Reg-106486-98

Part IV. Items of General Interest
Notice of Proposed Rulemaking;
Notice of Public Hearing;
and Withdrawal of Previous
Proposed Regulations Section
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
REG–106486–98;
INTL–0015–91
AGENCY: Internal
(IRS), Treasury.

Revenue

Service

ACTION: Notice of proposed rulemaking;
notice of public hearing; and withdrawal of
previous proposed regulations section.
SUMMARY: This document contains proposed regulations regarding the treatment
of contingent payment debt instruments
for which one or more payments are denominated in, or determined by reference
to, a currency other than the taxpayer’s
functional currency. These regulations are
necessary because current regulations do
not provide guidance concerning the tax
treatment of such instruments. The proposed regulations generally provide that
taxpayers should apply the existing rules
under section 1275 of the Internal Revenue
Code, with certain modifications, to nonfunctional currency contingent payment
debt instruments. This document also
withdraws existing proposed regulations
and provides notice of a public hearing on
these proposed regulations.
DATES: Written or electronic comments
and requests to speak (with outlines of oral
comments to be discussed) at the public
hearing scheduled for December 3, 2003,
at 10 a.m. must be submitted by November
12, 2003.
ADDRESSES: Send submissions to:
CC:PA:RU (REG–106486–98), room
5203, Internal Revenue Service, POB

2003-42 I.R.B.

7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand
delivered between the hours of 8 a.m. and
4 p.m. to: REG–106486–98, Courier’s
Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington,
DC, or sent electronically, via the IRS
Internet site at: www.irs.gov/regs. The
public hearing will be held in room 6718,
Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.
FOR
FURTHER
INFORMATION
CONTACT: Concerning the proposed regulations, Milton Cahn at (202) 622–3870;
concerning submission and delivery of
comments and the public hearing, Treena
Garrett, (202) 622–7180 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
PAPERWORK REDUCTION ACT
The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of
Management and Budget for review in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)).
Comments on the collections of information should be sent to the Office of
Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503,
with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance
Officer, W:CAR:MP:T:T:SP, Washington,
DC 20224. Comments on the collection
of Information should be received by
October 28, 2003. Comments are specifically requested concerning:
Whether the proposed collections of information is necessary for the proper performance of the functions of the Internal
Revenue Service, including whether the
information will have practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of
the information to be collected may be enhanced;

853

How the burden of complying with the
proposed collections of information may
be minimized, including through the application of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of service to provide information.
The collections of information in this
proposed regulation are in §1.988–6(a)(1)
(cross reference to §1.1275–4) and
§1.988–6(d)(3).
This information is
required to ensure consistency in the treatment of the debt instrument between the
issuer and the holders. This information
will be used for audit and examination
purposes. The disclosure of information is
mandatory as regards the issuers of nonfunctional currency contingent payment
debt instruments. The reporting of information is mandatory as regards holders
of debt instruments which determine their
own projected payment schedule. The
recordkeeping requirement is mandatory
for any party that determines the comparable yield and projected payment schedule
for a debt instrument. The likely respondents are business or other for-profit
institutions.
Taxpayers provide the information on a
statement attached to its timely filed federal income tax return for the taxable year
that includes the acquisition date of the
debt instrument.
Estimated total annual reporting, and/or
recordkeeping burden: 100 hours.
Estimated average annual burden hours
per respondent and/or recordkeeper: 1
hour.
Estimated number of respondents
and/or recordkeepers: 100
Estimated annual frequency of responses: on occasion.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Office of Management and Budget.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return

October 20, 2003

information are confidential, as required
by 26 U.S.C. 6103.
Background
On March 17, 1992, Treasury and
the IRS issued proposed regulations
(INTL–0015–91), §§1.988–1(a)(3), (4)
and (5), regarding contingent payment
debt instruments, dual currency debt instruments and multi-currency debt instruments. The proposed regulations followed
the general approach in the then-proposed
§1.1275–4(g) contingent payment debt
regulations (LR–189–84, 1986–1 C.B.
820 [51 FR 12022] (1986), amended at 56
FR 8308 (1991)) and bifurcated such debt
instruments into contingent and noncontingent components. After an instrument
was bifurcated, the proposed regulations
applied the rules in §§1.988–1 through
1.988–5, as appropriate, to the resulting
components.
On December 16, 1994, Treasury
and the IRS withdrew the then proposed §1.1275–4(g) regulations and
proposed a new set of §1.1275–4 regulations (FI–59–91, 1995–1 C.B. 895
[59 FR–64884]). These regulations were
finalized on June 14, 1996.
Section 1.1275–4 of the final regulations adopted the “noncontingent bond
method” for certain contingent payment
debt instruments. Under the noncontingent bond method, interest accrues on a
contingent payment debt instrument at a
rate equal to the instrument’s comparable yield, which is the yield at which an
issuer would issue a fixed rate debt instrument with terms and conditions similar
to those of the contingent payment debt
instrument. In addition, the noncontingent bond method treats all interest on a
debt instrument as original issue discount,
which must be taken into account as it accrues, regardless of the taxpayer’s normal
method of accounting.
Under the noncontingent bond method,
the comparable yield is used to construct
a projected payment schedule for the debt
instrument, which includes a projected
amount for each contingent payment. If
the actual amount of a contingent payment
is greater than the projected amount, the
difference is treated as additional interest.
If the actual amount of a contingent payment is less than the projected amount,

October 20, 2003

the difference generally offsets current
interest accruals. In some cases, the difference may result in a loss to the holder
and income to the issuer.
On August 2, 1999, as a result of
the withdrawal of the 1994 proposed
§1.1275–4(g) regulations and the promulgation of the final §1.1275–4 regulations,
the IRS issued Announcement 99–76,
1999–2 C.B. 223, which provided a description of a regulatory approach that
Treasury and the IRS were considering
as a replacement to the proposed regulations in §§1.988–1(a)(3), (4) and (5) for
contingent payment debt instruments with
one or more payments denominated in,
or determined by reference to, a nonfunctional currency. Announcement 99–76
stated that Treasury and the IRS were
considering issuing regulations that would
apply the noncontingent bond method in
the taxpayer’s nonfunctional currency and
would translate payments received on the
instrument into functional currency under
the rules of §§1.988–1 through 1.988–5.
Announcement 99–76 requested comments on this approach. No comments
were received.
Treasury and the IRS believe that proposed regulations §1.988–1(a)(3), (4) and
(5) should be withdrawn because they incorporate the bifurcation approach rather
than the noncontingent bond method ultimately adopted under §1.1275–4. Treasury and the IRS believe, as reflected in
Announcement 99–76, that nonfunctional
currency contingent payment debt instruments should be accounted for under rules
similar to those that govern the treatment
of functional currency contingent payment
debt instruments. Treasury and the IRS believe that providing a consistent set of rules
in this area is in the best interests of sound
tax administration.
Explanation of Provisions
In General
These proposed regulations provide
guidance for four different types of debt
instruments: (1) debt instruments issued
for money or publicly-traded property
for which all payments of principal and
interest are denominated in, or determined
by reference to, a single nonfunctional
currency and which have one or more

854

non-currency contingencies, (2) debt
instruments issued for money or publicly-traded property for which payments
of principal or interest are denominated in,
or determined by reference to, more than
one currency and which have no non-currency contingencies, (3) debt instruments
issued for money or publicly-traded property for which payments of principal or
interest are denominated in, or determined by reference to, more than one
currency and which also have one or more
non-currency contingencies, and (4) debt
instruments which otherwise would fall
into one of the three foregoing categories
but for the fact that the instruments are
not issued for money or publicly-traded
property. These proposed regulations do
not discuss the treatment of tax-exempt
obligations described in §1.1275–4(d)
which are denominated in one or more
nonfunctional currencies. Comments are
requested as to the proper treatment of
such instruments.
Consistent with the approach described
in Announcement 99–76, these proposed
regulations generally apply the rules of
§1.1275–4(b) (i.e., the noncontingent bond
method) to nonfunctional currency contingent payment debt instruments issued
for money or publicly traded property.
The proposed regulations generally provide that the noncontingent bond method
is applied in the currency in which the
instrument is denominated (the denomination currency).
Application of the §1.1275–4(b) rules
to nonfunctional currency contingent instruments generally requires taxpayers (i)
to accrue interest in the denomination currency at a yield at which the issuer would
issue a fixed rate debt instrument denominated in the denomination currency with
terms and conditions similar to those of
the contingent payment debt instrument,
(ii) to translate the interest accrued from
the denomination currency into the functional currency (and account for foreign
currency gain or loss on payments of interest and principal) under the principles
of §1.988–2(b), and (iii) to account for
gain or loss arising from contingencies
in a manner consistent with the rules of
§1.1275–4(b).

2003-42 I.R.B.

Applying the Noncontingent Bond Method
in the Denomination Currency
As noted, the proposed regulations require taxpayers to apply the noncontingent bond method in the instrument’s denomination currency. For example, in the
case of an instrument whose denomination
currency is the British pound, an issuer
whose functional currency is the U.S. dollar would first determine the comparable
yield of the instrument, that is, the yield at
which the issuer would issue a fixed rate
instrument in British pounds with terms
and conditions similar to those of the instrument actually being issued. Second,
the issuer would construct a projected payment schedule applying that yield. Third,
the amount of interest accrued in each taxable year would be determined in British
pounds based on the comparable yield and
translated into dollars under the principles
of section 988. Fourth, the issuer and
holder would account for differences between the projected amount of payments
and the actual amount of payments (socalled positive adjustments and negative
adjustments) under rules similar to those
in §1.1275–4(b). Consistent with the rules
of §1.1275–4(b), the proposed regulations
provide that net positive adjustments are
treated as additional interest on the instrument. Net negative adjustments generally offset current interest accruals, and
in some cases may result in a loss to the
holder and income to the issuer. Finally,
the issuer and holders would determine
foreign currency gain or loss with respect
to interest and principal payments on the
instrument.
Determination of the comparable yield
and projected payment schedule
Consistent with §1.1275–4(b)(4)(iv),
the holder uses the yield and projected payment schedule determined by the issuer
to determine the holder’s interest accruals
and adjustments for a debt instrument. If
the issuer does not determine a comparable yield and projected payment schedule
for the debt instrument, or if the issuer’s
comparable yield or projected payment
schedule is unreasonable, the holder of the
debt instrument must determine the comparable yield and the projected payment
schedule for the debt instrument under
the rules of the proposed regulations. A

2003-42 I.R.B.

holder that determines its own comparable
yield and projected payment schedule
must explicitly disclose, in the manner set
forth in §1.1275–4(b)(4)(iv), both this fact
and the reason why the holder made its
own determination.
Determination of Basis
In general, the proposed regulations
provide that a holder maintains its adjusted basis in functional currency by
computing basis adjustments in the denomination currency under the rules of
§1.1275–4(b)(7)(iii) and then translating
such adjustments into functional currency.
Thus, the proposed regulations provide
that a holder’s basis is increased by the
holder’s accrued but unpaid interest inclusions on the debt instrument, generally
without regard to any positive or negative adjustments, and decreased by the
amount of any noncontingent payment and
the projected amount of any contingent
payment previously made on the debt instrument to the holder. These amounts are
translated into functional currency under
the principles of §1.988–2(b).
Determination of Amount Realized
The proposed regulations generally
follow §1.1275–4(b)(7)(iv) in determining
the amount realized, but do so in the denomination currency. Thus, for purposes
of determining the amount realized by a
holder on the scheduled retirement of a
debt instrument, the holder generally is
treated as receiving the projected amount
of any contingent payment due at maturity.
In the case of a sale, exchange or unscheduled retirement of a debt instrument,
general recognition principles of tax law
generally apply (e.g., section 1001(b)).
However, the amount realized by a holder
on either the scheduled retirement, or the
sale, exchange, or unscheduled retirement
of a debt instrument, is reduced by any
negative adjustment carryforward existing
in the taxable year of the sale, exchange
or retirement.
To calculate gain or loss other than foreign currency gain or loss, the proposed
regulations require the translation of the
amount realized into functional currency.
Foreign currency gain or loss is computed
separately, as described below. The proposed regulations generally translate the

855

amount realized by reference to the rates
used to translate the components of interest and principal that make up adjusted basis. The amount realized is translated using the adjusted basis rates in order to separate from the foreign currency gain or loss
the amount of gain or loss on the sale, exchange or retirement of the debt instrument which does not result from changes
in foreign exchange rates. Thus, where
the amount realized in the denomination
currency equals the adjusted basis of the
instrument in the denomination currency
prior to translation, the amount realized
is translated in its entirety by reference to
the rates used to translate adjusted basis.
Where the amount realized differs from the
adjusted basis prior to translation, additional attribution and translation rules are
required.
Where the amount realized in the denomination currency is less than the adjusted basis in the denomination currency,
that is, where the holder realizes a loss (not
taking into account foreign currency gain
or loss), the following rules apply as to
which parts of adjusted basis are not recovered. In the case of a scheduled retirement at maturity, the loss is attributable to
principal (the amount in denomination currency which the holder paid to purchase the
debt instrument). The loss is attributable
to principal because the holder will not entirely recover the holder’s original investment in the debt instrument. In the case
of a sale or exchange, the loss is first attributable to accrued interest. Attributing
the loss first to interest results in symmetrical treatment between a loss resulting from
a negative adjustment and a loss resulting
from a sale.
When the holder’s amount realized in
the denomination currency exceeds the
amount of its basis in the denomination
currency prior to translation, that is, where
the holder realizes a gain (not taking into
account foreign currency gain or loss),
the excess of amount realized over adjusted basis is translated at the spot rate
on the date of receipt. This rule ensures
symmetrical treatment between a positive
adjustment and a gain on the instrument.
Determination of Foreign Currency Gain
or Loss
The proposed regulations provide that
foreign currency gain or loss is determined

October 20, 2003

on an instrument with respect to principal and interest based on the comparable
yield and projected payment schedule under the principles of §1.988–2(b). In general, no foreign currency gain or loss is recognized until payment is made or received
pursuant to the instrument, and no foreign
currency gain or loss is computed with respect to positive or negative adjustments.
However, foreign currency gain or loss
is determined with respect to positive adjustments described in §1.1275–4(b)(9)(ii)
(relating to certain fixed but deferred contingent payments), based upon the difference between the spot rate on the date the
positive adjustment becomes fixed and the
spot rate on the date the positive adjustment is paid or received.
Source Rules
Consistent with the rules of
§1.1275–4(b)(6)(ii), the proposed regulations provide that all gain (other than
foreign currency gain) on an instrument
is characterized as interest for all tax
purposes, including source and character rules. Losses of a holder from
a contingent payment debt instrument
are generally sourced by reference to
the rules of §1.1275–4(b)(9)(iv). Under
§1.1275–4(b)(9)(iv), a holder’s deductions
or loss related to a contingent payment
debt instrument that are treated as ordinary losses are treated as deductions that
are definitely related to the class of gross
income to which income from such debt
instrument belongs. Deductions or losses
that the holder treats as capital losses are
allocated, consistently with the general
principles of §1.865–1(b)(2), to the class
of gross income with respect to which
interest income from the instrument would
give rise.
Treatment of Subsequent Holders
The proposed regulations provide that
the rules of §1.1275–4(b)(9) generally
apply to subsequent holders of an instrument who purchase the instrument for an
amount greater or less than the instrument’s adjusted issue price (determined
in the denomination currency). Accordingly, to the extent that the purchase price
for an instrument exceeds the adjusted
issue price of the instrument, the holder
is required to allocate such excess to
interest accrued on the instrument or to

October 20, 2003

projected payments on the instrument in a
reasonable manner. Each such allocation
is treated as a negative adjustment on the
instrument, and the holder’s basis on the
instrument is decreased as these negative
adjustments are taken into account.
To the extent that the adjusted issue
price of the instrument exceeds its purchase price, the holder is required to allocate such excess to interest accrued on the
instrument or to projected payments on the
instrument in a reasonable manner. As the
difference is taken into account, the holder
is treated as receiving a positive adjustment on the instrument, and the holder’s
basis is increased as these positive adjustments are taken into account.
The proposed regulations generally
translate the difference between the purchase price and adjusted issue price into
functional currency at the rate used to
translate the interest or projected payment
subject to the adjustment. Thus, for example, a positive adjustment attributable
to interest is translated at the same rate
used to translate interest in the period in
which it accrues (e.g., the average rate for
the accrual period). The basis adjustment
corresponding to such a positive or negative adjustment is translated at the same
rate applicable to the positive or negative
adjustment itself.
Netting
The proposed regulations do not provide for the netting of market gain or loss
with currency gain or loss on nonfunctional currency contingent payment debt
instruments. On the one hand, different
character and source rules generally apply
to market gain or loss and currency gain
or loss, and netting such items may produce results inconsistent with the tax treatment of other types of instruments. On the
other hand, where market gain or loss and
currency gain or loss counteract each other
with respect to a taxpayer, requiring separate recognition of such gain and loss may
not accurately reflect the economic benefits and burdens associated with the instrument. Accordingly, Treasury and the
IRS request comments regarding the extent to which netting should be permitted or required. Examples 2 and 4 of the
proposed regulations demonstrate cases in

856

which netting potentially could be permitted or required because both illustrate instances in which market loss could be netted against currency gain.
Debt Instruments Denominated in
Multiple Currencies
In the case of an instrument for which
payments are denominated in, or determined by reference to, more than one
currency, the proposed regulations provide that the issuer must first determine
the instrument’s predominant currency,
which will be used as the instrument’s
denomination currency for purposes of
applying the rules of the proposed regulations. The predominant currency of the
instrument is determined on the issue date
by comparing the present value in functional currency of the noncontingent and
projected payments denominated in, or
determined by reference to, each currency.
For this purpose, the applicable discount
rate must be a nonfunctional currency discount rate, but the rate may be determined
using any method, consistently applied,
that reasonably reflects the instrument’s
economic substance. If a taxpayer does
not determine a discount rate using such
a method, the Commissioner may choose
a method for determining the discount
rate that does reflect the instrument’s economic substance.
After the denomination currency has
been determined, all payments on the instrument that are denominated in, or determined by reference to, a currency other
than the denomination currency are treated
as non-currency related contingent payments for purposes of applying the rules of
the proposed regulations. Treasury and the
IRS request comments regarding whether
all gain or loss with respect to a debt instrument for which payments are denominated in, or determined by reference to,
more than one currency and which has
no non-currency contingencies should be
treated as foreign currency gain or loss.
Debt Instruments Issued for Non-publicly
Traded Property
In the case of a nonfunctional currency
contingent debt instrument issued for nonpublicly traded property, the instrument is
not accounted for using the noncontingent
bond method. Rather, the debt instrument
is separated into its components based on

2003-42 I.R.B.

the currency in which the payments are denominated and whether the payments are
contingent or noncontingent. The noncontingent components in each currency are
treated as a separate debt instrument denominated in the currency in which the
payment (or payments) is denominated. A
component consisting of a contingent payment is generally treated in the manner
provided in §1.1275–4(c)(4). For purposes
of the contingent payment, the test rate (the
interest rate which is used to discount the
contingent payment so as to determine the
amount of the payment which is treated as
principal, and the amount which is treated
as interest) is determined by reference to
the dollar unless the dollar does not reasonably reflect the economic substance of
the contingent component.
Proposed Effective Dates
Section 1.988–6 is proposed to apply
to nonfunctional currency contingent payment debt instruments issued 60 days or
more after the date §1.988–6 is published
as a final regulation in the Federal Register.
Special Analysis
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory assessment is not required.
It is hereby certified that these regulations will not have a significant economic
impact on a substantial number of small
entities. This certification is based upon
the fact that few, if any, small entities issue
or hold foreign currency denominated contingent payment debt instruments. Generally, it is expected that the only domestic
holders of these instruments will likely be
financial institutions, investment banking
firms, investment funds, and other sophisticated investors, due to the foreign currency risk and other contingencies inherent
in these instruments. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is
not required.
Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact on small business.

2003-42 I.R.B.

Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written comments
(preferably a signed original and eight (8)
copies) that are submitted timely to the
IRS. The IRS and Treasury Department request comments on the clarity of the proposed regulations and how they can be
made easier to understand. All comments
will be available for public inspection and
copying.
A public hearing has been scheduled
for December 3, 2003, at 10 a.m. in room
6718, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC. Due to building security procedures,
visitors must enter at the Constitution
Avenue entrance. In addition, all visitors must present photo identification to
enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediate entrance area more
than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the “FOR FURTHER
INFORMATION CONTACT” section of
this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to
present oral comments at the hearing must
submit electronic or written comments and
an outline of the topics to be discussed and
the time to be devoted to each topic (signed
original and eight (8) copies) by November 12, 2003. A period of 10 minutes will
be allotted to each person for making comments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal author of these regulations is Milton Cahn of the Office of the
Associate Chief Counsel (International).
However, other personnel from the IRS
and Treasury Department participated in
their development.
*****
Section 1.988–1(a)(3), (4) and (5) as
proposed on March 17, 1992 at 57 FR 9218
income tax regulations are withdrawn, and

857

26 CFR part 1 is proposed to be amended
as follows:
Part 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.988–2 is amended by:
1.
Adding the text of paragraph
(b)(2)(i)(B)(1).
2. Removing the last sentence of paragraph (b)(2)(i)(B)(2).
The addition reads 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
debt instruments for which one or more
payments are denominated in, or determined by reference to, a nonfunctional currency.
*****
Par. 3. Section 1.988–6 is added to read
as follows:
§1.988–6 Nonfunctional currency
contingent payment debt instruments.
(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 currency
contingent payment debt instruments described in this paragraph (a)(1). Except as
set forth by the rule in this section, the rules
in §1.1275–4 (relating to contingent payment debt instruments) apply to the following instruments—
(i) A debt instrument described in
§1.1275–4(b)(1) for which all payments
of principal and interest are denominated
in, or determined by reference to, a single
nonfunctional currency and which has one
or more non-currency related contingencies;
(ii) A debt instrument described in
§1.1275–4(b)(1) for which payments of
principal or interest are denominated in, or
determined by reference to, more than one
currency and which has no non-currency
related contingencies;

October 20, 2003

(iii) A debt instrument described in
§1.1275–4(b)(1) for which payments of
principal or interest are denominated in,
or determined by reference to, more than
one currency and which has one or more
non-currency related contingencies; and
(iv) A debt instrument otherwise described in paragraph (a)(1)(i), (ii) or (iii) of
this section, except that the debt instrument
is described in §1.1275–4(c)(1) rather than
§1.1275–4(b)(1) (e.g., the instrument is issued for non-publicly traded property).
(2) Exception for hyperinflationary currencies—(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 noncurrency 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 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

October 20, 2003

determined with respect to accrued interest and principal on the instrument. Paragraph (b)(6) of this section provides rules
for determining the source and character
of any gain or loss with respect to the instrument. Paragraph (b)(7) of this section
provides rules for subsequent holders of
an instrument who purchase the instrument
for an amount other than the adjusted issue price of the instrument. Paragraph (c)
of this section provides examples of the
application of paragraph (b) of this section. See paragraph (d) of this section for
the determination of the denomination currency of an instrument described in paragraph (a)(1)(ii) or (iii) of this section. See
paragraph (e) of this section for the treatment of an instrument described in paragraph (a)(1)(iv) of this section.
(2) Application of noncontingent bond
method—(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 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

858

the denomination currency, the excess is
treated as ordinary loss (if the taxpayer
is a holder of the instrument) or ordinary
income (if the taxpayer is the issuer of
the instrument). The amount treated as
ordinary loss by a holder with respect to
a net negative adjustment is limited, however, to the amount by which the holder’s
total interest inclusions on the debt instrument (determined in the denomination
currency) exceed the total amount of the
holder’s net negative adjustments treated
as ordinary loss on the debt instrument
in prior taxable years (determined in the
denomination currency). Similarly, the
amount treated as ordinary income by
an issuer with respect to a net negative
adjustment is limited to the amount by
which the issuer’s total interest deductions
on the debt instrument (determined in the
denomination currency) exceed the total
amount of the issuer’s net negative adjustments treated as ordinary income on the
debt instrument in prior taxable years (determined in the denomination currency).
To the extent a net negative adjustment
exceeds the current year’s interest accrual
and the amount treated as ordinary loss
to a holder (or ordinary income to the
issuer), the excess is treated as a negative adjustment carryforward, within the
meaning of §1.1275–4(b)(6)(iii)(C), in the
denomination currency.
(iii) Adjusted issue price. The adjusted
issue price of an instrument described
in paragraph (a)(1)(i) of this section
is determined by applying the rules of
§1.1275–4(b)(7) in the denomination currency. Accordingly, the adjusted issue
price is equal to the debt instrument’s
issue price in the denomination currency,
increased by the interest previously accrued on the debt instrument (determined
without regard to any net positive or net
negative adjustments on the instrument)
and decreased by the amount of any noncontingent payment and the projected
amount of any contingent payment previously made on the instrument. All
adjustments to the adjusted issue price are
calculated in the denomination currency.
(iv) Adjusted basis. 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

2003-42 I.R.B.

by the interest previously accrued on the
debt instrument (translated into functional currency), without regard to any
net positive or net negative adjustments
on the instrument (except as provided in
paragraph (b)(7) or (8) of this section, if
applicable), and decreased by the amount
of any noncontingent payment and the
projected amount of any contingent payment previously made on the instrument
to the holder (translated into functional
currency). See paragraph (b)(3)(iii) of this
section for translation rules.
(v) Amount realized. 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) 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:

2003-42 I.R.B.

(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 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,
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.

859

(iii) Adjusted basis—(A) In general.
Except as otherwise provided in this paragraph and paragraphs (b)(7) or (8) of this
section, a holder determines and maintains
adjusted basis by translating the denomination currency amounts determined
under §1.1275–4(b)(7)(iii) into functional
currency as follows:
(1) 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 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 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

October 20, 2003

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 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 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

October 20, 2003

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 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. 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

860

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 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 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

2003-42 I.R.B.

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 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 issue price. If the purchase price
of the instrument (determined in the
denomination currency) exceeds the adjusted issue price of the instrument, the

2003-42 I.R.B.

holder shall, consistent with the rules of
§1.1275–4(b)(9)(i)(B), reasonably allocate such excess to the daily portions of
interest accrued on the instrument or to
a projected payment on the instrument.
To the extent attributable to interest, the
excess shall be reasonably allocated over
the remaining term of the instrument to
the daily portions of interest accrued and
shall be a negative adjustment on the dates
the daily portions accrue. On the date
of such adjustment, the holder’s adjusted
basis in the instrument is reduced by the
amount treated as a negative adjustment
under this paragraph (b)(7)(iii), translated
into functional currency at the rate used to
translate the interest which is offset by the
negative adjustment. To the extent related
to a projected payment, such excess shall
be treated as a negative adjustment on the
date the payment is made. On the date
of such adjustment, the holder’s adjusted
basis in the instrument is reduced by the
amount treated as a negative adjustment
under this paragraph (b)(7)(iii), translated
into functional currency at the spot rate on
the date the instrument was acquired.
(iv) Purchase price less than adjusted
issue price. If the purchase price of
the instrument (determined in the denomination currency) is less than the
adjusted issue price of the instrument, the
holder shall, consistent with the rules of
§1.1275–4(b)(9)(i)(C), reasonably allocate the difference to the daily portions of
interest accrued on the instrument or to a
projected payment on the instrument. To
the extent attributable to interest, the difference shall be reasonably allocated over
the remaining term of the instrument to
the daily portions of interest accrued and
shall be a positive adjustment on the dates
the daily portions accrue. On the date
of such adjustment, the holder’s adjusted
basis in the instrument is increased by the
amount treated as a positive adjustment
under this paragraph (b)(7)(iv), translated
into functional currency at the rate used
to translate the interest to which it relates.
For purposes of determining adjusted basis
under paragraph (b)(3)(iii) of this section,
such increase in adjusted basis shall be
treated as an additional accrual of interest
during the period to which the positive
adjustment relates. To the extent related to
a projected payment, such difference shall
be treated as a positive adjustment on the
date the payment is made. On the date

861

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 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
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

October 20, 2003

£1210 on December 31, 2006 (consisting of a noncontingent payment of £975 and a projected payment
of £235). The debt instrument is a capital asset in

the hands of Z. Z does not elect to use the spot-rate
convention described in §1.988–2(b)(2)(iii)(B). The
payment actually made on December 31, 2006, is

£1300. The relevant pound/dollar spot rates over the
term of the instrument are as follows:

Date

Spot rate (pounds to dollars)

Dec. 31, 2004
Dec. 31, 2005
Dec. 31, 2006

£1.00=$1.00
£1.00=$1.10
£1.00=$1.20

Accrual Period

Average rate (pounds to dollars)

2005
2006

£1.00=$1.05
£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 price of £1000 x 10 percent). Under paragraph
(b)(3)(i) of this section, Z translates the £100 at the
average exchange rate for the accrual period ($1.05 x
£100 = $105). Accordingly, Z has interest income in
2005 of $105.
(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted
issue price of the debt instrument determined in
pounds and Z’s adjusted basis in dollars in the debt
instrument are increased by the interest accrued in
2005. Thus, on January 1, 2006, the adjusted issue
price of the debt instrument is £1100. For purposes of
determining Z’s dollar basis in the debt instrument,
the $1000 basis ($1.00 x £1000 original cost basis) is
increased by the £100 of accrued interest, translated
at the rate at which interest was accrued for 2005.
See paragraph (b)(3)(iii) of this section. Accordingly, Z’s adjusted basis in the debt instrument as of
January 1, 2006, is $1105.
(iii) Treatment in 2006—(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 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the £110
at the average exchange rate for the accrual period
($1.15 x £110 = $126.50). Accordingly, Z has interest income in 2006 of $126.50.
(B) Effect of net positive adjustment. 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

October 20, 2003

the last day of the year ($1.20 x £90 = $108). Accordingly, Z has a net positive adjustment of $108 resulting in a total interest inclusion for 2006 of $234.50
($126.50 + $108 = $234.50).
(C) Adjusted issue price and basis. Based on the
projected payment schedule, the adjusted issue price
of the debt instrument immediately before the payment at maturity is £1210 (£1100 plus £110 of accrued interest for 2006). Z’s adjusted basis in dollars, based only on the noncontingent payment and
the projected amount of the contingent payment to be
received, is $1231.50 ($1105 plus $126.50 of accrued
interest for 2006).
(D) Amount realized. Even though Z receives
£1300 at maturity, for purposes of determining
the amount realized, Z is treated under paragraph
(b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31,
2006. Therefore, Z is treated as receiving £1210
on December 31, 2006. Under paragraph (b)(3)(iv)
of this section, Z translates its amount realized
into dollars and computes its gain or loss on the
instrument (other than foreign currency gain or loss)
by breaking the amount realized into its component
parts. Accordingly, £100 of the £1210 (representing
the interest accrued in 2005) is translated at the rate
at which it was accrued (£1 = $1.05), resulting in an
amount realized of $105; £110 of the £1210 (representing the interest accrued in 2006) is translated
into dollars at the rate at which it was accrued (£1 =
$1.15), resulting in an amount realized of $126.50;
and £1000 of the £1210 (representing a return of
principal) is translated into dollars at the spot rate
on the date the instrument was purchased (£1 = $1),
resulting in an amount realized of $1000. Z’s total
amount realized is $1231.50, the same as its basis,
and Z recognizes no gain or loss (before consideration of foreign currency gain or loss) on retirement
of the instrument.
(E) Foreign currency gain or loss. 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.

862

The amount of recognized foreign currency gain is
determined based on the difference between the spot
rate on the date the instrument matures and the rates
at which the principal and interest were taken into account. With respect to the portion of the payment attributable to interest accrued in 2005, the foreign currency gain is $15 [£100 x ($1.20 - $1.05)]. With respect to interest accrued in 2006, the foreign currency
gain equals $5.50 [£110 x ($1.20 - $1.15)]. With respect to principal, the foreign currency gain is $200
[£1000 x ($1.20 - $1.00)]. Thus, Z recognizes a total foreign currency gain on December 31, 2006, of
$220.50.
(F) Source. Z has interest income of $105 in 2005,
interest income of $234.50 in 2006 (attributable to
£110 of accrued interest and the £90 net positive adjustment), and a foreign currency gain of $220.50 in
2006. Under paragraph (b)(6) of this section and section 862(a)(1), the interest income is sourced by reference to the residence of the payor and is therefore
from sources without the United States. Under paragraph (b)(6) of this section and §1.988–4, Z’s foreign
currency gain of $220.50 is sourced by reference to
Z’s residence and is therefore from sources within the
United States.
Example 2. 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 x 10 percent). Under paragraph (b)(3)(i) of
this section, the £110 of accrued interest is translated
at the average exchange rate for the accrual period
($1.15 x £110 = $126.50).

2003-42 I.R.B.

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

Date

Spot rate (pounds to dollars)

Dec. 31, 2004
June 30, 2005
Dec. 31, 2005
June 30, 2006
Dec. 31, 2006

£1.00=$1.00
£1.00=$1.20
£1.00=$1.40
£1.00=$1.60
£1.00=$1.80

Accrual Period

Average rate (pounds to dollars)

Jan.–June 2005
July–Dec. 2005
Jan.–June 2006
July–Dec. 2006

£1.00=$1.10
£1.00=$1.30
£1.00=$1.50
£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

2003-42 I.R.B.

£50 of interest on the debt instrument for the January-June accrual period (issue price of £1000 x 10
percent/2). Under paragraph (b)(3)(i) of this section,

863

Z translates the £50 at the average exchange rate for
the accrual period ($1.10 x £50 = $55.00). Similarly,

October 20, 2003

Z accrues £51 of interest in the July-December accrual period [(£1000 + £50 - £30) x 10 percent/2],
which is translated at the average exchange rate for
the accrual period ($1.30 x £51 = $66.30). Accordingly, Z accrues $121.30 of interest income in 2005.
(B) Adjusted issue price and basis—(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, 2005,
the adjusted issue price of the debt instrument is
£1020 (£1000 + £50 - £30 = £1020). For purposes of
determining Z’s dollar basis in the debt instrument,
the $1000 basis is increased by the £50 of accrued
interest, translated, under paragraph (b)(3)(iii) of
this section, at the rate at which interest was accrued
for the January-June accrual period ($1.10 x £50 =
$55). The resulting amount is reduced by the £30
payment of interest made during the accrual period,
translated, under paragraph (b)(3)(iii) of this section
and §1.988–2(b)(7), at the rate applicable to accrued
interest ($1.10 x £30 = $33). Accordingly, Z’s
adjusted basis as of July 1, 2005, is $1022 ($1000 +
$55 - $33).
(2) 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, on January 1,
2006, the adjusted issue price of the instrument is
£1041 (£1020 + £51 - £30 = £1041). For purposes of
determining Z’s dollar basis in the debt instrument,
the $1022 basis is increased by the £51 of accrued
interest, translated, under paragraph (b)(3)(iii) of
this section, at the rate at which interest was accrued
for the July-December accrual period ($1.30 x £51
= $66.30). The resulting amount is reduced by the
£30 payment of interest made during the accrual
period, translated, under paragraph (b)(3)(iii) of this
section and §1.988–2(b)(7), at the rate applicable to
accrued interest ($1.30 x £30 = $39). Accordingly,
Z’s adjusted basis as of January 1, 2006, is $1049.30
($1022 + $66.30 - $39).
(C) Foreign currency gain or loss. Z will recognize foreign currency gain on the receipt of each £30
payment of interest actually received during 2005.
The amount of foreign currency gain in each case is
determined, under paragraph (b)(5)(ii) of this section,
by reference to the difference between the spot rate
on the date the £30 payment was made and the average exchange rate for the accrual period during which
the interest accrued. Accordingly, Z recognizes $3
of foreign currency gain on the January-June interest
payment [£30 x ($1.20 - $1.10)], and $3 of foreign
currency gain on the July-December interest payment
[£30 x ($1.40 - $1.30)]. Z recognizes in 2005 a total
of $6 of foreign currency gain.
(D) Source. 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

October 20, 2003

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 x 10 percent/2). Under paragraph (b)(3)(i) of this section, Z translates the
£52.05 at the average exchange rate for the accrual period ($1.50 x £52.05 = $78.08). Similarly, Z accrues
£53.15 of interest in the July-December accrual period [(£1041 + £52.05 - £30) x 10 percent/2], which
is translated at the average exchange rate for the accrual period ($1.70 x £53.15 = $90.35). Accordingly,
Z accrues £105.20, or $168.43, of interest income in
2006.
(B) Effect of net negative adjustment. 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, the adjusted
issue price of the debt instrument is £1063.05 (£1041
+ £52.05 - £30 = £1063.05). For purposes of determining Z’s dollar basis in the debt instrument, the
$1049.30 adjusted basis is increased by the £52.05
of accrued interest, translated, under paragraph
(b)(3)(iii) of this section, at the rate at which interest
was accrued for the January-June accrual period
($1.50 x £52.05 = $78.08). The resulting amount is
reduced by the £30 payment of interest made during the accrual period, translated, under paragraph
(b)(3)(iii) of this section and §1.988–2(b)(7), at the
rate applicable to accrued interest ($1.50 x £30 =
$45). Accordingly, Z’s adjusted basis as of July 1,
2006, is $1082.38 ($1049.30 + $78.08 - $45).
(2) 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
+ £53.15 - £30 = £1086.20). For purposes of determining Z’s dollar basis in the debt instrument, the
$1082.38 adjusted basis is increased by the £53.15
of accrued interest, translated, under paragraph
(b)(3)(iii) of this section, at the rate at which interest
was accrued for the July-December accrual period
($1.70 x £53.15 = $90.36). The resulting amount is
reduced by the £30 payment of interest made during the accrual period, translated, under paragraph
(b)(3)(iii) of this section and §1.988–2(b)(7), at the
rate applicable to accrued interest ($1.70 x £30 =

864

$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 loss)
by breaking the amount realized into its component
parts. Accordingly, £20 of the £1086.20 (representing the interest accrued in the January-June 2005
accrual period, less £30 interest paid) is translated
into dollars at the rate at which it was accrued (£1 =
$1.10), resulting in an amount realized of $22; £21 of
the £1086.20 (representing the interest accrued in the
July-December 2005 accrual period, less £30 interest
paid) is translated into dollars at the rate at which
it was accrued (£1 = $1.30), resulting in an amount
realized of $27.30; £22.05 of the £1086.20 (representing the interest accrued in the January-June 2006
accrual period, less £30 interest paid) is translated
into dollars at the rate at which it was accrued (£1
= $1.50), resulting in an amount realized of $33.08;
£23.15 of the £1086.20 (representing the interest
accrued in the July 1-December 31, 2006, accrual
period, less the £30 interest payment) is translated
into dollars at the rate at which it was accrued (£1
= $1.70), resulting in an amount realized of $39.36;
and £1000 (representing principal) is translated into
dollars at the spot rate on the date the instrument was
purchased (£1 = $1), resulting in an amount realized
of $1000. Accordingly, Z’s total amount realized is
$1121.74 ($22 + $27.30 + $33.08 + $39.36 + $1000),
the same as its basis, and Z recognizes no gain or
loss (before consideration of foreign currency gain
or loss) on retirement of the instrument.
(E) Foreign currency gain or loss. 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 x ($1.60
- $1.00)], and $24 of foreign currency gain on the
July-December 2006 interest payment [£30 x ($1.80
- $1.00)]. Z separately recognizes foreign currency
gain with respect to the consideration actually received at maturity, £981.00. The amount of such gain
is determined based on the difference between the
spot rate on the date the instrument matures and the
rates at which the principal and interest were taken
into account. With respect to the portion of the payment attributable to interest accrued in January-June
2005 (other than the £30 payments), the foreign currency gain is $14 [£20 x ($1.80 - $1.10)]. With respect to the portion of the payment attributable to interest accrued in July-December 2005 (other than the

2003-42 I.R.B.

£30 payments), the foreign currency gain is $10.50
[£21 x ($1.80 - $1.30)]. With respect to the portion
of the payment attributable to interest accrued in 2006
(other than the £30 payments), no foreign currency
gain or loss is recognized under paragraph (b)(5)(ii)
of this section because such interest was reduced to
zero by the net negative adjustment. With respect to
the portion of the payment attributable to principal,
the foreign currency gain is $752 [£940 x ($1.80 $1.00)]. Thus, Z recognizes a foreign currency gain
of $42 on receipt of the two £30 payments in 2006,
and $776.50 ($14 + $10.50 + $752) on receipt of the
payment at maturity, for a total 2006 foreign currency
gain of $818.50.
(F) Source. 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 a
single payment at maturity of £1349.70 (consisting
of a noncontingent payment of £1000 and a projected
payment of £349.70). At the time of the purchase,
the adjusted issue price of the debt instrument is
£1161.76, assuming semiannual accrual periods
ending on June 30 and December 31 of each year.
The increase in the value of the debt instrument over
its adjusted issue price is due to an increase in the
expected amount of the contingent payment. The
debt instrument is a capital asset in the hands of
Z. Z does not elect to use the spot-rate convention
described in §1.988–2(b)(2)(iii)(B). The payment
actually made on December 31, 2006, is £1400. The
relevant pound/dollar spot rates over the term of the
instrument are as follows:

Date

Spot rate (pounds to dollars)

July 1, 2005
Dec. 31, 2006

£1.00=$1.00
£1.00=$2.00

Accrual period

Average rate (pounds to dollars)

July 1– December 31, 2005
January 1–June 30, 2006
July 1–December 31, 2006

£1.00=$1.50
£1.00=$1.50
£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
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 x 10.25 percent/2). Under paragraph
(b)(3)(i) of this section, Z translates the £59.54 of
interest at the average exchange rate for the accrual
period ($1.50 x £59.54 = $89.31). Accordingly, Z
has interest income in 2005 of $89.31.
(B) Adjusted issue price and basis. 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

2003-42 I.R.B.

July-December 2005. Thus, on January 1, 2006,
the adjusted issue price of the debt instrument is
£1221.30 (£1161.76 + £59.54). For purposes of
determining Z’s dollar basis in the debt instrument
on January 1, 2006, the $1405 basis is increased by
the £59.54 of accrued interest, translated at the rate
at which interest was accrued for the July-December
2005 accrual period. Paragraph (b)(3)(iii) of this
section. Accordingly, Z’s adjusted basis in the instrument, as of January 1, 2006, is $1494.31 [$1405
+ (£59.54 x $1.50)].
(v) Treatment in 2006—(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 x 10.25 percent/2). Under paragraph
(b)(3)(i) of this section, Z translates the £62.59 of
accrued interest at the average exchange rate for the
accrual period ($1.50 x £62.59 = $93.89). Similarly,
Z accrues £65.80 of interest in the July-December
2006 accrual period [(£1221.30 + £62.59) x 10.25
percent/2], which is translated at the average exchange rate for the accrual period ($1.50 x £65.80
= $98.70). Accordingly, Z accrues £128.39, or
$192.59, of interest income in 2006.
(B) Effect of positive and negative adjustments—(1) Offset of positive adjustment.
The
payment actually made on December 31, 2006, is
£1400, rather than the projected £1349.70. Under

865

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 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 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

October 20, 2003

(£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 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 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 instrument with respect to the entire consideration actually
received at maturity, £1400. While foreign currency
gain or loss ordinarily would not have arisen with
respect to £50.30 of the £1400, which was initially
treated as a positive adjustment in 2006, the larger
negative adjustment in 2006 reduced this positive adjustment to zero. Accordingly, foreign currency gain
or loss is recognized with respect to the entire £1400.
Under paragraph (b)(5)(ii) of this section, however,
no foreign currency gain or loss is recognized with
respect to unpaid accrued interest reduced to zero by
the net negative adjustment resulting in 2006, and no
foreign currency gain or loss is recognized with respect to unpaid accrued interest from 2005, also reduced to zero by the ordinary loss. Therefore, the entire £1400 is treated as a return of principal for the
purpose of determining foreign currency gain or loss,
and Z recognizes a total foreign currency gain on December 31, 2001, of $1400 [£1400 x ($2.00 - $1.00)].
(F) Source. Z has an ordinary loss of $89.31,
a capital loss of $5, and a foreign currency gain of
$1400. Under paragraph (b)(6) of this section and

§1.1275–4(b)(9)(iv), the $89.31 ordinary loss generally reduces Z’s foreign source passive income under
section 904(d) and the regulations thereunder. Under
paragraph (b)(6) of this section and §1.865–1(b)(2),
the $5 capital loss is sourced by reference to how
interest income on the instrument would have been
sourced. Therefore, the $5 capital loss generally reduces Z’s foreign source passive income under section 904(d) and the regulations thereunder. Under
paragraph (b)(6) of this section and §1.988–4, Z’s foreign currency gain of $1400 is sourced by reference
to Z’s residence and is therefore from sources within
the United States.
Example 5. 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 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
Dec. 31, 2005
Dec. 31, 2006

£1.00=$1.00
£1.00=$2.00
£1.00=$2.00

Accrual period

Average rate (pounds to dollars)

January 1–December 31, 2004
January 1–December 31, 2005
January 1–December 31, 2006

£1.00=$2.00
£1.00=$2.00
£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 debt instrument for 2004 (issue price of £1000 x 10 percent). Under paragraph
(b)(3)(i) of this section, Z translates the £100 at the

October 20, 2003

average exchange rate for the accrual period ($2.00 x
£100 = $200). Accordingly, Z has interest income in
2004 of $200.
(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted
issue price of the debt instrument determined in

866

pounds and Z’s adjusted basis in dollars in the debt
instrument are increased by the interest accrued in
2004. Thus, on January 1, 2005, the adjusted issue
price of the debt instrument is £1100. For purposes of
determining Z’s dollar basis in the debt instrument,
the $1000 basis ($1.00 x £1000 original cost basis) is

2003-42 I.R.B.

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 £1100 x 10 percent). Under paragraph (b)(3)(i) of
this section, the £110 of accrued interest is translated
at the average exchange rate for the accrual period
($2.00 x £110 = $220).
(B) Effect of net negative adjustment. 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
= $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 in dollars, based only on the noncontingent payments and the projected amount of the contingent payments to be received, is $900 (determined
as described below). Z’s adjusted basis on January
1, 2006, is Z’s adjusted basis on January 1, 2005
($1200), increased by the functional currency amount
of interest accrued in 2005 ($220), and decreased by
the amount of the payments made in 2005, based
solely on the projected payment schedule, (£310).
The amount of the projected payment is first attributable to the interest accrued in 2005 (£110), and then
to the interest accrued in 2004 (£100), and the remaining amount to principal (£100). The interest component of the projected payment is translated into functional currency at the rates at which it was accrued,
and the principal component of the projected payment
is translated into functional currency at the spot rate
on the date the instrument was issued. See paragraph
(b)(3)(iii) of this section. Accordingly, Z’s adjusted
basis in the debt instrument, following the increase of
adjusted basis for interest accrued in 2005 ($1200 +
$220 = $1420), is decreased by $520 ($220 + $200 +
$100 = $520). Z’s adjusted basis on January 1, 2006,
is therefore, $900.

2003-42 I.R.B.

(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) x
£50 =$50]. Under paragraph (b)(6) of this section and
§1.988–4, Z’s foreign currency gain of $50 is sourced
by reference to Z’s residence and is therefore from
sources within the United States.
(iv) Treatment in 2006—(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 2004 (adjusted issue price of £900 x 10 percent). Under paragraph (b)(3)(i) of this section, Z translates the £90
at the average exchange rate for the accrual period
($2.00 x £90 = $180). Accordingly, prior to taking
into account the 2005 negative adjustment carryforward, Z has interest income in 2006 of $180.
(B) Effect of net negative adjustment. The £50
negative adjustment carryforward from 2005 is a negative adjustment for 2006. Since there are no other
positive or negative adjustments, there is a £50 negative adjustment in 2006 which reduces Z’s accrued interest income by £50. Accordingly, after giving effect
to the £50 negative adjustment carryforward, Z will
accrue $80 of interest income. [(£90-£50) x $2.00 =
$80]
(C) Adjusted issue price. Under paragraph
(b)(2)(iii) of this section, the adjusted issue price
of the debt instrument determined in pounds is
increased by the interest accrued in 2006 (prior to
taking into account the negative adjustment carryforward). Thus, on December 30, 2006, the adjusted
issue price of the debt instrument is £990.
(D) Adjusted basis. For purposes of determining
Z’s dollar basis in the debt instrument, Z’s $900 adjusted basis on January 1, 2006, is increased by the accrued interest, translated at the rate at which interest
was accrued for 2006. See paragraph (b)(3)(iii)(A)
of this section. Note, however, that under paragraph
(b)(3)(iii)(B) the amount of accrued interest which is
reduced as a result of the negative adjustment carryforward, i.e., £50, is treated for purposes of this section as principal, and is translated at the spot rate on
the date the instrument was issued, i.e., £1.00 =$1.00.
Accordingly, Z’s adjusted basis in the debt instrument
as of December 30, 2006, is $1030 ($900 + $50 +
$80).
(E) Amount realized. 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 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

867

adjusted basis. The remaining £40 of Z’s amount
realized is treated as principal under paragraph
(b)(3)(iii)(B) of this section, and is also is translated
by reference to the principal component of adjusted
basis. Accordingly, Z’s amount realized in functional
currency is $940. (No part of Z’s amount realized
is attributable to the interest accrued on the debt
instrument.) Z realizes a loss of $90 on the sale
of the debt instrument ($1030 basis - $940 amount
realized). Under paragraph (b)(4) of this section and
§1.1275–4(b)(8), $80 of the loss is characterized as
ordinary loss, and the remaining $10 of loss is characterized as capital loss. Under §§1.988–6(b)(6) and
1.1275–4(b)(9)(iv) the $80 ordinary loss is treated as
a deduction that is definitely related to the interest
income accrued on the debt instrument. Similarly,
under §§1.988–6(b)(6) and 1.865–1(b)(2) the $10
capital loss is also allocated to the interest income
from the debt instrument.
(F) Foreign currency gain or loss. Z recognizes
foreign currency gain with respect to the £940 he
received on the sale of the debt instrument. Under paragraph (b)(5)(iv) of this section, the £940
Z received is attributable to principal (and the
amount which is treated as principal under paragraph
(b)(3)(iii)(B) of this section). Thus, Z recognizes foreign currency gain on December 31, 2006, of $940.
[($2.00-$1.00) x £940]. Under paragraph (b)(6) of
this section and §1.988–4, Z’s foreign currency gain
of $940 is sourced by reference to Z’s residence and
is therefore from sources within the United States.

(d) Multicurrency
debt instruments—(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 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. The denomination currency
of an instrument described in paragraph
(a)(1)(ii) or (iii) of this section shall be
the predominant currency of the instrument. The predominant currency of the
instrument shall be determined by comparing the functional currency value of the
noncontingent and projected payments denominated in, or determined by reference
to, each currency on the issue date, discounted to present value (in each relevant
currency), and translated (if necessary)

October 20, 2003

into functional currency at the spot rate on
the issue date. For this purpose, the applicable discount rate may be determined
using any method, consistently applied,
that reasonably reflects the instrument’s
economic substance. If a taxpayer does
not determine a discount rate using such
a method, the Commissioner may choose
a method for determining the discount
rate that does reflect the instrument’s
economic substance. The predominant
currency is determined as of the issue date
and does not change based on subsequent
events (e.g., changes in value of one or
more currencies).
(3) Issuer/holder consistency.
The
issuer determines the denomination currency under the rules of paragraph (d)(2)
of this section and provides this information to the holders of the instrument
in a manner consistent with the issuer
disclosure rules of §1.1275–2(e). If the
issuer does not determine the denomination currency of the instrument, or if the
issuer’s determination is unreasonable, the
holder of the instrument must determine
the denomination currency under the rules
of paragraph (d)(2) of this section. A
holder that determines the denomination
currency itself must explicitly disclose
this fact on a statement attached to the
holder’s timely filed federal income tax
return for the taxable year that includes
the acquisition date of the instrument.
(4) Treatment of payments in currencies other than the denomination
currency. For purposes of applying the
rules of paragraph (b) of this section to
debt instruments described in paragraph
(a)(1)(ii) or (iii) of this section, payments
not denominated in (or determined by
reference to) the denomination currency
shall be treated as non-currency-related
contingent payments. Accordingly, if the
denomination currency of the instrument
is determined to be the taxpayer’s functional currency, the instrument shall be
accounted for under §1.1275–4(b) rather
than this section.
(e) Instruments issued for nonpublicly
traded property—(1) 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

October 20, 2003

§1.1275–4(b)(1). For example, this paragraph (e) generally applies to a contingent
debt instrument denominated in a nonfunctional currency that is issued for
non-publicly traded property. Generally
the rules of §1.1275–4(c) apply except as
set forth by the rules of this paragraph (e).
(2) Separation into components. An instrument described in this paragraph (e) is
not accounted for using the noncontingent
bond method of §1.1275–4(b) and paragraph (b) of this section. Rather, the instrument is separated into its component
payments. Each noncontingent payment
or group of noncontingent payments which
is denominated in a single currency shall
be considered a single component treated
as a separate debt instrument denominated
in the currency of the payment or group of
payments. Each contingent payment shall
be treated separately as provided in paragraph (e)(4) of this section.
(3) Treatment of components consisting of one or more noncontingent payments in the same currency. The issue
price of each component treated as a separate debt instrument which consists of
one or more noncontingent payments is
the sum of the present values of the noncontingent payments contained in the separate instrument. The present value of
any noncontingent payment shall be determined under §1.1274–2(c)(2), and the test
rate shall be determined under §1.1274–4
with respect to the currency in which each
separate instrument is considered denominated. No interest payments on the separate debt instrument are qualified stated
interest payments (within the meaning of
§1.1273–1(c)) and the de minimis rules of
section 1273(a)(3) and §1.1273–1(d) do
not apply to the separate debt instrument.
Interest income or expense is translated,
and exchange gain or loss is recognized on
the separate debt instrument as provided
in §1.988–2(b)(2), if the instrument is denominated in a nonfunctional currency.
(4) Treatment of components consisting of contingent payments—(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 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

868

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

2003-42 I.R.B.

Par. 4. 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);
*****
David A. Mader,
Acting Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on August 28,
2003, 8:45 a.m., and published in the issue of the Federal
Register for August 29, 2003, 68 F.R. 51944)

Notice of Proposed Rulemaking
Section 1446 Regulations
REG–108524–00
AGENCY: Internal
(IRS), Treasury.

Revenue

Service

ACTION: Notice of proposed rulemaking.
SUMMARY: This document contains proposed regulations regarding the obligation
of a partnership to pay a withholding tax on
effectively connected taxable income allocable under section 704 to a foreign partner. The regulations will affect partnerships engaged in a trade or business in the
United States that have one or more foreign
partners.
DATES: Written or electronic comments
and requests to speak, with outlines of topics to be discussed at the public hearing
scheduled for December 4, 2003, must be
received by November 13, 2003.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR
(REG–108524–00),
room 5203, Internal Revenue Service,
P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may
be hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m.
to: CC:PA:LPD:PR (REG–108524–00),
Courier’s Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may
submit comments electronically directly to

2003-42 I.R.B.

the IRS Internet site at www.irs.gov/regs.
The public hearing will be held in the IRS
Auditorium, Internal Revenue Building,
1111 Constitution Avenue, NW, Washington, DC.
FOR
FURTHER
INFORMATION
CONTACT: Concerning the proposed
regulations, David J. Sotos, at (202)
622–3860, or to be placed on the attendance list for the hearing, LaNita
Van Dyke at (202) 622–7180 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed rulemaking have been submitted to the Office of
Management and Budget for review in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)).
Comments on the collections of information should be sent to the Office of
Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503,
with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance
Officer, W:CAR:MP:T:T:SP, Washington
DC 20224. Comments on the collections
of information should be received by
November 3, 2003. Comments are specifically requested concerning:
Whether the proposed collections of information are necessary for the proper performance of the functions of the Internal
Revenue Service, including whether the
information will have practical utility;
The accuracy of the estimated burden
associated with the proposed collections of
information (see below);
How the quality, utility, and clarity of
the information to be collected may be enhanced;
How the burden of complying with the
proposed collections of information may
be minimized, including through the application of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of services to provide information.

869

The collections of information in this
proposed regulation are in §§1.871–10,
1.1446–1, 1.1446–3, and 1.1446–4. This
information is required to determine
whether a partnership is required to pay a
withholding tax with respect to a foreign
partner and provide information concerning the tax paid on such partner’s behalf,
and to determine the foreign person required to report the effectively connected
taxable income earned by such partnership and entitled to claim credit for the
withholding tax paid by the partnership.
This information will be used in issuing
refunds to foreign persons claiming credit
for withholding tax paid on their behalf,
as well as for audit and examination purposes. The reporting requirements in
§§1.871–10 and 1.1446–3 are mandatory.
The reporting requirement in §1.1446–1
and 1.1446–4 are voluntary. The likely
respondents include individuals, business
or other for profit institutions, and small
businesses or organizations.
Estimated total annual reporting burden: 7,805 hours.
Estimated average annual burden hours
per respondent: 0.5 hours.
Estimated number of respondents:
15,775.
Estimated annual frequency of responses: on occasion and quarterly.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Office of Management and Budget.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required
by 26 U.S.C. 6103.
Background
This document contains proposed
amendments to 26 CFR part 1 under section 1446 of the Internal Revenue Code
(Code). Section 1446 was added to the
Code by section 1246(a) of the Tax Reform Act of 1986 (Public Law 99–514,
100 Stat. 2085, 2582 (1986 Act)), to impose withholding at a rate of 20 percent on
distributions to a foreign partner by a partnership that was engaged in a U.S. trade
or business. Section 1012(s)(1)(A) of the

October 20, 2003