Td 8674

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
DEPARTMENT OF HEALTH AND
HUMAN SERVICES
Food and Drug Administration
21 CFR Part 558
New Animal Drugs For Use In Animal
Feeds; Virginiamycin
AGENCY:

Food and Drug Administration,

HHS.
ACTION:

Final rule.

SUMMARY: The Food and Drug
Administration (FDA) is amending the
animal drug regulations to reflect
approval of a supplemental new animal
drug application (NADA) filed by Pfizer
Inc. The supplement provides for use of
a 30% virginiamycin formulation of a
Type A medicated article to be used for
the manufacture of Type C medicated
feeds for cattle fed in confinement for
slaughter.
EFFECTIVE DATE: June 14, 1996.
FOR FURTHER INFORMATION CONTACT:
Russell G. Arnold, Center for Veterinary
Medicine (HFV–142), Food and Drug
Administration, 7500 Standish Pl.,
Rockville, MD 20855, 301–594–1674.
SUPPLEMENTARY INFORMATION: Pfizer Inc.,
235 East 42d St., New York, NY 10017,
filed a supplement to NADA 140–998
which provided for use of a 30%
virginiamycin Type A medicated article
formulation to be used in a microingredient production process for the
preparation of Type C medicated feeds
for cattle fed in confinement for
slaughter. The Type C medicated feed is
fed at 11 to 16 grams per ton (g/t) for
improved feed efficiency, 13.5 to 16 g/
t for reduction of incidence of liver
abscesses, and 16 to 22.5 g/t for
increased rate of weight gain. The feed
is not for animals intended for breeding.
The supplement is approved as of May
3, 1996, and the regulations are
amended in 21 CFR 558.635(b) to reflect
the approval.
Approval of this supplement does not
require submission of new safety or
effectiveness data. The supplement
provides for use of an additional level
of Type A medicated article to make a
Type C medicated feed fed at previously
approved levels and for previously
approved conditions of use.
The agency has determined under 21
CFR 25.24(d)(1)(iii) that this action is of
a type that does not individually or
cumulatively have a significant effect on
the human environment. Therefore,
neither an environmental assessment
nor an environmental impact statement
is required.
Under section 512(c)(2)(F)(iii) of the
Federal Food, Drug, and Cosmetic Act

(21 U.S.C. 360b(c)(2)(F)(iii)), this
approval does not qualify for marketing
exclusivity because reports of new
clinical or field investigations (other
than bioequivalence or residue studies)
and, in the case of food producing
animals, human food safety studies
(other than bioequivalence or residue
studies) essential to the approval and
conducted or sponsored by the
applicant were not required.
List of Subjects in 21 CFR Part 558
Animal drugs, Animal feeds.
Therefore, under the Federal Food,
Drug, and Cosmetic Act and under
authority delegated to the Commissioner
of Food and Drugs and redelegated to
the Center for Veterinary Medicine, 21
CFR part 558 is amended as follows:
PART 558—NEW ANIMAL DRUGS FOR
USE IN ANIMAL FEEDS
1. The authority citation for 21 CFR
part 558 continues to read as follows:
Authority: Secs. 512, 701 of the Federal
Food, Drug, and Cosmetic Act (21 U.S.C.
360b, 371).
§ 558.635

[Amended]

2. Section 558.635 Virginiamycin is
amended in paragraph (b)(1) by
removing ‘‘to 000069’’ and by adding in
its place ‘‘used as in paragraph (f) of this
section; and 30 percent activity (136.2
grams per pound) for the manufacture of
Type C medicated feed for cattle used as
in paragraph (f)(3); to 000069’’.
Dated: June 7, 1996.
Andrew J. Beaulieau,
Deputy Director, Office of New Animal Drug
Evaluation, Center for Veterinary Medicine.
[FR Doc. 96–15202 Filed 6–13–96; 8:45 am]
BILLING CODE 4160–01–F

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8674]
RIN 1545–AQ86; 1545–AS35

Debt Instruments With Original Issue
Discount; Contingent Payments; AntiAbuse Rule
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

This document contains final
regulations relating to the tax treatment
of debt instruments that provide for one
or more contingent payments. This
document also contains final regulations
SUMMARY:

30133

that treat a debt instrument and a
related hedge as an integrated
transaction. In addition, this document
contains amendments to the original
issue discount regulations, and finalizes
the anti-abuse rule relating to those
regulations. The final regulations in this
document provide needed guidance to
holders and issuers of contingent
payment debt instruments.
DATES: Except as noted below, the
regulations are effective August 13,
1996. The amendments to § 1.1275–5
are effective June 14, 1996, except for
paragraphs (a)(6), (b)(2), and (c)(1),
which are effective August 13, 1996.
The removal of § 1.483–2T is effective
June 14, 1996. The removal of § 1.1275–
2T is effective August 13, 1996.
For dates of applicability of these
regulations, see Effective Dates under
SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT:
Concerning the regulations (other than
§ 1.1275–6), William E. Blanchard, (202)
622–3950, or Jeffrey W. Maddrey, (202)
622–3940; or concerning § 1.1275–6,
Michael S. Novey, (202) 622–3900 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act
The collections of information
contained in these final regulations have
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork
Reduction Act (44 U.S.C. 3507) under
control number 1545–1450. Responses
to these collections of information are
required to determine a taxpayer’s
interest income or deductions on a
contingent payment debt instrument.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information
displays a valid control number.
The estimated annual burden per
respondent/recordkeeper varies from .3
hours to .5 hours, depending on
individual circumstances, with an
estimated average of .47 hours.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, T:FP,
Washington, DC 20224, and to the
Office of Management and Budget, Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to the
collections of information must be
retained as long as their contents may
become material in the administration

30134

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

of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.
Background
Section 1275(d) of the Internal
Revenue Code (Code) grants the
Secretary the authority to prescribe
regulations under the original issue
discount (OID) provisions of the Code
(sections 163(e) and 1271 through 1275),
including regulations relating to debt
instruments that provide for contingent
payments. On February 2, 1994, the IRS
published final OID regulations in the
Federal Register (59 FR 4799). However,
the final OID regulations did not contain
rules for contingent payment debt
instruments.
On December 16, 1994, the IRS
published a notice of proposed
rulemaking in the Federal Register (59
FR 62884) relating to the tax treatment
of debt instruments that provide for one
or more contingent payments. The
notice also contained proposed
amendments to the regulations under
sections 483 (relating to unstated
interest), 1001 (relating to the amount
realized on a sale, exchange, or other
disposition of property), 1272 (relating
to the accrual of OID), 1274 (relating to
debt instruments issued for nonpublicly
traded property), and 1275(c) (relating
to OID information reporting
requirements), and to § 1.1275–5
(relating to variable rate debt
instruments). In addition, the notice
contained proposed regulations relating
to the integration of a contingent
payment or variable rate debt
instrument with a related hedge. The
notice withdrew the proposed
regulations relating to contingent
payment debt instruments that were
previously published in the Federal
Register on April 8, 1986 (51 FR 12087),
and February 28, 1991 (56 FR 8308).
On March 16, 1995, the IRS held a
public hearing on the proposed
regulations. In addition, the IRS
received a number of written comments
on the proposed regulations. The
proposed regulations, with certain
changes to respond to comments, are
adopted as final regulations. In addition,
certain clarifying and conforming
amendments are made to the OID
regulations that were published in the
Federal Register on February 2, 1994.
The comments and significant changes
are discussed below.

Explanation of Provisions
Section 1.1275–4 Contingent Payment
Debt Instruments
A. Noncontingent Bond Method
Under the noncontingent bond
method in the proposed regulations, a
taxpayer computes interest accruals on
a contingent payment debt instrument
by setting a payment schedule as of the
issue date and applying the OID rules to
the payment schedule. The payment
schedule consists of all fixed payments
on the debt instrument and a projected
amount for each contingent payment.
For market-based contingencies (i.e.,
contingencies for which price quotes are
readily available), the projected amount
is the forward price of the contingency.
For other contingencies, the issuer first
determines a reasonable yield for the
debt instrument and then sets projected
amounts equal to the relative expected
payments on the contingencies so that
the payment schedule produces the
reasonable yield. These rules were
designed to produce a yield similar to
the yield the issuer would obtain on a
fixed rate debt instrument.
Commentators suggested that the
regulations could be simplified if they
used the same basic methodology for
both market-based and non-marketbased contingencies. In addition,
commentators suggested that forward
price quotes would be variable or
manipulable and that taxpayers will set
more appropriate payment schedules if
they first determine yield and then set
the payment schedule to fit the yield.
The final regulations adopt these
suggestions and generally conform the
treatment of debt instruments that
provide for either market-based or nonmarket-based contingent payments.
Thus, for any contingent payment debt
instrument subject to the noncontingent
bond method, a taxpayer first
determines the yield on the instrument
and then sets the payment schedule to
fit the yield. The yield is determined by
the yield at which the issuer would
issue a fixed rate debt instrument with
terms and conditions similar to the
contingent payment debt instrument
(the comparable yield). Relevant terms
and conditions include the level of
subordination, term, timing of
payments, and general market
conditions. For example, if a hedge is
available such that the issuer or holder
could integrate the debt instrument and
the hedge into a synthetic fixed-rate
debt instrument under the rules of
§ 1.1275–6, the comparable yield is the
yield that the synthetic fixed-rate debt
instrument would have. If a § 1.1275–6
hedge (or the substantial equivalent) is

not available, but similar fixed rate debt
instruments of the issuer trade at a price
that reflects a spread above a benchmark
rate, the comparable yield is the sum of
the value of the benchmark rate on the
issue date and the spread. In all cases,
the yield must be a reasonable yield for
the issuer and may not be less than the
applicable Federal rate (AFR).
Once the comparable yield is
determined, the payment schedule is set
to produce the comparable yield. The
final regulations retain the general
approach of the proposed regulations in
determining the payment schedule.
Thus, for market-based payments, the
projected payment is the forward price
of the payment. For non-market-based
payments, the projected payment is the
expected amount of the payment as of
the issue date.
Commentators were concerned that a
taxpayer could overstate the yield on a
contingent payment debt instrument
and, therefore, claim excess interest
deductions during the term of the
instrument. They were particularly
concerned about a long-term debt
instrument that has non-market-based
payments because the taxpayer’s
determination would be hard to verify
and any excess interest deductions
would not be recaptured for a long time.
The final regulations address this
concern by providing that the
comparable yield for a debt instrument
is presumed to be the AFR if the
instrument provides for a non-marketbased payment and is part of an issue
that is marketed or sold in substantial
part to tax-exempt investors or other
investors for whom the treatment of the
debt instrument is not expected to have
a substantial effect on their U.S. tax
liability. A taxpayer may overcome this
presumption only with clear and
convincing evidence that the
comparable yield for the debt
instrument should be a specific yield
that is higher than the AFR. Appraisals
and other valuations of nonpublicly
traded property cannot be used to
overcome the presumption, nor can
references to general market rates. An
issuer may, for example, overcome the
presumption by showing that recently
issued similar debt instruments of the
issuer trade at a price that reflects a
specific yield.
One commentator suggested that the
use of the term projected payment
schedule caused securities law
problems because the issuer could be
seen as making representations to the
holder about the expected payments.
The comparable yield and projected
payment schedule determined under
these regulations are for tax purposes
only and are not assurances by the

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
issuer with respect to the payments. The
final regulations retain the term
projected payment schedule, but an
issuer may use a different term to
describe the payment schedule (e.g.,
payment schedule determined under
§ 1.1275–4) if the language used by the
issuer is clear.
Under the proposed regulations,
projected payments rather than actual
payments are used to determine the
adjusted issue price of a debt
instrument, the holder’s basis in a debt
instrument, and the amount of any
contingent payment treated as made on
the scheduled retirement of a debt
instrument. One commentator
questioned the use of projected
payments to make these determinations.
The approach in the proposed
regulations is appropriate, however,
because a positive or negative
adjustment is used to take into account
the difference between the actual
amount and the projected amount of a
contingent payment. This difference
would be counted twice if the adjusted
issue price, the holder’s basis, and the
amount deemed paid on retirement
were based on the actual amount rather
than the projected amount of a
contingent payment. Thus, the approach
used in the proposed regulations is
retained in the final regulations.
B. Tax-Exempt Obligations
In response to comments, the rules
contained in § 1.1275–4(d) relating to
tax-exempt contingent payment
obligations have been revised. Under
the proposed regulations, tax-exempt
obligations are generally subject to the
noncontingent bond method, with the
following modifications: (1) The yield
on which interest accruals are based
may not exceed the greater of the yield
on the obligation, determined without
regard to the non-market-based
contingent payments, and the taxexempt AFR that applies to the
obligation; (2) Positive adjustments are
treated as gain from the sale or exchange
of the obligation rather than as interest;
and (3) Negative adjustments reduce the
amount of tax-exempt interest, and,
therefore, are generally not taken into
account as deductible losses. These
modifications to the noncontingent
bond method for tax-exempt obligations
were added because the IRS and
Treasury believe that when a property
right is embedded in a tax-exempt
obligation it is generally inappropriate
to treat payments on the right as interest
on an obligation of a state or political
subdivision.
Several commentators suggested that
the proposed regulations relating to taxexempt obligations are overly

restrictive. These commentators
questioned the reason for limiting the
rate of accrual to the tax-exempt AFR
and characterizing positive adjustments
as taxable gain rather than interest. They
also questioned the fairness of treating
negative adjustments as nondeductible
adjustments to tax-exempt interest when
positive adjustments are treated as
taxable gain. Some of the commentators
suggested that, at a minimum, the
interest limitations should not apply to
contingent obligations that pay interest
based on interest rate formulas that
reflect the cost of funds rather than
changes in the value of embedded
property rights. Finally, commentators
noted that programs involving
municipal refinancings of real estate
projects (for example, low-income
multi-family housing projects) would be
jeopardized by the proposed regulations
because payments on tax-exempt
obligations issued to finance these
projects are in certain cases contingent
in part on the revenues or appreciation
in value of the project.
The IRS and Treasury continue to
believe that gain from a property right
should not be recharacterized as taxexempt interest merely because the
property right is embedded in a taxexempt obligation. The IRS and
Treasury nevertheless recognize that
certain types of traditional tax-exempt
financings should not be subject to the
interest limitations of the proposed
regulations (e.g., financings on which
interest is computed in a manner that
relates to the cost of funds).
Accordingly, § 1.1275–4(d) has been
revised to include a category of taxexempt obligations that will be subject
to the noncontingent bond method
without the tax-exempt interest
limitations contained in the proposed
regulations. This category of tax-exempt
obligations includes (1) obligations that
would qualify as variable rate debt
instruments (VRDIs) except for the
failure to meet certain of the technical
requirements of the VRDI definition
(such as the cap and floor limitations, or
the requirement that interest be paid or
compounded at least annually), and (2)
certain obligations issued to refinance
an obligation, the proceeds of which
were used to finance a project.
For other tax-exempt obligations, the
interest restrictions of the proposed
regulations are adopted in final form.
Section 1.1275–4(d) has been revised,
however, to provide that a negative
adjustment is treated as a taxable loss
from the sale or exchange of the
obligation, rather than as a
nondeductible adjustment to tax-exempt
interest.

30135

C. Prepaid Tuition Plans
A number of commentators asked
whether contracts issued under statesponsored prepaid tuition plans are
subject to § 1.1275–4. Although the
terms of the contracts vary, the contracts
generally are issued pursuant to a plan
created by a state to enable the
participants in the plan to save for postsecondary education for themselves or
other designated beneficiaries. In
addition, the plans generally provide
protection against increases in the costs
of higher education or otherwise
subsidize these costs, often by providing
for contingent payments that are linked
to the future costs of post-secondary
education.
The commentators argue that
§ 1.1275–4 does not apply to the
contracts because the contracts are not
debt instruments for federal income tax
purposes. In addition, the commentators
argue that, even if the contracts are debt
instruments, the noncontingent bond
method would be unduly burdensome
and inappropriate for contracts of this
type.
The final regulations under § 1.1275–
4 do not affect the treatment of contracts
issued pursuant to state-sponsored
prepaid tuition plans, whether or not
the contracts are debt instruments. The
final regulations, like the proposed
regulations, only apply to debt
instruments. Thus, the final regulations
do not apply to contracts issued
pursuant to a plan created by a state to
enable participants to save for postsecondary education if the contracts are
not debt instruments. In addition, the
final regulations provide an exception
for any debt instrument issued pursuant
to a state-sponsored prepaid tuition
plan.
This exception applies to a contract
issued pursuant to a plan or
arrangement if: The plan or arrangement
is created by a state statute; the plan or
arrangement has a primary objective of
enabling the participants to pay for the
costs of post-secondary education for
themselves or their designated
beneficiaries; and the contingencies
under the contract are related to such
purpose. These characteristics are
intended to describe all existing statesponsored prepaid tuition plans.
Therefore, the final regulations do not
change the tax treatment of a contract
issued pursuant to these plans. As a
result, if the contract is a debt
instrument, the contingent payments on
the contract are not taken into account
by an individual until the payments are
made.
The exception in the final regulations
is intended to apply only to the existing

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

state-sponsored prepaid tuition plans
and to any future plans that are
substantially similar to the existing
plans. In addition, no inference is
intended as to whether contracts issued
by any state-sponsored prepaid tuition
plan are debt instruments.
D. Debt Instruments Subject to Section
1274
The proposed regulations provide a
method for contingent payment debt
instruments not subject to the
noncontingent bond method (i.e., a
nonpublicly traded debt instrument
issued in a sale or exchange of
nonpublicly traded property). Under the
method, a debt instrument’s
noncontingent payments are treated as a
separate debt instrument, which is
generally taxed under the rules for
noncontingent debt instruments. The
debt instrument’s contingent payments
are taken into account when made. A
portion of each contingent payment is
treated as principal, based on the
amount determined by discounting the
payment at the AFR from the payment
date to the issue date, and the remainder
is treated as interest. Special rules are
provided if a contingent payment
becomes fixed more than 6 months
before it is due.
The final regulations generally adopt
the method in the proposed regulations.
In addition, the final regulations contain
rules for a holder whose basis in a debt
instrument is different from the
instrument’s adjusted issue price (e.g., a
subsequent holder).
E. Inflation-Indexed Bonds
The Treasury recently announced that
it was considering issuing bonds
indexed to inflation (61 FR 25164).
Depending on their ultimate structure,
the noncontingent bond method might
be inappropriate for these bonds. If the
Treasury issues these bonds, the
Treasury and IRS may issue regulations
to provide a simplified tax treatment for
the bonds. The treatment would require
current accrual of the inflation
component.
Other Amendments to the OID
Regulations
A. Alternative Payment Schedules
Under § 1.1272–1(c)
Section 1.1272–1(c) provides rules to
determine the yield and maturity of
certain debt instruments that provide for
one or more alternative payment
schedules applicable upon the
occurrence of a contingency (or
contingencies), provided that the timing
and amounts of the payments that
comprise each payment schedule are

known as of the issue date. Under these
rules, the yield and maturity of a debt
instrument are generally determined by
assuming that the payments will be
made under the payment schedule most
likely to occur (based on all the facts
and circumstances as of the issue date).
Special rules are provided for
unconditional options and mandatory
sinking funds.
The general rules in § 1.1272–1(c)
produce a reasonable result when a debt
instrument has one stated payment
schedule that is very likely to occur and
one or more alternative payment
schedules that are unlikely to occur. In
this case, adherence to the stated
payment schedule will result in accruals
on the debt instrument that reasonably
reflect the expected return on the
instrument. The rules can lead to
unreasonable results, however, if a debt
instrument provides for a stated
payment schedule and one or more
alternative payment schedules that
differ significantly and that have a
comparable likelihood of occurring. In
this case, the accruals based on the
payment schedule identified as most
likely to occur could differ significantly
from the expected return on the debt
instrument, which would reflect all the
payment schedules and their relative
probabilities of occurrence.
Because the general rules of § 1.1272–
1(c) could produce unreasonable results,
these rules have been modified. Under
the final regulations, if a single payment
schedule is significantly more likely
than not to occur, the yield and maturity
of the debt instrument are calculated
based on that payment schedule. As a
result, any other debt instrument that
provides for an alternative payment
schedule (other than because of an
unconditional option or mandatory
sinking fund) will generally be subject
to the rules in § 1.1275–4 for contingent
payment debt instruments. The final
regulations generally retain the rules for
mandatory sinking funds and
unconditional options.
B. Remote and Incidental Contingencies
The proposed regulations provide that
a payment subject to a remote or
incidental contingency is not
considered a contingent payment for
purposes of § 1.1275–4. In response to a
comment, the rule relating to remote
and incidental contingencies has been
broadened, through the addition of new
§ 1.1275–2(h), to provide that remote
and incidental contingencies are
generally ignored for purposes of
sections 163(e) (other than section
163(e)(5)) and 1271 through 1275 and
the regulations thereunder. Thus, for
example, if an otherwise fixed payment

debt instrument provides for an
additional payment that will be made
upon the occurrence of a contingency
and there is a remote likelihood that the
contingency will occur, the contingent
payment is ignored for purposes of
computing OID accruals on the
instrument. If the contingency occurs,
however, then, solely for purposes of
sections 1272 and 1273, the debt
instrument is treated as reissued.
Therefore, OID on the debt instrument
is redetermined.
C. Definition of Qualified Stated Interest
The addition of the rules for remote
or incidental contingencies and the
changes to the rules for alternative
payment schedules allow simplification
of the definition of qualified stated
interest. Under § 1.1273–1(c), as
published in the Federal Register on
February 2, 1994, qualified stated
interest must be unconditionally
payable in cash or property at least
annually at a single fixed rate. Interest
is unconditionally payable only if late
payment (other than a late payment that
occurs within a reasonable grace period)
or nonpayment is expected to be
penalized or reasonable remedies exist
to compel payment.
This definition of unconditionally
payable can be read to conflict with the
alternative payment schedule rules. For
example, if a debt instrument has two
alternative payment schedules, one
schedule can be stated as the required
payment schedule and the other
schedule can be stated as a penalty if
the required payments are not made.
The required payments might then be
treated as unconditionally payable and,
therefore, as being qualified stated
interest even if they would not be
qualified stated interest if treated under
the alternative payment schedule rules.
Under this treatment, if a payment is not
made, the reissuance rules of the
alternative payment schedule regime do
not apply. Holders can thus argue that
no OID would accrue with respect to the
debt instrument even though OID would
accrue if the instrument were treated as
having an alternative payment schedule
and holders fully expect any unmade
payment to be made in the future.
The remote or incidental rules in
§ 1.1275–2(h) provide a better
mechanism for determining whether a
payment is qualified stated interest and
determining the treatment if no payment
is made. Thus, the final regulations
modify the definition of unconditionally
payable so that interest is
unconditionally payable only if
reasonable legal remedies exist to
compel payment or the debt instrument
otherwise provides terms and

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
conditions that make the likelihood of
late payment (other than a late payment
that occurs within a reasonable grace
period) or nonpayment remote. If the
payment is not made (other than
because of insolvency, default, or
similar circumstances), the final
regulations require a deemed reissuance
for OID purposes, which ensures that
OID will accrue. This approach should
simplify the treatment of many debt
instruments and yet ensure that OID
accrues in appropriate circumstances.
D. OID Anti-Abuse Rule
On February 2, 1994, the IRS
published in the Federal Register
temporary and proposed regulations
that contained an anti-abuse rule for
purposes of the OID regulations
(§ 1.1275–2T (59 FR 4831); § 1.1275–2(g)
(59 FR 4878)). Under the anti-abuse
rule, the Commissioner can apply or
depart from the regulations under
section 163(e) or sections 1271 through
1275 as necessary to achieve a
reasonable result if a principal purpose
in structuring a debt instrument or
engaging in a transaction is to achieve
a result under the regulations that is
unreasonable in light of the applicable
statutes. This rule is adopted as a final
regulation with some clarifying changes
and the addition of an example to
illustrate its application to certain
contingent payment debt instruments.
E. Determination of Issue Price Under
Section 1274
Under the proposed regulations, the
issue price of a contingent payment debt
instrument that is subject to section
1274 (i.e., a debt instrument issued in
exchange for nonpublicly traded
property) is determined without taking
into account the instrument’s contingent
payments. Thus, the issue price of the
debt instrument (and the buyer’s initial
basis in the property) is limited to an
amount determined by taking into
account only the noncontingent
payments. The buyer’s basis in the
property, however, is increased by the
amount of a contingent payment treated
as principal. This approach was adopted
primarily because it is inappropriate to
allow a buyer a basis in property that
reflects anticipated contingent payments
that are uncertain in amount. In
addition, this approach limits the ability
of the buyer to overstate interest
deductions over the term of the debt
instrument. The approach of the
proposed regulations has been adopted
in the final regulations for taxable debt
instruments subject to section 1274. See
§ 1.1274–2(g).
It is not appropriate, however, to
apply this approach to tax-exempt

contingent payment obligations subject
to section 1274. Because the present
value of projected contingent payments
generally is not included in the issue
price of a taxable debt instrument
subject to section 1274, the instrument
is accounted for under § 1.1275–4(c).
This regime is not appropriate for taxexempt obligations because it does not
distinguish between tax-exempt interest
and gain attributable to an embedded
property right. Thus, in order to permit
tax-exempt obligations to be subject to
the noncontingent bond method under
§ 1.1275–4(b), the final regulations
provide special rules to determine the
issue price of a tax-exempt contingent
payment obligation subject to section
1274.
Under these rules, the issue price of
a tax-exempt contingent payment
obligation subject to section 1274 is
equal to the fair market value of the
obligation on the issue date (or, in the
case of an obligation that provides for
interest-based or revenue-based
payments, the greater of the obligation’s
fair market value or stated principal
amount). In addition, the obligation is
subject to the rules of § 1.1275–4(d) (the
noncontingent bond method for taxexempt contingent payment obligations)
rather than § 1.1275–4(c). However, to
ensure that the buyer’s basis is the same
as if the buyer had issued a taxable debt
instrument, the final regulations limit
the buyer’s basis to the present value of
the fixed payments.
Section 1.1275–6 Integration Rules
Commentators generally approved of
the integration rules in the proposed
regulations, and those rules are adopted
with only two significant changes.
First, the final regulations allow (but
do not require) the integration of a
hedge with a fixed rate debt instrument.
For example, a taxpayer may integrate a
fixed rate debt instrument and a swap
into a VRDI. Although the hedging
transaction regulations (§ 1.446–4) cover
many of these transactions, the
integration rules provide more certain
treatment. The final regulations,
however, do not allow the
Commissioner to integrate a hedge with
either a fixed rate debt instrument or a
VRDI that provides for interest at a
qualified floating rate. In these cases,
treating the hedge and the debt
instrument separately is a longstanding
rule that generally clearly reflects
income.
Second, in limited circumstances, the
final regulations allow a hedge to be
entered into prior to the date the
taxpayer issues or acquires the debt
instrument. In these circumstances,
however, the taxpayer must identify the

30137

hedge as part of an integrated
transaction on the day the hedge is
entered into by the taxpayer. Under the
final regulations, if the hedging
transaction has not yet had any cash
flows (including amounts paid to enter
into or purchase the hedge), the
integration rules work appropriately so
that any built-in gain or loss on the
hedge at the time of integration is
included over the term of the synthetic
debt instrument. Thus, the final
regulations put no restriction on the
time the hedging transaction has to be
entered into in this case. If there have
been cash flows on the hedge, the final
regulations require the hedge to be
entered into no earlier than a date that
is substantially contemporaneous with
the date on which the debt instrument
is acquired. This approach should allow
commercially reasonable transactions to
be integrated without the need to create
complex rules to determine the
treatment of prior cash flows on the
hedging transaction.
The rules for remote and incidental
contingencies in § 1.1275–2(h) apply for
purposes of the integration rules. Thus,
if there is an incidental mismatch
between a § 1.1275–6 hedge and a
qualifying debt instrument, a taxpayer
may still integrate the hedge and the
instrument. The mismatch is dealt with
according to the rules for incidental
contingencies.
The final regulations also clarify the
timing of income, deductions, gains,
and losses from a hedge of a contingent
payment debt instrument not subject to
integration. Under § 1.446–4, the
income, deductions, gains, and losses
must match the income, deductions,
gains, and losses from the debt
instrument. The final regulations clarify
that gain or loss realized on a
transaction that hedges a contingent
payment on a debt instrument subject to
§ 1.1275–4(c) is taken into account
when the contingent payment is taken
into account under § 1.1275–4(c). This
treatment does not allow the taxpayer to
change the timing of the income,
deductions, gains, and losses from the
debt instrument.
Effective Dates
In general, the final regulations apply
to debt instruments issued on or after
August 13, 1996. Section 1.1275–6
applies to a qualifying debt instrument
issued on or after August 13, 1996.
Section 1.1275–6 also applies to a
qualifying debt instrument acquired by
the taxpayer on or after August 13, 1996,
if the qualifying debt instrument is a
fixed rate debt instrument or a VRDI or
if the qualifying debt instrument and the
§ 1.1275–6 hedge are acquired by the

30138

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

taxpayer substantially
contemporaneously. Except as
otherwise provided in the regulations,
the changes to § 1.1275–5 apply to debt
instruments issued on or after April 4,
1994.

List of Subjects

Debt Instruments Issued Before the
Effective Date of the Final Regulations

Reporting and recordkeeping
requirements.

For a contingent payment debt
instrument issued before August 13,
1996, a taxpayer may use any reasonable
method to account for the debt
instrument, including a method that
would have been required under the
proposed regulations when the debt
instrument was issued. However, unless
§ 1.1275–6 applies to the debt
instrument, integration is not a
reasonable method to account for the
instrument.

Adoption of Amendments to the
Regulations

Consent To Change Accounting Method

Authority: 26 U.S.C. 7805 * * *
Section 1.483–4 also issued under 26 U.S.C.
483(f). * * *
Section 1.1275–6 also issued under 26 U.S.C.
1275(d). * * *

The Commissioner grants consent for
a taxpayer to change its method of
accounting to follow the final
regulations in this document. This
consent is granted, however, only for a
change for the first taxable year in
which the taxpayer must account for a
debt instrument under the final
regulations. The change is made on a
cut-off basis (i.e., the new method only
applies to debt instruments issued on or
after August 13, 1996. Therefore, no
items of income or deduction are
omitted or duplicated, and no
adjustment under section 481 is
allowed.
Special Analyses
It has been determined that this
Treasury decision is not a significant
regulatory action as defined in EO
12866. Therefore, a regulatory
assessment is not required. It also has
been determined that section 553(b) of
the Administrative Procedure Act (5
U.S.C. chapter 5) and the Regulatory
Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and,
therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to
section 7805(f) of the Internal Revenue
Code, the notice of proposed rulemaking
preceding these regulations was
submitted to the Small Business
Administration for comment on its
impact on small business.
Drafting Information
Several persons from the Office of
Chief Counsel and the Treasury
Department, including Andrew C.
Kittler, formerly of the Office of the
Assistant Chief Counsel (Financial
Institutions and Products), participated
in developing these regulations.

26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
26 CFR Part 602

Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by removing the
entry for § 1.1275–2T and adding two
entries in numerical order to read as
follows:

Par. 2. Section 1.163–7 is amended by
adding a sentence at the end of
paragraph (a) to read as follows:
§ 1.163–7 Deduction for OID on certain
debt instruments.

(a) * * * To determine the amount of
interest (OID) that is deductible each
year on a debt instrument that provides
for contingent payments, see § 1.1275–4.
*
*
*
*
*
Par. 3. Section 1.446–4 is amended
by:
1. Redesignating paragraphs (a)(2)(ii)
and (a)(2)(iii) as paragraphs (a)(2)(iii)
and (a)(2)(iv), respectively.
2. Adding a new paragraph (a)(2)(ii).
3. Adding a sentence at the end of
paragraph (e)(4).
The additions read as follows:
§ 1.446–4

Hedging transactions.

(a) * * *
(2) * * *
(ii) An integrated transaction subject
to § 1.1275–6;
*
*
*
*
*
(e) * * *
(4) * * * Similarly, gain or loss
realized on a transaction that hedges a
contingent payment on a debt
instrument subject to § 1.1275–4(c) (a
contingent payment debt instrument
issued for nonpublicly traded property)
is taken into account when the
contingent payment is taken into
account under § 1.1275–4(c).
*
*
*
*
*
§ 1.483–2T

[Removed]

Par. 4. Section 1.483–2T is removed
effective June 14, 1996.

Par. 5. Section 1.483–4 is added to
read as follows:
§ 1.483–4

Contingent payments.

(a) In general. This section applies to
a contract for the sale or exchange of
property (the overall contract) if the
contract provides for one or more
contingent payments and the contract is
subject to section 483. This section
applies even if the contract provides for
adequate stated interest under § 1.483–
2. If this section applies to a contract,
interest under the contract is generally
computed and accounted for using rules
similar to those that would apply if the
contract were a debt instrument subject
to § 1.1275–4(c). Consequently, all
noncontingent payments under the
overall contract are treated as if made
under a separate contract, and interest
accruals on this separate contract are
computed under rules similar to those
contained in § 1.1275–4(c)(3). Each
contingent payment under the overall
contract is characterized as principal
and interest under rules similar to those
contained in § 1.1275–4(c)(4). However,
any interest, or amount treated as
interest, on a contract subject to this
section is taken into account by a
taxpayer under the taxpayer’s regular
method of accounting (e.g., an accrual
method or the cash receipts and
disbursements method).
(b) Examples. The following examples
illustrate the provisions of paragraph (a)
of this section:
Example 1. Deferred payment sale with
contingent interest—(i) Facts. On December
31, 1996, A sells depreciable personal
property to B. As consideration for the sale,
B issues to A a debt instrument with a
maturity date of December 31, 2001. The debt
instrument provides for a principal payment
of $200,000 on the maturity date, and a
payment of interest on December 31 of each
year, beginning in 1997, equal to a percentage
of the total gross income derived from the
property in that year. However, the total
interest payable on the debt instrument over
its entire term is limited to a maximum of
$50,000. Assume that on December 31, 1996,
the short-term applicable Federal rate is 4
percent, compounded annually, and the midterm applicable Federal rate is 5 percent,
compounded annually.
(ii) Treatment of noncontingent payment
as separate contract. Each payment of
interest is a contingent payment.
Accordingly, under paragraph (a) of this
section, for purposes of applying section 483
to the debt instrument, the right to the
noncontingent payment of $200,000 is
treated as a separate contract. The amount of
unstated interest on this separate contract is
equal to $43,295, which is the amount by
which the payment ($200,000) exceeds the
present value of the payment ($156,705),
calculated using the test rate of 5 percent,
compounded annually. The $200,000
payment is thus treated as consisting of a

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
payment of interest of $43,295 and a payment
of principal of $156,705. The interest is
includible in A’s gross income, and
deductible by B, under their respective
methods of accounting.
(iii) Treatment of contingent payments.
Assume that the amount of the contingent
payment that is paid on December 31, 1997,
is $20,000. Under paragraph (a) of this
section, the $20,000 payment is treated as a
payment of principal of $19,231 (the present
value, as of the date of sale, of the $20,000
payment, calculated using a test rate equal to
4 percent, compounded annually) and a
payment of interest of $769. The $769
interest payment is includible in A’s gross
income, and deductible by B, in their
respective taxable years in which the
payment occurs. The amount treated as
principal gives B additional basis in the
property on December 31, 1997. The
remaining contingent payments on the debt
instrument are accounted for similarly, using
a test rate of 4 percent, compounded
annually, for the payments made on
December 31, 1998, and December 31, 1999,
and a test rate of 5 percent, compounded
annually, for the payments made on
December 31, 2000, and December 31, 2001.
Example 2. Contingent stock payout—(i)
Facts. M Corporation and N Corporation each
owns one-half of the stock of O Corporation.
On December 31, 1996, pursuant to a
reorganization qualifying under section
368(a)(1)(B), M acquires the one-half interest
of O held by N in exchange for 30,000 shares
of M voting stock and a non-assignable right
to receive up to 10,000 additional shares of
M’s voting stock during the next 3 years,
provided the net profits of O exceed certain
amounts specified in the contract. No interest
is provided for in the contract. No additional
shares are received in 1997 or in 1998. In
1999, the annual earnings of O exceed the
specified amount, and, on December 31,
1999, an additional 3,000 M voting shares are
transferred to N. The fair market value of the
3,000 shares on December 31, 1999, is
$300,000. Assume that on December 31,
1996, the short-term applicable Federal rate
is 4 percent, compounded annually. M and
N are calendar year taxpayers.
(ii) Allocation of interest. Section 1274
does not apply to the right to receive the
additional shares because the right is not a
debt instrument for federal income tax
purposes. As a result, the transfer of the
3,000 M voting shares to N is a deferred
payment subject to section 483 and a portion
of the shares is treated as unstated interest
under that section. The amount of interest
allocable to the shares is equal to the excess
of $300,000 (the fair market value of the
shares on December 31, 1999) over $266,699
(the present value of $300,000, determined
by discounting the payment at the test rate
of 4 percent, compounded annually, from
December 31, 1999, to December 31, 1996).
As a result, the amount of interest allocable
to the payment of the shares is $33,301
($300,000–$266,699). Both M and N take the
interest into account in 1999.

(c) Effective date. This section applies
to sales and exchanges that occur on or
after August 13, 1996.

Par. 6. Section 1.1001–1 is amended
by revising paragraph (g) to read as
follows:
§ 1.1001–1

*

Computation of gain or loss.

*
*
*
*
(g) Debt instruments issued in
exchange for property—(1) In general. If
a debt instrument is issued in exchange
for property, the amount realized
attributable to the debt instrument is the
issue price of the debt instrument as
determined under § 1.1273–2 or
§ 1.1274–2, whichever is applicable. If,
however, the issue price of the debt
instrument is determined under section
1273(b)(4), the amount realized
attributable to the debt instrument is its
stated principal amount reduced by any
unstated interest (as determined under
section 483).
(2) Certain debt instruments that
provide for contingent payments—(i) In
general. Paragraph (g)(1) of this section
does not apply to a debt instrument
subject to either § 1.483–4 or § 1.1275–
4(c) (certain contingent payment debt
instruments issued for nonpublicly
traded property).
(ii) Special rule to determine amount
realized. If a debt instrument subject to
§ 1.1275–4(c) is issued in exchange for
property, and the income from the
exchange is not reported under the
installment method of section 453, the
amount realized attributable to the debt
instrument is the issue price of the debt
instrument as determined under
§ 1.1274–2(g), increased by the fair
market value of the contingent
payments payable on the debt
instrument. If a debt instrument subject
to § 1.483–4 is issued in exchange for
property, and the income from the
exchange is not reported under the
installment method of section 453, the
amount realized attributable to the debt
instrument is its stated principal
amount, reduced by any unstated
interest (as determined under section
483), and increased by the fair market
value of the contingent payments
payable on the debt instrument. This
paragraph (g)(2)(ii), however, does not
apply to a debt instrument if the fair
market value of the contingent
payments is not reasonably
ascertainable. Only in rare and
extraordinary cases will the fair market
value of the contingent payments be
treated as not reasonably ascertainable.
(3) Coordination with section 453. If a
debt instrument is issued in exchange
for property, and the income from the
exchange is not reported under the
installment method of section 453, this
paragraph (g) applies rather than
§ 15a.453–1(d)(2) to determine the

30139

taxpayer’s amount realized attributable
to the debt instrument.
(4) Effective date. This paragraph (g)
applies to sales or exchanges that occur
on or after August 13, 1996.
Par. 7. Section 1.1012–1 is amended
by revising paragraph (g) to read as
follows:
§ 1.1012–1

*

Basis of property.

*
*
*
*
(g) Debt instruments issued in
exchange for property—(1) In general.
For purposes of paragraph (a) of this
section, if a debt instrument is issued in
exchange for property, the cost of the
property that is attributable to the debt
instrument is the issue price of the debt
instrument as determined under
§ 1.1273–2 or § 1.1274–2, whichever is
applicable. If, however, the issue price
of the debt instrument is determined
under section 1273(b)(4), the cost of the
property attributable to the debt
instrument is its stated principal
amount reduced by any unstated
interest (as determined under section
483).
(2) Certain tax-exempt obligations.
This paragraph (g)(2) applies to a taxexempt obligation (as defined in section
1275(a)(3)) that is issued in exchange for
property and that has an issue price
determined under § 1.1274–2(j)
(concerning tax-exempt contingent
payment obligations and certain taxexempt variable rate debt instruments
subject to section 1274).
Notwithstanding paragraph (g)(1) of this
section, if this paragraph (g)(2) applies
to a tax-exempt obligation, for purposes
of paragraph (a) of this section, the cost
of the property that is attributable to the
obligation is the sum of the present
values of the noncontingent payments
(as determined under § 1.1274–2(c)).
(3) Effective date. This paragraph (g)
applies to sales or exchanges that occur
on or after August 13, 1996.
Par. 8. Section 1.1271–0(b) is
amended by:
1. Revising the entries for paragraphs
(c)(2), (c)(3), (c)(4), and (d) of § 1.1272–
1.
2. Adding an entry for paragraph
(c)(7) of § 1.1272–1.
3. Revising the entry for paragraph (g)
and adding entries for paragraphs (i)
and (j) of § 1.1274–2.
4. Revising the entry for paragraph (g)
and adding entries for paragraphs (g),
(h), (i), and (j) of § 1.1275–2.
5. Removing the entries for § 1.1275–
2T.
6. Adding entries for § 1.1275–4.
7. Adding entries for paragraphs (a)(5)
and (a)(6) of § 1.1275–5.
8. Revising the entries for paragraphs
(c)(1) and (c)(5) of § 1.1275–5.

30140

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

9. Adding entries for § 1.1275–6.
The revisions and additions read as
follows:
§ 1.1271–0 Original issue discount;
effective date; table of contents.

*

*
*
(b) * * *
*
*
*

*

*

*

*

§ 1.1272–1
Income

Current Inclusion of OID in

*

*

*

*

*

(c) * * *
(2) Payment schedule that is significantly
more likely than not to occur.
(3) Mandatory sinking fund provision.
(4) Consistency rule. [Reserved]

*

*

*

*

*

(7) Effective date.
(d) Certain debt instruments that provide
for a fixed yield.

*

*

*

*

*

§ 1.1274–2 Issue Price of Debt Instruments
to Which Section 1274 Applies

(8) Character on sale, exchange, or
retirement.
(9) Operating rules.
(c) Method for debt instruments not subject
to the noncontingent bond method.
(1) Applicability.
(2) Separation into components.
(3) Treatment of noncontingent payments.
(4) Treatment of contingent payments.
(5) Basis different from adjusted issue
price.
(6) Treatment of a holder on sale,
exchange, or retirement.
(7) Examples.
(d) Rules for tax-exempt obligations.
(1) In general.
(2) Certain tax-exempt obligations with
interest-based or revenue-based payments
(3) All other tax-exempt obligations.
(4) Basis different from adjusted issue
price.
(e) Amounts treated as interest under this
section.
(f) Effective date.

(g) Treatment of contingent payment debt
instrument.

§ 1.1275–5 Variable Rate Debt Instruments
(a) * * *
(5) No contingent principal payments.
(6) Special rule for debt instruments issued
for nonpublicly traded property.

*

*

*

*
*

*
*

*
*

*
*

(i) [Reserved]
(j) Special rules for tax-exempt obligations.
(1) Certain variable rate debt instruments.
(2) Contingent payment debt instruments.
(3) Effective date.

*

*

*

*

*

§ 1.1275–2 Special Rules Relating to Debt
Instruments

*

*

*

*

*

(g) Anti-abuse rule.
(1) In general.
(2) Unreasonable result.
(3) Examples.
(4) Effective date.
(h) Remote and incidental contingencies.
(1) In general.
(2) Remote contingencies.
(3) Incidental contingencies.
(4) Aggregation rule.
(5) Consistency rule.
(6) Subsequent adjustments.
(7) Effective date.
(i) [Reserved]
(j) Treatment of certain modifications.

*

*

*

*

*

§ 1.1275–4 Contingent Payment Debt
Instruments
(a) Applicability.
(1) In general.
(2) Exceptions.
(3) Insolvency and default.
(4) Convertible debt instruments.
(5) Remote and incidental contingencies.
(b) Noncontingent bond method.
(1) Applicability.
(2) In general.
(3) Description of method.
(4) Comparable yield and projected
payment schedule.
(5) Qualified stated interest.
(6) Adjustments.
(7) Adjusted issue price, adjusted basis,
and retirement.

*

*

*

*

*

*

(c) * * *
(1) Definition.

*

*

*

(5) Tax-exempt obligations.

*

*

*

*

*

§ 1.1275–6 Integration of Qualifying Debt
Instruments
(a) In general.
(b) Definitions.
(1) Qualifying debt instrument.
(2) Section 1.1275–6 hedge.
(3) Financial instrument.
(4) Synthetic debt instrument.
(c) Integrated transaction.
(1) Integration by taxpayer.
(2) Integration by Commissioner.
(d) Special rules for legging into and
legging out of an integrated transaction.
(1) Legging into.
(2) Legging out.
(e) Identification requirements.
(f) Taxation of integrated transactions.
(1) General rule.
(2) Issue date.
(3) Term.
(4) Issue price.
(5) Adjusted issue price.
(6) Qualified stated interest.
(7) Stated redemption price at maturity.
(8) Source of interest income and
allocation of expense.
(9) Effectively connected income.
(10) Not a short-term obligation.
(11) Special rules in the event of
integration by the Commissioner.
(12) Retention of separate transaction rules
for certain purposes.
(13) Coordination with consolidated return
rules.
(g) Predecessors and successors.
(h) Examples.
(i) [Reserved]
(j) Effective date.

Par. 9. Section 1.1272–1 is amended
by:
1. Revising paragraphs (b)(2)(ii), (c),
and (d).
2. Adding a sentence at the end of
paragraph (f)(2).
3. Removing the language
‘‘determining yield and maturity’’ from
the first sentence of paragraph (j)
Example 5 (iii) and adding the language
‘‘sections 1272 and 1273’’ in its place.
4. Removing the language
‘‘determining yield and maturity’’ from
the second sentence of paragraph (j)
Example 7 (v) and adding the language
‘‘sections 1272 and 1273’’ in its place.
The revisions and addition read as
follows:
§ 1.1272–1
income.

*

Current inclusion of OID in

*
*
*
*
(b) * * *
(2) * * *
(ii) A debt instrument that provides
for contingent payments, other than a
debt instrument described in paragraph
(c) or (d) of this section or except as
provided in § 1.1275–4; or
*
*
*
*
*
(c) Yield and maturity of certain debt
instruments subject to contingencies—
(1) Applicability. This paragraph (c)
provides rules to determine the yield
and maturity of certain debt instruments
that provide for an alternative payment
schedule (or schedules) applicable upon
the occurrence of a contingency (or
contingencies). This paragraph (c)
applies, however, only if the timing and
amounts of the payments that comprise
each payment schedule are known as of
the issue date and the debt instrument
is subject to paragraph (c) (2), (3), or (5)
of this section. A debt instrument does
not provide for an alternative payment
schedule merely because there is a
possibility of impairment of a payment
(or payments) by insolvency, default, or
similar circumstances. See § 1.1275–4
for the treatment of a debt instrument
that provides for a contingency that is
not described in this paragraph (c). See
§ 1.1273–1(c) to determine whether
stated interest on a debt instrument
subject to this paragraph (c) is qualified
stated interest.
(2) Payment schedule that is
significantly more likely than not to
occur. If, based on all the facts and
circumstances as of the issue date, a
single payment schedule for a debt
instrument, including the stated
payment schedule, is significantly more
likely than not to occur, the yield and
maturity of the debt instrument are
computed based on this payment
schedule.

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
(3) Mandatory sinking fund provision.
Notwithstanding paragraph (c)(2) of this
section, if a debt instrument is subject
to a mandatory sinking fund provision,
the provision is ignored for purposes of
computing the yield and maturity of the
debt instrument if the use and terms of
the provision meet reasonable
commercial standards. For purposes of
the preceding sentence, a mandatory
sinking fund provision is a provision
that meets the following requirements:
(i) The provision requires the issuer to
redeem a certain amount of debt
instruments in an issue prior to
maturity.
(ii) The debt instruments actually
redeemed are chosen by lot or
purchased by the issuer either in the
open market or pursuant to an offer
made to all holders (with any proration
determined by lot).
(iii) On the issue date, the specific
debt instruments that will be redeemed
on any date prior to maturity cannot be
identified.
(4) Consistency rule. [Reserved]
(5) Treatment of certain options.
Notwithstanding paragraphs (c) (2) and
(3) of this section, the rules of this
paragraph (c)(5) determine the yield and
maturity of a debt instrument that
provides the holder or issuer with an
unconditional option or options,
exercisable on one or more dates during
the term of the debt instrument, that, if
exercised, require payments to be made
on the debt instrument under an
alternative payment schedule or
schedules (e.g., an option to extend or
an option to call a debt instrument at a
fixed premium). Under this paragraph
(c)(5), an issuer is deemed to exercise or
not exercise an option or combination of
options in a manner that minimizes the
yield on the debt instrument, and a
holder is deemed to exercise or not
exercise an option or combination of
options in a manner that maximizes the
yield on the debt instrument. If both the
issuer and the holder have options, the
rules of this paragraph (c)(5) are applied
to the options in the order that they may
be exercised. See paragraph (j) Example
5 through Example 8 of this section.
(6) Subsequent adjustments. If a
contingency described in this paragraph
(c) (including the exercise of an option
described in paragraph (c)(5) of this
section) actually occurs or does not
occur, contrary to the assumption made
pursuant to this paragraph (c) (a change
in circumstances), then, solely for
purposes of sections 1272 and 1273, the
debt instrument is treated as retired and
then reissued on the date of the change
in circumstances for an amount equal to
its adjusted issue price on that date. See
paragraph (j) Example 5 and Example 7

of this section. If, however, the change
in circumstances results in a
substantially contemporaneous pro-rata
prepayment as defined in § 1.1275–
2(f)(2), the pro-rata prepayment is
treated as a payment in retirement of a
portion of the debt instrument, which
may result in gain or loss to the holder.
See paragraph (j) Example 6 and
Example 8 of this section.
(7) Effective date. This paragraph (c)
applies to debt instruments issued on or
after August 13, 1996.
(d) Certain debt instruments that
provide for a fixed yield. If a debt
instrument provides for one or more
contingent payments but all possible
payment schedules under the terms of
the instrument result in the same fixed
yield, the yield of the debt instrument
is the fixed yield. For example, the yield
of a debt instrument with principal
payments that are fixed in total amount
but that are uncertain as to time (such
as a demand loan) is the stated interest
rate if the issue price of the instrument
is equal to the stated principal amount
and interest is paid or compounded at
a fixed rate over the entire term of the
instrument. This paragraph (d) applies
to debt instruments issued on or after
August 13, 1996.
*
*
*
*
*
(f) * * *
(2) * * * For purposes of the
preceding sentence, the last possible
date that the debt instrument could be
outstanding is determined without
regard to § 1.1275–2(h) (relating to
payments subject to remote or
incidental contingencies).
*
*
*
*
*
Par. 10. Section 1.1273–1 is amended
by:
1. Removing the language ‘‘principal
payments uncertain as to time’’ in the
fourth sentence of paragraph (a) and
adding the language ‘‘a fixed yield’’ in
its place.
2. Revising paragraph (c)(1)(ii).
3. Revising paragraph (f) Example 4.
The revisions read as follows:
§ 1.1273–1

*

Definition of OID.

*
*
*
*
(c) * * * (1) * * *
(ii) Unconditionally payable. Interest
is unconditionally payable only if
reasonable legal remedies exist to
compel timely payment or the debt
instrument otherwise provides terms
and conditions that make the likelihood
of late payment (other than a late
payment that occurs within a reasonable
grace period) or nonpayment a remote
contingency (within the meaning of
§ 1.1275–2(h)). For purposes of the
preceding sentence, remedies or other

30141

terms and conditions are not taken into
account if the lending transaction does
not reflect arm’s length dealing and the
holder does not intend to enforce the
remedies or other terms and conditions.
For purposes of determining whether
interest is unconditionally payable, the
possibility of nonpayment due to
default, insolvency, or similar
circumstances, or due to the exercise of
a conversion option described in
§ 1.1272–1(e) is ignored. This paragraph
(c)(1)(ii) applies to debt instruments
issued on or after August 13, 1996.
*
*
*
*
*
(f) * * *
Example 4. Qualified stated interest on a
debt instrument that is subject to an option—
(i) Facts. On January 1, 1997, A issues, for
$100,000, a 10-year debt instrument that
provides for a $100,000 principal payment at
maturity and for annual interest payments of
$10,000. Under the terms of the debt
instrument, A has the option, exercisable on
January 1, 2002, to lower the annual interest
payments to $8,000. In addition, the debt
instrument gives the holder an unconditional
right to put the debt instrument back to A,
exercisable on January 1, 2002, in return for
$100,000.
(ii) Amount of qualified stated interest.
Under paragraph (c)(2) of this section, the
debt instrument provides for qualified stated
interest to the extent of the lowest fixed rate
at which qualified stated interest would be
payable under any payment schedule. If the
payment schedule determined by assuming
that the issuer’s option will be exercised and
the put option will not be exercised were
treated as the debt instrument’s sole payment
schedule, only $8,000 of each annual interest
payment would be qualified stated interest.
Under any other payment schedule, the debt
instrument would provide for annual
qualified stated interest payments of $10,000.
Accordingly, only $8,000 of each annual
interest payment is qualified stated interest.
Any excess of each annual interest payment
over $8,000 is included in the debt
instrument’s stated redemption price at
maturity.

*

*
*
*
*
Par. 11. Section 1.1274–2 is amended
by:
1. Removing the language ‘‘§ 1.1272–
1(c)(3)(ii)’’ from paragraph (e) and
adding the language ‘‘§ 1.1272–1(c)(3)’’
in its place.
2. Revising paragraph (g).
3. Adding and reserving paragraph (i)
and adding paragraph (j).
The revisions and additions read as
follows:
§ 1.1274–2 Issue price of debt instruments
to which section 1274 applies.

*

*
*
*
*
(g) Treatment of contingent payment
debt instruments. Notwithstanding
paragraph (b) of this section, if a debt
instrument subject to section 1274
provides for one or more contingent

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

payments, the issue price of the debt
instrument is the lesser of the
instrument’s noncontingent principal
payments and the sum of the present
values of the noncontingent payments
(as determined under paragraph (c) of
this section). However, if the debt
instrument is issued in a potentially
abusive situation, the issue price of the
debt instrument is the fair market value
of the noncontingent payments. For
additional rules relating to a debt
instrument that provides for one or
more contingent payments, see
§ 1.1275–4. This paragraph (g) applies to
debt instruments issued on or after
August 13, 1996.
*
*
*
*
*
(i) [Reserved]
(j) Special rules for tax-exempt
obligations—(1) Certain variable rate
debt instruments. Notwithstanding
paragraph (b) of this section, if a taxexempt obligation (as defined in section
1275(a)(3)) is a variable rate debt
instrument (within the meaning of
§ 1.1275–5) that pays interest at an
objective rate and is subject to section
1274, the issue price of the obligation is
the greater of the obligation’s fair market
value and its stated principal amount.
(2) Contingent payment debt
instruments. Notwithstanding
paragraphs (b) and (g) of this section, if
a tax-exempt obligation (as defined in
section 1275(a)(3)) is subject to section
1274 and § 1.1275–4, the issue price of
the obligation is the fair market value of
the obligation. However, in the case of
a tax-exempt obligation that is subject to
§ 1.1275–4(d)(2) (an obligation that
provides for interest-based or revenuebased payments), the issue price of the
obligation is the greater of the
obligation’s fair market value and its
stated principal amount.
(3) Effective date. This paragraph (j)
applies to debt instruments issued on or
after August 13, 1996.
Par. 12. Section 1.1275–2 is amended
by adding the text of paragraph (g), and
adding paragraph (h), adding and
reserving paragraph (i), and adding
paragraph (j) to read as follows:
§ 1.1275–2 Special rules relating to debt
instruments.

*

*
*
*
*
(g) Anti-abuse rule—(1) In general. If
a principal purpose in structuring a debt
instrument or engaging in a transaction
is to achieve a result that is
unreasonable in light of the purposes of
section 163(e), sections 1271 through
1275, or any related section of the Code,
the Commissioner can apply or depart
from the regulations under the
applicable sections as necessary or
appropriate to achieve a reasonable

result. For example, if this paragraph (g)
applies to a debt instrument that
provides for a contingent payment, the
Commissioner can treat the contingency
as if it were a separate position.
(2) Unreasonable result. Whether a
result is unreasonable is determined
based on all the facts and
circumstances. In making this
determination, a significant fact is
whether the treatment of the debt
instrument is expected to have a
substantial effect on the issuer’s or a
holder’s U.S. tax liability. In the case of
a contingent payment debt instrument,
another significant fact is whether the
result is obtainable without the
application of § 1.1275–4 and any
related provisions (e.g., if the debt
instrument and the contingency were
entered into separately). A result will
not be considered unreasonable,
however, in the absence of an expected
substantial effect on the present value of
a taxpayer’s tax liability.
(3) Examples. The following examples
illustrate the provisions of this
paragraph (g):
Example 1. A issues a current-pay,
increasing-rate note that provides for an early
call option. Although the option is deemed
exercised on the call date under § 1.1272–
1(c)(5), the option is not expected to be
exercised by A. In addition, a principal
purpose of including the option in the terms
of the note is to limit the amount of interest
income includible by the holder in the period
prior to the call date by virtue of the option
rules in § 1.1272–1(c)(5). Moreover, the
application of the option rules is expected to
substantially reduce the present value of the
holder’s tax liability. Based on these facts,
the application of § 1.1272–1(c)(5) produces
an unreasonable result. Therefore, under this
paragraph (g), the Commissioner can apply
the regulations (in whole or in part) to the
note without regard to § 1.1272–1(c)(5).
Example 2. C, a foreign corporation not
subject to U.S. taxation, issues to a U.S.
holder a debt instrument that provides for a
contingent payment. The debt instrument is
issued for cash and is subject to the
noncontingent bond method in § 1.1275–4(b).
Six months after issuance, C and the holder
modify the debt instrument so that there is
a deemed reissuance of the instrument under
section 1001. The new debt instrument is
subject to the rules of § 1.1275–4(c) rather
than § 1.1275–4(b). The application of
§ 1.1275–4(c) is expected to substantially
reduce the present value of the holder’s tax
liability as compared to the application of
§ 1.1275–4(b). In addition, a principal
purpose of the modification is to
substantially reduce the present value of the
holder’s tax liability through the application
of § 1.1275–4(c). Based on these facts, the
application of § 1.1275–4(c) produces an
unreasonable result. Therefore, under this
paragraph (g), the Commissioner can apply
the noncontingent bond method to the
modified debt instrument.

Example 3. D issues a convertible debt
instrument rather than an economically
equivalent investment unit consisting of a
debt instrument and a warrant. The
convertible debt instrument is issued at par
and provides for annual payments of interest.
D issues the convertible debt instrument
rather than the investment unit so that the
debt instrument would not have OID. See
§ 1.1273–2(j). In general, this is a reasonable
result in light of the purposes of the
applicable statutes. Therefore, the
Commissioner generally will not use the
authority under this paragraph (g) to depart
from the application of § 1.1273–2(j) in this
case.

(4) Effective date. This paragraph (g)
applies to debt instruments issued on or
after August 13, 1996.
(h) Remote and incidental
contingencies—(1) In general. This
paragraph (h) applies to a debt
instrument if one or more payments on
the instrument are subject to either a
remote or incidental contingency.
Whether a contingency is remote or
incidental is determined as of the issue
date of the debt instrument, including
any date there is a deemed reissuance of
the debt instrument under paragraph
(h)(6) (ii) or (j) of this section or
§ 1.1272–1(c)(6). Except as otherwise
provided, the treatment of the
contingency under this paragraph (h)
applies for all purposes of sections
163(e) (other than sections 163(e)(5))
and 1271 through 1275 and the
regulations thereunder. For purposes of
this paragraph (h), the possibility of
impairment of a payment by insolvency,
default, or similar circumstances is not
a contingency.
(2) Remote contingencies. A
contingency is remote if there is a
remote likelihood either that the
contingency will occur or that the
contingency will not occur. If there is a
remote likelihood that the contingency
will occur, it is assumed that the
contingency will not occur. If there is a
remote likelihood that the contingency
will not occur, it is assumed that the
contingency will occur.
(3) Incidental contingencies—(i)
Contingency relating to amount. A
contingency relating to the amount of a
payment is incidental if, under all
reasonably expected market conditions,
the potential amount of the payment is
insignificant relative to the total
expected amount of the remaining
payments on the debt instrument. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(i), the payment
is ignored until the payment is made.
However, see paragraph (h)(6)(i)(B) of
this section for the treatment of the debt
instrument if a change in circumstances

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
occurs prior to the date the payment is
made.
(ii) Contingency relating to time. A
contingency relating to the timing of a
payment is incidental if, under all
reasonably expected market conditions,
the potential difference in the timing of
the payment (from the earliest date to
the latest date) is insignificant. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(ii), the payment
is treated as made on the earliest date
that the payment could be made
pursuant to the contingency. If the
payment is not made on this date, a
taxpayer makes appropriate adjustments
to take into account the delay in
payment. However, see paragraph
(h)(6)(i)(C) of this section for the
treatment of the debt instrument if the
delay is not insignificant.
(4) Aggregation rule. For purposes of
paragraph (h)(2) of this section, if a debt
instrument provides for multiple
contingencies each of which has a
remote likelihood of occurring but,
when all of the contingencies are
considered together, there is a greater
than remote likelihood that at least one
of the contingencies will occur, none of
the contingencies is treated as a remote
contingency. For purposes of paragraph
(h)(3)(i) of this section, if a debt
instrument provides for multiple
contingencies each of which is
incidental but the potential total amount
of all of the payments subject to the
contingencies is not, under reasonably
expected market conditions,
insignificant relative to the total
expected amount of the remaining
payments on the debt instrument, none
of the contingencies is treated as
incidental.
(5) Consistency rule. For purposes of
paragraphs (h)(2) and (3) of this section,
the issuer’s determination that a
contingency is either remote or
incidental is binding on all holders.
However, the issuer’s determination is
not binding on a holder that explicitly
discloses that its determination is
different from the issuer’s
determination. Unless otherwise
prescribed by the Commissioner, the
disclosure must be made on a statement
attached to the holder’s timely filed
federal income tax return for the taxable
year that includes the acquisition date
of the debt instrument. See § 1.1275–
2(e) for rules relating to the issuer’s
obligation to disclose certain
information to holders.
(6) Subsequent adjustments—(i)
Applicability. This paragraph (h)(6)
applies to a debt instrument when there
is a change in circumstances. For

purposes of the preceding sentence,
there is a change in circumstances if—
(A) A remote contingency actually
occurs or does not occur, contrary to the
assumption made in paragraph (h)(2) of
this section;
(B) A payment subject to an incidental
contingency described in paragraph
(h)(3)(i) of this section becomes fixed in
an amount that is not insignificant
relative to the total expected amount of
the remaining payments on the debt
instrument; or
(C) A payment subject to an incidental
contingency described in paragraph
(h)(3)(ii) of this section becomes fixed
such that the difference between the
assumed payment date and the due date
of the payment is not insignificant.
(ii) In general. If a change in
circumstances occurs, solely for
purposes of sections 1272 and 1273, the
debt instrument is treated as retired and
then reissued on the date of the change
in circumstances for an amount equal to
the instrument’s adjusted issue price on
that date.
(iii) Contingent payment debt
instruments. Notwithstanding paragraph
(h)(6)(ii) of this section, in the case of a
contingent payment debt instrument
subject to § 1.1275–4, if a change in
circumstances occurs, no retirement or
reissuance is treated as occurring, but
any payment that is fixed as a result of
the change in circumstances is governed
by the rules in § 1.1275–4 that apply
when the amount of a contingent
payment becomes fixed.
(7) Effective date. This paragraph (h)
applies to debt instruments issued on or
after August 13, 1996.
(i) [Reserved]
(j) Treatment of certain modifications.
If the terms of a debt instrument are
modified to defer one or more
payments, and the modification does
not cause an exchange under section
1001, then, solely for purposes of
sections 1272 and 1273, the debt
instrument is treated as retired and then
reissued on the date of the modification
for an amount equal to the instrument’s
adjusted issue price on that date. This
paragraph (j) applies to debt instruments
issued on or after August 13, 1996.
§ 1.1275–2T

[Removed]

Par. 13. Section 1.1275–2T is
removed effective August 13, 1996.
Par. 14. In § 1.1275–3, paragraph
(b)(1)(i) is revised to read as follows:
§ 1.1275–3 OID information reporting
requirements.

*

*
*
*
*
(b) * * * (1) * * *
(i) Set forth on the face of the debt
instrument the issue price, the amount

30143

of OID, the issue date, the yield to
maturity, and, in the case of a debt
instrument subject to the rules of
§ 1.1275–4(b), the comparable yield and
projected payment schedule; or
*
*
*
*
*
Par. 15. Section 1.1275–4 is added to
read as follows:
§ 1.1275–4 Contingent payment debt
instruments.

(a) Applicability—(1) In general.
Except as provided in paragraph (a)(2)
of this section, this section applies to
any debt instrument that provides for
one or more contingent payments. In
general, paragraph (b) of this section
applies to a contingent payment debt
instrument that is issued for money or
publicly traded property and paragraph
(c) of this section applies to a contingent
payment debt instrument that is issued
for nonpublicly traded property.
Paragraph (d) of this section provides
special rules for tax-exempt obligations.
See § 1.1275–6 for a taxpayer’s
treatment of a contingent payment debt
instrument and a hedge.
(2) Exceptions. This section does not
apply to—
(i) A debt instrument that has an issue
price determined under section
1273(b)(4) (e.g., a debt instrument
subject to section 483);
(ii) A variable rate debt instrument (as
defined in § 1.1275–5);
(iii) A debt instrument subject to
§ 1.1272–1(c) (a debt instrument that
provides for certain contingencies) or
§ 1.1272–1(d) (a debt instrument that
provides for a fixed yield);
(iv) A debt instrument subject to
section 988 (except as provided in
section 988 and the regulations
thereunder);
(v) A debt instrument to which
section 1272(a)(6) applies (certain
interests in or mortgages held by a
REMIC, and certain other debt
instruments with payments subject to
acceleration);
(vi) A debt instrument (other than a
tax-exempt obligation) described in
section 1272(a)(2) (e.g., U.S. savings
bonds, certain loans between natural
persons, and short-term taxable
obligations); or
(vii) A debt instrument issued
pursuant to a plan or arrangement if—
(A) The plan or arrangement is
created by a state statute;
(B) A primary objective of the plan or
arrangement is to enable the
participants to pay for the costs of postsecondary education for themselves or
their designated beneficiaries; and
(C) Contingent payments on the debt
instrument are related to such objective.

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(3) Insolvency and default. A payment
is not contingent merely because of the
possibility of impairment by insolvency,
default, or similar circumstances.
(4) Convertible debt instruments. A
debt instrument does not provide for
contingent payments merely because it
provides for an option to convert the
debt instrument into the stock of the
issuer, into the stock or debt of a related
party (within the meaning of section
267(b) or 707(b)(1)), or into cash or other
property in an amount equal to the
approximate value of such stock or debt.
(5) Remote and incidental
contingencies. A payment is not a
contingent payment merely because of a
contingency that, as of the issue date, is
either remote or incidental. See
§ 1.1275–2(h) for the treatment of
remote and incidental contingencies.
(b) Noncontingent bond method—(1)
Applicability. The noncontingent bond
method described in this paragraph (b)
applies to a contingent payment debt
instrument that has an issue price
determined under § 1.1273–2 (e.g., a
contingent payment debt instrument
that is issued for money or publicly
traded property).
(2) In general. Under the
noncontingent bond method, interest on
a debt instrument must be taken into
account whether or not the amount of
any payment is fixed or determinable in
the taxable year. The amount of interest
that is taken into account for each
accrual period is determined by
constructing a projected payment
schedule for the debt instrument and
applying rules similar to those for
accruing OID on a noncontingent debt
instrument. If the actual amount of a
contingent payment is not equal to the
projected amount, appropriate
adjustments are made to reflect the
difference.
(3) Description of method. The
following steps describe how to
compute the amount of income,
deductions, gain, and loss under the
noncontingent bond method:
(i) Step one: Determine the
comparable yield. Determine the
comparable yield for the debt
instrument under the rules of paragraph
(b)(4) of this section. The comparable
yield is determined as of the debt
instrument’s issue date.
(ii) Step two: Determine the projected
payment schedule. Determine the
projected payment schedule for the debt
instrument under the rules of paragraph
(b)(4) of this section. The projected
payment schedule is determined as of
the issue date and remains fixed
throughout the term of the debt
instrument (except under paragraph
(b)(9)(ii) of this section, which applies

to a payment that is fixed more than 6
months before it is due).
(iii) Step three: Determine the daily
portions of interest. Determine the daily
portions of interest on the debt
instrument for a taxable year as follows.
The amount of interest that accrues in
each accrual period is the product of the
comparable yield of the debt instrument
(properly adjusted for the length of the
accrual period) and the debt
instrument’s adjusted issue price at the
beginning of the accrual period. See
paragraph (b)(7)(ii) of this section to
determine the adjusted issue price of the
debt instrument. The daily portions of
interest are determined by allocating to
each day in the accrual period the
ratable portion of the interest that
accrues in the accrual period. Except as
modified by paragraph (b)(3)(iv) of this
section, the daily portions of interest are
includible in income by a holder for
each day in the holder’s taxable year on
which the holder held the debt
instrument and are deductible by the
issuer for each day during the issuer’s
taxable year on which the issuer was
primarily liable on the debt instrument.
(iv) Step four: Adjust the amount of
income or deductions for differences
between projected and actual contingent
payments. Make appropriate
adjustments to the amount of income or
deductions attributable to the debt
instrument in a taxable year for any
differences between projected and
actual contingent payments. See
paragraph (b)(6) of this section to
determine the amount of an adjustment
and the treatment of the adjustment.
(4) Comparable yield and projected
payment schedule. This paragraph (b)(4)
provides rules for determining the
comparable yield and projected
payment schedule for a debt instrument.
The comparable yield and projected
payment schedule must be supported by
contemporaneous documentation
showing that both are reasonable, are
based on reliable, complete, and
accurate data, and are made in good
faith.
(i) Comparable yield—(A) In general.
Except as provided in paragraph
(b)(4)(i)(B) of this section, the
comparable yield for a debt instrument
is the yield at which the issuer would
issue a fixed rate debt instrument with
terms and conditions similar to those of
the contingent payment debt instrument
(the comparable fixed rate debt
instrument), including the level of
subordination, term, timing of
payments, and general market
conditions. For example, if a § 1.1275–
6 hedge (or the substantial equivalent) is
available, the comparable yield is the
yield on the synthetic fixed rate debt

instrument that would result if the
issuer entered into the § 1.1275–6
hedge. If a § 1.1275–6 hedge (or the
substantial equivalent) is not available,
but similar fixed rate debt instruments
of the issuer trade at a price that reflects
a spread above a benchmark rate, the
comparable yield is the sum of the value
of the benchmark rate on the issue date
and the spread. In determining the
comparable yield, no adjustments are
made for the riskiness of the
contingencies or the liquidity of the
debt instrument. The comparable yield
must be a reasonable yield for the issuer
and must not be less than the applicable
Federal rate (based on the overall
maturity of the debt instrument).
(B) Presumption for certain debt
instruments. This paragraph (b)(4)(i)(B)
applies to a debt instrument if the
instrument provides for one or more
contingent payments not based on
market information and the instrument
is part of an issue that is marketed or
sold in substantial part to persons for
whom the inclusion of interest under
this paragraph (b) is not expected to
have a substantial effect on their U.S.
tax liability. If this paragraph (b)(4)(i)(B)
applies to a debt instrument, the
instrument’s comparable yield is
presumed to be the applicable Federal
rate (based on the overall maturity of the
debt instrument). A taxpayer may
overcome this presumption only with
clear and convincing evidence that the
comparable yield for the debt
instrument should be a specific yield
(determined using the principles in
paragraph (b)(4)(i)(A) of this section)
that is higher than the applicable
Federal rate. The presumption may not
be overcome with appraisals or other
valuations of nonpublicly traded
property. Evidence used to overcome
the presumption must be specific to the
issuer and must not be based on
comparable issuers or general market
conditions.
(ii) Projected payment schedule. The
projected payment schedule for a debt
instrument includes each noncontingent
payment and an amount for each
contingent payment determined as
follows:
(A) Market-based payments. If a
contingent payment is based on market
information (a market-based payment),
the amount of the projected payment is
the forward price of the contingent
payment. The forward price of a
contingent payment is the amount one
party would agree, as of the issue date,
to pay an unrelated party for the right
to the contingent payment on the
settlement date (e.g., the date the
contingent payment is made). For
example, if the right to a contingent

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
payment is substantially similar to an
exchange-traded option, the forward
price is the spot price of the option (the
option premium) compounded at the
applicable Federal rate from the issue
date to the date the contingent payment
is due.
(B) Other payments. If a contingent
payment is not based on market
information (a non-market-based
payment), the amount of the projected
payment is the expected value of the
contingent payment as of the issue date.
(C) Adjustments to the projected
payment schedule. The projected
payment schedule must produce the
comparable yield. If the projected
payment schedule does not produce the
comparable yield, the schedule must be
adjusted consistent with the principles
of this paragraph (b)(4) to produce the
comparable yield. For example, the
adjusted amounts of non-market-based
payments must reasonably reflect the
relative expected values of the payments
and must not be set to accelerate or
defer income or deductions. If the debt
instrument contains both market-based
and non-market-based payments,
adjustments are generally made first to
the non-market-based payments because
more objective information is available
for the market-based payments.
(iii) Market information. For purposes
of this paragraph (b), market
information is any information on
which an objective rate can be based
under § 1.1275–5(c)(1) or (2).
(iv) Issuer/holder consistency. The
issuer’s projected payment schedule is
used to determine the holder’s interest
accruals and adjustments. The issuer
must provide the projected payment
schedule to the holder in a manner
consistent with the issuer disclosure
rules of § 1.1275–2(e). If the issuer does
not create a projected payment schedule
for a debt instrument or the issuer’s
projected payment schedule is
unreasonable, the holder of the debt
instrument must determine the
comparable yield and projected
payment schedule for the debt
instrument under the rules of this
paragraph (b)(4). A holder that
determines its own projected payment
schedule must explicitly disclose this
fact and the reason why the holder set
its own schedule (e.g., why the issuer’s
projected payment schedule is
unreasonable). Unless otherwise
prescribed by the Commissioner, the
disclosure must be made on a statement
attached to the holder’s timely filed
federal income tax return for the taxable
year that includes the acquisition date
of the debt instrument.
(v) Issuer’s determination respected—
(A) In general. If the issuer maintains

the contemporaneous documentation
required by this paragraph (b)(4), the
issuer’s determination of the
comparable yield and projected
payment schedule will be respected
unless either is unreasonable.
(B) Unreasonable determination. For
purposes of paragraph (b)(4)(v)(A) of
this section, a comparable yield or
projected payment schedule generally
will be considered unreasonable if it is
set with a purpose to overstate,
understate, accelerate, or defer interest
accruals on the debt instrument. In a
determination of whether a comparable
yield or projected payment schedule is
unreasonable, consideration will be
given to whether the treatment of the
debt instrument under this section is
expected to have a substantial effect on
the issuer’s or holder’s U.S. tax liability.
For example, if a taxable issuer markets
a debt instrument to a holder not subject
to U.S. taxation, the comparable yield
will be given close scrutiny and will not
be respected unless contemporaneous
documentation shows that the yield is
not too high.
(C) Exception. Paragraph (b)(4)(v)(A)
of this section does not apply to a debt
instrument subject to paragraph
(b)(4)(i)(B) of this section (concerning a
yield presumption for certain debt
instruments that provide for nonmarket-based payments).
(vi) Examples. The following
examples illustrate the provisions of
this paragraph (b)(4). In each example,
assume that the instrument described is
a debt instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Market-based payment—(i)
Facts. On December 31, 1996, X corporation
issues for $1,000,000 a debt instrument that
matures on December 31, 2006. The debt
instrument provides for annual payments of
interest, beginning in 1997, at the rate of 6
percent and for a payment at maturity equal
to $1,000,000 plus the excess, if any, of the
price of 10,000 shares of publicly traded
stock in an unrelated corporation on the
maturity date over $350,000, or less the
excess, if any, of $350,000 over the price of
10,000 shares of the stock on the maturity
date. On the issue date, the forward price to
purchase 10,000 shares of the stock on
December 31, 2006, is $350,000.
(ii) Comparable yield. Under paragraph
(b)(4)(i) of this section, the debt instrument’s
comparable yield is the yield on the synthetic
debt instrument that would result if X
corporation entered into a § 1.1275–6 hedge.
A § 1.1275–6 hedge in this case is a forward
contract to purchase 10,000 shares of the
stock on December 31, 2006. If X corporation
entered into this hedge, the resulting
synthetic debt instrument would yield 6
percent, compounded annually. Thus, the

30145

comparable yield on the debt instrument is
6 percent, compounded annually.
(iii) Projected payment schedule. Under
paragraph (b)(4)(ii) of this section, the
projected payment schedule for the debt
instrument consists of 10 annual payments of
$60,000 and a projected amount for the
contingent payment at maturity. Because the
right to the contingent payment is based on
market information, the projected amount of
the contingent payment is the forward price
of the payment. The right to the contingent
payment is substantially similar to a right to
a payment of $1,000,000 combined with a
cash-settled forward contract for the
purchase of 10,000 shares of the stock for
$350,000 on December 31, 2006. Because the
forward price to purchase 10,000 shares of
the stock on December 31, 2006, is $350,000,
the amount to be received or paid under the
forward contract is projected to be zero. As
a result, the projected amount of the
contingent payment at maturity is
$1,000,000, consisting of the $1,000,000 base
amount and no additional amount to be
received or paid under the forward contract.
(A) Assume, alternatively, that on the issue
date the forward price to purchase 10,000
shares of the stock on December 31, 2006, is
$370,000. If X corporation entered into a
§ 1.1275–6 hedge (a forward contract to
purchase the shares for $370,000), the
resulting synthetic debt instrument would
yield 6.15 percent, compounded annually.
Thus, the comparable yield on the debt
instrument is 6.15 percent, compounded
annually. The projected payment schedule
for the debt instrument consists of 10 annual
payments of $60,000 and a projected amount
for the contingent payment at maturity. The
projected amount of the contingent payment
is $1,020,000, consisting of the $1,000,000
base amount plus the excess $20,000 of the
forward price of the stock over the purchase
price of the stock under the forward contract.
(B) Assume, alternatively, that on the issue
date the forward price to purchase 10,000
shares of the stock on December 31, 2006, is
$330,000. If X corporation entered into a
§ 1.1275–6 hedge, the resulting synthetic debt
instrument would yield 5.85 percent,
compounded annually. Thus, the comparable
yield on the debt instrument is 5.85 percent,
compounded annually. The projected
payment schedule for the debt instrument
consists of 10 annual payments of $60,000
and a projected amount for the contingent
payment at maturity. The projected amount
of the contingent payment is $980,000,
consisting of the $1,000,000 base amount
minus the excess $20,000 of the purchase
price of the stock under the forward contract
over the forward price of the stock.
Example 2. Non-market-based payments—
(i) Facts. On December 31, 1996, Y issues to
Z for $1,000,000 a debt instrument that
matures on December 31, 2000. The debt
instrument has a stated principal amount of
$1,000,000, payable at maturity, and provides
for payments on December 31 of each year,
beginning in 1997, of $20,000 plus 1 percent
of Y’s gross receipts, if any, for the year. On
the issue date, Y has outstanding fixed rate
debt instruments with maturities of 2 to 10
years that trade at a price that reflects an
average of 100 basis points over Treasury

30146

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

bonds. These debt instruments have terms
and conditions similar to those of the debt
instrument. Assume that on December 31,
1996, 4-year Treasury bonds have a yield of
6.5 percent, compounded annually, and that
no § 1.1275–6 hedge is available for the debt
instrument. In addition, assume that the
interest inclusions attributable to the debt
instrument are expected to have a substantial
effect on Z’s U.S. tax liability.
(ii) Comparable yield. The comparable
yield for the debt instrument is equal to the
value of the benchmark rate (i.e., the yield on
4-year Treasury bonds) on the issue date plus
the spread. Thus, the debt instrument’s
comparable yield is 7.5 percent, compounded
annually.
(iii) Projected payment schedule. Y
anticipates that it will have no gross receipts
in 1997, but that it will have gross receipts
in later years, and those gross receipts will
grow each year for the next three years. Based
on its business projections, Y believes that it
is not unreasonable to expect that its gross
receipts in 1999 and each year thereafter will
grow by between 6 percent and 13 percent
over the prior year. Thus, Y must take these
expectations into account in establishing a
projected payment schedule for the debt
instrument that results in a yield of 7.5
percent, compounded annually. Accordingly,
Y could reasonably set the following
projected payment schedule for the debt
instrument:

which total positive adjustments on a
debt instrument in a taxable year exceed
the total negative adjustments on the
debt instrument in the taxable year is a
net positive adjustment. A net positive
adjustment is treated as additional
interest for the taxable year.
(iii) Treatment of net negative
adjustments. The amount, if any, by
which total negative adjustments on a
debt instrument in a taxable year exceed
the total positive adjustments on the
debt instrument in the taxable year is a
net negative adjustment. A taxpayer’s
net negative adjustment on a debt
instrument for a taxable year is treated
as follows:
(A) Reduction of interest accruals. A
net negative adjustment first reduces
interest for the taxable year that the
taxpayer would otherwise account for
on the debt instrument under paragraph
(b)(3)(iii) of this section.
(B) Ordinary income or loss. If the net
negative adjustment exceeds the interest
for the taxable year that the taxpayer
would otherwise account for on the debt
instrument under paragraph (b)(3)(iii) of
this section, the excess is treated as
ordinary loss by a holder and ordinary
income by an issuer. However, the
amount treated as ordinary loss by a
holder is limited to the amount by
NoncontinContinDate
gent paygent pay- which the holder’s total interest
ment
ment
inclusions on the debt instrument
12/31/1997 ............
$20,000
0 exceed the total amount of the holder’s
12/31/1998 ............
20,000
70,000 net negative adjustments treated as
12/31/1999 ............
20,000
75,600 ordinary loss on the debt instrument in
12/31/2000 ............
1,020,000
83,850 prior taxable years. The amount treated
as ordinary income by an issuer is
limited to the amount by which the
(5) Qualified stated interest. No
issuer’s total interest deductions on the
amounts payable on a debt instrument
debt instrument exceed the total amount
to which this paragraph (b) applies are
of the issuer’s net negative adjustments
qualified stated interest within the
treated as ordinary income on the debt
meaning of § 1.1273–1(c).
(6) Adjustments. This paragraph (b)(6) instrument in prior taxable years.
(C) Carryforward. If the net negative
provides rules for the treatment of
positive and negative adjustments under adjustment exceeds the sum of the
amounts treated by the taxpayer as a
the noncontingent bond method. A
reduction of interest and as ordinary
taxpayer takes into account only those
income or loss (as the case may be) on
adjustments that occur during a taxable
the debt instrument for the taxable year,
year while the debt instrument is held
the excess is a negative adjustment
by the taxpayer or while the taxpayer is
primarily liable on the debt instrument. carryforward for the taxable year. In
general, a taxpayer treats a negative
(i) Determination of positive and
adjustment carryforward for a taxable
negative adjustments. If the amount of
year as a negative adjustment on the
a contingent payment is more than the
debt instrument on the first day of the
projected amount of the contingent
succeeding taxable year. However, if a
payment, the difference is a positive
holder of a debt instrument has a
adjustment on the date of the payment.
negative adjustment carryforward on the
If the amount of a contingent payment
debt instrument in a taxable year in
is less than the projected amount of the
which the debt instrument is sold,
contingent payment, the difference is a
exchanged, or retired, the negative
negative adjustment on the date of the
adjustment carryforward reduces the
payment (or on the scheduled date of
holder’s amount realized on the sale,
the payment if the amount of the
exchange, or retirement. If an issuer of
payment is zero).
(ii) Treatment of net positive
a debt instrument has a negative
adjustments. The amount, if any, by
adjustment carryforward on the debt

instrument for a taxable year in which
the debt instrument is retired, the issuer
takes the negative adjustment
carryforward into account as ordinary
income.
(D) Treatment under section 67. A net
negative adjustment is not subject to
section 67 (the 2-percent floor on
miscellaneous itemized deductions).
(iv) Cross-references. If a holder has a
basis in a debt instrument that is
different from the debt instrument’s
adjusted issue price, the holder may
have additional positive or negative
adjustments under paragraph (b)(9)(i) of
this section. If the amount of a
contingent payment is fixed more than
6 months before the date it is due, the
amount and timing of the adjustment
are determined under paragraph
(b)(9)(ii) of this section.
(7) Adjusted issue price, adjusted
basis, and retirement—(i) In general. If
a debt instrument is subject to the
noncontingent bond method, this
paragraph (b)(7) provides rules to
determine the adjusted issue price of the
debt instrument, the holder’s basis in
the debt instrument, and the treatment
of any scheduled or unscheduled
retirements. In general, because any
difference between the actual amount of
a contingent payment and the projected
amount of the payment is taken into
account as an adjustment to income or
deduction, the projected payments are
treated as the actual payments for
purposes of making adjustments to issue
price and basis and determining the
amount of any contingent payment
made on a scheduled retirement.
(ii) Definition of adjusted issue price.
The adjusted issue price of a debt
instrument is equal to the debt
instrument’s issue price, increased by
the interest previously accrued on the
debt instrument under paragraph
(b)(3)(iii) of this section (determined
without regard to any adjustments taken
into account under paragraph (b)(3)(iv)
of this section), and decreased by the
amount of any noncontingent payment
and the projected amount of any
contingent payment previously made on
the debt instrument. See paragraph
(b)(9)(ii) of this section for special rules
that apply when a contingent payment
is fixed more than 6 months before it is
due.
(iii) Adjustments to basis. A holder’s
basis in a debt instrument is increased
by the interest previously accrued by
the holder on the debt instrument under
paragraph (b)(3)(iii) of this section
(determined without regard to any
adjustments taken into account under
paragraph (b)(3)(iv) of this section), and
decreased by the amount of any
noncontingent payment and the

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
projected amount of any contingent
payment previously made on the debt
instrument to the holder. See paragraph
(b)(9)(i) of this section for special rules
that apply when basis is different from
adjusted issue price and paragraph
(b)(9)(ii) of this section for special rules
that apply when a contingent payment
is fixed more than 6 months before it is
due.
(iv) Scheduled retirements. For
purposes of determining the amount
realized by a holder and the repurchase
price paid by the issuer on the
scheduled retirement of a debt
instrument, a holder is treated as
receiving, and the issuer is treated as
paying, the projected amount of any
contingent payment due at maturity. If
the amount paid or received is different
from the projected amount, see
paragraph (b)(6) of this section for the
treatment of the difference by the
taxpayer. Under paragraph (b)(6)(iii)(C)
of this section, the amount realized by
a holder on the retirement of a debt
instrument is reduced by any negative
adjustment carryforward determined in
the taxable year of the retirement.
(v) Unscheduled retirements. An
unscheduled retirement of a debt
instrument (or the receipt of a pro-rata
prepayment that is treated as a
retirement of a portion of a debt
instrument under § 1.1275–2(f)) is
treated as a repurchase of the debt
instrument (or a pro-rata portion of the
debt instrument) by the issuer from the
holder for the amount paid by the issuer
to the holder.
(vi) Examples. The following
examples illustrate the provisions of
paragraphs (b) (6) and (7) of this section.
In each example, assume that the
instrument described is a debt
instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Treatment of positive and
negative adjustments—(i) Facts. On
December 31, 1996, Z, a calendar year
taxpayer, purchases a debt instrument subject
to this paragraph (b) at original issue for
$1,000. The debt instrument’s comparable
yield is 10 percent, compounded annually,
and the projected payment schedule provides
for payments of $500 on December 31, 1997
(consisting of a noncontingent payment of
$375 and a projected amount of $125) and
$660 on December 31, 1998 (consisting of a
noncontingent payment of $600 and a
projected amount of $60). The debt
instrument is a capital asset in the hands of
Z.
(ii) Adjustment in 1997. Based on the
projected payment schedule, Z’s total daily
portions of interest on the debt instrument
are $100 for 1997 (issue price of $1,000 x 10

percent). Assume that the payment actually
made on December 31, 1997, is $375, rather
than the projected $500. Under paragraph
(b)(6)(i) of this section, Z has a negative
adjustment of $125 on December 31, 1997,
attributable to the difference between the
amount of the actual payment and the
amount of the projected payment. Because Z
has no positive adjustments for 1997, Z has
a net negative adjustment of $125 on the debt
instrument for 1997. This net negative
adjustment reduces to zero the $100 total
daily portions of interest Z would otherwise
include in income in 1997. Accordingly, Z
has no interest income on the debt
instrument for 1997. Because Z had no
interest inclusions on the debt instrument for
prior taxable years, the remaining $25 of the
net negative adjustment is a negative
adjustment carryforward for 1997 that results
in a negative adjustment of $25 on January
1, 1998.
(iii) Adjustment to issue price and basis.
Z’s total daily portions of interest on the debt
instrument are $100 for 1997. The adjusted
issue price of the debt instrument and Z’s
adjusted basis in the debt instrument are
increased by this amount, despite the fact
that Z does not include this amount in
income because of the net negative
adjustment for 1997. In addition, the adjusted
issue price of the debt instrument and Z’s
adjusted basis in the debt instrument are
decreased on December 31, 1997, by the
projected amount of the payment on that date
($500). Thus, on January 1, 1998, Z’s adjusted
basis in the debt instrument and the adjusted
issue price of the debt instrument are $600.
(iv) Adjustments in 1998. Based on the
projected payment schedule, Z’s total daily
portions of interest are $60 for 1998 (adjusted
issue price of $600 x 10 percent). Assume
that the payment actually made on December
31, 1998, is $700, rather than the projected
$660. Under paragraph (b)(6)(i) of this
section, Z has a positive adjustment of $40
on December 31, 1998, attributable to the
difference between the amount of the actual
payment and the amount of the projected
payment. Because Z also has a negative
adjustment of $25 on January 1, 1998, Z has
a net positive adjustment of $15 on the debt
instrument for 1998 (the excess of the $40
positive adjustment over the $25 negative
adjustment). As a result, Z has $75 of interest
income on the debt instrument for 1998 (the
$15 net positive adjustment plus the $60 total
daily portions of interest that are taken into
account by Z in that year).
(v) Retirement. Based on the projected
payment schedule, Z’s adjusted basis in the
debt instrument immediately before the
payment at maturity is $660 ($600 plus $60
total daily portions of interest for 1998). Even
though Z receives $700 at maturity, for
purposes of determining the amount realized
by Z on retirement of the debt instrument, Z
is treated as receiving the projected amount
of the contingent payment on December 31,
1998. Therefore, Z is treated as receiving
$660 on December 31, 1998. Because Z’s
adjusted basis in the debt instrument
immediately before its retirement is $660, Z
recognizes no gain or loss on the retirement.
Example 2. Negative adjustment
carryforward for year of sale—(i) Facts.

30147

Assume the same facts as in Example 1 of
this paragraph (b)(7)(vi), except that Z sells
the debt instrument on January 1, 1998, for
$630.
(ii) Gain on sale. On the date the debt
instrument is sold, Z’s adjusted basis in the
debt instrument is $600. Because Z has a
negative adjustment of $25 on the debt
instrument on January 1, 1998, and has no
positive adjustments on the debt instrument
in 1998, Z has a net negative adjustment for
1998 of $25. Because Z has not included in
income any interest on the debt instrument,
the entire $25 net negative adjustment is a
negative adjustment carryforward for the
taxable year of the sale. Under paragraph
(b)(6)(iii)(C) of this section, the $25 negative
adjustment carryforward reduces the amount
realized by Z on the sale of the debt
instrument from $630 to $605. Thus, Z has
a gain on the sale of $5 ($605¥$600). Under
paragraph (b)(8)(i) of this section, the gain is
treated as interest income.
Example 3. Negative adjustment
carryforward for year of retirement—(i) Facts.
Assume the same facts as in Example 1 of
this paragraph (b)(7)(vi), except that the
payment actually made on December 31,
1998, is $615, rather than the projected $660.
(ii) Adjustments in 1998. Under paragraph
(b)(6)(i) of this section, Z has a negative
adjustment of $45 on December 31, 1998,
attributable to the difference between the
amount of the actual payment and the
amount of the projected payment. In
addition, Z has a negative adjustment of $25
on January 1, 1998. See Example 1(ii) of this
paragraph (b)(7)(vi). Because Z has no
positive adjustments in 1998, Z has a net
negative adjustment of $70 for 1998. This net
negative adjustment reduces to zero the $60
total daily portions of interest Z would
otherwise include in income for 1998.
Therefore, Z has no interest income on the
debt instrument for 1998. Because Z had no
interest inclusions on the debt instrument for
1997, the remaining $10 of the net negative
adjustment is a negative adjustment
carryforward for 1998 that reduces the
amount realized by Z on retirement of the
debt instrument.
(iii) Loss on retirement. Immediately before
the payment at maturity, Z’s adjusted basis
in the debt instrument is $660. Under
paragraph (b)(7)(iv) of this section, Z is
treated as receiving the projected amount of
the contingent payment, or $660, as the
payment at maturity. Under paragraph
(b)(6)(iii)(C) of this section, however, this
amount is reduced by any negative
adjustment carryforward determined for the
taxable year of retirement to calculate the
amount Z realizes on retirement of the debt
instrument. Thus, Z has a loss of $10 on the
retirement of the debt instrument, equal to
the amount by which Z’s adjusted basis in
the debt instrument ($660) exceeds the
amount Z realizes on the retirement of the
debt instrument ($660 minus the $10
negative adjustment carryforward). Under
paragraph (b)(8)(ii) of this section, the loss is
a capital loss.

(8) Character on sale, exchange, or
retirement—(i) Gain. Any gain
recognized by a holder on the sale,

30148

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

exchange, or retirement of a debt
instrument subject to this paragraph (b)
is interest income.
(ii) Loss. Any loss recognized by a
holder on the sale, exchange, or
retirement of a debt instrument subject
to this paragraph (b) is ordinary loss to
the extent that the holder’s total interest
inclusions on the debt instrument
exceed the total net negative
adjustments on the debt instrument the
holder took into account as ordinary
loss. Any additional loss is treated as
loss from the sale, exchange, or
retirement of the debt instrument.
However, any loss that would otherwise
be ordinary under this paragraph
(b)(8)(ii) and that is attributable to the
holder’s basis that could not be
amortized under section 171(b)(4) is loss
from the sale, exchange, or retirement of
the debt instrument.
(iii) Special rule if there are no
remaining contingent payments on the
debt instrument—(A) In general.
Notwithstanding paragraphs (b)(8) (i)
and (ii) of this section, if, at the time of
the sale, exchange, or retirement of the
debt instrument, there are no remaining
contingent payments due on the debt
instrument under the projected payment
schedule, any gain or loss recognized by
the holder is gain or loss from the sale,
exchange, or retirement of the debt
instrument. See paragraph (b)(9)(ii) of
this section to determine whether there
are no remaining contingent payments
on a debt instrument that provides for
fixed but deferred contingent payments.
(B) Exception for certain positive
adjustments. Notwithstanding
paragraph (b)(8)(iii)(A) of this section, if
a positive adjustment on a debt
instrument is spread under paragraph
(b)(9)(ii) (F) or (G) of this section, any
gain recognized by the holder on the
sale, exchange, or retirement of the
instrument is treated as interest income
to the extent of the positive adjustment
that has not yet been accrued and
included in income by the holder.
(iv) Examples. The following
examples illustrate the provisions of
this paragraph (b)(8). In each example,
assume that the instrument described is
a debt instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Gain on sale—(i) Facts. On
January 1, 1998, D, a calendar year taxpayer,
sells a debt instrument that is subject to
paragraph (b) of this section for $1,350. The
projected payment schedule for the debt
instrument provides for contingent payments
after January 1, 1998. On January 1, 1998, D
has an adjusted basis in the debt instrument
of $1,200. In addition, D has a negative

adjustment carryforward of $50 for 1997 that,
under paragraph (b)(6)(iii)(C) of this section,
results in a negative adjustment of $50 on
January 1, 1998. D has no positive
adjustments on the debt instrument on
January 1, 1998.
(ii) Character of gain. Under paragraph
(b)(6) of this section, the $50 negative
adjustment on January 1, 1998, results in a
negative adjustment carryforward for 1998,
the taxable year of the sale of the debt
instrument. Under paragraph (b)(6)(iii)(C) of
this section, the negative adjustment
carryforward reduces the amount realized by
D on the sale of the debt instrument from
$1,350 to $1,300. As a result, D realizes a
$100 gain on the sale of the debt instrument,
equal to the $1,300 amount realized minus
D’s $1,200 adjusted basis in the debt
instrument. Under paragraph (b)(8)(i) of this
section, the gain is interest income to D.
Example 2. Loss on sale—(i) Facts. On
December 31, 1996, E, a calendar year
taxpayer, purchases a debt instrument at
original issue for $1,000. The debt instrument
is a capital asset in the hands of E. The debt
instrument provides for a single payment on
December 31, 1998 (the maturity date of the
instrument), of $1,000 plus an amount based
on the increase, if any, in the price of a
specified commodity over the term of the
instrument. The comparable yield for the
debt instrument is 9.54 percent, compounded
annually, and the projected payment
schedule provides for a payment of $1,200 on
December 31, 1998. Based on the projected
payment schedule, the total daily portions of
interest are $95 for 1997 and $105 for 1998.
(ii) Ordinary loss. Assume that E sells the
debt instrument for $1,050 on December 31,
1997. On that date, E has an adjusted basis
in the debt instrument of $1,095 ($1,000
original basis, plus total daily portions of $95
for 1997). Therefore, E realizes a $45 loss on
the sale of the debt instrument ($1,050–
$1,095). The loss is ordinary to the extent E’s
total interest inclusions on the debt
instrument ($95) exceed the total net negative
adjustments on the instrument that E took
into account as an ordinary loss. Because E
has not had any net negative adjustments on
the debt instrument, the $45 loss is an
ordinary loss.
(iii) Capital loss. Alternatively, assume that
E sells the debt instrument for $990 on
December 31, 1997. E realizes a $105 loss on
the sale of the debt instrument ($990 ¥
$1,095). The loss is ordinary to the extent E’s
total interest inclusions on the debt
instrument ($95) exceed the total net negative
adjustments on the instrument that E took
into account as an ordinary loss. Because E
has not had any net negative adjustments on
the debt instrument, $95 of the $105 loss is
an ordinary loss. The remaining $10 of the
$105 loss is a capital loss.

(9) Operating rules. The rules of this
paragraph (b)(9) apply to a debt
instrument subject to the noncontingent
bond method notwithstanding any other
rule of this paragraph (b).
(i) Basis different from adjusted issue
price. This paragraph (b)(9)(i) provides
rules for a holder whose basis in a debt
instrument is different from the adjusted

issue price of the debt instrument (e.g.,
a subsequent holder that purchases the
debt instrument for more or less than
the instrument’s adjusted issue price).
(A) General rule. The holder accrues
interest under paragraph (b)(3)(iii) of
this section and makes adjustments
under paragraph (b)(3)(iv) of this section
based on the projected payment
schedule determined as of the issue date
of the debt instrument. However, upon
acquiring the debt instrument, the
holder must reasonably allocate any
difference between the adjusted issue
price and the basis to daily portions of
interest or projected payments over the
remaining term of the debt instrument.
Allocations are taken into account
under paragraphs (b)(9)(i) (B) and (C) of
this section.
(B) Basis greater than adjusted issue
price. If the holder’s basis in the debt
instrument exceeds the debt
instrument’s adjusted issue price, the
amount of the difference allocated to a
daily portion of interest or to a projected
payment is treated as a negative
adjustment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s
adjusted basis in the debt instrument is
reduced by the amount the holder treats
as a negative adjustment under this
paragraph (b)(9)(i)(B). See paragraph
(b)(9)(ii)(E) of this section for a special
rule that applies when a contingent
payment is fixed more than 6 months
before it is due.
(C) Basis less than adjusted issue
price. If the holder’s basis in the debt
instrument is less than the debt
instrument’s adjusted issue price, the
amount of the difference allocated to a
daily portion of interest or to a projected
payment is treated as a positive
adjustment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s
adjusted basis in the debt instrument is
increased by the amount the holder
treats as a positive adjustment under
this paragraph (b)(9)(i)(C). See
paragraph (b)(9)(ii)(E) of this section for
a special rule that applies when a
contingent payment is fixed more than
6 months before it is due.
(D) Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1272(a)(7), 1276, and 1281 do not apply.
Other rules of those sections, such as
section 171(b)(4), continue to apply to
the extent relevant.
(E) Safe harbor for exchange listed
debt instruments. If the debt instrument
is exchange listed property (within the
meaning of § 1.1273–2(f)(2)), it is
reasonable for the holder to allocate any
difference between the holder’s basis

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
and the adjusted issue price of the debt
instrument pro-rata to daily portions of
interest (as determined under paragraph
(b)(3)(iii) of this section) over the
remaining term of the debt instrument.
A pro-rata allocation is not reasonable,
however, to the extent the holder’s yield
on the debt instrument, determined after
taking into account the amounts
allocated under this paragraph
(b)(9)(i)(E), is less than the applicable
Federal rate for the instrument. For
purposes of the preceding sentence, the
applicable Federal rate for the debt
instrument is determined as if the
purchase date were the issue date and
the remaining term of the instrument
were the term of the instrument.
(F) Examples. The following examples
illustrate the provisions of this
paragraph (b)(9)(i). In each example,
assume that the instrument described is
a debt instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes. In addition, assume that
each instrument is not exchange listed
property.
Example 1. Basis greater than adjusted
issue price—(i) Facts. On July 1, 1998, Z
purchases for $1,405 a debt instrument that
matures on December 31, 1999, and promises
to pay on the maturity date $1,000 plus the
increase, if any, in the price of a specified
amount of a commodity from the issue date
to the maturity date. The debt instrument
was originally issued on December 31, 1996,
for an issue price of $1,000. The comparable
yield for the debt instrument is 10.25
percent, compounded semiannually, and the
projected payment schedule for the debt
instrument (determined as of the issue date)
provides for a single payment at maturity of
$1,350. At the time of the purchase, the debt
instrument has an adjusted issue price of
$1,162, assuming semiannual accrual periods
ending on December 31 and June 30 of each
year. The increase in the value of the debt
instrument over its adjusted issue price is
due to an increase in the expected amount of
the contingent payment and not to a decrease
in market interest rates. The debt instrument
is a capital asset in the hands of Z. Z is a
calendar year taxpayer.
(ii) Allocation of the difference between
basis and adjusted issue price. Z’s basis in
the debt instrument on July 1, 1998, is
$1,405. Under paragraph (b)(9)(i)(A) of this
section, Z allocates the $243 difference
between basis ($1,405) and adjusted issue
price ($1,162) to the contingent payment at
maturity. Z’s allocation of the difference
between basis and adjusted issue price is
reasonable because the increase in the value
of the debt instrument over its adjusted issue
price is due to an increase in the expected
amount of the contingent payment.
(iii) Treatment of debt instrument for 1998.
Based on the projected payment schedule,
$60 of interest accrues on the debt
instrument from July 1, 1998 to December 31,
1998 (the product of the debt instrument’s

adjusted issue price on July 1, 1998 ($1,162)
and the comparable yield properly adjusted
for the length of the accrual period (10.25
percent/2)). Z has no net negative or positive
adjustments for 1998. Thus, Z includes in
income $60 of total daily portions of interest
for 1998. On December 31, 1998, Z’s adjusted
basis in the debt instrument is $1,465 ($1,405
original basis, plus total daily portions of $60
for 1998).
(iv) Effect of allocation to contingent
payment at maturity. Assume that the
payment actually made on December 31,
1999, is $1,400, rather than the projected
$1,350. Thus, under paragraph (b)(6)(i) of this
section, Z has a positive adjustment of $50
on December 31, 1999. In addition, under
paragraph (b)(9)(i)(B) of this section, Z has a
negative adjustment of $243 on December 31,
1999, which is attributable to the difference
between Z’s basis in the debt instrument on
July 1, 1998, and the instrument’s adjusted
issue price on that date. As a result, Z has
a net negative adjustment of $193 for 1999.
This net negative adjustment reduces to zero
the $128 total daily portions of interest Z
would otherwise include in income in 1999.
Accordingly, Z has no interest income on the
debt instrument for 1999. Because Z had $60
of interest inclusions for 1998, $60 of the
remaining $65 net negative adjustment is
treated by Z as an ordinary loss for 1999. The
remaining $5 of the net negative adjustment
is a negative adjustment carryforward for
1999 that reduces the amount realized by Z
on the retirement of the debt instrument from
$1,350 to $1,345.
(v) Loss at maturity. On December 31,
1999, Z’s basis in the debt instrument is
$1,350 ($1,405 original basis, plus total daily
portions of $60 for 1998 and $128 for 1999,
minus the negative adjustment of $243). As
a result, Z realizes a loss of $5 on the
retirement of the debt instrument (the
difference between the amount realized on
the retirement ($1,345) and Z’s adjusted basis
in the debt instrument ($1,350)). Under
paragraph (b)(8)(ii) of this section, the $5 loss
is treated as loss from the retirement of the
debt instrument. Consequently, Z realizes a
total loss of $65 on the debt instrument for
1999 (a $60 ordinary loss and a $5 capital
loss).
Example 2. Basis less than adjusted issue
price—(i) Facts. On January 1, 1999, Y
purchases for $910 a debt instrument that
pays 7 percent interest semiannually on June
30 and December 31 of each year, and that
promises to pay on December 31, 2001,
$1,000 plus or minus $10 times the positive
or negative difference, if any, between a
specified amount and the value of an index
on December 31, 2001. However, the
payment on December 31, 2001, may not be
less than $650. The debt instrument was
originally issued on December 31, 1996, for
an issue price of $1,000. The comparable
yield for the debt instrument is 9.80 percent,
compounded semiannually, and the
projected payment schedule for the debt
instrument (determined as of the issue date)
provides for semiannual payments of $35 and
a contingent payment at maturity of $1,175.
On January 1, 1999, the debt instrument has
an adjusted issue price of $1,060, assuming
semiannual accrual periods ending on

30149

December 31 and June 30 of each year. Y is
a calendar year taxpayer.
(ii) Allocation of the difference between
basis and adjusted issue price. Y’s basis in
the debt instrument on January 1, 1999, is
$910. Under paragraph (b)(9)(i)(A) of this
section, Y must allocate the $150 difference
between basis ($910) and adjusted issue price
($1,060) to daily portions of interest or to
projected payments. These amounts will be
positive adjustments taken into account at
the time the daily portions accrue or the
payments are made.
(A) Assume that, because of a decrease in
the relevant index, the expected value of the
payment at maturity has declined by about 9
percent. Based on forward prices on January
1, 1999, Y determines that approximately
$105 of the difference between basis and
adjusted issue price is allocable to the
contingent payment. Y allocates the
remaining $45 to daily portions of interest on
a pro-rata basis (i.e., the amount allocated to
an accrual period equals the product of $45
and a fraction, the numerator of which is the
total daily portions for the accrual period and
the denominator of which is the total daily
portions remaining on the debt instrument on
January 1, 1999). This allocation is
reasonable.
(B) Assume alternatively that, based on
yields of comparable debt instruments and its
purchase price for the debt instrument, Y
determines that an appropriate yield for the
debt instrument is 13 percent, compounded
semiannually. Based on this determination, Y
allocates $55.75 of the difference between
basis and adjusted issue price to daily
portions of interest as follows: $15.19 to the
daily portions of interest for the taxable year
ending December 31, 1999; $18.40 to the
daily portions of interest for the taxable year
ending December 31, 2000; and $22.16 to the
daily portions of interest for the taxable year
ending December 31, 2001. Y allocates the
remaining $94.25 to the contingent payment
at maturity. This allocation is reasonable.

(ii) Fixed but deferred contingent
payments. This paragraph (b)(9)(ii)
provides rules that apply when the
amount of a contingent payment
becomes fixed before the payment is
due. For purposes of paragraph (b) of
this section, if a contingent payment
becomes fixed within the 6-month
period ending on the due date of the
payment, the payment is treated as a
contingent payment even after the
payment is fixed. If a contingent
payment becomes fixed more than 6
months before the payment is due, the
following rules apply to the debt
instrument.
(A) Determining adjustments. The
amount of the adjustment attributable to
the contingent payment is equal to the
difference between the present value of
the amount that is fixed and the present
value of the projected amount of the
contingent payment. The present value
of each amount is determined by
discounting the amount from the date
the payment is due to the date the

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

payment becomes fixed, using a
discount rate equal to the comparable
yield on the debt instrument. The
adjustment is treated as a positive or
negative adjustment, as appropriate, on
the date the contingent payment
becomes fixed. See paragraph
(b)(9)(ii)(G) of this section to determine
the timing of the adjustment if all
remaining contingent payments on the
debt instrument become fixed
substantially contemporaneously.
(B) Payment schedule. The contingent
payment is no longer treated as a
contingent payment after the date the
amount of the payment becomes fixed.
On the date the contingent payment
becomes fixed, the projected payment
schedule for the debt instrument is
modified prospectively to reflect the
fixed amount of the payment. Therefore,
no adjustment is made under paragraph
(b)(3)(iv) of this section when the
contingent payment is actually made.
(C) Accrual period. Notwithstanding
the determination under § 1.1272–
1(b)(1)(ii) of accrual periods for the debt
instrument, an accrual period ends on
the day the contingent payment
becomes fixed, and a new accrual
period begins on the day after the day
the contingent payment becomes fixed.
(D) Adjustments to basis and adjusted
issue price. The amount of any positive
adjustment on a debt instrument
determined under paragraph (b)(9)(ii)(A)
of this section increases the adjusted
issue price of the instrument and the
holder’s adjusted basis in the
instrument. Similarly, the amount of
any negative adjustment on a debt
instrument determined under paragraph
(b)(9)(ii)(A) of this section decreases the
adjusted issue price of the instrument
and the holder’s adjusted basis in the
instrument.
(E) Basis different from adjusted issue
price. If a holder’s basis in a debt
instrument exceeds the debt
instrument’s adjusted issue price, the
amount allocated to a projected
payment under paragraph (b)(9)(i) of
this section is treated as a negative
adjustment on the date the payment
becomes fixed. If a holder’s basis in a
debt instrument is less than the debt
instrument’s adjusted issue price, the
amount allocated to a projected
payment under paragraph (b)(9)(i) of
this section is treated as a positive
adjustment on the date the payment
becomes fixed.
(F) Special rule for certain contingent
interest payments. Notwithstanding
paragraph (b)(9)(ii)(A) of this section,
this paragraph (b)(9)(ii)(F) applies to
contingent stated interest payments that
are adjusted to compensate for
contingencies regarding the

reasonableness of the debt instrument’s
stated rate of interest. For example, this
paragraph (b)(9)(ii)(F) applies to a debt
instrument that provides for an increase
in the stated rate of interest if the credit
quality of the issuer or liquidity of the
debt instrument deteriorates. Contingent
stated interest payments of this type are
recognized over the period to which
they relate in a reasonable manner.
(G) Special rule when all contingent
payments become fixed.
Notwithstanding paragraph (b)(9)(ii)(A)
of this section, if all the remaining
contingent payments on a debt
instrument become fixed substantially
contemporaneously, any positive or
negative adjustments on the instrument
are taken into account in a reasonable
manner over the period to which they
relate. For purposes of the preceding
sentence, a payment is treated as a fixed
payment if all remaining contingencies
with respect to the payment are remote
or incidental (within the meaning of
§ 1.1275–2(h)).
(H) Example. The following example
illustrates the provisions of this
paragraph (b)(9)(ii). In this example,
assume that the instrument described is
a debt instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example. Fixed but deferred payments—(i)
Facts. On December 31, 1996, B, a calendar
year taxpayer, purchases a debt instrument at
original issue for $1,000. The debt instrument
matures on December 31, 2002, and provides
for a payment of $1,000 at maturity. In
addition, on December 31, 1999, and
December 31, 2002, the debt instrument
provides for payments equal to the excess of
the average daily value of an index for the
6-month period ending on September 30 of
the preceding year over a specified amount.
The debt instrument’s comparable yield is 10
percent, compounded annually, and the
instrument’s projected payment schedule
consists of a payment of $250 on December
31, 1999, and a payment of $1,439 on
December 31, 2002. B uses annual accrual
periods.
(ii) Interest accrual for 1997. Based on the
projected payment schedule, B includes a
total of $100 of daily portions of interest in
income in 1997. B’s adjusted basis in the debt
instrument and the debt instrument’s
adjusted issue price on December 31, 1997,
is $1,100.
(iii) Interest accrual for 1998—(A)
Adjustment. Based on the projected payment
schedule, B would include $110 of total daily
portions of interest in income in 1998.
However, assume that on September 30,
1998, the payment due on December 31,
1999, fixes at $300, rather than the projected
$250. Thus, on September 30, 1998, B has an
adjustment equal to the difference between
the present value of the $300 fixed amount
and the present value of the $250 projected

amount of the contingent payment. The
present values of the two payments are
determined by discounting each payment
from the date the payment is due (December
31, 1999) to the date the payment becomes
fixed (September 30, 1998), using a discount
rate equal to 10 percent, compounded
annually. The present value of the fixed
payment is $266.30 and the present value of
the projected amount of the contingent
payment is $221.91. Thus, on September 30,
1998, B has a positive adjustment of $44.39
($266.30–$221.91).
(B) Effect of adjustment. Under paragraph
(b)(9)(ii)(C) of this section, B’s accrual period
ends on September 30, 1998. The daily
portions of interest on the debt instrument
for the period from January 1, 1998 to
September 30, 1998 total $81.51. The
adjusted issue price of the debt instrument
and B’s adjusted basis in the debt instrument
are thus increased over this period by
$125.90 (the sum of the daily portions of
interest of $81.51 and the positive adjustment
of $44.39 made at the end of the period) to
$1,225.90. For purposes of all future accrual
periods, including the new accrual period
from October 1, 1998, to December 31, 1998,
the debt instrument’s projected payment
schedule is modified to reflect a fixed
payment of $300 on December 31, 1999.
Based on the new adjusted issue price of the
debt instrument and the new projected
payment schedule, the yield on the debt
instrument does not change.
(C) Interest accrual for 1998. Based on the
modified projected payment schedule, $29.56
of interest accrues during the accrual period
that ends on December 31, 1998. Because B
has no other adjustments during 1998, the
$44.39 positive adjustment on September 30,
1998, results in a net positive adjustment for
1998, which is additional interest for that
year. Thus, B includes $155.46
($81.51+$29.56+$44.39) of interest in income
in 1998. B’s adjusted basis in the debt
instrument and the debt instrument’s
adjusted issue price on December 31, 1998,
is $1,255.46 ($1,225.90 from the end of the
prior accrual period plus $29.56 total daily
portions for the current accrual period).

(iii) Timing contingencies. This
paragraph (b)(9)(iii) provides rules for
debt instruments that have payments
that are contingent as to time.
(A) Treatment of certain options. If a
taxpayer has an unconditional option to
put or call the debt instrument, to
exchange the debt instrument for other
property, or to extend the maturity date
of the debt instrument, the projected
payment schedule is determined by
using the principles of § 1.1272–1(c)(5).
(B) Other timing contingencies.
[Reserved]
(iv) Cross-border transactions—(A)
Allocation of deductions. For purposes
of § 1.861–8, the holder of a debt
instrument shall treat any deduction or
loss treated as an ordinary loss under
paragraph (b)(6)(iii)(B) or (b)(8)(ii) of
this section as a deduction that is
definitely related to the class of gross

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
income to which income from such debt
instrument belongs. Accordingly, if a
U.S. person holds a debt instrument
issued by a related controlled foreign
corporation and, pursuant to section
904(d)(3) and the regulations
thereunder, any interest accrued by
such U.S. person with respect to such
debt instrument would be treated as
foreign source general limitation
income, any deductions relating to a net
negative adjustment will reduce the U.S.
person’s foreign source general
limitation income. The holder shall
apply the general rules relating to
allocation and apportionment of
deductions to any other deduction or
loss realized by the holder with respect
to the debt instrument.
(B) Investments in United States real
property. Notwithstanding paragraph
(b)(8)(i) of this section, gain on the sale,
exchange, or retirement of a debt
instrument that is a United States real
property interest is treated as gain for
purposes of sections 897, 1445, and
6039C.
(v) Coordination with subchapter M
and related provisions. For purposes of
sections 852(c)(2) and 4982 and § 1.852–
11, any positive adjustment, negative
adjustment, income, or loss on a debt
instrument that occurs after October 31
of a taxable year is treated in the same
manner as foreign currency gain or loss
that is attributable to a section 988
transaction.
(vi) Coordination with section 1092. A
holder treats a negative adjustment and
an issuer treats a positive adjustment as
a loss with respect to a position in a
straddle if the debt instrument is a
position in a straddle and the
contingency (or any portion of the
contingency) to which the adjustment
relates would be part of the straddle if
entered into as a separate position.
(c) Method for debt instruments not
subject to the noncontingent bond
method—(1) Applicability. This
paragraph (c) applies to a contingent
payment debt instrument (other than a
tax-exempt obligation) that has an issue
price determined under § 1.1274–2. For
example, this paragraph (c) generally
applies to a contingent payment debt
instrument that is issued for
nonpublicly traded property.
(2) Separation into components. If
paragraph (c) of this section applies to
a debt instrument (the overall debt
instrument), the noncontingent
payments are subject to the rules in
paragraph (c)(3) of this section, and the
contingent payments are accounted for
separately under the rules in paragraph
(c)(4) of this section.
(3) Treatment of noncontingent
payments. The noncontingent payments

are treated as a separate debt
instrument. The issue price of the
separate debt instrument is the issue
price of the overall debt instrument,
determined under § 1.1274–2(g). No
interest payments on the separate debt
instrument are qualified stated interest
payments (within the meaning of
§ 1.1273–1(c)) and the de minimis rules
of section 1273(a)(3) and § 1.1273–1(d)
do not apply to the separate debt
instrument.
(4) Treatment of contingent
payments—(i) In general. Except as
provided in paragraph (c)(4)(iii) of this
section, the portion of a contingent
payment treated as interest under
paragraph (c)(4)(ii) of this section is
includible in gross income by the holder
and deductible from gross income by
the issuer in their respective taxable
years in which the payment is made.
(ii) Characterization of contingent
payments as principal and interest—(A)
General rule. A contingent payment is
treated as a payment of principal in an
amount equal to the present value of the
payment, determined by discounting the
payment at the test rate from the date
the payment is made to the issue date.
The amount of the payment in excess of
the amount treated as principal under
the preceding sentence is treated as a
payment of interest.
(B) Test rate. The test rate used for
purposes of paragraph (c)(4)(ii)(A) of
this section is the rate that would be the
test rate for the overall debt instrument
under § 1.1274–4 if the term of the
overall debt instrument began on the
issue date of the overall debt instrument
and ended on the date the contingent
payment is made. However, in the case
of a contingent payment that consists of
a payment of stated principal
accompanied by a payment of stated
interest at a rate that exceeds the test
rate determined under the preceding
sentence, the test rate is the stated
interest rate.
(iii) Certain delayed contingent
payments—(A) General rule.
Notwithstanding paragraph (c)(4)(ii) of
this section, if a contingent payment
becomes fixed more than 6 months
before the payment is due, the issuer
and holder are treated as if the issuer
had issued a separate debt instrument
on the date the payment becomes fixed,
maturing on the date the payment is
due. This separate debt instrument is
treated as a debt instrument to which
section 1274 applies. The stated
principal amount of this separate debt
instrument is the amount of the
payment that becomes fixed. An amount
equal to the issue price of this debt
instrument is characterized as interest
or principal under the rules of

30151

paragraph (c)(4)(ii) of this section and
accounted for as if this amount had been
paid by the issuer to the holder on the
date that the amount of the payment
becomes fixed. To determine the issue
price of the separate debt instrument,
the payment is discounted at the test
rate from the maturity date of the
separate debt instrument to the date that
the amount of the payment becomes
fixed.
(B) Test rate. The test rate used for
purposes of paragraph (c)(4)(iii)(A) of
this section is determined in the same
manner as the test rate under paragraph
(c)(4)(ii)(B) of this section is determined
except that the date the contingent
payment is due is used rather than the
date the contingent payment is made.
(5) Basis different from adjusted issue
price. This paragraph (c)(5) provides
rules for a holder whose basis in a debt
instrument is different from the
instrument’s adjusted issue price (e.g., a
subsequent holder). This paragraph
(c)(5), however, does not apply if the
holder is reporting income under the
installment method of section 453.
(i) Allocation of basis. The holder
must allocate basis to the noncontingent
component (i.e., the right to the
noncontingent payments) and to any
separate debt instruments described in
paragraph (c)(4)(iii) of this section in an
amount up to the total of the adjusted
issue price of the noncontingent
component and the adjusted issue
prices of the separate debt instruments.
The holder must allocate the remaining
basis, if any, to the contingent
component (i.e., the right to the
contingent payments).
(ii) Noncontingent component. Any
difference between the holder’s basis in
the noncontingent component and the
adjusted issue price of the
noncontingent component, and any
difference between the holder’s basis in
a separate debt instrument and the
adjusted issue price of the separate debt
instrument, is taken into account under
the rules for market discount, premium,
and acquisition premium that apply to
a noncontingent debt instrument.
(iii) Contingent component. Amounts
received by the holder that are treated
as principal payments under paragraph
(c)(4)(ii) of this section reduce the
holder’s basis in the contingent
component. If the holder’s basis in the
contingent component is reduced to
zero, any additional principal payments
on the contingent component are treated
as gain from the sale or exchange of the
debt instrument. Any basis remaining
on the contingent component on the
date the final contingent payment is
made increases the holder’s adjusted
basis in the noncontingent component

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

(or, if there are no remaining
noncontingent payments, is treated as
loss from the sale or exchange of the
debt instrument).
(6) Treatment of a holder on sale,
exchange, or retirement. This paragraph
(c)(6) provides rules for the treatment of
a holder on the sale, exchange, or
retirement of a debt instrument subject
to this paragraph (c). Under this
paragraph (c)(6), the holder must
allocate the amount received from the
sale, exchange, or retirement of a debt
instrument first to the noncontingent
component and to any separate debt
instruments described in paragraph
(c)(4)(iii) of this section in an amount up
to the total of the adjusted issue price
of the noncontingent component and
the adjusted issue prices of the separate
debt instruments. The holder must
allocate the remaining amount received,
if any, to the contingent component.
(i) Amount allocated to the
noncontingent component. The amount
allocated to the noncontingent
component and any separate debt
instruments is treated as an amount
realized from the sale, exchange, or
retirement of the noncontingent
component or separate debt instrument.
(ii) Amount allocated to the
contingent component. The amount
allocated to the contingent component
is treated as a contingent payment that
is made on the date of the sale,
exchange, or retirement and is
characterized as interest and principal
under the rules of paragraph (c)(4)(ii) of
this section.
(7) Examples. The following examples
illustrate the provisions of this
paragraph (c). In each example, assume
that the instrument described is a debt
instrument for federal income tax
purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Contingent interest payments—
(i) Facts. A owns Blackacre, unencumbered
depreciable real estate. On January 1, 1997,
A sells Blackacre to B. As consideration for
the sale, B makes a downpayment of
$1,000,000 and issues to A a debt instrument
that matures on December 31, 2001. The debt
instrument provides for a payment of
principal at maturity of $5,000,000 and a
contingent payment of interest on December
31 of each year equal to a fixed percentage
of the gross rents B receives from Blackacre
in that year. Assume that the debt instrument
is not issued in a potentially abusive
situation. Assume also that on January 1,
1997, the short-term applicable Federal rate
is 5 percent, compounded annually, and the
mid-term applicable Federal rate is 6 percent,
compounded annually.
(ii) Determination of issue price. Under
§ 1.1274–2(g), the issue price of the debt

instrument is $3,736,291, which is the
present value, as of the issue date, of the
$5,000,000 noncontingent payment due at
maturity, calculated using a discount rate
equal to the mid-term applicable Federal rate.
Under § 1.1012–1(g)(1), B’s basis in Blackacre
on January 1, 1997, is $4,736,291 ($1,000,000
down payment plus the $3,736,291 issue
price of the debt instrument).
(iii) Noncontingent payment treated as
separate debt instrument. Under paragraph
(c)(3) of this section, the right to the
noncontingent payment of principal at
maturity is treated as a separate debt
instrument. The issue price of this separate
debt instrument is $3,736,291 (the issue price
of the overall debt instrument). The separate
debt instrument has a stated redemption
price at maturity of $5,000,000 and,
therefore, OID of $1,263,709.
(iv) Treatment of contingent payments.
Assume that the amount of contingent
interest that is fixed and paid on December
31, 1997, is $200,000. Under paragraph
(c)(4)(ii) of this section, this payment is
treated as consisting of a payment of
principal of $190,476, which is the present
value of the payment, determined by
discounting the payment at the test rate of 5
percent, compounded annually, from the
date the payment is made to the issue date.
The remainder of the $200,000 payment
($9,524) is treated as interest. The additional
amount treated as principal gives B
additional basis in Blackacre on December
31, 1997. The portion of the payment treated
as interest is includible in gross income by
A and deductible by B in their respective
taxable years in which December 31, 1997
occurs. The remaining contingent payments
on the debt instrument are accounted for
similarly, using a test rate of 5 percent,
compounded annually, for the contingent
payments due on December 31, 1998, and
December 31, 1999, and a test rate of 6
percent, compounded annually, for the
contingent payments due on December 31,
2000, and December 31, 2001.
Example 2. Fixed but deferred payment—
(i) Facts. The facts are the same as in
paragraph (c)(7) Example 1 of this section,
except that the contingent payment of
interest that is fixed on December 31, 1997,
is not payable until December 31, 2001, the
maturity date.
(ii) Treatment of deferred contingent
payment. Assume that the amount of the
payment that becomes fixed on December 31,
1997, is $200,000. Because this amount is not
payable until December 31, 2001, under
paragraph (c)(4)(iii) of this section, a separate
debt instrument to which section 1274
applies is treated as issued by B on December
31, 1997 (the date the payment is fixed). The
maturity date of this separate debt instrument
is December 31, 2001 (the date on which the
payment is due). The stated principal amount
of this separate debt instrument is $200,000,
the amount of the payment that becomes
fixed. The imputed principal amount of the
separate debt instrument is $158,419, which
is the present value, as of December 31, 1997,
of the $200,000 payment, computed using a
discount rate equal to the test rate of the
overall debt instrument (6 percent,
compounded annually). An amount equal to

the issue price of the separate debt
instrument is treated as an amount paid on
December 31, 1997, and characterized as
interest and principal under the rules of
paragraph (c)(4)(ii) of this section. The
amount of the deemed payment characterized
as principal is equal to $150,875, which is
the present value, as of January 1, 1997 (the
issue date of the overall debt instrument), of
the deemed payment, computed using a
discount rate of 5 percent, compounded
annually. The amount of the deemed
payment characterized as interest is $7,544
($158,419 ¥$150,875), which is includible in
gross income by A and deductible by B in
their respective taxable years in which
December 31, 1997 occurs.

(d) Rules for tax-exempt obligations—
(1) In general. Except as modified by
this paragraph (d), the noncontingent
bond method described in paragraph (b)
of this section applies to a tax-exempt
obligation (as defined in section
1275(a)(3)) to which this section
applies. Paragraph (d)(2) of this section
applies to certain tax-exempt obligations
that provide for interest-based payments
or revenue-based payments and
paragraph (d)(3) of this section applies
to all other obligations. Paragraph (d)(4)
of this section provides rules for a
holder whose basis in a tax-exempt
obligation is different from the adjusted
issue price of the obligation.
(2) Certain tax-exempt obligations
with interest-based or revenue-based
payments—(i) Applicability. This
paragraph (d)(2) applies to a tax-exempt
obligation that provides for interestbased payments or revenue-based
payments.
(ii) Interest-based payments. A taxexempt obligation provides for interestbased payments if the obligation would
otherwise qualify as a variable rate debt
instrument under § 1.1275–5 except
that—
(A) The obligation provides for more
than one fixed rate;
(B) The obligation provides for one or
more caps, floors, or governors (or
similar restrictions) that are fixed as of
the issue date;
(C) The interest on the obligation is
not compounded or paid at least
annually; or
(D) The obligation provides for
interest at one or more rates equal to the
product of a qualified floating rate and
a fixed multiple greater than zero and
less than .65, or at one or more rates
equal to the product of a qualified
floating rate and a fixed multiple greater
than zero and less than .65, increased or
decreased by a fixed rate.
(iii) Revenue-based payments. A taxexempt obligation provides for revenuebased payments if the obligation—
(A) Is issued to refinance (including a
series of refinancings) an obligation (in
a series of refinancings, the original

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
obligation), the proceeds of which were
used to finance a project or enterprise;
and
(B) Would otherwise qualify as a
variable rate debt instrument under
§ 1.1275–5 except that it provides for
stated interest payments at least
annually based on a single fixed
percentage of the revenue, value, change
in value, or other similar measure of the
performance of the refinanced project or
enterprise.
(iv) Modifications to the
noncontingent bond method. If a taxexempt obligation is subject to this
paragraph (d)(2), the following
modifications to the noncontingent
bond method described in paragraph (b)
of this section apply to the obligation.
(A) Daily portions and net positive
adjustments. The daily portions of
interest determined under paragraph
(b)(3)(iii) of this section and any net
positive adjustment on the obligation
are interest for purposes of section 103.
(B) Net negative adjustments. A net
negative adjustment for a taxable year
reduces the amount of tax-exempt
interest the holder would otherwise
account for on the obligation for the
taxable year under paragraph (b)(3)(iii)
of this section. If the net negative
adjustment exceeds this amount, the
excess is a nondeductible,
noncapitalizable loss. If a regulated
investment company (RIC) within the
meaning of section 851 has a net
negative adjustment in a taxable year
that would be a nondeductible,
noncapitalizable loss under the prior
sentence, the RIC must use this loss to
reduce its tax-exempt interest income
on other tax-exempt obligations held
during the taxable year.
(C) Gains. Any gain recognized on the
sale, exchange, or retirement of the
obligation is gain from the sale or
exchange of the obligation.
(D) Losses. Any loss recognized on the
sale, exchange, or retirement of the
obligation is treated the same as a net
negative adjustment under paragraph
(d)(2)(iv)(B) of this section.
(E) Special rule for losses and net
negative adjustments. Notwithstanding
paragraphs (d)(2)(iv) (B) and (D) of this
section, on the sale, exchange, or
retirement of the obligation, the holder
may claim a loss from the sale or
exchange of the obligation to the extent
the holder has not received in cash or
property the sum of its original
investment in the obligation and any
amounts included in income under
paragraph (d)(4)(ii) of this section.
(3) All other tax-exempt obligations—
(i) Applicability. This paragraph (d)(3)
applies to a tax-exempt obligation that

is not subject to paragraph (d)(2) of this
section.
(ii) Modifications to the
noncontingent bond method. If a taxexempt obligation is subject to this
paragraph (d)(3), the following
modifications to the noncontingent
bond method described in paragraph (b)
of this section apply to the obligation.
(A) Modification to projected payment
schedule. The comparable yield for the
obligation is the greater of the
obligation’s yield, determined without
regard to the contingent payments, and
the tax-exempt applicable Federal rate
that applies to the obligation. The
Internal Revenue Service publishes the
tax-exempt applicable Federal rate for
each month in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii) of this
chapter).
(B) Daily portions. The daily portions
of interest determined under paragraph
(b)(3)(iii) of this section are interest for
purposes of section 103.
(C) Adjustments. A net positive
adjustment on the obligation is treated
as gain to the holder from the sale or
exchange of the obligation in the taxable
year of the adjustment. A net negative
adjustment on the obligation is treated
as a loss to the holder from the sale or
exchange of the obligation in the taxable
year of the adjustment.
(D) Gains and losses. Any gain or loss
recognized on the sale, exchange, or
retirement of the obligation is gain or
loss from the sale or exchange of the
obligation.
(4) Basis different from adjusted issue
price. This paragraph (d)(4) provides
rules for a holder whose basis in a taxexempt obligation is different from the
adjusted issue price of the obligation.
The rules of paragraph (b)(9)(i) of this
section do not apply to tax-exempt
obligations.
(i) Basis greater than adjusted issue
price. If the holder’s basis in the
obligation exceeds the obligation’s
adjusted issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis over
the remaining term of the obligation.
The amount allocated to a daily portion
of interest is not deductible by the
holder. However, the holder’s basis in
the obligation is reduced by the amount
allocated to a daily portion of interest
on the date the daily portion accrues.
(ii) Basis less than adjusted issue
price. If the holder’s basis in the
obligation is less than the obligation’s
adjusted issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis over
the remaining term of the obligation.

30153

The amount allocated to a daily portion
of interest is includible in income by the
holder as ordinary income on the date
the daily portion accrues. The holder’s
adjusted basis in the obligation is
increased by the amount includible in
income by the holder under this
paragraph (d)(4)(ii) on the date the daily
portion accrues.
(iii) Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1276, and 1288 do not apply. Other
rules of those sections continue to apply
to the extent relevant.
(e) Amounts treated as interest under
this section. Amounts treated as interest
under this section are treated as OID for
all purposes of the Internal Revenue
Code.
(f) Effective date. This section applies
to debt instruments issued on or after
August 13, 1996.
Par. 16. Section 1.1275–5 is amended
by:
1. Revising paragraph (a)(1).
2. Removing the language ‘‘The debt
instrument must provide for stated
interest’’ from the introductory language
of paragraph (a)(3)(i) and adding the
language ‘‘The debt instrument must not
provide for any stated interest other
than stated interest’’ in its place.
3. Removing the language ‘‘less than
1 year’’ from the first sentence of
paragraph (a)(3)(ii) and adding the
language ‘‘1 year or less’’ in its place.
4. Adding paragraphs (a)(5) and (a)(6).
5. Revising paragraph (b)(2).
6. Revising paragraphs (c)(1) and
(c)(5).
7. Removing the language ‘‘cost of
newly borrowed funds’’ from paragraph
(c)(3)(ii) and adding the language
‘‘qualified floating rate’’ in its place.
8. Revising paragraph (d) introductory
text; revising Examples 4 through 9; and
adding Example 10.
9. Revising paragraph (e)(2).
10. Revising paragraph (e)(3)(v)
introductory text; revising Example 3
(ii); and removing Example 3 (iii).
The revisions and additions read as
follows:
§ 1.1275–5

Variable rate debt instruments.

(a) Applicability—(1) In general. This
section provides rules for variable rate
debt instruments. Except as provided in
paragraph (a)(6) of this section, a
variable rate debt instrument is a debt
instrument that meets the conditions
described in paragraphs (a)(2), (3), (4),
and (5) of this section. If a debt
instrument that provides for a variable
rate of interest does not qualify as a
variable rate debt instrument, the debt
instrument is a contingent payment debt
instrument. See § 1.1275–4 for the

30154

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

treatment of a contingent payment debt
instrument. See § 1.1275–6 for a
taxpayer’s treatment of a variable rate
debt instrument and a hedge.
*
*
*
*
*
(5) No contingent principal payments.
Except as provided in paragraph (a)(2)
of this section, the debt instrument must
not provide for any principal payments
that are contingent (within the meaning
of § 1.1275–4(a)).
(6) Special rule for debt instruments
issued for nonpublicly traded property.
A debt instrument (other than a taxexempt obligation) that would otherwise
qualify as a variable rate debt
instrument under this section is not a
variable rate debt instrument if section
1274 applies to the instrument and any
stated interest payments on the
instrument are treated as contingent
payments under § 1.1274–2. This
paragraph (a)(6) applies to debt
instruments issued on or after August
13, 1996.
(b) * * *
(2) Certain rates based on a qualified
floating rate. For a debt instrument
issued on or after August 13, 1996, a
variable rate is a qualified floating rate
if it is equal to either—
(i) The product of a qualified floating
rate described in paragraph (b)(1) of this
section and a fixed multiple that is
greater than .65 but not more than 1.35;
or
(ii) The product of a qualified floating
rate described in paragraph (b)(1) of this
section and a fixed multiple that is
greater than .65 but not more than 1.35,
increased or decreased by a fixed rate.
*
*
*
*
*
(c) Objective rate—(1) Definition—(i)
In general. For debt instruments issued
on or after August 13, 1996, an objective
rate is a rate (other than a qualified
floating rate) that is determined using a
single fixed formula and that is based on
objective financial or economic
information. For example, an objective
rate generally includes a rate that is
based on one or more qualified floating
rates or on the yield of actively traded
personal property (within the meaning
of section 1092(d)(1)).
(ii) Exception. For purposes of
paragraph (c)(1)(i) of this section, an
objective rate does not include a rate
based on information that is within the
control of the issuer (or a related party
within the meaning of section 267(b) or
707(b)(1)) or that is unique to the
circumstances of the issuer (or a related
party within the meaning of section
267(b) or 707(b)(1)), such as dividends,
profits, or the value of the issuer’s stock.
However, a rate does not fail to be an

objective rate merely because it is based
on the credit quality of the issuer.
*
*
*
*
*
(5) Tax-exempt obligations.
Notwithstanding paragraph (c)(1) of this
section, in the case of a tax-exempt
obligation (within the meaning of
section 1275(a)(3)), a variable rate is an
objective rate only if it is a qualified
inverse floating rate or a qualified
inflation rate. A rate is a qualified
inflation rate if the rate measures
contemporaneous changes in inflation
based on a general inflation index.
(d) Examples. The following examples
illustrate the rules of paragraphs (b) and
(c) of this section. For purposes of these
examples, assume that the debt
instrument is not a tax-exempt
obligation. In addition, unless otherwise
provided, assume that the rate is not
reasonably expected to result in a
significant front-loading or back-loading
of interest and that the rate is not based
on objective financial or economic
information that is within the control of
the issuer (or a related party) or that is
unique to the circumstances of the
issuer (or a related party).
*
*
*
*
*
Example 4. Rate based on changes in the
value of a commodity index. On January 1,
1997, X issues a debt instrument that
provides for annual interest payments at the
end of each year at a rate equal to the
percentage increase, if any, in the value of an
index for the year immediately preceding the
payment. The index is based on the prices of
several actively traded commodities.
Variations in the value of this interest rate
cannot reasonably be expected to measure
contemporaneous variations in the cost of
newly borrowed funds. Accordingly, the rate
is not a qualified floating rate. However,
because the rate is based on objective
financial information using a single fixed
formula, the rate is an objective rate.
Example 5. Rate based on a percentage of
S&P 500 Index. On January 1, 1997, X issues
a debt instrument that provides for annual
interest payments at the end of each year
based on a fixed percentage of the value of
the S&P 500 Index. Variations in the value of
this interest rate cannot reasonably be
expected to measure contemporaneous
variations in the cost of newly borrowed
funds and, therefore, the rate is not a
qualified floating rate. Although the rate is
described in paragraph (c)(1)(i) of this
section, the rate is not an objective rate
because, based on historical data, it is
reasonably expected that the average value of
the rate during the first half of the
instrument’s term will be significantly less
than the average value of the rate during the
final half of the instrument’s term.
Example 6. Rate based on issuer’s profits.
On January 1, 1997, Z issues a debt
instrument that provides for annual interest
payments equal to 1 percent of Z’s gross
profits earned during the year immediately
preceding the payment. Variations in the

value of this interest rate cannot reasonably
be expected to measure contemporaneous
variations in the cost of newly borrowed
funds. Accordingly, the rate is not a qualified
floating rate. In addition, because the rate is
based on information that is unique to the
issuer’s circumstances, the rate is not an
objective rate.
Example 7. Rate based on a multiple of an
interest index. On January 1, 1997, Z issues
a debt instrument with annual interest
payments at a rate equal to two times the
value of 1-year LIBOR as of the payment date.
Because the rate is a multiple greater than
1.35 times a qualified floating rate, the rate
is not a qualified floating rate. However,
because the rate is based on objective
financial information using a single fixed
formula, the rate is an objective rate.
Example 8. Variable rate based on the cost
of borrowed funds in a foreign currency. On
January 1, 1997, Y issues a 5-year dollar
denominated debt instrument that provides
for annual interest payments at a rate equal
to the value of 1-year French franc LIBOR as
of the payment date. Variations in the value
of French franc LIBOR do not measure
contemporaneous changes in the cost of
newly borrowed funds in dollars. As a result,
the rate is not a qualified floating rate for an
instrument denominated in dollars. However,
because the rate is based on objective
financial information using a single fixed
formula, the rate is an objective rate.
Example 9. Qualified inverse floating rate.
On January 1, 1997, X issues a debt
instrument that provides for annual interest
payments at the end of each year at a rate
equal to 12 percent minus the value of 1-year
LIBOR as of the payment date. On the issue
date, the value of 1-year LIBOR is 6 percent.
Because the rate can reasonably be expected
to inversely reflect contemporaneous
variations in 1-year LIBOR, it is a qualified
inverse floating rate. However, if the value of
1-year LIBOR on the issue date were 11
percent rather than 6 percent, the rate would
not be a qualified inverse floating rate
because the rate could not reasonably be
expected to inversely reflect
contemporaneous variations in 1-year LIBOR.
Example 10. Rate based on an inflation
index. On January 1, 1997, X issues a debt
instrument that provides for annual interest
payments at the end of each year at a rate
equal to 400 basis points (4 percent) plus the
annual percentage change in a general
inflation index (e.g., the Consumer Price
Index, U.S. City Average, All Items, for all
Urban Consumers, seasonally unadjusted).
The rate, however, may not be less than zero.
Variations in the value of this interest rate
cannot reasonably be expected to measure
contemporaneous variations in the cost of
newly borrowed funds. Accordingly, the rate
is not a qualified floating rate. However,
because the rate is based on objective
economic information using a single fixed
formula, the rate is an objective rate.

(e) * * *
(2) Variable rate debt instrument that
provides for annual payments of interest
at a single variable rate. If a variable rate
debt instrument provides for stated
interest at a single qualified floating rate

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
or objective rate and the interest is
unconditionally payable in cash or in
property (other than debt instruments of
the issuer), or will be constructively
received under section 451, at least
annually, the following rules apply to
the instrument:
(i) All stated interest with respect to
the debt instrument is qualified stated
interest.
(ii) The amount of qualified stated
interest and the amount of OID, if any,
that accrues during an accrual period is
determined under the rules applicable
to fixed rate debt instruments by
assuming that the variable rate is a fixed
rate equal to—
(A) In the case of a qualified floating
rate or qualified inverse floating rate,
the value, as of the issue date, of the
qualified floating rate or qualified
inverse floating rate; or
(B) In the case of an objective rate
(other than a qualified inverse floating
rate), a fixed rate that reflects the yield
that is reasonably expected for the debt
instrument.
(iii) The qualified stated interest
allocable to an accrual period is
increased (or decreased) if the interest
actually paid during an accrual period
exceeds (or is less than) the interest
assumed to be paid during the accrual
period under paragraph (e)(2)(ii) of this
section.
(3) * * *
(v) Examples. The following examples
illustrate the rules in paragraphs (e) (2)
and (3) of this section:
*
*
*
*
*
Example 3. * * *
(ii) Accrual of OID and qualified stated
interest. Under paragraph (e)(2) of this
section, the variable rate debt instrument is
treated as a 2-year debt instrument that has
an issue price of $90,000, a stated principal
amount of $100,000, and interest payments of
$5,000 at the end of each year. The debt
instrument has $10,000 of OID and the
annual interest payments of $5,000 are
qualified stated interest payments. Under
§ 1.1272–1, the debt instrument has a yield
of 10.82 percent, compounded annually. The
amount of OID allocable to the first annual
accrual period (assuming Z uses annual
accrual periods) is $4,743.25
(($90,000×.1082)¥ $5,000), and the amount
of OID allocable to the second annual accrual
period is $5,256.75 ($100,000¥$94,743.25).
Under paragraph (e)(2)(iii) of this section, the
$2,000 difference between the $7,000 interest
payment actually made at maturity and the
$5,000 interest payment assumed to be made
at maturity under the equivalent fixed rate
debt instrument is treated as additional
qualified stated interest for the period.

*

*
*
*
*
Par. 17. Section 1.1275–6 is added to
read as follows:

§ 1.1275–6 Integration of qualifying debt
instruments.

(a) In general. This section generally
provides for the integration of a
qualifying debt instrument with a hedge
or combination of hedges if the
combined cash flows of the components
are substantially equivalent to the cash
flows on a fixed or variable rate debt
instrument. The integrated transaction
is generally subject to the rules of this
section rather than the rules to which
each component of the transaction
would be subject on a separate basis.
The purpose of this section is to permit
a more appropriate determination of the
character and timing of income,
deductions, gains, or losses than would
be permitted by separate treatment of
the components. The rules of this
section affect only the taxpayer who
holds (or issues) the qualifying debt
instrument and enters into the hedge.
(b) Definitions—(1) Qualifying debt
instrument. A qualifying debt
instrument is any debt instrument
(including an integrated transaction as
defined in paragraph (c) of this section)
other than—
(i) A tax-exempt obligation as defined
in section 1275(a)(3);
(ii) A debt instrument to which
section 1272(a)(6) applies (certain
interests in or mortgages held by a
REMIC, and certain other debt
instruments with payments subject to
acceleration); or
(iii) A debt instrument that is subject
to § 1.483–4 or § 1.1275–4(c) (certain
contingent payment debt instruments
issued for nonpublicly traded property).
(2) Section 1.1275–6 hedge—(i) In
general. A § 1.1275–6 hedge is any
financial instrument (as defined in
paragraph (b)(3) of this section) if the
combined cash flows of the financial
instrument and the qualifying debt
instrument permit the calculation of a
yield to maturity (under the principles
of section 1272), or the right to the
combined cash flows would qualify
under § 1.1275–5 as a variable rate debt
instrument that pays interest at a
qualified floating rate or rates (except
for the requirement that the interest
payments be stated as interest). A
financial instrument is not a § 1.1275–
6 hedge, however, if the resulting
synthetic debt instrument does not have
the same term as the remaining term of
the qualifying debt instrument. A
financial instrument that hedges
currency risk is not a § 1.1275–6 hedge.
(ii) Limitations—(A) A debt
instrument issued by a taxpayer and a
debt instrument held by the taxpayer
cannot be part of the same integrated
transaction.

30155

(B) A debt instrument can be a
§ 1.1275–6 hedge only if it is issued
substantially contemporaneously with,
and has the same maturity (including
rights to accelerate or delay payments)
as, the qualifying debt instrument.
(3) Financial instrument. For
purposes of this section, a financial
instrument is a spot, forward, or futures
contract, an option, a notional principal
contract, a debt instrument, or a similar
instrument, or combination or series of
financial instruments. Stock is not a
financial instrument for purposes of this
section.
(4) Synthetic debt instrument. The
synthetic debt instrument is the
hypothetical debt instrument with the
same cash flows as the combined cash
flows of the qualifying debt instrument
and the § 1.1275–6 hedge.
(c) Integrated transaction—(1)
Integration by taxpayer. Except as
otherwise provided in this section, a
qualifying debt instrument and a
§ 1.1275–6 hedge are an integrated
transaction if all of the following
requirements are satisfied:
(i) The taxpayer satisfies the
identification requirements of paragraph
(e) of this section on or before the date
the taxpayer enters into the § 1.1275–6
hedge.
(ii) None of the parties to the
§ 1.1275–6 hedge are related within the
meaning of section 267(b) or 707(b)(1),
or, if the parties are related, the party
providing the hedge uses, for federal
income tax purposes, a mark-to-market
method of accounting for the hedge and
all similar or related transactions.
(iii) Both the qualifying debt
instrument and the § 1.1275–6 hedge are
entered into by the same individual,
partnership, trust, estate, or corporation
(regardless of whether the corporation is
a member of an affiliated group of
corporations that files a consolidated
return).
(iv) If the taxpayer is a foreign person
engaged in a U.S. trade or business and
the taxpayer issues or acquires a
qualifying debt instrument, or enters
into a § 1.1275–6 hedge, through the
trade or business, all items of income
and expense associated with the
qualifying debt instrument and the
§ 1.1275–6 hedge (other than interest
expense that is subject to § 1.882–5)
would have been effectively connected
with the U.S. trade or business
throughout the term of the qualifying
debt instrument had this section not
applied.
(v) Neither the qualifying debt
instrument, nor any other debt
instrument that is part of the same issue
as the qualifying debt instrument, nor
the § 1.1275–6 hedge was, with respect

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to the taxpayer, part of an integrated
transaction that was terminated or
otherwise legged out of within the 30
days immediately preceding the date
that would be the issue date of the
synthetic debt instrument.
(vi) The qualifying debt instrument is
issued or acquired by the taxpayer on or
before the date of the first payment on
the § 1.1275–6 hedge, whether made or
received by the taxpayer (including a
payment made to purchase the hedge).
If the qualifying debt instrument is
issued or acquired by the taxpayer after,
but substantially contemporaneously
with, the date of the first payment on
the § 1.1275–6 hedge, the qualifying
debt instrument is treated, solely for
purposes of this paragraph (c)(1)(vi), as
meeting the requirements of the
preceding sentence.
(vii) Neither the § 1.1275–6 hedge nor
the qualifying debt instrument was,
with respect to the taxpayer, part of a
straddle (as defined in section 1092(c))
prior to the issue date of the synthetic
debt instrument.
(2) Integration by Commissioner. The
Commissioner may treat a qualifying
debt instrument and a financial
instrument (whether entered into by the
taxpayer or by a related party) as an
integrated transaction if the combined
cash flows on the qualifying debt
instrument and financial instrument are
substantially the same as the combined
cash flows required for the financial
instrument to be a § 1.1275–6 hedge.
The Commissioner, however, may not
integrate a transaction unless the
qualifying debt instrument either is
subject to § 1.1275–4 or is subject to
§ 1.1275–5 and pays interest at an
objective rate. The circumstances under
which the Commissioner may require
integration include, but are not limited
to, the following:
(i) A taxpayer fails to identify a
qualifying debt instrument and the
§ 1.1275–6 hedge under paragraph (e) of
this section.
(ii) A taxpayer issues or acquires a
qualifying debt instrument and a related
party (within the meaning of section
267(b) or 707(b)(1)) enters into the
§ 1.1275–6 hedge.
(iii) A taxpayer issues or acquires a
qualifying debt instrument and enters
into the § 1.1275–6 hedge with a related
party (within the meaning of section
267(b) or 707(b)(1)).
(iv) The taxpayer legs out of an
integrated transaction and within 30
days enters into a new § 1.1275–6 hedge
with respect to the same qualifying debt
instrument or another debt instrument
that is part of the same issue.
(d) Special rules for legging into and
legging out of an integrated

transaction—(1) Legging into—(i)
Definition. Legging into an integrated
transaction under this section means
that a § 1.1275–6 hedge is entered into
after the date the qualifying debt
instrument is issued or acquired by the
taxpayer, and the requirements of
paragraph (c)(1) of this section are
satisfied on the date the § 1.1275–6
hedge is entered into (the leg-in date).
(ii) Treatment. If a taxpayer legs into
an integrated transaction, the taxpayer
treats the qualifying debt instrument
under the applicable rules for taking
interest and OID into account up to the
leg-in date, except that the day before
the leg-in date is treated as the end of
an accrual period. As of the leg-in date,
the qualifying debt instrument is subject
to the rules of paragraph (f) of this
section.
(iii) Anti-abuse rule. If a taxpayer legs
into an integrated transaction with a
principal purpose of deferring or
accelerating income or deductions on
the qualifying debt instrument, the
Commissioner may—
(A) Treat the qualifying debt
instrument as sold for its fair market
value on the leg-in date; or
(B) Refuse to allow the taxpayer to
integrate the qualifying debt instrument
and the § 1.1275–6 hedge.
(2) Legging out—(i) Definition—(A)
Legging out if the taxpayer has
integrated. If a taxpayer has integrated a
qualifying debt instrument and a
§ 1.1275–6 hedge under paragraph (c)(1)
of this section, legging out means that,
prior to the maturity of the synthetic
debt instrument, the § 1.1275–6 hedge
ceases to meet the requirements for a
§ 1.1275–6 hedge, the taxpayer fails to
meet any requirement of paragraph
(c)(1) of this section, or the taxpayer
disposes of or otherwise terminates all
or a part of the qualifying debt
instrument or § 1.1275–6 hedge. If the
taxpayer fails to meet the requirements
of paragraph (c)(1) of this section but
meets the requirements of paragraph
(c)(2) of this section, the Commissioner
may treat the taxpayer as not legging
out.
(B) Legging out if the Commissioner
has integrated. If the Commissioner has
integrated a qualifying debt instrument
and a financial instrument under
paragraph (c)(2) of this section, legging
out means that, prior to the maturity of
the synthetic debt instrument, the
requirements for Commissioner
integration under paragraph (c)(2) of
this section are not met or the taxpayer
fails to meet the requirements for
taxpayer integration under paragraph
(c)(1) of this section and the
Commissioner agrees to allow the
taxpayer to be treated as legging out.

(C) Exception for certain
nonrecognition transactions. If, in a
single nonrecognition transaction, a
taxpayer disposes of, or ceases to be
primarily liable on, the qualifying debt
instrument and the § 1.1275–6 hedge,
the taxpayer is not treated as legging
out. Instead, the integrated transaction
is treated under the rules governing the
nonrecognition transaction. For
example, if a holder of an integrated
transaction is acquired in a
reorganization under section
368(a)(1)(A), the holder is treated as
disposing of the synthetic debt
instrument in the reorganization rather
than legging out. If the successor holder
is not eligible for integrated treatment,
the successor is treated as legging out.
(ii) Operating rules. If a taxpayer legs
out (or is treated as legging out) of an
integrated transaction, the following
rules apply:
(A) The transaction is treated as an
integrated transaction during the time
the requirements of paragraph (c)(1) or
(2) of this section, as appropriate, are
satisfied.
(B) Immediately before the taxpayer
legs out, the taxpayer is treated as
selling or otherwise terminating the
synthetic debt instrument for its fair
market value and, except as provided in
paragraph (d)(2)(ii)(D) of this section,
any income, deduction, gain, or loss is
realized and recognized at that time.
(C) If, immediately after the taxpayer
legs out, the taxpayer holds or remains
primarily liable on the qualifying debt
instrument, adjustments are made to
reflect any difference between the fair
market value of the qualifying debt
instrument and the adjusted issue price
of the qualifying debt instrument. If,
immediately after the taxpayer legs out,
the taxpayer is a party to a § 1.1275–6
hedge, the § 1.1275–6 hedge is treated as
entered into at its fair market value.
(D) If a taxpayer legs out of an
integrated transaction by disposing of or
otherwise terminating a § 1.1275–6
hedge within 30 days of legging into the
integrated transaction, then any loss or
deduction determined under paragraph
(d)(2)(ii)(B) of this section is not
allowed. Appropriate adjustments are
made to the qualifying debt instrument
for any disallowed loss. The
adjustments are taken into account on a
yield to maturity basis over the
remaining term of the qualifying debt
instrument.
(E) If a holder of a debt instrument
subject to § 1.1275–4 legs into an
integrated transaction with respect to
the instrument and subsequently legs
out of the integrated transaction, any
gain recognized under paragraph
(d)(2)(ii)(B) or (C) of this section is

Federal Register / Vol. 61, No. 116 / Friday, June 14, 1996 / Rules and Regulations
treated as interest income to the extent
determined under the principles of
§ 1.1275–4(b)(8)(iii)(B) (rules for
determining the character of gain on the
sale of a debt instrument all of the
payments on which have been fixed). If
the synthetic debt instrument would
qualify as a variable rate debt
instrument, the equivalent fixed rate
debt instrument determined under
§ 1.1275–5(e) is used for this purpose.
(e) Identification requirements. For
each integrated transaction, a taxpayer
must enter and retain as part of its books
and records the following information—
(1) The date the qualifying debt
instrument was issued or acquired (or is
expected to be issued or acquired) by
the taxpayer and the date the § 1.1275–
6 hedge was entered into by the
taxpayer;
(2) A description of the qualifying
debt instrument and the § 1.1275–6
hedge; and
(3) A summary of the cash flows and
accruals resulting from treating the
qualifying debt instrument and the
§ 1.1275–6 hedge as an integrated
transaction (i.e., the cash flows and
accruals on the synthetic debt
instrument).
(f) Taxation of integrated
transactions—(1) General rule. An
integrated transaction is generally
treated as a single transaction by the
taxpayer during the period that the
transaction qualifies as an integrated
transaction. Except as provided in
paragraph (f)(12) of this section, while a
qualifying debt instrument and a
§ 1.1275–6 hedge are part of an
integrated transaction, neither the
qualifying debt instrument nor the
§ 1.1275–6 hedge is subject to the rules
that would apply on a separate basis to
the debt instrument and the § 1.1275–6
hedge, including section 1092 or
§ 1.446–4. The rules that would govern
the treatment of the synthetic debt
instrument generally govern the
treatment of the integrated transaction.
For example, the integrated transaction
may be subject to section 263(g) or, if
the synthetic debt instrument would be
part of a straddle, section 1092.
Generally, the synthetic debt instrument
is subject to sections 163(e) and 1271
through 1275, with terms as set forth in
paragraphs (f)(2) through (13) of this
section.
(2) Issue date. The issue date of the
synthetic debt instrument is the first
date on which the taxpayer entered into
all of the components of the synthetic
debt instrument.
(3) Term. The term of the synthetic
debt instrument is the period beginning
on the issue date of the synthetic debt

instrument and ending on the maturity
date of the qualifying debt instrument.
(4) Issue price. The issue price of the
synthetic debt instrument is the
adjusted issue price of the qualifying
debt instrument on the issue date of the
synthetic debt instrument. If, as a result
of entering into the § 1.1275–6 hedge,
the taxpayer pays or receives one or
more payments that are substantially
contemporaneous with the issue date of
the synthetic debt instrument, the
payments reduce or increase the issue
price as appropriate.
(5) Adjusted issue price. In general,
the adjusted issue price of the synthetic
debt instrument is determined under the
principles of § 1.1275–1(b).
(6) Qualified stated interest. No
amounts payable on the synthetic debt
instrument are qualified stated interest
within the meaning of § 1.1273–1(c).
(7) Stated redemption price at
maturity—(i) Synthetic debt instruments
that are borrowings. In general, if the
synthetic debt instrument is a
borrowing, the instrument’s stated
redemption price at maturity is the sum
of all amounts paid or to be paid on the
qualifying debt instrument and the
§ 1.1275–6 hedge, reduced by any
amounts received or to be received on
the § 1.1275–6 hedge.
(ii) Synthetic debt instruments that
are held by the taxpayer. In general, if
the synthetic debt instrument is held by
the taxpayer, the instrument’s stated
redemption price at maturity is the sum
of all amounts received or to be received
by the taxpayer on the qualifying debt
instrument and the § 1.1275–6 hedge,
reduced by any amounts paid or to be
paid by the taxpayer on the § 1.1275–6
hedge.
(iii) Certain amounts ignored. For
purposes of this paragraph (f)(7), if an
amount paid or received on the
§ 1.1275–6 hedge is taken into account
under paragraph (f)(4) of this section to
determine the issue price of the
synthetic debt instrument, the amount is
not taken into account to determine the
synthetic debt instrument’s stated
redemption price at maturity.
(8) Source of interest income and
allocation of expense. The source of
interest income from the synthetic debt
instrument is determined by reference
to the source of income of the qualifying
debt instrument under sections 861(a)(1)
and 862(a)(1). For purposes of section
904, the character of interest from the
synthetic debt instrument is determined
by reference to the character of the
interest income from the qualifying debt
instrument. Interest expense is allocated
and apportioned under regulations
under section 861 or under § 1.882–5.

30157

(9) Effectively connected income. If
the requirements of paragraph (c)(1)(iv)
of this section are satisfied, any interest
income resulting from the synthetic debt
instrument entered into by the foreign
person is treated as effectively
connected with a U.S. trade or business,
and any interest expense resulting from
the synthetic debt instrument entered
into by the foreign person is allocated
and apportioned under § 1.882–5.
(10) Not a short-term obligation. For
purposes of section 1272(a)(2)(C), a
synthetic debt instrument is not treated
as a short-term obligation.
(11) Special rules in the event of
integration by the Commissioner. If the
Commissioner requires integration,
appropriate adjustments are made to the
treatment of the synthetic debt
instrument, and, if necessary, the
qualifying debt instrument and financial
instrument. For example, the
Commissioner may treat a financial
instrument that is not a § 1.1275–6
hedge as a § 1.1275–6 hedge when
applying the rules of this section. The
issue date of the synthetic debt
instrument is the date determined
appropriate by the Commissioner to
require integration.
(12) Retention of separate transaction
rules for certain purposes. This
paragraph (f)(12) provides for the
retention of separate transaction rules
for certain purposes. In addition, by
publication in the Internal Revenue
Bulletin (see § 601.601(d)(2)(ii) of this
chapter), the Commissioner may require
use of separate transaction rules for any
aspect of an integrated transaction.
(i) Foreign persons that enter into
integrated transactions giving rise to
U.S. source income not effectively
connected with a U.S. trade or business.
If a foreign person enters into an
integrated transaction that gives rise to
U.S. source interest income (determined
under the source rules for the synthetic
debt instrument) not effectively
connected with a U.S. trade or business
of the foreign person, paragraph (f) of
this section does not apply for purposes
of sections 871(a), 881, 1441, 1442, and
6049. These sections of the Internal
Revenue Code are applied to the
qualifying debt instrument and the
§ 1.1275–6 hedge on a separate basis.
(ii) Relationship between taxpayer
and other persons. Because the rules of
this section affect only the taxpayer that
enters into an integrated transaction
(i.e., either the issuer or a particular
holder of a qualifying debt instrument),
any provisions of the Internal Revenue
Code or regulations that govern the
relationship between the taxpayer and
any other person are applied on a
separate basis. For example, taxpayers

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must comply with any reporting or
disclosure requirements on any
qualifying debt instrument as if it were
not part of an integrated transaction.
Thus, if required under § 1.1275–4(b)(4),
an issuer of a contingent payment debt
instrument subject to integrated
treatment must provide the projected
payment schedule to holders. Similarly,
if a U.S. corporation enters into an
integrated transaction that includes a
notional principal contract, the source
of any payment received by the
counterparty on the notional principal
contract is determined under § 1.863–7
as if the contract were not part of an
integrated transaction, and, if received
by a foreign person who is not engaged
in a U.S. trade or business, the payment
is non-U.S. source income that is not
subject to U.S. withholding tax.
(13) Coordination with consolidated
return rules. If a taxpayer enters into a
§ 1.1275–6 hedge with a member of the
same consolidated group (the
counterparty) and the § 1.1275–6 hedge
is part of an integrated transaction for
the taxpayer, the § 1.1275–6 hedge is not
treated as an intercompany transaction
for purposes of § 1.1502–13. If the
taxpayer legs out of integrated
treatment, the taxpayer and the
counterparty are each treated as
disposing of its position in the § 1.1275–
6 hedge under the principles of
paragraph (d)(2) of this section. If the
§ 1.1275–6 hedge remains in existence
after the leg-out date, the § 1.1275–6
hedge is treated under the rules that
would otherwise apply to the
transaction (including § 1.1502–13 if the
transaction is between members).
(g) Predecessors and successors. For
purposes of this section, any reference
to a taxpayer, holder, issuer, or person
includes, where appropriate, a reference
to a predecessor or successor. For
purposes of the preceding sentence, a
predecessor is a transferor of an asset or
liability (including an integrated
transaction) to a transferee (the
successor) in a nonrecognition
transaction. Appropriate adjustments, if
necessary, are made in the application
of this section to predecessors and
successors.
(h) Examples. The following examples
illustrate the provisions of this section.
In each example, assume that the
qualifying debt instrument is a debt
instrument for federal income tax
purposes. No inference is intended,
however, as to whether the debt
instrument is a debt instrument for
federal income tax purposes.
Example 1. Issuer hedge—(i) Facts. On
January 1, 1997, V, a domestic corporation,
issues a 5-year debt instrument for $1,000.
The debt instrument provides for annual

payments of interest at a rate equal to the
value of 1-year LIBOR and a principal
payment of $1,000 at maturity. On the same
day, V enters into a 5-year interest rate swap
agreement with an unrelated party. Under the
swap, V pays 6 percent and receives 1-year
LIBOR on a notional principal amount of
$1,000. The payments on the swap are fixed
and made on the same days as the payments
on the debt instrument. On January 1, 1997,
V identifies the debt instrument and the
swap as an integrated transaction in
accordance with the requirements of
paragraph (e) of this section.
(ii) Eligibility for integration. The debt
instrument is a qualifying debt instrument.
The swap is a § 1.1275–6 hedge because it is
a financial instrument and a yield to maturity
on the combined cash flows of the swap and
the debt instrument can be calculated. V has
met the identification requirements, and the
other requirements of paragraph (c)(1) of this
section are satisfied. Therefore, the
transaction is an integrated transaction under
this section.
(iii) Treatment of the synthetic debt
instrument. The synthetic debt instrument is
a 5-year debt instrument that has an issue
price of $1,000 and provides for annual
interest payments of $60 and a principal
payment of $1,000 at maturity. Under
paragraph (f)(6) of this section, no amounts
payable on the synthetic debt instrument are
qualified stated interest. Thus, under
paragraph (f)(7)(i) of this section, the
synthetic debt instrument has a stated
redemption price at maturity of $1,300 (the
sum of all amounts to be paid on the
qualifying debt instrument and the swap,
reduced by amounts to be received on the
swap). The synthetic debt instrument,
therefore, has $300 of OID.
Example 2. Issuer hedge with an option—
(i) Facts. On December 31, 1996, W, a
domestic corporation, issues for $1,000 a
debt instrument that matures on December
31, 1999. The debt instrument has a stated
principal amount of $1,000 payable at
maturity. The debt instrument also provides
for a payment at maturity equal to $10 times
the increase, if any, in the value of a
nationally known composite index of stocks
from December 31, 1996, to the maturity
date. On December 31, 1996, W purchases
from an unrelated party an option that pays
$10 times the increase, if any, in the stock
index from December 31, 1996, to December
31, 1999. W pays $250 for the option. On
December 31, 1996, W identifies the debt
instrument and option as an integrated
transaction in accordance with the
requirements of paragraph (e) of this section.
(ii) Eligibility for integration. The debt
instrument is a qualifying debt instrument.
The option is a § 1.1275–6 hedge because it
is a financial instrument and a yield to
maturity on the combined cash flows of the
option and the debt instrument can be
calculated. W has met the identification
requirements, and the other requirements of
paragraph (c)(1) of this section are satisfied.
Therefore, the transaction is an integrated
transaction under this section.
(iii) Treatment of the synthetic debt
instrument. Under paragraph (f)(4) of this
section, the issue price of the synthetic debt

instrument is equal to the issue price of the
debt instrument ($1,000) reduced by the
payment for the option ($250). As a result,
the synthetic debt instrument is a 3-year debt
instrument with an issue price of $750.
Under paragraph (f)(7) of this section, the
synthetic debt instrument has a stated
redemption price at maturity of $1,000 (the
$250 payment for the option is not taken into
account). The synthetic debt instrument,
therefore, has $250 of OID.
Example 3. Hedge with prepaid swap—(i)
Facts. On January 1, 1997, H purchases for
£1,000 a 5-year debt instrument that provides
for semiannual payments based on 6-month
pound LIBOR and a payment of the £1,000
principal at maturity. On the same day, H
enters into a swap with an unrelated third
party under which H receives semiannual
payments, in pounds, of 10 percent,
compounded semiannually, and makes
semiannual payments, in pounds, of 6-month
pound LIBOR on a notional principal amount
of £1,000. Payments on the swap are fixed
and made on the same dates as the payments
on the debt instrument. H also makes a £162
prepayment on the swap. On January 1, 1997,
H identifies the swap and the debt
instrument as an integrated transaction in
accordance with the requirements of
paragraph (e) of this section.
(ii) Eligibility for integration. The debt
instrument is a qualifying debt instrument.
The swap is a § 1.1275–6 hedge because it is
a financial instrument and a yield to maturity
on the combined cash flows of the swap and
the debt instrument can be calculated.
Although the debt instrument is
denominated in pounds, the swap hedges
only interest rate risk, not currency risk.
Therefore, the transaction is an integrated
transaction under this section. See § 1.988–
5(a) for the treatment of a debt instrument
and a swap if the swap hedges currency risk.
(iii) Treatment of the synthetic debt
instrument. Under paragraph (f)(4) of this
section, the issue price of the synthetic debt
instrument is equal to the issue price of the
debt instrument (£1,000) increased by the
prepayment on the swap (£162). As a result,
the synthetic debt instrument is a 5-year debt
instrument that has an issue price of £1,162
and provides for semiannual interest
payments of £50 and a principal payment of
£1,000 at maturity. Under paragraph (f)(6) of
this section, no amounts payable on the
synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(ii) of
this section, the synthetic debt instrument’s
stated redemption price at maturity is £1,500
(the sum of all amounts to be received on the
qualifying debt instrument and the § 1.1275–
6 hedge, reduced by all amounts to be paid
on the § 1.1275–6 hedge other than the £162
prepayment for the swap). The synthetic debt
instrument, therefore, has £338 of OID.
Example 4. Legging into an integrated
transaction by a holder—(i) Facts. On
December 31, 1996, X corporation purchases
for $1,000,000 a debt instrument that matures
on December 31, 2006. The debt instrument
provides for annual payments of interest at
the rate of 6 percent and for a payment at
maturity equal to $1,000,000, increased by
the excess, if any, of the price of 1,000 units
of a commodity on December 31, 2006, over

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$350,000, and decreased by the excess, if
any, of $350,000 over the price of 1,000 units
of the commodity on that date. The projected
amount of the payment at maturity
determined under § 1.1275–4(b)(4) is
$1,020,000. On December 31, 1999, X enters
into a cash-settled forward contract with an
unrelated party to sell 1,000 units of the
commodity on December 31, 2006, for
$450,000. On December 31, 1999, X also
identifies the debt instrument and the
forward contract as an integrated transaction
in accordance with the requirements of
paragraph (e) of this section.
(ii) Eligibility for integration. X meets the
requirements for integration as of December
31, 1999. Therefore, X legged into an
integrated transaction on that date. Prior to
that date, X treats the debt instrument under
the applicable rules of § 1.1275–4.
(iii) Treatment of the synthetic debt
instrument. As of December 31, 1999, the
debt instrument and the forward contract are
treated as an integrated transaction. The issue
price of the synthetic debt instrument is
equal to the adjusted issue price of the
qualifying debt instrument on the leg-in date,
$1,004,804 (assuming one year accrual
periods). The term of the synthetic debt
instrument is from December 31, 1999, to
December 31, 2006. The synthetic debt
instrument provides for annual interest
payments of $60,000 and a principal
payment at maturity of $1,100,000
($1,000,000 + $450,000 ¥ $350,000). Under
paragraph (f)(6) of this section, no amounts
payable on the synthetic debt instrument are
qualified stated interest. Thus, under
paragraph (f)(7)(ii) of this section, the
synthetic debt instrument’s stated
redemption price at maturity is $1,520,000
(the sum of all amounts to be received by X
on the qualifying debt instrument and the
§ 1.1275–6 hedge, reduced by all amounts to
be paid by X on the § 1.1275–6 hedge). The
synthetic debt instrument, therefore, has
$515,196 of OID.
Example 5. Abusive leg-in—(i) Facts. On
January 1, 1997, Y corporation purchases for
$1,000,000 a debt instrument that matures on
December 31, 2001. The debt instrument
provides for annual payments of interest at
the rate of 6 percent, a payment on December
31, 1999, of the increase, if any, in the price
of a commodity from January 1, 1997, to
December 31, 1999, and a payment at
maturity of $1,000,000 and the increase, if
any, in the price of the commodity from
December 31, 1999 to maturity. Because the
debt instrument is a contingent payment debt
instrument subject to § 1.1275–4, Y accrues
interest based on the projected payment
schedule.
(ii) Leg-in. By late 1999, the price of the
commodity has substantially increased, and
Y expects a positive adjustment on December
31, 1999. In late 1999, Y enters into an
agreement to exchange the two commodity
based payments on the debt instrument for
two payments on the same dates of $100,000
each. Y identifies the transaction as an
integrated transaction in accordance with the
requirements of paragraph (e) of this section.
Y disposes of the hedge in early 2000.
(iii) Treatment. The legging into an
integrated transaction has the effect of

deferring the positive adjustment from 1999
to 2000. Because Y legged into the integrated
transaction with a principal purpose to defer
the positive adjustment, the Commissioner
may treat the debt instrument as sold for its
fair market value on the leg-in date or refuse
to allow integration.
Example 6. Integration of offsetting debt
instruments—(i) Facts. On January 1, 1997, Z
issues two 10-year debt instruments. The
first, Issue 1, has an issue price of $1,000,
pays interest annually at 6 percent, and, at
maturity, pays $1,000, increased by $1 times
the increase, if any, in the value of the S&P
100 Index over the term of the instrument
and reduced by $1 times the decrease, if any,
in the value of the S&P 100 Index over the
term of the instrument. However, the amount
paid at maturity may not be less than $500
or more than $1,500. The second, Issue 2, has
an issue price of $1,000, pays interest
annually at 8 percent, and, at maturity, pays
$1,000, reduced by $1 times the increase, if
any, in the value of the S&P 100 Index over
the term of the instrument and increased by
$1 times the decrease, if any, in the value of
the S&P 100 Index over the term of the
instrument. The amount paid at maturity
may not be less than $500 or more than
$1,500. On January 1, 1997, Z identifies Issue
1 as the qualifying debt instrument, Issue 2
as a § 1.1275–6 hedge, and otherwise meets
the identification requirements of paragraph
(e) of this section.
(ii) Eligibility for integration. Both Issue 1
and Issue 2 are qualifying debt instruments.
Z has met the identification requirements by
identifying Issue 1 as the qualifying debt
instrument and Issue 2 as the § 1.1275–6
hedge. The other requirements of paragraph
(c)(1) of this section are satisfied. Therefore,
the transaction is an integrated transaction
under this section.
(iii) Treatment of the synthetic debt
instrument. The synthetic debt instrument
has an issue price of $2,000, provides for a
payment at maturity of $2,000, and, in
addition, provides for annual payments of
$140. Under paragraph (f)(6) of this section,
no amounts payable on the synthetic debt
instrument are qualified stated interest. Thus,
under paragraph (f)(7)(i) of this section, the
synthetic debt instrument’s stated
redemption price at maturity is $3,400 (the
sum of all amounts to be paid on the
qualifying debt instrument and the § 1.1275–
6 hedge, reduced by amounts to be received
on the § 1.1275–6 hedge other than the
$1,000 payment received on the issue date).
The synthetic debt instrument, therefore, has
$1,400 of OID.
Example 7. Integrated transaction entered
into by a foreign person—(i) Facts. X, a
foreign person, enters into an integrated
transaction by purchasing a qualifying debt
instrument that pays U.S. source interest and
entering into a notional principal contract
with a U.S. corporation. Neither the income
from the qualifying debt instrument nor the
income from the notional principal contract
is effectively connected with a U.S. trade or
business. The notional principal contract is
a § 1.1275–6 hedge.
(ii) Treatment of integrated transaction.
Under paragraph (f)(8) of this section, X will
receive U.S. source income from the

integrated transaction. However, under
paragraph (f)(12)(i) of this section, the
qualifying debt instrument and the notional
principal contract are treated as if they are
not part of an integrated transaction for
purposes of determining whether tax is due
and must be withheld on income.
Accordingly, because the § 1.1275–6 hedge
would produce foreign source income under
§ 1.863–7 to X if it were not part of an
integrated transaction, any income on the
§ 1.1275–6 hedge generally will not be
subject to tax under sections 871(a) and 881,
and the U.S. corporation that is the
counterparty will not be required to withhold
tax on payments under the § 1.1275–6 hedge
under sections 1441 and 1442.

(i) [Reserved]
(j) Effective date. This section applies
to a qualifying debt instrument issued
on or after August 13, 1996. This section
also applies to a qualifying debt
instrument acquired by the taxpayer on
or after August 13, 1996, if—
(1) The qualifying debt instrument is
a fixed rate debt instrument or a variable
rate debt instrument; or
(2) The qualifying debt instrument
and the § 1.1275–6 hedge are acquired
by the taxpayer substantially
contemporaneously.
PART 602—OMB CONTROL NUMBERS
UNDER THE PAPERWORK
REDUCTION ACT
Par. 18. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.

Par. 19. Section 602.101, paragraph
(c) is amended by:
1. Removing the following entries
from the table:
§ 602.101

*

OMB Control numbers.

*
*
(c) * * *

*

*

Current
OMB control No.

CFR part or section where
identified and described

*
*
*
*
*
1.1272–1(c)(4) ..........................
1545–1353
*
*
*
*
*
1.1275–3(b) ...............................
1545–1353
1.1275–3(c) ...............................
1545–0887
*

*

*

*

*

2. Adding entries in numerical order
to the table to read as follows:
§ 602.101

*

OMB Control numbers.

*
*
(c) * * *

*

*

30160

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

CFR part or section where
identified and described

*
*
*
*
*
1.1275–2 ...................................
1545–1450
1.1275–3 ...................................
1545–0887
1545–1353
1545–1450
1.1275–4 ...................................
1545–1450
1.1275–6 ...................................
1545–1450
*

*

*

*

*

Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: March 22, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96–14918 Filed 6–11–96; 8:45 am]
BILLING CODE 4830–01–P

PENSION BENEFIT GUARANTY
CORPORATION
29 CFR Parts 2619 and 2676
Valuation of Plan Benefits in SingleEmployer Plans; Valuation of Plan
Benefits and Plan Assets Following
Mass Withdrawal; Amendments
Adopting Additional PBGC Rates
Pension Benefit Guaranty
Corporation.
ACTION: Final rule.
AGENCY:

SUMMARY: This final rule amends the
Pension Benefit Guaranty Corporation’s
regulations on Valuation of Plan
Benefits in Single-Employer Plans and
Valuation of Plan Benefits and Plan
Assets Following Mass Withdrawal. The
former regulation contains the interest
assumptions that the PBGC uses to
value benefits under terminating singleemployer plans. The latter regulation
contains the interest assumptions for
valuations of multiemployer plans that
have undergone mass withdrawal. The
amendments set out in this final rule
adopt the interest assumptions
applicable to single-employer plans
with termination dates in July 1996, and
to multiemployer plans with valuation
dates in July 1996. The effect of these
amendments is to advise the public of
the adoption of these assumptions.
EFFECTIVE DATE: July 1, 1996.
FOR FURTHER INFORMATION CONTACT:
Harold J. Ashner, Assistant General
Counsel, Office of the General Counsel,
Pension Benefit Guaranty Corporation,
1200 K Street, NW., Washington, DC
20005, 202–326–4024 (202–326–4179
for TTY and TDD).
SUPPLEMENTARY INFORMATION: This rule
adopts the July 1996 interest

assumptions to be used under the
Pension Benefit Guaranty Corporation’s
regulations on Valuation of Plan
Benefits in Single-Employer Plans (29
CFR part 2619, the ‘‘single-employer
regulation’’) and Valuation of Plan
Benefits and Plan Assets Following
Mass Withdrawal (29 CFR part 2676, the
‘‘multiemployer regulation’’).
Part 2619 sets forth the methods for
valuing plan benefits of terminating
single-employer plans covered under
title IV of the Employee Retirement
Income Security Act of 1974, as
amended. Under ERISA section 4041(c),
all single-employer plans wishing to
terminate in a distress termination must
value guaranteed benefits and ‘‘benefit
liabilities,’’ i.e., all benefits provided
under the plan as of the plan
termination date, using the formulas set
forth in part 2619, subpart C. (Plans
terminating in a standard termination
may, for purposes of the Standard
Termination Notice filed with PBGC,
use these formulas to value benefit
liabilities, although this is not required.)
In addition, when the PBGC terminates
an underfunded plan involuntarily
pursuant to ERISA section 4042(a), it
uses the subpart C formulas to
determine the amount of the plan’s
underfunding. Part 2676 prescribes
rules for valuing benefits and certain
assets of multiemployer plans under
sections 4219(c)(1)(D) and 4281(b) of
ERISA.
Appendix B to part 2619 sets forth the
interest rates and factors under the
single-employer regulation. Appendix B
to part 2676 sets forth the interest rates
and factors under the multiemployer
regulation. Because these rates and
factors are intended to reflect current
conditions in the financial and annuity
markets, it is necessary to update the
rates and factors periodically.
The PBGC issues two sets of interest
rates and factors, one set to be used for
the valuation of benefits to be paid as
annuities and one set for the valuation
of benefits to be paid as lump sums. The
same assumptions apply to terminating
single-employer plans and to
multiemployer plans that have
undergone a mass withdrawal. This
amendment adds to appendix B to parts
2619 and 2676 sets of interest rates and
factors for valuing benefits in singleemployer plans that have termination
dates during July 1996 and
multiemployer plans that have
undergone mass withdrawal and have
valuation dates during July 1996.
For annuity benefits, the interest rates
will be 6.20% for the first 20 years
following the valuation date and 4.75%
thereafter. For benefits to be paid as
lump sums, the interest assumptions to

be used by the PBGC will be 5.00% for
the period during which benefits are in
pay status, 4.25% during the seven-year
period directly preceding the benefit’s
placement in pay status, and 4.0%
during any other years preceding the
benefit’s placement in pay status. These
annuity and lump sum interest
assumptions are unchanged from those
in effect for June 1996.
Generally, the interest rates and
factors under these regulations are in
effect for at least one month. However,
the PBGC publishes its interest
assumptions each month regardless of
whether they represent a change from
the previous month’s assumptions. The
assumptions normally will be published
in the Federal Register by the 15th of
the preceding month or as close to that
date as circumstances permit.
The PBGC has determined that notice
and public comment on these
amendments are impracticable and
contrary to the public interest. This
finding is based on the need to
determine and issue new interest rates
and factors promptly so that the rates
and factors can reflect, as accurately as
possible, current market conditions.
Because of the need to provide
immediate guidance for the valuation of
benefits in single-employer plans whose
termination dates fall during July 1996,
and in multiemployer plans that have
undergone mass withdrawal and have
valuation dates during July 1996, the
PBGC finds that good cause exists for
making the rates and factors set forth in
this amendment effective less than 30
days after publication.
The PBGC has determined that this
action is not a ‘‘significant regulatory
action’’ under the criteria set forth in
Executive Order 12866.
Because no general notice of proposed
rulemaking is required for this
amendment, the Regulatory Flexibility
Act of 1980 does not apply. See 5 U.S.C.
601(2).
List of Subjects
29 CFR Part 2619
Employee benefit plans, Pension
insurance, and Pensions.
29 CFR Part 2676
Employee benefit plans and Pensions.
In consideration of the foregoing,
parts 2619 and 2676 of chapter XXVI,
title 29, Code of Federal Regulations, are
hereby amended as follows:
PART 2619—[AMENDED]
1. The authority citation for part 2619
continues to read as follows:
Authority: 29 U.S.C. 1301(a), 1302(b)(3),
1341, 1344, 1362.