translated into functional currency. Under paragraph (b) (2) (ii) of this section, Z treats the remaining £150 net negative adjustment as an ordinary loss to the extent of the £100 previously accrued interest in 2004. This £100 ordinary loss is attributable to interest accrued but not paid in the preceding year. Therefore, under paragraph (b) (3) (ii) (B) (2) of this section, Z translates the loss into dollars at the average rate for such year (£1   [*75]  = $2.00). Accordingly, Z has an ordinary loss of $200 in 2005. The remaining £50 of net negative adjustment is a negative adjustment carryforward under paragraph (b) (2) (ii) of this section.
(C) Adjusted issue price and basis. Based on the projected payment schedule, the adjusted issue price of the debt instrument on January 1, 2006, is £900, i.e., the adjusted issue price of the debt instrument on January 1, 2005 (£1100), increased by the interest accrued in 2005 (£110), and decreased by the projected amount of the December 31, 2005, payment (£310). See paragraph (b) (2) (iii) of this section. Z's adjusted basis on January 1, 2006, is Z's adjusted basis on January 1, 2005 ($ 1200), increased by the functional currency amount of interest accrued in 2005 ($220), and decreased by the amount of the payments made in 2005, based solely on the projected payment schedule, (£310). The amount of the projected payment is first attributable to the interest accrued in 2005 (110), and then to the interest accrued in 2004 (£100), and the remaining amount to principal (£100). The interest component of the projected payment is translated into functional currency at the rates at which it was accrued,   [*76]  and the principal component of the projected payment is translated into functional currency at the spot rate on the date the instrument was issued. See paragraph (b) (3) (iii) of this section. Accordingly, Z's adjusted basis in the debt instrument, following the increase of adjusted basis for interest accrued in 2005 ($1200 + $220 = $1420), is decreased by $520 ($220 + $200 + $100 = $520). Z's adjusted basis on January 1, 2006, is therefore, $900.
(D) Foreign currency gain or loss. Z will recognize foreign currency gain on the receipt of the £50 payment actually received on December 31, 2005. Based on paragraph (b) (5) (iv) of this section, the £50 payment is attributable to principal since the accrued unpaid interest was completely eliminated by the net negative adjustment. The amount of foreign currency gain is determined, under paragraph (b) (5) (iii) of this section, by reference to the difference between the spot rate on the date the £50 payment was made and the spot rate on the date the debt instrument was issued. Accordingly, Z recognizes $50 of foreign currency gain on the £50 payment. [($2.00 - $1.00) × £50 =$50]. Under paragraph (b) (6) of this section and § 1.988-4,   [*77]  Z's foreign currency gain of $50 is sourced by reference to Z's residence and is therefore from sources within the United States.
(iv) Treatment in 2006-(A) Determination of accrued interest. Under paragraph (b) (2) (i) of this section, and based on the comparable yield, Z accrues £90 of interest on the debt instrument for 2006 (adjusted issue price of £900 × 10 percent). Under paragraph (b) (3) (i) of this section, Z translates the £90 at the average exchange rate for the accrual period ($2.00 × £90 = $180). Accordingly, prior to taking into account the 2005 negative adjustment carryforward, Z has interest income in 2006 of $180.
(B) Effect of net negative adjustment. The £50 negative adjustment carryforward from 2005 is a negative adjustment for 2006. Since there are no other positive or negative adjustments, there is a £50 negative adjustment in 2006 which reduces Z's accrued interest income by £50. Accordingly, after giving effect to the £50 negative adjustment carryforward, Z will accrue $80 of interest income. [(£90-£50) × $2.00 = $80]
(C) Adjusted issue price. Under paragraph (b) (2) (iii) of this section, the adjusted issue price of the debt instrument determined in pounds is   [*78]  increased by the interest accrued in 2006 (prior to taking into account the negative adjustment carryforward). Thus, on December 30, 2006, the adjusted issue price of the debt instrument is £990.
(D) Adjusted basis. For purposes of determining Z's dollar basis in the debt instrument, Z's $900 adjusted basis on January 1, 2006, is increased by the accrued interest, translated at the rate at which interest was accrued for 2006. See paragraph (b) (3) (iii) (A) of this section. Note, however, that under paragraph (b) (3) (iii) (B) of this section the amount of accrued interest which is reduced as a result of the negative adjustment carryforward, i.e., £50, is treated for purposes of this section as principal, and is translated at the spot rate on the date the instrument was issued, i.e., £1.00 = $1.00. Accordingly, Z's adjusted basis in the debt instrument as of December 30, 2006, is $1030 ($900+ $50+ $80).
(E) Amount realized. Z's amount realized in denomination currency is £940, i.e., the amount of pounds Z received on the sale of the debt instrument. Under paragraph (b) (3) (iv) (B) (1) of this section, Z's amount realized is first translated by reference to the principal component of   [*79]  basis (including the amount which is treated as principal under paragraph (b) (3) (iii) (B) of this section) and then the remaining amount realized, if any, is translated by reference to the accrued unpaid interest component of adjusted basis. Thus, £900 of Z's amount realized is translated by reference to the principal component of adjusted basis. The remaining £40 of Z's amount realized is treated as principal under paragraph (b) (3) (iii) (B) of this section, and is also is translated by reference to the principal component of adjusted basis. Accordingly, Z's amount realized in functional currency is $940. (No part of Z's amount realized is attributable to the interest accrued on the debt instrument.) Z realizes a loss of $90 on the sale of the debt instrument ($1030 basis - $940 amount realized). Under paragraph (b) (4) of this section and § 1.1275-4 (b) (8), $80 of the loss is characterized as ordinary loss, and the remaining $ 10 of loss is characterized as capital loss. Under §§ 1.988-6 (b) (6) and 1.1275-4 (b) (9) (iv) the $80 ordinary loss is treated as a deduction that is definitely related to the interest income accrued on the debt instrument. Similarly, under §§1.988-6 (b) (6)   [*80]  and 1.865-1 (b) (2) the $10 capital loss is also allocated to the interest income from the debt instrument. (F) Foreign currency gain or loss. Z recognizes foreign currency gain with respect to the £940 he received on the sale of the debt instrument. Under paragraph (b) (5) (iv) of this section, the £940 Z received is attributable to principal (and the amount which is treated as principal under paragraph (b) (3) (iii) (B) of this section). Thus, Z recognizes foreign currency gain on December 31, 2006, of $940. [($2.00-$1.00) × £940]. Under paragraph (b) (6) of this section and §1.988-4, Z's foreign currency gain of $940 is sourced by reference to Z's residence and is therefore from sources within the United States.

(d) Multicurrency debt instruments-(1) In general. Except as provided in this paragraph (d), a multicurrency debt instrument described in paragraph (a) (1) (ii) or (iii) of this section shall be treated as an instrument described in paragraph (a) (1) (i) of this section and shall be accounted for under the rules of paragraph (b) of this section. Because payments on an instrument described in paragraph (a) (1) (ii) or (iii) of this section are denominated in, or determined   [*81]  by reference to, more than one currency, the issuer and holder or holders of the instrument are required to determine the denomination currency of the instrument under paragraph (d) (2) of this section before applying the rules of paragraph (b) of this section.
(2) Determination of denomination currency-(i) In general. The denomination currency of an instrument described in paragraph (a) (1) (ii) or (iii) of this section shall be the predominant currency of the instrument. Except as otherwise provided in paragraph (d) (2) (ii) of this section, the predominant currency of the instrument shall be the currency with the greatest value determined by comparing the functional currency value of the noncontingent and projected payments denominated in, or determined by reference to, each currency on the issue date, discounted to present value (in each relevant currency), and translated (if necessary) into functional currency at the spot rate on the issue date. For this purpose, the applicable discount rate may be determined using any method, consistently applied, that reasonably reflects the instrument's economic substance. If a taxpayer does not determine a discount rate using such a method,   [*82]  the Commissioner may choose a method for determining the discount rate that does reflect the instrument's economic substance. The predominant currency is determined as of the issue date and does not change based on subsequent events (e.g., changes in value of one or more currencies).
(ii) Difference in discount rate of greater than 10 percentage points. This §1.988-6 (d) (2) (ii) applies if no currency has a value determined under paragraph (d) (2) (i) of this section that is greater than 50% of the total value of all payments. In such a case, if the difference between the discount rate in the denomination currency otherwise determined under (d) (2) (i) of this section and the discount rate determined under paragraph (d) (2) (i) of this section with respect to any other currency in which payments are made (or determined by reference to) pursuant to the instrument is greater than 10 percentage points, then the Commissioner may determine the predominant currency under any reasonable method.
(3) Issuer/holder consistency. The issuer determines the denomination currency under the rules of paragraph (d) (2) of this section and provides this information to the holders of the instrument in   [*83]  a manner consistent with the issuer disclosure rules of §1.1275-2 (e). If the issuer does not determine the denomination currency of the instrument, or if the issuer's determination is unreasonable, the holder of the instrument must determine the denomination currency under the rules of paragraph (d) (2) of this section. A holder that determines the denomination currency itself must explicitly disclose this fact on a statement attached to the holder's timely filed federal income tax return for the taxable year that includes the acquisition date of the instrument.
(4) Treatment of payments in currencies other than the denomination currency. For purposes of applying the rules of paragraph (b) of this section to debt instruments described in paragraph (a) (1) (ii) or (iii) of this section, payments not denominated in (or determined by reference to) the denomination currency shall be treated as non-currency-related contingent payments. Accordingly, if the denomination currency of the instrument is determined to be the taxpayer's functional currency, the instrument shall be accounted for under §1.1275-4 (b) rather than under this section.
(e) Instruments issued for nonpublicly traded property-(1)   [*84]  Applicability. This paragraph (e) applies to debt instruments issued for nonpublicly traded property that would be described in paragraph (a) (1) (i), (ii), or (iii) of this section, but for the fact that such instruments are described in §1.1275-4 (c) (1) rather than §1.1275-4 (b) (1). For example, this paragraph (e) generally applies to a contingent payment debt instrument denominated in a nonfunctional currency that is issued for non-publicly traded property. Generally the rules of §1.1275-4 (c) apply except as set forth by the rules of this paragraph (e).
(2) Separation into components. An instrument described in this paragraph (e) is not accounted for using the noncontingent bond method of §1.1275-4 (b) and paragraph (b) of this section. Rather, the instrument is separated into its component payments. Each noncontingent payment or group of noncontingent payments which is denominated in a single currency shall be considered a single component treated as a separate debt instrument denominated in the currency of the payment or group of payments. Each contingent payment shall be treated separately as provided in paragraph (e) (4) of this section.
(3) Treatment of components consisting   [*85]  of one or more noncontingent payments in the same currency. The issue price of each component treated as a separate debt instrument which consists of one or more noncontingent payments is the sum of the present values of the non-contingent payments contained in the separate instrument. The present value of any non-contingent payment shall be determined under §1.1274-2 (c) (2), and the test rate shall be determined under §1.1274-4 with respect to the currency in which each separate instrument is considered denominated. No interest payments on the separate debt instrument are qualified stated interest payments (within the meaning of §1.1273-1 (c)) and the de minimis rules of section 1273 (a) (3) and §1.1273-1 (d) do not apply to the separate debt instrument. Interest income or expense is translated, and exchange gain or loss is recognized on the separate debt instrument as provided in §1.988-2 (b) (2), if the instrument is denominated in a nonfunctional currency.
(4) Treatment of components consisting of contingent payments-(i) General rule. A component consisting of a contingent payment shall generally be treated in the manner provided in §1.1275-4 (c) (4). However, except as provided   [*86]  in paragraph (e) (4) (ii) of this section, the test rate shall be determined by reference to the U.S. dollar unless the dollar does not reasonably reflect the economic substance of the contingent component. In such case, the test rate shall be determined by reference to the currency which most reasonably reflects the economic substance of the contingent component. Any amount received in nonfunctional currency from a component consisting of a contingent payment shall be translated into functional currency at the spot rate on the date of receipt. Except in the case when the payment becomes fixed more than six months before the payment is due, no foreign currency gain or loss shall be recognized on a contingent payment component.
(ii) Certain delayed contingent payments-(A) Separate debt instrument relating to the fixed component. The rules of §1.1275-4 (c) (4) (iii) shall apply to a contingent component the payment of which becomes fixed more than 6 months before the payment is due. For this purpose, the denomination currency of the separate debt instrument relating to the fixed payment shall be the currency in which payment is to be made and the test rate for such separate debt instrument   [*87]  shall be determined in the currency of that instrument. If the separate debt instrument relating to the fixed payment is denominated in nonfunctional currency, the rules of §1.988-2 (b) (2) shall apply to that instrument for the period beginning on the date the payment is fixed and ending on the payment date.
(B) Contingent component. With respect to the contingent component, the issue price considered to have been paid by the issuer to the holder under §1.1275-4 (c) (4) (iii) (A) shall be translated, if necessary, into the functional currency of the issuer or holder at the spot rate on the date the payment becomes fixed.
(5) Basis different from adjusted issue price. The rules of §1.1275-4 (c) (5) shall apply to an instrument subject to this paragraph (e).
(6) Treatment of a holder on sale, exchange, or retirement. The rules of §1.1275-4 (c) (6) shall apply to an instrument subject to this paragraph (e).
(f) Rules for nonfunctional currency tax exempt obligations described in §1.1275-4 (d)-(1) In general. Except as provided in paragraph (f) (2) of this section, section 1.988-6 shall not apply to a debt instrument the interest on which is excluded from gross income under section 103 (a).
(2)   [*88]  Operative rules. [RESERVED].
(g) Effective date. This section shall apply to debt instruments issued on or after October 29, 2004.

Par. 5. In §1.1275-2, paragraph (g) (1) is amended by adding a sentence at the end of the paragraph to read as follows:

§1.1275-2 Special rules relating to debt instruments. 
* * *
(g)* * *(1)* * * See also §1.988-2 (b) (18) for debt instruments with payments denominated in (or determined by reference to) a currency other than the taxpayer's functional currency.
* * *

Par. 6. In §1.1275-4, paragraph (a) (2) (iv) is revised to read as follows:

§1.1275-4 Contingent payment debt instruments. 
(a) * * *
(2) * * *
(iv) A debt instrument subject to section 988 (except as provided in §1.988-6);
* * *

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT 
Par. 7. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 8. Section 602.101, paragraph (b) is amended by adding an entry to the table in numerical order to read, in part, as follows:

§602.101 OMB Control numbers. 
* * *
(b) * * *
CFR part or section where identified and described	Current OMB control No.	
* * *		
1.988-6	1545-1831	
* * *		
Nancy J. Jardini,
Acting Deputy Commissioner for Services   [*89]  and Enforcement.
Approved July 16, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on August 27, 2004, 8:45 a.m., and published in the issue of the Federal Register for August 30, 2004, 69 F.R. 52816)

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