[Federal Register Volume 59, Number 22 (Wednesday, February 2, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-2073]
[[Page Unknown]]
[Federal Register: February 2, 1994]
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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602
[TD 8517]
RIN 1545-AH46
Debt Instruments With Original Issue Discount; Imputed Interest
on Deferred Payment Sales or Exchanges of Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the tax
treatment of debt instruments with original issue discount and the
imputation of interest on deferred payments under certain contracts for
the sale or exchange of property. The final regulations provide needed
guidance to holders and issuers of debt instruments with original issue
discount and to buyers and sellers of property.
DATES: The removal of Secs. 1.163-11T, 1.1275-3T, 1.1275-6T and
1.6050H-2 is effective February 2, 1994. The remaining regulations are
effective April 4, 1994.
For dates of applicability of these regulations, see Effective
Dates under SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: William E. Blanchard, 202-622-3950
(not a toll-free number), or Andrew C. Kittler, 202-622-3940 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this final regulation
have been reviewed and approved by the Office of Management and Budget
in accordance with the requirements of the Paperwork Reduction Act (44
U.S.C. 3504(h)) under control number 1545-1353. The estimated annual
burden per respondent varies from .3 hours to .5 hours, depending on
individual circumstances, with an estimated average of .4 hours.
These estimates are an approximation of the average time expected
to be necessary for a collection of information. They are based on such
information as is available to the IRS. Individual respondents may
require more or less time, depending on their particular circumstances.
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, PC: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.
Background
On December 22, 1992, the IRS published a notice of proposed
rulemaking in the Federal Register (57 FR 60750) relating to original
issue discount (OID) under section 163(e) and sections 1271 through
1275 of the Internal Revenue Code (Code). The notice also contained
proposed amendments to the regulations under sections 446 (relating to
the accrual of interest), 483 (relating to unstated interest), 1001
(relating to amount realized), and 1012 (relating to basis). The notice
withdrew most of the proposed regulations that were previously
published in the Federal Register on April 8, 1986 (51 FR 12022), as
amended on May 7, 1991 (56 FR 21112), and July 12, 1991 (56 FR 31887).
On February 16, 1993, 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; to
permit further comment, Sec. 1.446-2(e)(3) remains outstanding in
proposed form. The changes, as well as several comments and suggestions
that were not adopted in the final regulations, are discussed below.
Explanation of Provisions
Section 1.163-7 Deduction for OID on Certain Debt Instruments
The final regulations retain the rule of the proposed regulations
that allows the issuer of a debt instrument to deduct de minimis OID
using a straight line method. As requested by a commentator, the final
regulations also allow the issuer the choice of deducting de minimis
OID at maturity or in proportion to stated interest payments.
Because the proposed regulations permit flexible accrual periods, a
commentator requested guidance on what accrual period controls to
determine whether a debt instrument is an applicable high yield debt
obligation under section 163(i). The final regulations provide that the
issuer's choice of accrual periods governs for purposes of section
163(i).
A commentator requested that an immediate deduction be allowed for
a repurchase premium in a debt-for-debt exchange even if the issue
price of the debt instrument received in the exchange is determined
under section 1274. The IRS and Treasury, however, believe that
taxpayers could inappropriately accelerate deductions in these
situations because of the flexibility inherent in section 1274 for
determining the issue price of a debt instrument. Thus, the final
regulations retain the rule in the proposed regulations.
Section 1.446-2 Method of Accounting for Interest
The proposed regulations provide a special payment allocation rule
for certain small transactions. Because of the rule's limited scope and
uncertainty regarding its application, the IRS and Treasury believe
that the rule should not be finalized. However, to allow further
comment on the need for this rule, Sec. 1.446-2(e)(3) is reserved in
the final regulations and remains in proposed form.
Section 1.483-1 Through 1.483-3 Unstated Interest
The proposed regulations provide that stated or unstated interest
under a contract subject to section 483 is taken into account under a
taxpayer's regular method of accounting. One commentator suggested that
an accrual method taxpayer should account for unstated interest in the
year a payment is due, which was the rule in previous final regulations
under section 483. The IRS and Treasury, however, believe that it is
appropriate to treat stated and unstated interest consistently. Thus,
the final regulations retain the rule in the proposed regulations.
Sections 1.1001-1(g) and 1.1012-1(g) Amount Realized and Basis
If a debt instrument is issued in exchange for property, the
proposed regulations provide that the issue price of the debt
instrument is used to determine the seller's amount realized and the
buyer's basis. The final regulations adopt the rules of the proposed
regulations, but clarify the treatment of a debt instrument with an
issue price determined under section 1273(b)(4).
Section 1.1271-1 Special Rules Applicable to Amounts Received on
Retirement, Sale, or Exchange of Debt Instruments
As requested by a commentator, the final regulations provide that
the intention to call rules do not apply to debt instruments sold
pursuant to a private placement memorandum that is distributed to more
than ten offerees and that is subject to certain sanctions of the
Securities Act of 1933 or the Securities Exchange Act of 1934.
Section 1.1272-1 Current Inclusion of OID in Income
The proposed regulations provide that accrual periods may be of any
length and may vary in length over the term of the debt instrument,
provided that each accrual period is not longer than one year and that
all payments are made at the end of an accrual period. In response to
one comment, the final regulations provide that payments also may be
made on the first day of an accrual period.
The rule permitting accrual periods to vary in length was provided
in response to commentators who criticized the prior proposed
regulations as too mechanical and inflexible. While commentators
commended the flexibility of the rule, they noted that the rule raised
several technical issues: (1) the accrual periods used to determine
whether an instrument is an applicable high yield debt obligation under
section 163(i); (2) the accrual periods used by a subsequent holder to
determine adjusted issue price for purposes of OID accruals, market
discount, and acquisition premium; and (3) the accrual periods used for
Form 1099 reporting. As noted above, Sec. 1.163-7 of the final
regulations provides that the issuer's determination of accrual periods
controls for purposes of determining whether a debt instrument is an
applicable high yield debt obligation. In addition, Sec. 1.1275-1(b)(2)
of the final regulations provides that a subsequent holder determines
adjusted issue price for purposes of OID accruals, market discount, and
acquisition premium in any manner consistent with these final
regulations. Rules on Form 1099 reporting will be addressed in a
separate project. Until guidance regarding Form 1099 reporting is
issued, however, an issuer should use the same accrual periods for Form
1099 purposes as it uses for computing OID deductions.
The proposed regulations provide rules to determine the yield and
maturity of a debt instrument with a stated contingency that could
result in the acceleration or deferral of payments if the timing and
amounts payable upon occurrence of the contingency are fixed. The
contingency is ignored unless, based on all the facts and
circumstances, the contingency is more likely than not to occur. The
final regulations clarify that this rule applies when the contingency,
if triggered, would result in an alternative payment schedule as long
as the timing and amounts of the payments comprising the alternative
payment schedule are known as of the issue date. The final regulations
also clarify that these rules apply if the debt instrument is subject
to multiple contingencies that result in alternative payment schedules.
The final regulations retain the rule in the proposed regulations for
determining the yield and the maturity of a debt instrument in the case
of a put or call option.
The final regulations modify the proposed rules regarding
subsequent adjustments that are required when a contingency occurs (or
does not occur) contrary to the assumption initially made. This
modification treats both the acceleration and deferral of payments as a
deemed reissuance for purposes of OID accruals. In addition, the
subsequent adjustment rules are coordinated with the new pro rata
prepayment rule described below in connection with the description of
Sec. 1.1275-2.
Finally, in response to a comment, an example describing the
consequences of a pay-in-kind debt instrument issued at par has been
included in the final regulations.
Section 1.1272-2 Treatment of Debt Instruments Purchased at a Premium
The final regulations retain the rules in the proposed regulations
for debt instruments purchased at a premium. Thus, the holder's basis
in a debt instrument that is acquired in exchange for property and that
otherwise would take a substituted basis generally will not exceed the
fair market value of the property immediately after the exchange. This
rule corresponds to a similar rule in section 171(b)(4) of the Code.
The final regulations clarify the application of the rule to a
situation in which a debt instrument is received in a distribution from
a partnership.
Section 1.1272-3 Election by a Holder to Treat all Interest on a Debt
Instrument as OID
The proposed regulations permit accrual method holders to treat all
interest on a debt instrument as OID. In response to comments, the
final regulations extend this election to holders that use the cash
receipts and disbursements method of accounting.
Section 1.1273-1 Definition of OID
The final regulations retain the definition of qualified stated
interest, but clarify that a conversion feature is ignored for purposes
of determining whether stated interest is unconditionally payable. In
response to a comment, the final regulations provide that if a debt
instrument has payment intervals that are equal in length throughout
the term of the instrument, except for the first or final payment
interval (or both intervals), the interest payment for that interval
(or intervals) is considered to be made at a fixed rate if the value of
the rate on which the payment is based is adjusted in any reasonable
manner to take into account the length of the interval. The final
regulations also clarify the determination of qualified stated interest
for a debt instrument that provides for an alternative payment schedule
(or schedules) upon the occurrence of one or more contingencies. In the
case of these debt instruments, each alternative payment schedule
(including the stated payment schedule) is treated as if it were the
debt instrument's sole payment schedule. Based on this analysis, 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.
The final regulations also provide rules for a subsequent holder's
treatment of a debt instrument issued with de minimis OID. Under these
rules, if a subsequent holder purchases the debt instrument at a
premium, the subsequent holder does not include any de minimis OID in
income. Because the debt instrument is treated as having zero OID under
section 1273(a)(3), if a subsequent holder purchases the debt
instrument at a discount, the subsequent holder reports the discount
under the market discount rules of sections 1276 through 1278 of the
Code, rather than under the rules for de minimis OID.
Finally, the final regulations retain the rule of the proposed
regulations that de minimis OID is includible in the income of the
holder as principal payments are made. Commentators objected to the
fact that this rule is written as applying on a loan-by-loan basis
because it could preclude a financial institution from using the loan
liquidation method. Although the rule is stated in terms of a single
loan, the IRS and Treasury recognize that it may be appropriate to
permit financial institutions to account for de minimis OID on an
aggregate basis. The IRS is reviewing its published position with
respect to the loan liquidation method and plans to issue updated
guidance that permits financial institutions to use some form of
aggregate accounting.
Section 1.1273-2 Determination of Issue Price and Issue Date
If an issue of debt instruments sold for money is publicly offered,
the proposed regulations provide that the issue price of each debt
instrument in the issue is the first price at which a substantial
amount of the debt instruments in the issue is sold to the public.
However, if the issue is not publicly offered, the issue price of each
debt instrument in the issue is the price paid by the first buyer of a
debt instrument that is part of the issue. Commentators suggested that
the issue price rules should be the same for publicly offered and non-
publicly offered issues. In addition, commentators suggested that all
debt instruments in an issue should be fungible with other debt
instruments in the issue.
In response to these comments, the definition of issue price has
been modified. Under the final regulations, if a substantial amount of
debt instruments in an issue is sold for money, the issue price of each
instrument in the issue is the first price at which a substantial
amount is sold for money. If an issue is not subject to this rule, but
a substantial amount of the instruments in the issue is publicly
traded, the issue price of each instrument in the issue is the fair
market value of the instrument as of the issue date. If an issue is not
subject to either of these rules, but a substantial amount of
instruments in the issue is issued in exchange for publicly traded
property, the issue price of each instrument in the issue is the fair
market value of the property as of the issue date. Finally, if an issue
of debt instruments is not described in any of the above rules, the
issue price of each debt instrument in the issue is determined as if
the instrument were a separate issue.
The proposed regulations define publicly traded property generally
to include exchange listed property, property traded on a board of
trade or an interbank market, property appearing on a quotation medium,
and debt instruments for which price quotations are readily available.
In response to a comment, the final regulations clarify that, for
purposes of determining whether an instrument is publicly traded, a
quotation medium is limited to a medium that provides a reasonable
basis to determine fair market value. One commentator suggested that
the rule regarding readily available price quotations should be
eliminated. The IRS and Treasury, however, believe that one principal
way in which debt instruments are traded is through brokers and dealers
from whom price quotations are readily available, that this market is
liquid, and that instruments so traded are susceptible to ready
valuation. In such a case, it is consistent with the purposes of the
rules applicable to publicly traded property that the instruments be
considered publicly traded.
The final regulations clarify the determination of issue price for
a debt instrument that is part of an investment unit. In general, the
issue price of an investment unit is determined as if the investment
unit were a debt instrument. The issue price of the investment unit is
then allocated between the debt instrument and the property right that
comprise the investment unit based on their relative fair market
values. If, however, the issue price of the investment unit is not
determined under the rules of paragraph (a)(1), (b)(1), or (c)(1) of
Sec. 1.1273-2 (e.g., because the investment unit is not issued for
money or publicly traded property), the issue price of the debt
instrument included in the investment unit is determined under section
1273(b)(4) or 1274, whichever is applicable.
To coordinate the definition of issue date with the revised
definition of issue price discussed above, the definition of issue date
has been moved from Sec. 1.1275-1 of the proposed regulations to
Sec. 1.1273-2 of the final regulations.
Sections 1.1274-1 Through 1.1274-5 Determination of Issue Price in the
Case of Certain Debt Instruments Issued for Property
The final regulations modify the rule to determine the test rate
for purposes of sections 483 and 1274. Under the modified rule, the
test rate is generally the lowest of the applicable Federal rates
(based on the appropriate compounding period) in effect during either
(i) the 3-month period ending with the first month in which there is a
binding written contract that substantially sets forth the terms under
which the sale or exchange is ultimately consummated, or (ii) the 3-
month period ending with the month in which the sale or exchange
occurs.
The proposed regulations generally provide that the imputed
principal amount of a contingent payment debt instrument is the sum of
the present values of the noncontingent payments and the fair market
value of the contingent payments. Several comments and questions were
received on this rule, including the comment that the rule should be
reserved pending the resolution of the contingent payment rules in
regulations under section 1275. To allow further study of this issue
and coordination with the contingent payment regulations under section
1275, the final regulations do not adopt the rule in the proposed
regulations. Thus, for example, consistent with existing authorities,
the value of contingent payments is not taken into account for purposes
of determining the basis of property under section 1012. With the
publication of the final regulations in the Federal Register,
Sec. 1.1274-2(e) of the proposed regulations no longer remains as a
proposed regulation. Pending resolution of the issue and publication of
new proposed regulations, paragraphs (c) and (d) of Sec. 1.1275-4 of
the proposed regulations, as proposed in 1986, remain authority under
section 6662 of the Code for a nonpublicly traded debt instrument
issued in exchange for nonpublicly traded property.
Section 1.1274A-1 Special Rules for Certain Transactions Where Stated
Principal Amount Does Not Exceed $2,800,000
No comments were received on these regulations and no material
changes were made to this section.
Section 1.1275-1 Definitions
In response to a comment, the definition of issue has been
expanded. As a result, debt instruments issued in different markets or
for different consideration can be part of the same issue.
Section 1.1275-2 Special Rules Relating to Debt Instruments
The proposed regulations provide that all payments (other than
qualified stated interest payments) consist first of accrued but unpaid
OID, then of principal. Several commentators suggested that unscheduled
prepayments should be treated as partial retirements of the debt
instrument. In response to these comments, the final regulations add
new rules for the treatment of pro rata prepayments. In general, a pro
rata prepayment is an unscheduled payment made on a debt instrument
prior to maturity that results in a substantially pro rata reduction of
each payment of principal and interest remaining on the instrument. If
a prepayment on a debt instrument is a pro rata prepayment, the
prepayment is treated as a payment in retirement of a portion of the
instrument, which may result in gain or loss to the holder. The gain or
loss is calculated by assuming that the debt instrument consists of two
instruments, one that is retired and one that remains outstanding, and
by allocating the adjusted issue price, the holder's adjusted basis,
and the accrued but unpaid qualified stated interest between the two
instruments based on the portion of the instrument that is treated as
retired by the pro rata prepayment. In the case of a pro rata
prepayment, the issuer may realize discharge of indebtedness income (as
determined under Sec. 1.61-12) or repurchase premium (as determined
under Sec. 1.163-7).
Partial retirement treatment is restricted to pro rata prepayments
because the IRS and Treasury believe that this type of prepayment is
common. The extension of the rule to non-pro rata prepayments would add
undue complexity to the regulations. In addition, extension of the rule
to non-pro rata prepayments may cause inappropriate recognition of gain
or loss if, in addition to a prepayment, the interest rate or the
payment schedule is altered. Furthermore, as noted by one commentator,
a rule for non-pro rata prepayments may not be necessary because an
unscheduled prepayment may, depending on the circumstances, result in a
deemed exchange under section 1001.
The proposed regulations contain a number of rules that generally
require a holder to follow the issuer's treatment of an item, such as
whether a debt instrument is issued in a potentially abusive situation.
In response to comments, the final regulations provide that the issuer
must make information relating to its treatment of the item available
to the holder in a reasonable manner.
Section 1.1275-2T, which is published elsewhere in this issue of
the Federal Register, provides for an anti-abuse rule. Under the rule,
the Commissioner of Internal Revenue, in certain circumstances, can
apply or depart from the final regulations in a manner that ensures a
reasonable result in light of the purposes of the statutes governing
OID.
Section 1.1275-3 OID Information Reporting Requirements
The legending requirements in the final regulations for debt
instruments with OID are generally the same as the requirements in the
proposed regulations.
Section 1.1275-5 Variable Rate Debt Instruments
In response to comments that the definition of a variable rate debt
instrument contained in the proposed regulations is overly restrictive,
the final regulations liberalize the rules in several respects. First,
the regulations allow the issue price of a variable rate debt
instrument to exceed the total noncontingent principal payments on the
instrument, provided that the excess is not greater than a specified
amount. Second, the regulations allow a variable rate debt instrument
to provide for stated interest at more than two qualified floating
rates, at a single fixed rate and one or more qualified floating rates,
and at a single fixed rate and an objective rate that is a qualified
inverse floating rate. Third, the regulations provide that interest
that is stated at an initial fixed rate for a period of not more than
one year, followed by a qualified floating rate or an objective rate,
is treated as stated at a single qualified floating rate or an
objective rate in certain circumstances. This rule applies, for
example, if interest for the initial accrual period is set a short time
prior to the issue date at a fixed rate chosen to approximate the
expected value of the qualified floating rate or objective rate on the
issue date. Fourth, the regulations allow certain multiples of a
qualified floating rate to be treated as qualified floating rates.
Fifth, the regulations expand the definition of an objective rate to
include a rate based on the yield of actively traded property, a rate
that would be a qualified floating rate if the debt instrument were
denominated in a foreign currency, and any combination of objective
rates. In addition, the final regulations provide that other rates may
be treated as objective rates if designated by revenue ruling or
revenue procedure.
In response to a comment, the definition of an objective rate has
been narrowed in two respects. While the proposed regulations permit a
rate based on the price of actively traded personal property, the final
regulations permit only a rate based on the change in the price of
actively traded personal property to be an objective rate. In addition,
the final regulations provide a more general rule relating to the
frontloading or backloading of interest such that a variable rate is
not an objective rate if it results in significant frontloading or
backloading of interest.
The rules in the proposed regulations relating to permissible
objective rates on tax-exempt debt instruments have been changed in the
final regulations. Under the revised rules, a variable rate on a tax-
exempt debt instrument is an objective rate only if it is a qualified
inverse floating rate. In general, an objective rate is a qualified
inverse floating rate if the rate is equal to a fixed rate minus a
qualified floating rate and the rate varies in a manner that inversely
reflects contemporaneous variations in the cost of newly borrowed
funds.
The rules in the proposed regulations for determining the accrual
of OID and the amount of qualified stated interest on a variable rate
debt instrument have been revised and simplified in the final
regulations. Under the revised rules, a debt instrument providing for
qualified floating rates is converted to an equivalent fixed rate debt
instrument by assuming that each qualified floating rate will remain at
its value as of the issue date. A debt instrument providing for an
objective rate is converted to an equivalent fixed rate debt instrument
by assuming that the objective rate will equal a fixed rate that
reflects the yield that is reasonably expected for the instrument. The
rules applicable to fixed rate debt instruments are then applied to
determine the OID accruals and the qualified stated interest payments
on the equivalent fixed rate debt instrument. Appropriate adjustments
to these amounts are made in each accrual period if the interest
actually accrued or paid during the accrual period is greater than or
less than the interest assumed to be accrued or paid under the
equivalent fixed rate debt instrument.
In response to a comment, the final regulations provide a special
rule for certain variable rate debt instruments (such as auction rate
or adjustable rate debt instruments) that provide for a fixed rate of
interest for an initial period, followed by a period during which the
interest is reset to a rate that will enable the instrument to trade at
a fixed amount when the reset becomes effective. Under this special
rule, the debt instrument is treated as maturing on the date the reset
rate becomes effective and reissued on that date for the fixed amount.
As a result of this rule, for example, if a debt instrument is issued
at a discount (i.e., the issue price of the debt instrument is less
than its par value) and is reset to par after an initial period, the
discount on the instrument will be accrued entirely in the initial
period rather than over the full term of the instrument.
Effective Dates
These regulations apply to debt instruments issued on or after
April 4, 1994, and to lending transactions, sales, and exchanges that
occur on or after April 4, 1994. However, Sec. 1.1272-3 applies to debt
instruments acquired on or after April 4, 1994, and Sec. 1.1275-2(d)(2)
applies to qualified reopenings that occur on or after March 25, 1992.
Reliance on Final Regulations
Except for Sec. 1.1272-3, taxpayers may rely on the final
regulations for debt instruments issued after December 21, 1992, and
for lending transactions, sales, and exchanges that occur after
December 21, 1992.
Authority Under Section 6662
Although the final regulations dispose of the underlying proposed
regulations (other than Sec. 1.446-2(e)(3)), the IRS will allow
taxpayers to treat the proposed regulations as authority under section
6662 of the Code for debt instruments issued after December 21, 1992,
and prior to April 4, 1994, and for lending transactions, sales, and
exchanges that occurred after December 21, 1992, and prior to April 4,
1994. The IRS also will allow taxpayers to treat the OID regulations
that were proposed in 1986 and 1991 as authority under section 6662 for
debt instruments issued prior to December 22, 1992, and for lending
transactions, sales, and exchanges that occurred prior to December 22,
1992.
Special Analyses
It has been determined that these regulations are not major rules
as defined in Executive Order 12291. Therefore, a Regulatory Impact
Analysis 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 Code, the notice of
proposed rulemaking was submitted to the Small Business Administration
for comment on its impact on small business.
Drafting Information
The principal authors of these regulations are William E. Blanchard
and Andrew C. Kittler of the Office of Assistant Chief Counsel
(Financial Institutions and Products), IRS. However, other personnel
from the IRS and Treasury Department participated in their development.
List of Subjects
26 CFR part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
removing the entry for ``Section 1.1275-3'' and adding the following
citations in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Secs. 1.483-1 through 1.483-3 also issued under 26 U.S.C.
483(f). * * *
Secs. 1.1271-1 through 1.1274-5 also issued under 26 U.S.C.
1275(d).
Sec. 1.1274A-1 also issued under 26 U.S.C. 1274A(e) and 26
U.S.C. 1275(d).
Secs. 1.1275-1 through 1.1275-5 also issued under 26 U.S.C.
1275(d). * * *
Par. 2. Section 1.163-7 is added to read as follows:
Sec. 1.163-7 Deduction for OID on certain debt instruments.
(a) General rule. Except as otherwise provided in paragraph (b) of
this section, an issuer (including a transferee) determines the amount
of OID that is deductible each year under section 163(e)(1) by using
the constant yield method described in Sec. 1.1272-1(b). This
determination, however, is made without regard to section 1272(a)(7)
(relating to acquisition premium) and Sec. 1.1273-1(d) (relating to de
minimis OID). An issuer is permitted a deduction under section
163(e)(1) only to the extent the issuer is primarily liable on the debt
instrument. For certain limitations on the deductibility of OID, see
sections 163(e) and 1275(b)(2).
(b) Special rules for de minimis OID--(1) Stated interest. If a
debt instrument has a de minimis amount of OID (within the meaning of
Sec. 1.1273-1(d)), the issuer treats all stated interest on the debt
instrument as qualified stated interest. See Secs. 1.446-2(b) and
1.461-1 for the treatment of qualified stated interest.
(2) Deduction of de minimis OID on other than a constant yield
basis. In lieu of deducting de minimis OID under the general rule of
paragraph (a) of this section, an issuer of a debt instrument with a de
minimis amount of OID (other than a de minimis amount treated as
qualified stated interest under paragraph (b)(1) of this section) may
choose to deduct the OID at maturity, on a straight-line basis over the
term of the debt instrument, or in proportion to stated interest
payments. The issuer makes this choice by reporting the de minimis OID
in a manner consistent with the method chosen on the issuer's timely
filed Federal income tax return for the taxable year in which the debt
instrument is issued.
(c) Deduction upon repurchase. Except to the extent disallowed by
any other section of the Internal Revenue Code (e.g., section 249) or
this paragraph (c), if a debt instrument is repurchased by the issuer
for a price in excess of its adjusted issue price (as defined in
Sec. 1.1275-1(b)), the excess (repurchase premium) is deductible as
interest for the taxable year in which the repurchase occurs. If the
issuer repurchases a debt instrument in a debt-for-debt exchange, the
repurchase price is the issue price of the newly issued debt instrument
(reduced by any unstated interest within the meaning of section 483).
However, if the issue price of the newly issued debt instrument is
determined under either section 1273(b)(4) or section 1274, any
repurchase premium is not deductible in the year of the repurchase, but
is amortized over the term of the newly issued debt instrument in the
same manner as if it were OID.
(d) Choice of accrual periods to determine whether a debt
instrument is an applicable high yield discount obligation (AHYDO).
Section 163(e)(5) affects an issuer's OID deductions for certain high
yield debt instruments that have significant OID. For purposes of
section 163(i)(2), which defines significant OID, the issuer's choice
of accrual periods to determine OID accruals is used to determine
whether a debt instrument has significant OID. See Sec. 1.1275-2(e) for
rules relating to the issuer's obligation to disclose certain
information to holders.
(e) Effective date. This section applies to debt instruments issued
on or after April 4, 1994. Taxpayers, however, may rely on this section
for debt instruments issued after December 21, 1992, and before April
4, 1994.
Sec. 1.163-11T [Removed]
Par. 3. Section 1.163-11T is removed as of February 2, 1994.
Par. 4. Section 1.446-2 is added to read as follows:
Sec. 1.446-2 Method of accounting for interest.
(a) Applicability--(1) In general. This section provides rules for
determining the amount of interest that accrues during an accrual
period (other than interest described in paragraph (a)(2) of this
section) and for determining the portion of a payment that consists of
accrued interest. For purposes of this section, interest includes
original issue discount and amounts treated as interest (whether stated
or unstated) in any lending or deferred payment transaction. Accrued
interest determined under 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).
Application of an exception described in paragraph (a)(2) of this
section to one party to a transaction does not affect the application
of this section to any other party to the transaction.
(2) Exceptions--(i) Interest included or deducted under certain
other provisions. This section does not apply to interest that is taken
into account under--
(A) Sections 1272(a), 1275, and 163(e) (income and deductions
relating to original issue discount);
(B) Section 467(a)(2) (certain payments for the use of property or
services);
(C) Sections 1276 through 1278 (market discount);
(D) Sections 1281 through 1283 (discount on certain short-term
obligations);
(E) Section 7872(a) (certain loans with below-market interest
rates); or
(F) Section 1.1272-3 (an election by a holder to treat all interest
on a debt instrument as original issue discount).
(ii) De minimis original issue discount. This section does not
apply to de minimis original issue discount (other than de minimis
original issue discount treated as qualified stated interest) as
determined under Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment
of de minimis original issue discount by the issuer and Secs. 1.1273-
1(d) and 1.1272-3 for the treatment of de minimis original issue
discount by the holder.
(b) Accrual of qualified stated interest. Qualified stated interest
(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual
period (or periods) to which it is attributable and accrues at the
stated rate for the period (or periods).
(c) Accrual of interest other than qualified stated interest.
Subject to the modifications in paragraph (d) of this section, the
amount of interest (other than qualified stated interest) that accrues
for any accrual period is determined under rules similar to those in
the regulations under sections 1272 and 1275 for the accrual of
original issue discount. The preceding sentence applies regardless of
any contrary formula agreed to by the parties.
(d) Modifications--(1) Issue price. The issue price of the loan or
contract is equal to--
(i) In the case of a contract for the sale or exchange of property
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
(ii) In the case of a contract for the sale or exchange of property
to which section 483 does not apply, the stated principal amount; or
(iii) In any other case, the amount loaned.
(2) Principal payments that are not deferred payments. In the case
of a contract to which section 483 applies, principal payments that are
not deferred payments are ignored for purposes of determining yield and
adjusted issue price.
(e) Allocation of interest to payments--(1) In general. Except as
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each
payment under a loan (other than payments of additional interest or
similar charges provided with respect to amounts that are not paid when
due) is treated as a payment of interest to the extent of the accrued
and unpaid interest determined under paragraphs (b) and (c) of this
section as of the date the payment becomes due.
(2) Special rule for points deductible under section 461(g)(2). If
a payment of points is deductible by the borrower under section
461(g)(2), the payment is treated by the borrower as a payment of
interest.
(3) Allocation respected in certain small transactions. [Reserved]
(4) Pro rata prepayments. Accrued but unpaid interest is allocated
to a pro rata prepayment under rules similar to those for allocating
accrued but unpaid original issue discount to a pro rata prepayment
under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro
rata prepayment is a payment that is made prior to maturity that--
(i) Is not made pursuant to the contract's payment schedule; and
(ii) Results in a substantially pro rata reduction of each payment
remaining to be paid on the contract.
(f) Aggregation rule. For purposes of this section, all contracts
calling for deferred payments arising from the same transaction (or a
series of related transactions) are treated as a single contract. This
rule, however, generally only applies to contracts involving a single
borrower and a single lender.
(g) Debt instruments denominated in a currency other than the U.S.
dollar. This section applies to a debt instrument that provides for all
payments denominated in, or determined by reference to, the functional
currency of the taxpayer or qualified business unit of the taxpayer
(even if that currency is other than the U.S. dollar). See Sec. 1.988-
2(b) to determine interest income or expense for debt instruments that
provide for payments denominated in, or determined by reference to, a
nonfunctional currency.
(h) Example. The following example illustrates the rules of this
section.
Example. Allocation of unstated interest to deferred payments--
(i) Facts. On July 1, 1996, A sells his personal residence to B for
a stated purchase price of $1,297,143.66. The property is not
personal use property (within the meaning of section 1275(b)(3)) in
the hands of B. Under the loan agreement, B is required to make two
installment payments of $648,571.83 each, the first due on June 30,
1998, and the second due on June 30, 2000. Both A and B use the cash
receipts and disbursements method of accounting and use a calendar
year for their taxable year.
(ii) Amount of unstated interest. Under section 483, the
agreement does not provide for adequate stated interest. Thus, the
loan's yield is the test rate of interest determined under
Sec. 1.483-3. Assume that both A and B use annual accrual periods
and that the test rate of interest is 9.2 percent, compounded
annually. Under Sec. 1.483-2, the present value of the deferred
payments is $1,000,000. Thus, the agreement has unstated interest of
$297,143.66.
(iii) First two accrual periods. Under paragraph (d)(1) of this
section, the issue price at the beginning of the first accrual
period is $1,000,000 (the amount described in Sec. 1.483-
2(a)(1)(i)). Under paragraph (c) of this section, the amount of
interest that accrues for the first accrual period is $92,000
($1,000,000 x .092) and the amount of interest that accrues for the
second accrual period is $100,464 ($1,092,000 x .092). Thus,
$192,464 of interest has accrued as of the end of the second accrual
period. Under paragraph (e)(1) of this section, the $648,571.83
payment made on June 30, 1998, is treated first as a payment of
interest to the extent of $192,464. The remainder of the payment
($456,107.83) is treated as a payment of principal. Both A and B
take the payment of interest ($192,464) into account in 1998.
(iv) Second two accrual periods. The adjusted issue price at the
beginning of the third accrual period is $543,892.17
($1,092,000+$100,464-$648,571.83). The amount of interest that
accrues for the third accrual period is $50,038.08
($543,892.17 x .092) and the amount of interest that accrues for the
final accrual period is $54,641.58, the excess of the amount payable
at maturity ($648,571.83), over the adjusted issue price at the
beginning of the accrual period ($593,930.25). As of the date the
second payment becomes due, $104,679.66 of interest has accrued.
Thus, of the $648,571.83 payment made on June 30, 2000, $104,679.66
is treated as interest and $543,892.17 is treated as principal. Both
A and B take the payment of interest ($104,679.66) into account in
2000.
(i) [Reserved]
(j) Effective date. This section applies to debt instruments issued
on or after April 4, 1994, and to lending transactions, sales, and
exchanges that occur on or after April 4, 1994. Taxpayers, however, may
rely on this section for debt instruments issued after December 21,
1992, and before April 4, 1994, and for lending transactions, sales,
and exchanges that occur after December 21, 1992, and before April 4,
1994.
Par. 5. Sections 1.483-1 and 1.483-2 are revised to read as
follows:
Sec. 1.483-1 Interest on certain deferred payments.
(a) Amount constituting interest in certain deferred payment
transactions--(1) In general. Except as provided in paragraph (c) of
this section, section 483 applies to a contract for the sale or
exchange of property if the contract provides for one or more payments
due more than 1 year after the date of the sale or exchange, and the
contract does not provide for adequate stated interest. In general, a
contract has adequate stated interest if the contract provides for a
stated rate of interest that is at least equal to the test rate
(determined under Sec. 1.483-3) and the interest is paid or compounded
at least annually. Section 483 may apply to a contract whether the
contract is express (written or oral) or implied. For purposes of
section 483, a sale or exchange is any transaction treated as a sale or
exchange for tax purposes. In addition, for purposes of section 483,
property includes debt instruments and investment units, but does not
include money, services, or the right to use property. For the
treatment of certain obligations given in exchange for services or the
use of property, see sections 404 and 467. For purposes of this
paragraph (a), money includes functional currency and, in certain
circumstances, nonfunctional currency. See Sec. 1.988-2(b)(2) for
circumstances when nonfunctional currency is treated as money rather
than as property.
(2) Treatment of contracts to which section 483 applies--(i)
Treatment of unstated interest. If section 483 applies to a contract,
unstated interest under the contract is treated as interest for tax
purposes. Thus, for example, unstated interest is not treated as part
of the amount realized from the sale or exchange of property (in the
case of the seller), and is not included in the purchaser's basis in
the property acquired in the sale or exchange.
(ii) Method of accounting for interest on contracts subject to
section 483. Any stated or unstated interest on a contract subject to
section 483 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). See Secs. 1.446-1, 1.451-1, and
1.461-1. For purposes of the preceding sentence, the amount of interest
(including unstated interest) allocable to a payment under a contract
to which section 483 applies is determined under Sec. 1.446-2(e).
(b) Definitions--(1) Deferred payments. For purposes of the
regulations under section 483, a deferred payment means any payment
that constitutes all or a part of the sales price (as defined in
paragraph (b)(2) of this section), and that is due more than 6 months
after the date of the sale or exchange. Except as provided in section
483(c)(2) (relating to the treatment of a debt instrument of the
purchaser), a payment may be made in the form of cash, stock or
securities, or other property.
(2) Sales price. For purposes of section 483, the sales price for
any sale or exchange is the sum of the amount due under the contract
(other than stated interest) and the amount of any liability included
in the amount realized from the sale or exchange. See Sec. 1.1001-2.
Thus, the sales price for any sale or exchange includes any amount of
unstated interest under the contract.
(c) Exceptions to and limitations on the application of section
483--(1) In general. Sections 483(d), 1274(c)(4), and 1275(b) contain
exceptions to and limitations on the application of section 483.
(2) Sales price of $3,000 or less. Section 483(d)(2) applies only
if it can be determined at the time of the sale or exchange that the
sales price cannot exceed $3,000, regardless of whether the sales price
eventually paid for the property is less than $3,000.
(3) Other exceptions and limitations--(i) Certain transfers subject
to section 1041. Section 483 does not apply to any transfer of property
subject to section 1041 (relating to transfers of property between
spouses or incident to divorce).
(ii) Treatment of certain obligees. Section 483 does not apply to
an obligee under a contract for the sale or exchange of personal use
property (within the meaning of section 1275(b)(3)) in the hands of the
obligor and that evidences a below-market loan described in section
7872(c)(1).
(iii) Transactions involving certain demand loans. Section 483 does
not apply to any payment under a contract that evidences a demand loan
that is a below-market loan described in section 7872(c)(1).
(iv) Transactions involving certain annuity contracts. Section 483
does not apply to any payment under an annuity contract described in
section 1275(a)(1)(B) (relating to annuity contracts excluded from the
definition of debt instrument).
(v) Options. Section 483 does not apply to any payment under an
option to buy or sell property.
(d) Assumptions. If a debt instrument is assumed, or property is
taken subject to a debt instrument, in connection with a sale or
exchange of property, the debt instrument is treated for purposes of
section 483 in a manner consistent with the rules of Sec. 1.1274-5.
(e) Aggregation rule. For purposes of section 483, all sales or
exchanges that are part of the same transaction (or a series of related
transactions) are treated as a single sale or exchange, and all
contracts calling for deferred payments arising from the same
transaction (or a series of related transactions) are treated as a
single contract. This rule, however, generally only applies to
contracts and to sales or exchanges involving a single buyer and a
single seller.
(f) Effective date. This section applies to sales and exchanges
that occur on or after April 4, 1994. Taxpayers, however, may rely on
this section for sales and exchanges that occur after December 21,
1992, and before April 4, 1994.
Sec. 1.483-2 Unstated interest.
(a) In general--(1) Adequate stated interest. For purposes of
section 483, a contract has unstated interest if the contract does not
provide for adequate stated interest. A contract does not provide for
adequate stated interest if the sum of the deferred payments exceeds--
(i) The sum of the present values of the deferred payments and the
present values of any stated interest payments due under the contract;
or
(ii) In the case of a cash method debt instrument (within the
meaning of section 1274A(c)(2)) received in exchange for property in a
potentially abusive situation (as defined in Sec. 1.1274-3), the fair
market value of the property reduced by the fair market value of any
consideration other than the debt instrument, and reduced by the sum of
all principal payments that are not deferred payments.
(2) Amount of unstated interest. For purposes of section 483,
unstated interest means an amount equal to the excess of the sum of the
deferred payments over the amount described in paragraph (a)(1)(i) or
(a)(1)(ii) of this section, whichever is applicable.
(b) Operational rules--(1) In general. For purposes of paragraph
(a) of this section, rules similar to those in Sec. 1.1274-2 apply to
determine whether a contract has adequate stated interest and the
amount of unstated interest, if any, on the contract.
(2) Present value. For purposes of paragraph (a) of this section,
the present value of any deferred payment or interest payment is
determined by discounting the payment from the date it becomes due to
the date of the sale or exchange at the test rate of interest
applicable to the contract in accordance with Sec. 1.483-3.
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Contract that does not have adequate stated interest.
On January 1, 1995, A sells B nonpublicly traded property under a
contract that calls for a $100,000 payment of principal on January
1, 2005, and 10 annual interest payments of $9,000 on January 1 of
each year, beginning on January 1, 1996. Assume that the test rate
of interest is 9.2 percent, compounded annually. The contract does
not provide for adequate stated interest because it does not provide
for interest equal to 9.2 percent, compounded annually. The present
value of the deferred payments is $98,727.69. As a result, the
contract has unstated interest of $1,272.31 ($100,000 - $98,727.69).
Example 2. Contract that does not have adequate stated interest;
no interest for initial short period. On May 1, 1996, A sells B
nonpublicly traded property under a contract that calls for B to
make a principal payment of $200,000 on December 31, 1998, and
semiannual interest payments of $9,000, payable on June 30 and
December 31 of each year, beginning on December 31, 1996. Assume
that the test rate of interest is 9 percent, compounded
semiannually. Even though the contract calls for a stated rate of
interest no lower than the test rate of interest, the contract does
not provide for adequate stated interest because the stated rate of
interest does not apply for the short period from May 1, 1996,
through June 30, 1996.
Example 3. Potentially abusive situation--(i) Facts. In a
potentially abusive situation, a contract for the sale of
nonpublicly traded personal property calls for the issuance of a
cash method debt instrument (as defined in section 1274A(c)(2)) with
a stated principal amount of $700,000, payable in 5 years. No other
consideration is given. The debt instrument calls for annual
payments of interest over its entire term at a rate of 9.2 percent,
compounded annually (the test rate of interest applicable to the
debt instrument). Thus, the present value of the deferred payment
and the interest payments is $700,000. Assume that the fair market
value of the property is $500,000.
(ii) Amount of unstated interest. A cash method debt instrument
received in exchange for property in a potentially abusive situation
provides for adequate stated interest only if the sum of the
deferred payments under the instrument does not exceed the fair
market value of the property. Because the deferred payment
($700,000) exceeds the fair market value of the property ($500,000),
the debt instrument does not provide for adequate stated interest.
Therefore, the debt instrument has unstated interest of $200,000.
Example 4. Variable rate debt instrument with adequate stated
interest; variable rate as of the issue date greater than the test
rate--(i) Facts. A contract for the sale of nonpublicly traded
property calls for the issuance of a debt instrument in the
principal amount of $75,000 due in 10 years. The debt instrument
calls for interest payable semiannually at a rate of 3 percentage
points above the yield on 6-month Treasury bills at the mid-point of
the semiannual period immediately preceding each interest payment
date. Assume that the interest rate is a qualified floating rate and
that the debt instrument is a variable rate debt instrument within
the meaning of Sec. 1.1275-5.
(ii) Adequate stated interest. Under paragraph (b)(1) of this
section, rules similar to those in Sec. 1.1274-2(f) apply to
determine whether the debt instrument has adequate stated interest.
Assume that the test rate of interest applicable to the debt
instrument is 9 percent, compounded semiannually. Assume also that
the yield on 6-month Treasury bills on the date of the sale is 8.89
percent, which is greater than the yield on 6-month Treasury bills
on the first date on which there is a binding written contract that
substantially sets forth the terms under which the sale is
consummated. Under Sec. 1.1274-2(f), the debt instrument is tested
for adequate stated interest as if it provided for a stated rate of
interest of 11.89 percent (3 percent plus 8.89 percent), compounded
semiannually, payable over its entire term. Because the test rate of
interest is 9 percent, compounded semiannually, and the debt
instrument is treated as providing for stated interest of 11.89
percent, compounded semiannually, the debt instrument provides for
adequate stated interest.
(d) Effective date. This section applies to sales and exchanges
that occur on or after April 4, 1994. Taxpayers, however, may rely on
this section for sales and exchanges that occur after December 21,
1992, and before April 4, 1994.
Par. 6. Section 1.483-3 is added to read as follows:
Sec. 1.483-3 Test rate of interest applicable to a contract.
(a) General rule. For purposes of section 483, the test rate of
interest for a contract is the same as the test rate that would apply
under Sec. 1.1274-4 if the contract were a debt instrument. Paragraph
(b) of this section, however, provides for a lower test rate in the
case of certain sales or exchanges of land between related individuals.
(b) Lower rate for certain sales or exchanges of land between
related individuals--(1) Test rate. In the case of a qualified sale or
exchange of land between related individuals (described in section
483(e)), the test rate is not greater than 6 percent, compounded
semiannually, or an equivalent rate based on an appropriate compounding
period.
(2) Special rules. The following rules and definitions apply in
determining whether a sale or exchange is a qualified sale under
section 483(e):
(i) Definition of family members. The members of an individual's
family are determined as of the date of the sale or exchange. The
members of an individual's family include those individuals described
in section 267(c)(4) and the spouses of those individuals. In addition,
for purposes of section 267(c)(4), full effect is given to a legal
adoption, ancestor means parents and grandparents, and lineal
descendants means children and grandchildren.
(ii) $500,000 limitation. Section 483(e) does not apply to the
extent that the stated principal amount of the debt instrument issued
in the sale or exchange, when added to the aggregate stated principal
amount of any other debt instruments to which section 483(e) applies
that were issued in prior qualified sales between the same two
individuals during the same calendar year, exceeds $500,000. See
Example 3 of paragraph (b)(3) of this section.
(iii) Other limitations. Section 483(e) does not apply if the
parties to a contract include persons other than the related
individuals and the parties enter into the contract with an intent to
circumvent the purposes of section 483(e). In addition, if the property
sold or exchanged includes any property other than land, section 483(e)
applies only to the extent that the stated principal amount of the debt
instrument issued in the sale or exchange is attributable to the land
(based on the relative fair market values of the land and the other
property).
(3) Examples. The following examples illustrate the rules of this
paragraph (b).
Example 1. On January 1, 1995, A sells land to B, A's child, for
$650,000. The contract for sale calls for B to make a $250,000 down
payment and issue a debt instrument with a stated principal amount
of $400,000. Because the stated principal amount of the debt
instrument is less than $500,000, the sale is a qualified sale and
section 483(e) applies to the debt instrument.
Example 2. The facts are the same as in Example 1 of paragraph
(b)(3) of this section, except that on June 1, 1995, A sells
additional land to B under a contract that calls for B to issue a
debt instrument with a stated principal amount of $100,000. The
stated principal amount of this debt instrument ($100,000) when
added to the stated principal amount of the prior debt instrument
($400,000) does not exceed $500,000. Thus, section 483(e) applies to
both debt instruments.
Example 3. The facts are the same as in Example 1 of paragraph
(b)(3) of this section, except that on June 1, 1995, A sells
additional land to B under a contract that calls for B to issue a
debt instrument with a stated principal amount of $150,000. The
stated principal amount of this debt instrument when added to the
stated principal amount of the prior debt instrument ($400,000)
exceeds $500,000. Thus, for purposes of section 483(e), the debt
instrument issued in the sale of June 1, 1995, is treated as two
separate debt instruments: a $100,000 debt instrument (to which
section 483(e) applies) and a $50,000 debt instrument (to which
section 1274, if otherwise applicable, applies).
(c) Effective date. This section applies to sales and exchanges
that occur on or after April 4, 1994. Taxpayers, however, may rely on
this section for sales and exchanges that occur after December 21,
1992, and before April 4, 1994.
Par. 7. In Sec. 1.1001-1, paragraph (g) is revised to read as
follows:
Sec. 1.1001-1 Computation of gain or loss.
* * * * *
(g) Debt instruments issued in exchange for property. 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 Sec. 1.1273-2 or Sec. 1.1274-2(b),
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).
This paragraph (g) applies to sales or exchanges that occur on or after
April 4, 1994. Taxpayers, however, may rely on this paragraph (g) for
sales and exchanges that occur after December 21, 1992, and before
April 4, 1994.
Par. 8. In Sec. 1.1012-1, paragraph (f) is amended by removing the
last sentence and paragraph (g) is added to read as follows:
Sec. 1.1012-1 Basis of property.
* * * * *
(g) Debt instruments issued in exchange for property. 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 Sec. 1.1273-2 or Sec. 1.1274-2(b), 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).
This paragraph (g) applies to sales or exchanges that occur on or after
April 4, 1994. Taxpayers, however, may rely on this paragraph (g) for
sales and exchanges that occur after December 21, 1992, and before
April 4, 1994.
Par. 9. Sections 1.1271-0, 1.1271-1, 1.1272-1 through 1.1272-3,
1.1273-1, 1.1273-2, 1.1274-1 through 1.1274-3 are added to read as
follows:
Sec. 1.1271-0 Original issue discount; effective date; table of
contents.
(a) Effective date. Except as otherwise provided, Secs. 1.1271-1
through 1.1275-5 apply to debt instruments issued on or after April 4,
1994. Taxpayers, however, may rely on these sections for debt
instruments issued after December 21, 1992, and before April 4, 1994.
(b) Table of contents. This section lists captioned paragraphs
contained in Secs. 1.1271-1 through 1.1275-5.
Sec. 1.1271-1 Special rules applicable to amounts received on
retirement, sale, or exchange of debt instruments.
(a) Intention to call before maturity.
(1) In general.
(2) Exceptions.
(b) Short-term obligations.
(1) In general.
(2) Method of making elections.
(3) Counting conventions.
Sec. 1.1272-1 Current inclusion of OID in income.
(a) Overview.
(1) In general.
(2) Debt instruments not subject to OID inclusion rules.
(b) Accrual of OID.
(1) Constant yield method.
(2) Exceptions.
(3) Modifications.
(4) Special rules for determining the OID allocable to an
accrual period.
(c) Yield and maturity of certain debt instruments subject to
contingencies.
(1) Applicability.
(2) General rule.
(3) Contingencies that are likely to occur.
(4) Consistency rule.
(5) Treatment of certain options.
(6) Subsequent adjustments.
(d) Certain debt instruments that provide for principal payments
uncertain as to time.
(e) Convertible debt instruments.
(f) Special rules to determine whether a debt instrument is a short-
term obligation.
(1) Counting of either the issue date or maturity date.
(2) Coordination with paragraph (c) of this section for certain
sections of the Internal Revenue Code.
(g) Basis adjustment.
(h) Debt instruments denominated in a currency other than the U.S.
dollar.
(i) [Reserved]
(j) Examples.
Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.
(a) In general.
(b) Definitions and special rules.
(1) Purchase.
(2) Premium.
(3) Acquisition premium.
(4) Acquisition premium fraction.
(5) Election to accrue discount on a constant yield basis.
(6) Special rules for determining basis.
(c) Examples.
Sec. 1.1272-3 Election by a holder to treat all interest on a debt
instrument as OID.
(a) Election.
(b) Scope of election.
(1) In general.
(2) Exceptions, limitations, and special rules.
(c) Mechanics of the constant yield method.
(1) In general.
(2) Special rules to determine adjusted basis.
(d) Time and manner of making the election.
(e) Revocation of election.
(f) Effective date.
Sec. 1.1273-1 Definition of OID.
(a) In general.
(b) Stated redemption price at maturity.
(c) Qualified stated interest.
(1) Definition.
(2) Debt instruments subject to contingencies.
(3) Variable rate debt instrument.
(4) Stated interest in excess of qualified stated interest.
(5) Short-term obligations.
(d) De minimis OID.
(1) In general.
(2) De minimis amount.
(3) Installment obligations.
(4) Special rule for interest holidays, teaser rates, and other
interest shortfalls.
(5) Treatment of de minimis OID by holders.
(e) Definitions.
(1) Installment obligation.
(2) Self-amortizing installment obligation.
(3) Weighted average maturity.
(f) Examples.
Sec. 1.1273-2 Determination of issue price and issue date.
(a) Debt instruments issued for money.
(1) Issue price.
(2) Issue date.
(b) Publicly traded debt instruments issued for property.
(1) Issue price.
(2) Issue date.
(c) Debt instruments issued for publicly traded property.
(1) Issue price.
(2) Issue date.
(d) Other debt instruments.
(1) Issue price.
(2) Issue date.
(e) Special rule for certain sales to bond houses, brokers, or
similar persons.
(f) Traded on an established market (publicly traded).
(1) In general.
(2) Exchange listed property.
(3) Market traded property.
(4) Property appearing on a quotation medium.
(5) Readily quotable debt instruments.
(6) Effect of certain temporary restrictions on trading.
(7) Convertible debt instruments.
(g) Treatment of certain cash payments incident to lending
transactions.
(1) Applicability.
(2) Payments from borrower to lender.
(3) Payments from lender to borrower.
(4) Payments between lender and third party.
(5) Examples.
(h) Investment units.
(1) In general.
(2) Consistent allocation by holders and issuer.
(i) [Reserved]
(j) Convertible debt instruments.
(k) Below-market loans subject to section 7872(b).
(l) [Reserved]
(m) Treatment of amounts representing pre-issuance accrued interest.
(1) Applicability.
(2) Exclusion of pre-issuance accrued interest from issue price.
(3) Example.
Sec. 1.1274-1 Debt instruments to which section 1274 applies.
(a) In general.
(b) Exceptions.
(1) Debt instrument with adequate stated interest and no OID .
(2) Exceptions under sections 1274(c)(1)(B), 1274(c)(3),
1274A(c), and 1275(b)(1).
(3) Other exceptions to section 1274.
(c) Examples.
Sec. 1.1274-2 Issue price of debt instruments to which section 1274
applies.
(a) In general.
(b) Issue price.
(1) Debt instruments that provide for adequate stated interest;
stated principal amount.
(2) Debt instruments that do not provide for adequate stated
interest; imputed principal amount.
(3) Debt instruments issued in a potentially abusive situation;
fair market value.
(c) Determination of whether a debt instrument provides for adequate
stated interest.
(1) In general.
(2) Determination of present value.
(d) Treatment of certain options.
(e) Mandatory sinking funds.
(f) Treatment of variable rate debt instruments.
(1) Stated interest at a qualified floating rate.
(2) Stated interest at a single objective rate.
(g) Contingent payments. [Reserved]
(h) Examples.
Sec. 1.1274-3 Potentially abusive situations defined.
(a) In general.
(b) Operating rules.
(1) Debt instrument exchanged for nonrecourse financing.
(2) Nonrecourse debt with substantial down payment.
(3) Clearly excessive interest.
(c) Other situations to be specified by Commissioner.
(d) Consistency rule.
Sec. 1.1274-4 Test rate.
(a) Determination of test rate of interest.
(1) In general.
(2) Test rate for certain debt instruments.
(b) Applicable Federal rate.
(c) Special rules to determine the term of a debt instrument for
purposes of determining the applicable Federal rate.
(1) Installment obligations.
(2) Certain variable rate debt instruments.
(3) Counting of either the issue date or the maturity date.
(4) Certain debt instruments that provide for principal payments
uncertain as to time.
(d) Foreign currency loans.
(e) Examples.
Sec. 1.1274-5 Assumptions.
(a) In general.
(b) Modifications of debt instruments.
(1) In general.
(2) Election to treat buyer as modifying the debt instrument.
(c) Wraparound indebtedness.
(d) Consideration attributable to assumed debt.
Sec. 1.1274A-1 Special rules for certain transactions where stated
principal amount does not exceed $2,800,000.
(a) In general.
(b) Rules for both qualified and cash method debt instruments.
(1) Sale-leaseback transactions.
(2) Debt instruments calling for contingent payments.
(3) Aggregation of transactions.
(4) Inflation adjustment of dollar amounts.
(c) Rules for cash method debt instruments.
(1) Time and manner of making cash method election.
(2) Successors of electing parties.
(3) Modified debt instrument.
(4) Debt incurred or continued to purchase or carry a cash
method debt instrument.
Sec. 1.1275-1 Definitions.
(a) Applicability.
(b) Adjusted issue price.
(1) In general.
(2) Adjusted issue price for subsequent holders.
(c) OID.
(d) Debt instrument.
(e) Tax-exempt obligations.
(f) Issue.
(g) Debt instruments issued by a natural person.
(h) Publicly offered debt instrument.
Sec. 1.1275-2 Special rules relating to debt instruments.
(a) Payment ordering rule.
(1) In general.
(2) Exceptions.
(b) Debt instruments distributed by corporations with respect to
stock.
(1) Treatment of distribution.
(2) Issue date.
(c) Aggregation of debt instruments.
(1) General rule.
(2) Exception if separate issue price established.
(3) Special rule for debt instruments that provide for the
issuance of additional debt instruments.
(4) Examples.
(d) Special rules for Treasury securities.
(1) Issue price and issue date.
(2) Reopenings of Treasury securities.
(e) Disclosure of certain information to holders.
(f) Treatment of pro rata prepayments.
(1) Treatment as retirement of separate debt instrument.
(2) Definition of pro rata prepayment.
(g) Anti-abuse rule. [Reserved]
Sec. 1.1275-2T Special rules relating to debt instruments (temporary).
(a) through (f). [Reserved]
(g) Anti-abuse rule.
(1) In general.
(2) Effective date.
Sec. 1.1275-3 OID information reporting requirements.
(a) In general.
(b) Information required to be set forth on face of debt instruments
that are not publicly offered.
(1) In general.
(2) Time for legending.
(3) Legend must survive reissuance upon transfer.
(4) Exceptions.
(c) Information required to be reported to Secretary upon issuance
of publicly offered debt instruments.
(1) In general.
(2) Time for filing information return.
(3) Exceptions.
(d) Application to foreign issuers and U.S. issuers of
foreigntargeted debt instruments.
(e) Penalties.
(f) Effective date.
Sec. 1.1275-5 Variable rate debt instruments.
(a) Applicability.
(1) In general.
(2) Principal payments.
(3) Stated interest.
(4) Current value.
(b) Qualified floating rate.
(1) In general.
(2) Certain rates based on a qualified floating rate.
(3) Restrictions on the stated rate of interest.
(c) Objective rate.
(1) In general.
(2) Other objective rates to be specified by Commissioner.
(3) Qualified inverse floating rate.
(4) Significant front-loading or back-loading of interest.
(5) Tax-exempt debt.
(d) Examples.
(e) Qualified stated interest and OID with respect to a variable
rate debt instrument.
(1) In general.
(2) Variable rate debt instrument that provides for annual
payments of interest at a single variable rate.
(3) All other variable rate debt instruments except for those
that provide for a fixed rate.
(4) Variable rate debt instrument that provides for a single
fixed rate.
(f) Special rule for certain reset bonds.
Sec. 1.1271-1 Special rules applicable to amounts received on
retirement, sale, or exchange of debt instruments.
(a) Intention to call before maturity--(1) In general. For purposes
of section 1271(a)(2), all or a portion of gain realized on a sale or
exchange of a debt instrument to which section 1271 applies is treated
as interest income if there was an intention to call the debt
instrument before maturity. An intention to call a debt instrument
before maturity means a written or oral agreement or understanding not
provided for in the debt instrument between the issuer and the original
holder of the debt instrument that the issuer will redeem the debt
instrument before maturity. In the case of debt instruments that are
part of an issue, the agreement or understanding must be between the
issuer and the original holders of a substantial amount of the debt
instruments in the issue. An intention to call before maturity can
exist even if the intention is conditional (e.g., the issuer's decision
to call depends on the financial condition of the issuer on the
potential call date) or is not legally binding. For purposes of this
section, original holder means the first holder (other than an
underwriter or dealer that purchased the debt instrument for resale in
the ordinary course of its trade or business).
(2) Exceptions. In addition to the exceptions provided in sections
1271(a)(2)(B) and 1271(b), section 1271(a)(2) does not apply to--
(i) A debt instrument that is publicly offered (as defined in
Sec. 1.1275-1(h));
(ii) A debt instrument to which section 1272(a)(6) applies
(relating to certain interests in or mortgages held by a REMIC, and
certain other debt instruments with payments subject to acceleration);
or
(iii) A debt instrument sold pursuant to a private placement
memorandum that is distributed to more than ten offerees and that is
subject to the sanctions of section 12(2) of the Securities Act of 1933
(15 U.S.C. 77l) or the prohibitions of section 10(b) of the Securities
Exchange Act of 1934 (15 U.S.C. 78j).
(b) Short-term obligations--(1) In general. Under sections
1271(a)(3) and (a)(4), all or a portion of the gain realized on the
sale or exchange of a short-term government or nongovernment obligation
is treated as interest income. Sections 1271(a)(3) and (a)(4), however,
do not apply to any short-term obligation subject to section 1281. See
Sec. 1.1272-1(f) for rules to determine if an obligation is a short-
term obligation.
(2) Method of making elections. Elections to accrue on a constant
yield basis under sections 1271(a)(3)(E) and (a)(4)(D) are made on an
obligation-by-obligation basis by reporting the transaction on the
basis of daily compounding on the taxpayer's timely filed Federal
income tax return for the year of the sale or exchange. These elections
are irrevocable.
(3) Counting conventions. In computing the ratable share of
acquisition discount under section 1271(a)(3) or OID under section
1271(a)(4), any reasonable counting convention may be used (e.g., 30
days per month/360 days per year).
Sec. 1.1272-1 Current inclusion of OID in income.
(a) Overview--(1) In general. Under section 1272(a)(1), a holder of
a debt instrument includes accrued OID in gross income (as interest),
regardless of the holder's regular method of accounting. A holder
includes qualified stated interest (as defined in Sec. 1.1273-1(c)) in
income under the holder's regular method of accounting. See
Secs. 1.446-2 and 1.451-1.
(2) Debt instruments not subject to OID inclusion rules. Sections
1272(a)(2) and 1272(c) list exceptions to the general inclusion rule of
section 1272(a)(1). For purposes of section 1272(a)(2)(E) (relating to
certain loans between natural persons), a loan does not include a
stripped bond or stripped coupon within the meaning of section 1286(e),
and the rule in section 1272(a)(2)(E)(iii), which treats a husband and
wife as 1 person, does not apply to loans made between a husband and
wife.
(b) Accrual of OID--(1) Constant yield method. Except as provided
in paragraphs (b)(2) and (b)(3) of this section, the amount of OID
includible in the income of a holder of a debt instrument for any
taxable year is determined using the constant yield method as described
under this paragraph (b)(1).
(i) Step one: Determine the debt instrument's yield to maturity.
The yield to maturity or yield of a debt instrument is the discount
rate that, when used in computing the present value of all principal
and interest payments to be made under the debt instrument, produces an
amount equal to the issue price of the debt instrument. The yield must
be constant over the term of the debt instrument and, when expressed as
a percentage, must be calculated to at least two decimal places. See
paragraph (c) of this section for rules relating to the yield of
certain debt instruments subject to contingencies.
(ii) Step two: Determine the accrual periods. An accrual period is
an interval of time over which the accrual of OID is measured. Accrual
periods may be of any length and may vary in length over the term of
the debt instrument, provided that each accrual period is no longer
than 1 year and each scheduled payment of principal or interest occurs
either on the final day of an accrual period or on the first day of an
accrual period. In general, the computation of OID is simplest if
accrual periods correspond to the intervals between payment dates
provided by the terms of the debt instrument. In computing the length
of accrual periods, any reasonable counting convention may be used
(e.g., 30 days per month/360 days per year).
(iii) Step three: Determine the OID allocable to each accrual
period. Except as provided in paragraph (b)(4) of this section, the OID
allocable to an accrual period equals the product of the adjusted issue
price of the debt instrument (as defined in Sec. 1.1275-1(b)) at the
beginning of the accrual period and the yield of the debt instrument,
less the amount of any qualified stated interest allocable to the
accrual period. In performing this calculation, the yield must be
stated appropriately taking into account the length of the particular
accrual period. Example 1 in paragraph (j) of this section provides a
formula for converting a yield based upon an accrual period of one
length to an equivalent yield based upon an accrual period of a
different length.
(iv) Step four: Determine the daily portions of OID. The daily
portions of OID are determined by allocating to each day in an accrual
period the ratable portion of the OID allocable to the accrual period.
The holder of the debt instrument includes in income the daily portions
of OID for each day during the taxable year on which the holder held
the debt instrument.
(2) Exceptions. Paragraph (b)(1) of this section does not apply
to--
(i) 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);
(ii) A debt instrument that provides for contingent payments,
except as provided in paragraph (c) of this section or in regulations
under section 1275(d); or
(iii) A variable rate debt instrument to which Sec. 1.1275-5
applies, except as provided in Sec. 1.1275-5.
(3) Modifications. The amount of OID includible in income by a
holder under paragraph (b)(1) of this section is adjusted if--
(i) The holder purchased the debt instrument at a premium or an
acquisition premium (within the meaning of Sec. 1.1272-2); or
(ii) The holder made an election for the debt instrument under
Sec. 1.1272-3 to treat all interest as OID.
(4) Special rules for determining the OID allocable to an accrual
period. The following rules apply to determine the OID allocable to an
accrual period under paragraph (b)(1)(iii) of this section.
(i) Unpaid qualified stated interest allocable to an accrual
period. In determining the OID allocable to an accrual period, if an
interval between payments of qualified stated interest contains more
than 1 accrual period--
(A) The amount of qualified stated interest payable at the end of
the interval (including any qualified stated interest that is payable
on the first day of the accrual period immediately following the
interval) is allocated on a pro rata basis to each accrual period in
the interval; and
(B) The adjusted issue price at the beginning of each accrual
period in the interval must be increased by the amount of any qualified
stated interest that has accrued prior to the first day of the accrual
period but that is not payable until the end of the interval. See
Example 2 of paragraph (j) of this section for an example illustrating
the rules in this paragraph (b)(4)(i).
(ii) Final accrual period. The OID allocable to the final accrual
period is the difference between the amount payable at maturity (other
than a payment of qualified stated interest) and the adjusted issue
price at the beginning of the final accrual period.
(iii) Initial short accrual period. If all accrual periods are of
equal length, except for either an initial shorter accrual period or an
initial and a final shorter accrual period, the amount of OID allocable
to the initial accrual period may be computed using any reasonable
method. See Example 3 in paragraph (j) of this section.
(iv) Payment on first day of an accrual period. The adjusted issue
price at the beginning of an accrual period is reduced by the amount of
any payment (other than a payment of qualified stated interest) that is
made on the first day of the accrual period.
(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 a debt instrument that provides 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. 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 regulations under
section 1275(d) for the treatment of debt instruments with payments
that are otherwise contingent as to timing or amount. See Sec. 1.1273-
1(c) to determine whether stated interest on a debt instrument subject
to this paragraph (c) is qualified stated interest.
(2) General rule. In general, the yield and maturity of a debt
instrument subject to this paragraph (c) are determined by assuming
that the payments will be made according to the instrument's stated
payment schedule.
(3) Contingencies that are likely to occur--(i) Contingency taken
into account. Notwithstanding the rule in paragraph (c)(2) of this
section, if, based on all the facts and circumstances as of the issue
date, it is more likely than not that the debt instrument's stated
payment schedule will not occur, then the yield and maturity of the
debt instrument are computed based on the payment schedule most likely
to occur.
(ii) Mandatory sinking fund provision. Paragraph (c)(3)(i) of this
section does not apply to a mandatory sinking fund provision 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 requires the issuer to redeem a certain amount of
debt instruments in an issue prior to maturity, provided that 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), and provided that on
the issue date the specific debt instruments that will be redeemed on
any date prior to maturity cannot be identified.
(4) Consistency rule. The payment schedule determined by the issuer
under paragraphs (c)(2) and (c)(3) of this section is binding on all
holders of the debt instrument. However, the issuer's determination is
not binding on a holder that explicitly discloses that its
determination of the yield and maturity of the debt instrument 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 Sec. 1.1275-2(e) for rules relating to the issuer's obligation to
disclose certain information to holders.
(5) Treatment of certain options. Notwithstanding paragraphs (c)(2)
and (c)(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 will be 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 will be 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. Thus, the deemed
exercise of one option may eliminate other options that are later in
time. See Example 5 through Example 8 in paragraph (j) 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 the accrual of
OID, the yield and maturity of the debt instrument are redetermined by
treating the debt instrument as reissued on the date of the change in
circumstances for an amount equal to its adjusted issue price on that
date. See Example 5 and Example 7 in paragraph (j) of this section. If,
however, the change in circumstances results in a substantially
contemporaneous pro rata prepayment as defined in Sec. 1.1275-2(f)(2)
(e.g., because a partial put or call option treated under paragraph
(c)(5) of this section as not exercised is, in fact, exercised), 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 Example 6 and Example 8 in paragraph (j) of this section.
(d) Certain debt instruments that provide for principal payments
uncertain as to time. 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 debt instrument at intervals of 1 year or less.
(e) Convertible debt instruments. For purposes of section 1272, an
option is ignored if it is an option to convert a 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.
(f) Special rules to determine whether a debt instrument is a
short-term obligation--(1) Counting of either the issue date or
maturity date. For purposes of determining whether a debt instrument is
a short-term obligation (i.e., a debt instrument with a fixed maturity
date that is not more than 1 year from the date of issue), the term of
the debt instrument includes either the issue date or the maturity
date, but not both dates.
(2) Coordination with paragraph (c) of this section for certain
sections of the Internal Revenue Code. Notwithstanding paragraph (c) of
this section, solely for purposes of determining whether a debt
instrument is a short-term obligation under sections 871(g)(1)(B)(i),
881, 1271(a)(3), 1271(a)(4), 1272(a)(2)(C), and 1283(a)(1), the
maturity date of a debt instrument is the last possible date that the
instrument could be outstanding under the terms of the instrument.
(g) Basis adjustment. The basis of a debt instrument in the hands
of the holder is increased by the amount of OID included in the
holder's gross income and decreased by the amount of any payment from
the issuer to the holder under the debt instrument other than a payment
of qualified stated interest. See, however, Sec. 1.1275-2(f) for rules
regarding basis adjustments on a pro rata prepayment.
(h) Debt instruments denominated in a currency other than the U.S.
dollar. Section 1272 and this section apply to a debt instrument that
provides for all payments denominated in, or determined by reference
to, the functional currency of the taxpayer or qualified business unit
of the taxpayer (even if that currency is other than the U.S. dollar).
See Sec. 1.988-2(b) to determine interest income or expense for debt
instruments that provide for payments denominated in, or determined by
reference to, a nonfunctional currency.
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section. Each example assumes that all taxpayers use the calendar year
as the taxable year. In addition, each example assumes a 30-day month,
360-day year, and that the initial accrual period begins on the issue
date and the final accrual period ends on the day before the stated
maturity date. Although, for purposes of simplicity, the yield as
stated is rounded to two decimal places, the computations do not
reflect any such rounding convention.
Example 1. Accrual of OID on zero coupon debt instrument; choice
of accrual periods--(i) Facts. On July 1, 1994, A purchases at
original issue, for $675,564.17, a debt instrument that matures on
July 1, 1999, and provides for a single payment of $1,000,000 at
maturity.
(ii) Determination of yield. Under paragraph (b)(1)(i) of this
section, the yield of the debt instrument is 8 percent, compounded
semiannually.
(iii) Determination of accrual period. Under paragraph
(b)(1)(ii) of this section, accrual periods may be of any length,
provided that each accrual period is no longer than 1 year and each
scheduled payment of principal or interest occurs either on the
first or final day of an accrual period. The yield to maturity to be
used in computing OID accruals in any accrual period, however, must
reflect the length of the accrual period chosen. A yield based on
compounding b times per year is equivalent to a yield based on
compounding c times per year as indicated by the following formula:
r=c{(1+i/b) b/c-1}
In which:
i=The yield based on compounding b times per year expressed as a
decimal
r=The equivalent yield based on compounding c times per year
expressed as a decimal
b=The number of compounding periods in a year on which i is based
(for example, 12, if i is based on monthly compounding)
c=The number of compounding periods in a year on which r is based
(iv) Determination of OID allocable to each accrual period.
Assume that A decides to compute OID on the debt instrument using
semiannual accrual periods. Under paragraph (b)(1)(iii) of this
section, the OID allocable to the first semiannual accrual period is
$27,022.56: the product of the issue price ($675,564.17) and the
yield properly adjusted for the length of the accrual period (8
percent/2), less qualified stated interest allocable to the accrual
period ($0). The daily portion of OID for the first semiannual
accrual period is $150.13 ($27,022.56/180).
(v) Determination of OID if monthly accrual periods are used.
Alternatively, assume that A decides to compute OID on the debt
instrument using monthly accrual periods. Using the above formula,
the yield on the debt instrument reflecting monthly compounding is
7.87 percent, compounded monthly (12{(1+.08/2)2/12-1}). Under
paragraph (b)(1)(iii) of this section, the OID allocable to the
first monthly accrual period is $4,430.48: the product of the issue
price ($675,564.17) and the yield properly adjusted for the length
of the accrual period (7.87 percent/12), less qualified stated
interest allocable to the accrual period ($0). The daily portion of
OID for the first monthly accrual period is $147.68 ($4,430.48/30).
Example 2. Accrual of OID on debt instrument with qualified
stated interest--(i) Facts. On September 1, 1994, A purchases at
original issue, for $90,000, B corporation's debt instrument that
matures on September 1, 2004, and has a stated principal amount of
$100,000, payable on that date. The debt instrument provides for
semiannual payments of interest of $3,000, payable on September 1
and March 1 of each year, beginning on March 1, 1995.
(ii) Determination of yield. The debt instrument is a 10-year
debt instrument with an issue price of $90,000 and a stated
redemption price at maturity of $100,000. The semiannual payments of
$3,000 are qualified stated interest payments. Under paragraph
(b)(1)(i) of this section, the yield is 7.44 percent, compounded
semiannually.
(iii) Accrual of OID if semiannual accrual periods are used.
Assume that A decides to compute OID on the debt instrument using
semiannual accrual periods. Under paragraph (b)(1)(iii) of this
section, the OID allocable to the first semiannual accrual period
equals the product of the issue price ($90,000) and the yield
properly adjusted for the length of the accrual period (7.44
percent/2), less qualified stated interest allocable to the accrual
period ($3,000). Therefore, the amount of OID for the first
semiannual accrual period is $345.78 ($3,345.78-$3,000).
(iv) Adjustment for accrued but unpaid qualified stated interest
if monthly accrual periods are used. Assume, alternatively, that A
decides to compute OID on the debt instrument using monthly accrual
periods. The yield, compounded monthly, is 7.32 percent. Under
paragraph (b)(1)(iii) of this section, the OID allocable to the
first monthly accrual period is the product of the issue price
($90,000) and the yield properly adjusted for the length of the
accrual period (7.32 percent/12), less qualified stated interest
allocable to the accrual period. Under paragraph (b)(4)(i)(A) of
this section, the qualified stated interest allocable to the first
monthly accrual period is the pro rata amount of qualified stated
interest allocable to the interval between payment dates
($3,000 x \1/6\, or $500). Therefore, the amount of OID for the
first monthly accrual period is $49.18 ($549.18-$500). Under
paragraph (b)(4)(i)(B) of this section, the adjusted issue price of
the debt instrument for purposes of determining the amount of OID
for the second monthly accrual period is $90,549.18 ($90,000 +
$49.18 + $500). Although the adjusted issue price of the debt
instrument for this purpose includes the amount of qualified stated
interest allocable to the first monthly accrual period, A includes
the qualified stated interest in income based on A's regular method
of accounting (e.g., an accrual method or the cash receipts and
disbursements method).
Example 3. Accrual of OID for debt instrument with initial short
accrual period--(i) Facts. On May 1, 1994, G purchases at original
issue, for $80,000, H corporation's debt instrument maturing on July
1, 2004. The debt instrument provides for a single payment at
maturity of $250,000. G computes its OID using 6-month accrual
periods ending on January 1 and July 1 of each year and an initial
short 2-month accrual period from May 1, 1994, through June 30,
1994.
(ii) Determination of yield. The yield on the debt instrument is
11.53 percent, compounded semiannually.
(iii) Determination of OID allocable to initial short accrual
period. Under paragraph (b)(4)(iii) of this section, G may use any
reasonable method to compute OID for the initial short accrual
period. One reasonable method is to calculate the amount of OID
pursuant to the following formula:
OIDshort=IP x (i/k) x f
In which:
OIDshort=The amount of OID allocable to the initial short
accrual period
IP=The issue price of the debt instrument
i=The yield to maturity expressed as a decimal
k=The number of accrual periods in a year
f=A fraction whose numerator is the number of days in the initial
short accrual period, and whose denominator is the number of days in
a full accrual period
(iv) Amount of OID for the initial short accrual period. Under
this method, the amount of OID for the initial short accrual period
is $1,537 ($80,000 x (11.53 percent/2) x (60/180)).
(v) Alternative method. Another reasonable method is to
calculate the amount of OID for the initial short accrual period
using the yield based on bi-monthly compounding, computed pursuant
to the formula set forth in Example 1 of paragraph (j) of this
section. Under this method, the amount of OID for the initial short
accrual period is $1,508.38 ($80,000 x (11.31 percent/6)).
Example 4. Impermissible accrual of OID using a method other
than constant yield method--(i) Facts. On July 1, 1994, B purchases
at original issue, for $100,000, C corporation's debt instrument
that matures on July 1, 1999, and has a stated principal amount of
$100,000. The debt instrument provides for a single payment at
maturity of $148,024.43. The yield of the debt instrument is 8
percent, compounded semiannually.
(ii) Determination of yield. Assume that C uses 6 monthly
accrual periods to compute its OID for 1994. The yield must reflect
monthly compounding (as determined using the formula described in
Example 1 of paragraph (j) of this section). As a result, the
monthly yield of the debt instrument is 7.87 percent, divided by 12.
C may not compute its monthly yield for the last 6 months in 1994 by
dividing 8 percent by 12.
Example 5. Debt instrument subject to put option--(i) Facts. On
January 1, 1995, G purchases at original issue, for $70,000, H
corporation's debt instrument maturing on January 1, 2010, with a
stated principal amount of $100,000, payable at maturity. The debt
instrument provides for semiannual payments of interest of $4,000,
payable on January 1 and July 1 of each year, beginning on July 1,
1995. The debt instrument gives G an unconditional right to put the
bond back to H, exercisable on January 1, 2005, in return for
$85,000 (exclusive of the $4,000 of stated interest payable on that
date).
(ii) Determination of yield and maturity. Yield determined
without regard to the put option is 12.47 percent, compounded
semiannually. Yield determined by assuming that the put option is
exercised (i.e., by using January 1, 2005, as the maturity date and
$85,000 as the stated principal amount payable on that date) is
12.56 percent, compounded semiannually. Thus, under paragraph (c)(5)
of this section, it is assumed that G will exercise the put option,
because exercise of the option would increase the yield of the debt
instrument. Thus, for purposes of calculating OID, the debt
instrument is assumed to be a 10-year debt instrument with an issue
price of $70,000, a stated redemption price at maturity of $85,000,
and a yield of 12.56 percent, compounded semiannually.
(iii) Consequences if put option is, in fact, not exercised. If
the put option is, in fact, not exercised, then, under paragraph
(c)(6) of this section, the debt instrument is treated, solely for
purposes of determining yield and maturity, as if it were reissued
on January 1, 2005, for an amount equal to its adjusted issue price
on that date, $85,000. The new debt instrument matures on January 1,
2010, with a stated principal amount of $100,000 payable on that
date and provides for semiannual payments of interest of $4,000. The
yield of the new debt instrument is 12.08 percent, compounded
semiannually.
Example 6. Debt instrument subject to partial call option--(i)
Facts. On January 1, 1995, H purchases at original issue, for
$95,000, J corporation's debt instrument that matures on January 1,
2000, and has a stated principal amount of $100,000, payable on that
date. The debt instrument provides for semiannual payments of
interest of $4,000, payable on January 1 and July 1 of each year,
beginning on July 1, 1995. On January 1, 1998, J has an
unconditional right to call 50 percent of the principal amount of
the debt instrument for $55,000 (exclusive of the $4,000 of stated
interest payable on that date). If the call is exercised, the
semiannual payments of interest made after the call date will be
reduced to $2,000.
(ii) Determination of yield and maturity. Yield determined
without regard to the call option is 9.27 percent, compounded
semiannually. Yield determined by assuming J exercises its call
option is 10.75 percent, compounded semiannually. Thus, under
paragraph (c)(5) of this section, it is assumed that J will not
exercise the call option because exercise of the option would
increase the yield of the debt instrument. Thus, for purposes of
calculating OID, the debt instrument is assumed to be a 5-year debt
instrument with a single principal payment at maturity of $100,000,
and a yield of 9.27 percent, compounded semiannually.
(iii) Consequences if the call option is, in fact, exercised. If
the call option is, in fact, exercised, then under paragraph (c)(6)
of this section, the debt instrument is treated as if the issuer
made a pro rata prepayment of $55,000 that is subject to
Sec. 1.1275-2(f). Consequently, under Sec. 1.1275-2(f)(1), the
instrument is treated as consisting of two debt instruments, one
that is retired on the call date and one that remains outstanding
after the call date. The adjusted issue price, adjusted basis in the
hands of the holder, and accrued OID of the original debt instrument
is allocated between the two instruments based on the portion of the
original instrument treated as retired. Since each payment remaining
to be made after the call date is reduced by one-half, one-half of
the adjusted issue price, adjusted basis, and accrued OID is
allocated to the debt instrument that is treated as retired. The
adjusted issue price of the original debt instrument immediately
prior to the call date is $97,725.12, which equals the issue price
of the original debt instrument ($95,000) increased by the OID
previously includible in gross income ($2,725.12). One-half of this
adjusted issue price is allocated to the debt instrument treated as
retired, and the other half is allocated to the debt instrument that
is treated as remaining outstanding. Thus, the debt instrument
treated as remaining outstanding has an adjusted issue price
immediately after the call date of $97,725.12/2, or $48,862.56. The
yield of this debt instrument continues to be 9.27 percent,
compounded semiannually. In addition, the portion of H's adjusted
basis allocated to the debt instrument treated as retired is
$97,725.12/2 or $48,862.56. Accordingly, under section 1271, H
realizes a gain on the deemed retirement equal to $6,137.44 ($55,000
- $48,862.56).
Example 7. Debt instrument issued at par that provides for
payment of interest in kind--(i) Facts. On January 1, 1995, A
purchases at original issue, for $100,000, X corporation's debt
instrument maturing on January 1, 2000, at a stated principal amount
of $100,000, payable on that date. The debt instrument provides for
annual payments of interest of $6,000 on January 1 of each year,
beginning on January 1, 1996. The debt instrument gives X the
unconditional right to issue, in lieu of the first interest payment,
a second debt instrument (PIK instrument) maturing on January 1,
2000, with a stated principal amount of $6,000. The PIK instrument,
if issued, would provide for annual payments of interest of $360 on
January 1 of each year, beginning on January 1, 1997.
(ii) Aggregation of PIK instrument with original debt
instrument. Under Sec. 1.1275-2(c)(3), the issuance of the PIK
instrument is not considered a payment made on the original debt
instrument, and the PIK instrument is aggregated with the original
debt instrument. The issue date of the PIK instrument is the same as
the original debt instrument.
(iii) Determination of yield and maturity. The right to issue
the PIK instrument is treated as an option to defer the initial
interest payment until maturity. Yield determined without regard to
the option is 6 percent, compounded annually, Yield determined by
assuming X exercises the option is 6 percent, compounded annually.
Thus, under paragraph (c)(5) of this section, it is assumed that X
will not exercise the option by issuing the PIK instrument because
exercise of the option would not decrease the yield of the debt
instrument. For purposes of calculating OID, the debt instrument is
assumed to be a 5-year debt instrument with a single principal
payment at maturity of $100,000 and ten semiannual interest payments
of $6,000, beginning on January 1, 1996. As a result, the debt
instrument's yield is 6 percent, compounded annually.
(iv) Determination of OID. Under the payment schedule that would
result if the option was exercised, none of the interest on the debt
instrument would be qualified stated interest. Accordingly, under
Sec. 1.1273-1(c)(2), no payments on the debt instrument are
qualified stated interest payments. Thus, $6,000 of OID accrues
during the first annual accrual period. If the PIK instrument is not
issued, $6,000 of OID accrues during each annual accrual period.
(v) Consequences if the PIK instrument is issued. Under
paragraph (c)(6) of this section, if X issues the PIK instrument on
January 1, 1996, the issuance of the PIK instrument is not a payment
on the debt instrument. Solely for purposes of determining yield and
maturity, the debt instrument is deemed reissued on January 1, 1996,
for an issue price of $106,000. The recomputed yield is 6 percent,
compounded annually. The OID for the first annual accrual period
after the deemed reissuance is $6,360. The adjusted issue price of
the debt instrument at the beginning of the next annual accrual
period is $106,000 ($106,000 + $6,360 - $6,360). The OID for each of
the four remaining annual accrual periods is $6,360.
Example 8. Debt instrument issued at a discount that provides
for payment of interest in kind--(i) Facts. On January 1, 1995, T
purchases at original issue, for $75,500, U corporation's debt
instrument maturing on January 1, 2000, at a stated principal amount
of $100,000, payable on that date. The debt instrument provides for
annual payments of interest of $4,000 on January 1 of each year,
beginning on January 1, 1996. The debt instrument gives U the
unconditional right to issue, in lieu of the first interest payment,
a second debt instrument (PIK instrument) maturing on January 1,
2000, with a stated principal amount of $4,000. The PIK instrument,
if issued, would provide for annual payments of interest of $160 on
January 1 of each year, beginning on January 1, 1997.
(ii) Aggregation of PIK instrument with original debt
instrument. Under Sec. 1.1275-2(c)(3), the issuance of the PIK
instrument is not considered a payment made on the original debt
instrument, and the PIK instrument is aggregated with the original
debt instrument. The issue date of the PIK instrument is the same as
the original debt instrument.
(iii) Determination of yield and maturity. The right to issue
the PIK instrument is treated as an option to defer the initial
interest payment until maturity. Yield determined without regard to
the option is 10.55 percent, compounded annually. Yield determined
by assuming U exercises the option is 10.32 percent, compounded
annually. Thus, under paragraph (c)(5) of this section, it is
assumed that U will exercise the option by issuing the PIK
instrument because exercise of the option would decrease the yield
of the debt instrument. For purposes of calculating OID, the debt
instrument is assumed to be a 5-year debt instrument with a single
principal payment at maturity of $104,000 and four annual interest
payments of $4,160, beginning on January 1, 1997. As a result, the
yield is 10.32 percent, compounded annually.
(iv) Consequences if the PIK instrument is not issued. Assume
that T chooses to compute OID accruals on the basis of an annual
accrual period. On January 1, 1996, the adjusted issue price of the
debt instrument, and T's adjusted basis in the instrument, is
$83,295.15. Under paragraph (c)(6) of this section, if U actually
makes the $4,000 interest payment on January 1, 1996, the debt
instrument is treated as if U made a pro rata prepayment (within the
meaning of Sec. 1.1275-2(f)(2)) of $4,000, which reduces the amount
of each payment remaining on the instrument by a factor of 4/104, or
1/26. Thus, under Sec. 1.1275-2(f)(1) and section 1271, T realizes a
gain of $796.34 ($4,000 -($83,295.15/26)). The adjusted issue price
of the debt instrument and T's adjusted basis immediately after the
payment is $80,091.49 ($83,295.15 x 25/26) and the yield continues
to be 10.32 percent, compounded annually.
Example 9. Debt instrument with stepped interest rate--(i)
Facts. On July 1, 1994, G purchases at original issue, for $85,000,
H corporation's debt instrument maturing on July 1, 2004. The debt
instrument has a stated principal amount of $100,000, payable on the
maturity date and provides for semiannual interest payments on
January 1 and July 1 of each year, beginning on January 1, 1995. The
amount of each payment is $2,000 for the first 5 years and $5,000
for the final 5 years.
(ii) Determination of OID. Assume that G computes its OID using
6-month accrual periods ending on January 1 and July 1 of each year.
The yield of the debt instrument, determined under paragraph
(b)(1)(i) of this section, is 8.65 percent, compounded semiannually.
Interest is unconditionally payable at a fixed rate of at least 4
percent, compounded semiannually, for the entire term of the debt
instrument. Consequently, under Sec. 1.1273-1(c)(1), the semiannual
payments are qualified stated interest payments to the extent of
$2,000. The amount of OID for the first 6-month accrual period is
$1,674.34 (the issue price of the debt instrument ($85,000) times
the yield of the debt instrument for that accrual period (.0865/2)
less the amount of any qualified stated interest allocable to that
accrual period ($2,000)).
Example 10. Debt instrument payable on demand that provides for
interest at a constant rate--(i) Facts. On January 1, 1995, V
purchases at original issue, for $100,000, W corporation's debt
instrument. The debt instrument calls for interest to accrue at a
rate of 9 percent, compounded annually. The debt instrument is
redeemable at any time at the option of V for an amount equal to
$100,000, plus accrued interest. V uses annual accrual periods to
accrue OID on the debt instrument.
(ii) Amount of OID. Pursuant to paragraph (d) of this section,
the yield of the debt instrument is 9 percent, compounded annually.
If the debt instrument is not redeemed during 1995, the amount of
OID allocable to the year is $9,000.
Sec. 1.1272-2 Treatment of debt instruments purchased at a premium.
(a) In general. Under section 1272(c)(1), if a holder purchases a
debt instrument at a premium, the holder does not include any OID in
gross income. Under section 1272(a)(7), if a holder purchases a debt
instrument at an acquisition premium, the holder reduces the amount of
OID includible in gross income by the fraction determined under
paragraph (b)(4) of this section.
(b) Definitions and special rules--(1) Purchase. For purposes of
section 1272 and this section, purchase means any acquisition of a debt
instrument, including the acquisition of a newly issued debt instrument
in a debt-for-debt exchange or the acquisition of a debt instrument
from a donor.
(2) Premium. A debt instrument is purchased at a premium if its
adjusted basis, immediately after its purchase by the holder (including
a purchase at original issue), exceeds the sum of all amounts payable
on the instrument after the purchase date other than payments of
qualified stated interest (as defined in Sec. 1.1273-1(c)).
(3) Acquisition premium. A debt instrument is purchased at an
acquisition premium if its adjusted basis, immediately after its
purchase (including a purchase at original issue), is--
(i) Less than or equal to the sum of all amounts payable on the
instrument after the purchase date other than payments of qualified
stated interest (as defined in Sec. 1.1273-1(c)); and
(ii) Greater than the instrument's adjusted issue price (as defined
in Sec. 1.1275-1(b)).
(4) Acquisition premium fraction. In applying section 1272(a)(7),
the cost of a debt instrument is its adjusted basis immediately after
its acquisition by the purchaser. Thus, the numerator of the fraction
determined under section 1272(a)(7)(B) is the excess of the adjusted
basis of the debt instrument immediately after its acquisition by the
purchaser over the adjusted issue price of the debt instrument. The
denominator of the fraction determined under section 1272(a)(7)(B) is
the excess of the sum of all amounts payable on the debt instrument
after the purchase date, other than payments of qualified stated
interest, over the instrument's adjusted issue price.
(5) Election to accrue discount on a constant yield basis. Rather
than applying the acquisition premium fraction, a holder of a debt
instrument purchased at an acquisition premium may elect under
Sec. 1.1272-3 to compute OID accruals by treating the purchase as a
purchase at original issuance and applying the mechanics of the
constant yield method.
(6) Special rules for determining basis--(i) Debt instruments
acquired in exchange for other property. For purposes of section
1272(a)(7), section 1272(c)(1), and this section, if a debt instrument
is acquired in an exchange for other property (other than in a
reorganization defined in section 368) and the basis of the debt
instrument is determined, in whole or in part, by reference to the
basis of the other property, the basis of the debt instrument may not
exceed its fair market value immediately after the exchange. For
example, if a debt instrument is distributed by a partnership to a
partner in a liquidating distribution and the partner's basis in the
debt instrument would otherwise be determined under section 732, the
partner's basis in the debt instrument may not exceed its fair market
value for purposes of this section.
(ii) Acquisition by gift. For purposes of this section, a donee's
adjusted basis in a debt instrument is the donee's basis for
determining gain under section 1015(a).
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Debt instrument purchased at an acquisition premium--
(i) Facts. On July 1, 1994, A purchased at original issue, for $500,
a debt instrument issued by Corporation X. The debt instrument
matures on July 1, 1999, and calls for a single payment at maturity
of $1,000. Under section 1273(a), the debt instrument has a stated
redemption price at maturity of $1,000 and, thus, OID of $500. On
July 1, 1996, when the debt instrument's adjusted issue price is
$659.75, A sells the debt instrument to B for $750 in cash.
(ii) Acquisition premium fraction. Because the cost to B of the
debt instrument is less than the amount payable on the debt
instrument after the purchase date, but is greater than the debt
instrument's adjusted issue price, B has paid an acquisition premium
for the debt instrument. Accordingly, the daily portion of OID for
any day that B holds the debt instrument is reduced by a fraction,
the numerator of which is $90.25 (the excess of the cost of the debt
instrument over its adjusted issue price) and the denominator of
which is $340.25 (the excess of the sum of all payments after the
purchase date over its adjusted issue price).
Example 2. Debt-for-debt exchange where holder is considered to
purchase new debt instrument at a premium--(i) Facts. On January 1,
1995, H purchases at original issue, for $1,000, a debt instrument
issued by Corporation X. On July 1, 1997, when H's adjusted basis in
the debt instrument is $1,000, Corporation X issues a new debt
instrument with a stated redemption price at maturity of $750 to H
in exchange for the old debt instrument. Assume that the issue price
of the new debt instrument is $600. Thus, under section 1273(a), the
debt instrument has OID of $150. The exchange qualifies as a
recapitalization under section 368(a)(1)(E), with the consequence
that, under sections 354 and 358, H recognizes no loss on the
exchange and has an adjusted basis in the new debt instrument of
$1,000.
(ii) Application of section 1272(c)(1). Under paragraphs (b)(1)
and (b)(2) of this section, H purchases the new debt instrument at a
premium of $250. Accordingly, under section 1272(c)(1), H is not
required to include OID in income with respect to the new debt
instrument.
Example 3. Debt-for-debt exchange where holder is considered to
purchase new debt instrument at an acquisition premium--(i) Facts.
The facts are the same as in Example 2 of paragraph (c) of this
section, except that H purchases the old debt instrument from
another holder on July 1, 1995, and on July 1, 1997, H's adjusted
basis in the old debt instrument is $700. Under section 1273(a), the
new debt instrument is issued with OID of $150.
(ii) Application of section 1272(a)(7). Under paragraphs (b)(1)
and (b)(3) of this section, H purchases the new debt instrument at
an acquisition premium of $100. Accordingly, the daily portion of
OID that is includible in H's income is reduced by the fraction
determined under section 1272(a)(7).
Example 4. Treatment of acquisition premium for debt instrument
acquired by gift--(i) Facts. On July 1, 1994, D receives as a gift a
debt instrument with a stated redemption price at maturity of $1,000
and an adjusted issue price of $800. On that date, the fair market
value of the debt instrument is $900 and the donor's adjusted basis
in the debt instrument is $950.
(ii) Application of section 1272(a)(7). Under paragraphs (b)(1),
(b)(3), and (b)(6)(ii) of this section, D is considered to have
purchased the debt instrument at an acquisition premium of $150.
Accordingly, the daily portion of OID that is includible in D's
income is reduced by the fraction determined under section
1272(a)(7).
Sec. 1.1272-3 Election by a holder to treat all interest on a debt
instrument as OID.
(a) Election. A holder of a debt instrument may elect to include in
gross income all interest that accrues on the instrument by using the
constant yield method described in paragraph (c) of this section. For
purposes of this election, interest includes stated interest,
acquisition discount, OID, de minimis OID, market discount, de minimis
market discount, and unstated interest, as adjusted by any amortizable
bond premium or acquisition premium.
(b) Scope of election--(1) In general. Except as provided in
paragraph (b)(2) of this section, a holder may make the election for
any debt instrument.
(2) Exceptions, limitations, and special rules--(i) Debt instrument
with amortizable bond premium (as determined under section 171). (A) A
holder may make the election for a debt instrument with amortizable
bond premium only if the instrument qualifies as a bond under section
171(d).
(B) If a holder makes the election under this section for a debt
instrument with amortizable bond premium, the holder is deemed to have
made the election under section 171(c)(2) for the taxable year in which
the instrument was acquired. If the holder has previously made the
election under section 171(c)(2), the requirements of that election
with respect to any debt instrument are satisfied by electing to
amortize the bond premium under the rules provided by this section.
(ii) Debt instrument with market discount. (A) A holder may make
the election under this section for a debt instrument with market
discount only if the holder is eligible to make an election under
section 1278(b).
(B) If a holder makes the election under this section for a debt
instrument with market discount, the holder is deemed to have made both
the election under section 1276(b)(2) for that instrument and the
election under section 1278(b) for the taxable year in which the
instrument was acquired. If the holder has previously made the election
under section 1278(b), the requirements of that election with respect
to any debt instrument are satisfied by electing to include the market
discount in income in accordance with the rules provided by this
section.
(iii) Tax-exempt debt instrument. A holder may not make the
election for a tax-exempt obligation as defined in section 1275(a)(3).
(c) Mechanics of the constant yield method--(1) In general. For
purposes of this section, the amount of interest that accrues during an
accrual period is determined under rules similar to those under section
1272 (the constant yield method). In applying the constant yield
method, however, a debt instrument subject to the election is treated
as if--
(i) The instrument is issued for the holder's adjusted basis
immediately after its acquisition by the holder;
(ii) The instrument is issued on the holder's acquisition date; and
(iii) None of the interest payments provided for in the instrument
are qualified stated interest payments.
(2) Special rules to determine adjusted basis. For purposes of
paragraph (c)(1)(i) of this section--
(i) If the debt instrument is acquired in an exchange for other
property (other than in a reorganization defined in section 368) and
the basis of the debt instrument is determined, in whole or in part, by
reference to the basis of the other property, the adjusted basis of the
debt instrument may not exceed its fair market value immediately after
the exchange; and
(ii) If the debt instrument was acquired with amortizable bond
premium (as determined under section 171), the adjusted basis of the
debt instrument is reduced by an amount equal to the value attributable
to any conversion feature.
(d) Time and manner of making the election. The election must be
made for the taxable year in which the holder acquires the debt
instrument. A holder makes the election by attaching to the holder's
timely filed Federal income tax return a statement that the holder is
making an election under this section and that identifies the debt
instruments subject to the election. A holder may make the election for
a class or group of debt instruments by attaching a statement
describing the type or types of debt instruments being designated for
the election.
(e) Revocation of election. The election may not be revoked unless
approved by the Commissioner.
(f) Effective date. This section applies to debt instruments
acquired on or after April 4, 1994.
Sec. 1.1273-1 Definition of OID.
(a) In general. Section 1273(a)(1) defines OID as the excess of a
debt instrument's stated redemption price at maturity over its issue
price. Section 1.1273-2 defines issue price, and paragraph (b) of this
section defines stated redemption price at maturity. Paragraph (d) of
this section provides rules for de minimis amounts of OID. Although the
total amount of OID for a debt instrument may be indeterminate,
Sec. 1.1272-1(d) provides a rule to determine OID accruals on certain
debt instruments that provide for principal payments uncertain as to
time. See Example 10 in Sec. 1.1272-1(j).
(b) Stated redemption price at maturity. A debt instrument's stated
redemption price at maturity is the sum of all payments provided by the
debt instrument other than qualified stated interest payments. If the
payment schedule of a debt instrument is determined under Sec. 1.1272-
1(c) (relating to certain debt instruments subject to contingencies),
that payment schedule is used to determine the instrument's stated
redemption price at maturity.
(c) Qualified stated interest--(1) Definition--(i) In general.
Qualified stated interest is stated interest that is unconditionally
payable in cash or in property (other than debt instruments of the
issuer), or that will be constructively received under section 451, at
least annually at a single fixed rate (within the meaning of paragraph
(c)(1)(iii) of this section).
(ii) Unconditionally payable. 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. Notwithstanding the
preceding sentence, interest is not unconditionally payable if the
lending transaction does not reflect arm's length dealing and the
holder does not intend to enforce such remedies. 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 right described
in Sec. 1.1272-1(e) is ignored.
(iii) Single fixed rate--(A) In general. Interest is payable at a
single fixed rate only if the rate appropriately takes into account the
length of the interval between payments. Thus, if the interval between
payments varies during the term of the debt instrument, the value of
the fixed rate on which a payment is based generally must be adjusted
to reflect a compounding assumption that is consistent with the length
of the interval preceding the payment. See Example 1 in paragraph (f)
of this section.
(B) Special rule for certain first and final payment intervals.
Notwithstanding paragraph (c)(1)(iii)(A) of this section, if a debt
instrument provides for payment intervals that are equal in length
throughout the term of the instrument, except that the first or final
payment interval differs in length from the other payment intervals,
the first or final interest payment is considered to be made at a fixed
rate if the value of the rate on which the payment is based is adjusted
in any reasonable manner to take into account the length of the
interval. See Example 2 of paragraph (f) of this section. The rule in
this paragraph (c)(1)(iii)(B) also applies if the lengths of both the
first and final payment intervals differ from the length of the other
payment intervals.
(2) Debt instruments subject to contingencies. The determination of
whether a debt instrument described in Sec. 1.1272-1(c) (a debt
instrument providing for an alternative payment schedule (or schedules)
upon the occurrence of one or more contingencies) provides for
qualified stated interest is made by analyzing each alternative payment
schedule (including the stated payment schedule) as if it were the debt
instrument's sole payment schedule. Under this analysis, 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. See Example (4) of paragraph (f) of this
section.
(3) Variable rate debt instrument. In the case of a variable rate
debt instrument, qualified stated interest is determined under
Sec. 1.1275-5(e).
(4) Stated interest in excess of qualified stated interest. To the
extent that stated interest payable under a debt instrument exceeds
qualified stated interest, the excess is included in the debt
instrument's stated redemption price at maturity.
(5) Short-term obligations. In the case of a debt instrument with a
term that is not more than 1 year from the date of issue, no payments
of interest are treated as qualified stated interest payments.
(d) De minimis OID--(1) In general. If the amount of OID with
respect to a debt instrument is less than the de minimis amount, the
amount of OID is treated as zero, and all stated interest (including
stated interest that would otherwise be characterized as OID) is
treated as qualified stated interest.
(2) De minimis amount. The de minimis amount is an amount equal to
0.0025 multiplied by the product of the stated redemption price at
maturity and the number of complete years to maturity from the issue
date.
(3) Installment obligations. In the case of an installment
obligation (as defined in paragraph (e)(1) of this section), paragraph
(d)(2) of this section is applied by substituting for the number of
complete years to maturity the weighted average maturity (as defined in
paragraph (e)(3) of this section). Alternatively, in the case of a debt
instrument that provides for payments of principal no more rapidly than
a self-amortizing installment obligation (as defined in paragraph
(e)(2) of this section), the de minimis amount defined in paragraph
(d)(2) of this section may be calculated by substituting 0.00167 for
0.0025.
(4) Special rule for interest holidays, teaser rates, and other
interest shortfalls--(i) In general. This paragraph (d)(4) provides a
special rule to determine whether a debt instrument with a teaser rate
(or rates), an interest holiday, or any other interest shortfall has de
minimis OID. This rule applies if--
(A) The amount of OID on the debt instrument is more than the de
minimis amount as otherwise determined under paragraph (d) of this
section; and
(B) All stated interest provided for in the debt instrument would
be qualified stated interest under paragraph (c) of this section except
that for 1 or more accrual periods the interest rate is below the rate
applicable for the remainder of the instrument's term (e.g., if as a
result of an interest holiday, none of the stated interest is qualified
stated interest).
(ii) Redetermination of OID for purposes of the de minimis test.
For purposes of determining whether a debt instrument described in
paragraph (d)(4)(i) of this section has de minimis OID, the
instrument's stated redemption price at maturity is treated as equal to
the instrument's issue price plus the greater of the amount of foregone
interest or the excess (if any) of the instrument's stated principal
amount over its issue price. The amount of foregone interest is the
amount of additional stated interest that would be required to be
payable on the debt instrument during the period of the teaser rate,
holiday, or shortfall so that all stated interest would be qualified
stated interest under paragraph (c) of this section. See Example 5 and
Example 6 of paragraph (f) of this section. In addition, for purposes
of computing the de minimis amount of OID, the weighted average
maturity of the debt instrument is determined by treating all stated
interest payments as qualified stated interest payments.
(5) Treatment of de minimis OID by holders--(i) Allocation of de
minimis OID to principal payments. The holder of a debt instrument
includes any de minimis OID (other than de minimis OID treated as
qualified stated interest under paragraph (d)(1) of this section, such
as de minimis OID attributable to a teaser rate or interest holiday) in
income as stated principal payments are made. The amount includible in
income with respect to each principal payment equals the product of the
total amount of de minimis OID on the debt instrument and a fraction,
the numerator of which is the amount of the principal payment made and
the denominator of which is the stated principal amount of the
instrument.
(ii) Character of de minimis OID--(A) De minimis OID treated as
gain recognized on retirement. Any amount of de minimis OID includible
in income under this paragraph (d)(5) is treated as gain recognized on
retirement of the debt instrument. See section 1271 to determine
whether a retirement is treated as an exchange of the debt instrument.
(B) Treatment of de minimis OID on sale or exchange. Any gain
attributable to de minimis OID that is recognized on the sale or
exchange of a debt instrument is capital gain if the debt instrument is
a capital asset in the hands of the seller.
(iii) Treatment of subsequent holders. If a subsequent holder
purchases a debt instrument issued with de minimis OID at a premium (as
defined in Sec. 1.1272-2(b)(2)), the subsequent holder does not include
the de minimis OID in income. Otherwise, a subsequent holder includes
any discount in income under the market discount rules (sections 1276
through 1278) rather than under the rules of this paragraph (d)(5).
(iv) Cross-reference. See Sec. 1.1272-3 for an election by a holder
to treat de minimis OID as OID.
(e) Definitions--(1) Installment obligation. An installment
obligation is a debt instrument that provides for the payment of any
amount other than qualified stated interest before maturity.
(2) Self-amortizing installment obligation. A self-amortizing
installment obligation is an obligation that provides for equal
payments composed of principal and qualified stated interest that are
unconditionally payable at least annually during the entire term of the
debt instrument with no significant additional payment required at
maturity.
(3) Weighted average maturity. The weighted average maturity of a
debt instrument is the sum of the following amounts determined for each
payment under the instrument (other than a payment of qualified stated
interest)--
(i) The number of complete years from the issue date until the
payment is made; multiplied by
(ii) A fraction, the numerator of which is the amount of the
payment and the denominator of which is the debt instrument's stated
redemption price at maturity.
(f) Examples. The following examples illustrate the rules of this
section.
Example 1. Qualified stated interest--(i) Facts. On January 1,
1995, A purchases at original issue, for $100,000, a debt instrument
that matures on January 1, 1999, and has a stated principal amount
of $100,000, payable at maturity. The debt instrument provides for
interest payments of $8,000 on January 1, 1996, and January 1, 1997,
and quarterly interest payments of $1,942.65, beginning on April 1,
1997.
(ii) Amount of qualified stated interest. The annual payments of
$8,000 and the quarterly payments of $1,942.65 are payable at a
single fixed rate because 8 percent, compounded annually, is
equivalent to 7.77 percent, compounded quarterly. Consequently, all
stated interest payments under the debt instrument are qualified
stated interest payments.
Example 2. Qualified stated interest with short initial payment
interval. On October 1, 1994, A purchases at original issue, for
$100,000, a debt instrument that matures on January 1, 1998, and has
a stated principal amount of $100,000, payable at maturity. The debt
instrument provides for an interest payment of $2,000 on January 1,
1995, and interest payments of $8,000 on January 1, 1996, January 1,
1997, and January 1, 1998. Under paragraph (c)(1)(iii)(B) of this
section, all stated interest payments on the debt instrument are
computed at a single fixed rate and are qualified stated interest
payments.
Example 3. Stated interest in excess of qualified stated
interest--(i) Facts. On January 1, 1995, B purchases at original
issue, for $100,000, C corporation's 5-year debt instrument. The
debt instrument provides for a principal payment of $100,000,
payable at maturity, and calls for annual interest payments of
$10,000 for the first 3 years and annual interest payments of
$10,600 for the last 2 years.
(ii) Payments in excess of qualified stated interest. All of the
first three interest payments and $10,000 of each of the last two
interest payments are qualified stated interest payments within the
meaning of paragraph (c)(1) of this section. Under paragraph (c)(4)
of this section, the remaining $600 of each of the last two interest
payments is included in the stated redemption price at maturity, so
that the stated redemption price at maturity is $101,200. Pursuant
to paragraph (e)(3) of this section, the weighted average maturity
of the debt instrument is 4.994 years [(4 years x $600/$101,200)+(5
years x $100,600/$101,200)]. The de minimis amount, or one-fourth of
1 percent of the stated redemption price at maturity multiplied by
the weighted average maturity, is $1,263.50. Because the actual
amount of discount, $1,200, is less than the de minimis amount, the
instrument is treated as having no OID, and, under paragraph (d)(1)
of this section, all of the interest payments are treated as
qualified stated interest payments.
Example 4. Qualified stated interest on a debt instrument that
is subject to a contingency--(i) Facts. On January 1, 1995, 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,
however, the interest payments for each of the final five years will
be reduced to $5,000 if a specified annual level of earnings is not
attained by A by the end of year five.
(ii) Amount of qualified stated interest. If the payment
schedule determined by assuming that the specified earnings level
will be attained is treated as the debt instrument's sole payment
schedule, the instrument would provide for annual qualified stated
interest payments of $10,000. If the payment schedule determined by
assuming that the specified earnings level will not be attained is
treated as the instrument's sole payment schedule, however, only
$5,000 of each annual interest payment would constitute qualified
stated interest. Accordingly, under paragraph (c)(2) of this
section, only $5,000 of each annual interest payment constitutes
qualified stated interest. Any excess of each annual interest
payment over $5,000 is included in the debt instrument's stated
redemption price at maturity.
Example 5. De minimis OID; interest holiday--(i) Facts. On
January 1, 1995, C purchases at original issue, for $97,561, a debt
instrument that matures on January 1, 2007, and has a stated
principal amount of $100,000, payable at maturity. The debt
instrument provides for an initial interest holiday of 1 quarter and
quarterly interest payments of $2,500 thereafter (beginning on July
1, 1995). The issue price of the debt instrument is $97,561. C
chooses to accrue OID based on quarterly accrual periods.
(ii) De minimis amount of OID. But for the interest holiday, all
stated interest on the debt instrument would be qualified stated
interest. Under paragraph (d)(4) of this section, for purposes of
determining whether the debt instrument has de minimis OID, the
stated redemption price at maturity of the instrument is $100,061
($97,561 (issue price) plus $2,500 (the greater of the amount of
foregone interest ($2,500) and the amount equal to the excess of the
instrument's stated principal amount over its issue price ($2,439)).
Thus, the debt instrument is treated as having OID of $2,500
($100,061 minus $97,561). Because this amount is less than the de
minimis amount of $3,001.83 (0.0025 multiplied by $100,061
multiplied by 12 complete years to maturity), the debt instrument is
treated as having no OID, and all stated interest is treated as
qualified stated interest.
Example 6. De minimis OID; teaser rate--(i) Facts. The facts are
the same as in Example 5 of this paragraph (f) except that C uses an
initial semiannual accrual period rather than an initial quarterly
accrual period.
(ii) De minimis amount of OID. The debt instrument provides for
an initial teaser rate because the interest rate for the semiannual
accrual period is less than the interest rate applicable to the
subsequent quarterly accrual periods. But for the initial teaser
rate, all stated interest on the debt instrument would be qualified
stated interest. Under paragraph (d)(4) of this section, for
purposes of determining whether the debt instrument has de minimis
OID, the stated redemption price at maturity of the instrument is
$100,123.50 ($97,561 (issue price) plus $2,562.50 (the greater of
the amount of foregone interest ($2,562.50) and the amount equal to
the excess of the instrument's stated principal amount over its
issue price ($2,439)). Thus, the debt instrument is treated as
having OID of $2,562.50 ($100,123.50 minus $97,561). Because this
amount is less than the de minimis amount of $3,003.71 (0.0025
multiplied by $100,123.50 multiplied by 12 complete years to
maturity), the debt instrument is treated as having no OID, and all
stated interest is treated as qualified stated interest.
Sec. 1.1273-2 Determination of issue price and issue date.
(a) Debt instruments issued for money--(1) Issue price. If a
substantial amount of the debt instruments in an issue is issued for
money, the issue price of each debt instrument in the issue is the
first price at which a substantial amount of the debt instruments is
sold for money. Thus, if an issue consists of a single debt instrument
that is issued for money, the issue price of the debt instrument is the
amount paid for the instrument. For example, in the case of a debt
instrument evidencing a loan to a natural person, the issue price of
the instrument is the amount loaned. See Sec. 1.1275-2(d) for rules
regarding Treasury securities. For purposes of this paragraph (a),
money includes functional currency and, in certain circumstances,
nonfunctional currency. See Sec. 1.988-2(b)(2) for circumstances when
nonfunctional currency is treated as money rather than as property.
(2) Issue date. The issue date of an issue described in paragraph
(a)(1) of this section is the first settlement date or closing date,
whichever is applicable, on which a substantial amount of the debt
instruments in the issue is sold for money.
(b) Publicly traded debt instruments issued for property--(1) Issue
price. If a substantial amount of the debt instruments in an issue is
traded on an established market (within the meaning of paragraph (f) of
this section) and the issue is not described in paragraph (a)(1) of
this section, the issue price of each debt instrument in the issue is
the fair market value of the debt instrument, determined as of the
issue date (as defined in paragraph (b)(2) of this section).
(2) Issue date. The issue date of an issue described in paragraph
(b)(1) of this section is the first date on which a substantial amount
of the traded debt instruments in the issue is issued.
(c) Debt instruments issued for publicly traded property--(1) Issue
price. If a substantial amount of the debt instruments in an issue is
issued for property that is traded on an established market (within the
meaning of paragraph (f) of this section) and the issue is not
described in paragraph (a)(1) or (b)(1) of this section, the issue
price of each debt instrument in the issue is the fair market value of
the property, determined as of the issue date (as defined in paragraph
(c)(2) of this section). For purposes of the preceding sentence,
property means a debt instrument, stock, security, contract, commodity,
or nonfunctional currency. But see Sec. 1.988-2(b)(2) for circumstances
when nonfunctional currency is treated as money rather than as
property.
(2) Issue date. The issue date of an issue described in paragraph
(c)(1) of this section is the first date on which a substantial amount
of the debt instruments in the issue is issued for traded property.
(d) Other debt instruments--(1) Issue price. If an issue of debt
instruments is not described in paragraph (a)(1), (b)(1), or (c)(1) of
this section, the issue price of each debt instrument in the issue is
determined as if the debt instrument were a separate issue. If the
issue price of a debt instrument that is treated as a separate issue
under the preceding sentence is not determined under paragraph (a)(1),
(b)(1), or (c)(1) of this section, and if section 1274 applies to the
debt instrument, the issue price of the instrument is determined under
section 1274. Otherwise, the issue price of the debt instrument is its
stated redemption price at maturity under section 1273(b)(4). See
section 1274(c) and Sec. 1.1274-1 to determine if section 1274 applies
to a debt instrument.
(2) Issue date. The issue date of an issue described in paragraph
(d)(1) of this section is the date on which the debt instrument is
issued for money or in a sale or exchange.
(e) Special rule for certain sales to bond houses, brokers, or
similar persons. For purposes of determining the issue price and issue
date of a debt instrument under this section, sales to bond houses,
brokers, or similar persons or organizations acting in the capacity of
underwriters, placement agents, or wholesalers are ignored.
(f) Traded on an established market (publicly traded)--(1) In
general. Property (including a debt instrument described in paragraph
(b)(1) of this section) is traded on an established market for purposes
of this section if, at any time during the 60-day period ending 30 days
after the issue date, the property is described in paragraph (f)(2),
(f)(3), (f)(4), or (f)(5) of this section.
(2) Exchange listed property. Property is described in this
paragraph (f)(2) if it is listed on--
(i) A national securities exchange registered under section 6 of
the Securities Exchange Act of 1934 (15 U.S.C. 78f);
(ii) An interdealer quotation system sponsored by a national
securities association registered under section 15A of the Securities
Exchange Act of 1934 (15 U.S.C. 78o-3); or
(iii) The International Stock Exchange of the United Kingdom and
the Republic of Ireland, Limited, the Frankfurt Stock Exchange, the
Tokyo Stock Exchange, or any other foreign exchange or board of trade
that is designated by the Commissioner in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2)(ii) of this chapter).
(3) Market traded property. Property is described in this paragraph
(f)(3) if it is property of a kind that is traded either on a board of
trade designated as a contract market by the Commodities Futures
Trading Commission or on an interbank market.
(4) Property appearing on a quotation medium. Property is described
in this paragraph (f)(4) if it appears on a system of general
circulation (including a computer listing disseminated to subscribing
brokers, dealers, or traders) that provides a reasonable basis to
determine fair market value by disseminating either recent price
quotations (including rates, yields, or other pricing information) of
one or more identified brokers, dealers, or traders or actual prices
(including rates, yields, or other pricing information) of recent sales
transactions (a quotation medium). A quotation medium does not include
a directory or listing of brokers, dealers, or traders for specific
securities, such as yellow sheets, that provides neither price
quotations nor actual prices of recent sales transactions.
(5) Readily quotable debt instruments--(i) In general. A debt
instrument is described in this paragraph (f)(5) if price quotations
are readily available from dealers, brokers, or traders.
(ii) Safe harbors. A debt instrument is not considered to be
described in paragraph (f)(5)(i) of this section if--
(A) No other outstanding debt instrument of the issuer (or of any
person who guarantees the debt instrument) is described in paragraph
(f)(2), (f)(3), or (f)(4) of this section (other traded debt);
(B) The original stated principal amount of the issue that includes
the debt instrument does not exceed $25 million;
(C) The conditions and covenants relating to the issuer's
performance with respect to the debt instrument are materially less
restrictive than the conditions and covenants included in all of the
issuer's other traded debt (e.g., the debt instrument is subject to an
economically significant subordination provision whereas the issuer's
other traded debt is senior); or
(D) The maturity date of the debt instrument is more than 3 years
after the latest maturity date of the issuer's other traded debt.
(6) Effect of certain temporary restrictions on trading. If there
is any temporary restriction on trading a purpose of which is to avoid
the characterization of the property as one that is traded on an
established market for Federal income tax purposes, then the property
is treated as traded on an established market. For purposes of the
preceding sentence, a temporary restriction on trading need not be
imposed by the issuer.
(7) Convertible debt instruments. A debt instrument is not treated
as traded on an established market solely because the debt instrument
is convertible into property that is so traded.
(g) Treatment of certain cash payments incident to lending
transactions--(1) Applicability. The provisions of this paragraph (g)
apply to cash payments made incident to private lending transactions
(including seller financing).
(2) Payments from borrower to lender--(i) Money lending
transaction. In a lending transaction to which section 1273(b)(2)
applies, a payment from the borrower to the lender (other than a
payment for property or for services provided by the lender, such as
commitment fees or loan processing costs) reduces the issue price of
the debt instrument evidencing the loan. However, solely for purposes
of determining the tax consequences to the borrower, the issue price is
not reduced if the payment is deductible under section 461(g)(2).
(ii) Section 1274 transaction. In a lending transaction to which
section 1274 applies, a payment from the buyer-borrower to the seller-
lender that is designated as interest or points reduces the stated
principal amount of the debt instrument evidencing the loan, but is
included in the purchase price of the property. If the payment is
deductible under section 461(g)(2), however, the issue price of the
debt instrument (as otherwise determined under section 1274 and the
rule in the preceding sentence) is increased by the amount of the
payment to compute the buyer-borrower's interest deductions under
section 163.
(3) Payments from lender to borrower. A payment from the lender to
the borrower in a lending transaction is treated as an amount loaned.
(4) Payments between lender and third party. If, as part of a
lending transaction, a party other than the borrower (the third party)
makes a payment to the lender, that payment is treated in appropriate
circumstances as made from the third party to the borrower followed by
a payment in the same amount from the borrower to the lender and
governed by the provisions of paragraph (g)(2) of this section. If, as
part of a lending transaction, the lender makes a payment to a third
party, that payment is treated in appropriate circumstances as an
additional amount loaned to the borrower and then paid by the borrower
to the third party. The character of the deemed payment between the
borrower and the third party depends on the substance of the
transaction.
(5) Examples. The following examples illustrate the rules of this
paragraph (g).
Example 1. Payments from borrower to lender in a cash
transaction--(i) Facts. A lends $100,000 to B for a term of 10
years. At the time the loan is made, B pays $4,000 in points to A.
Assume that the points are not deductible by B under section
461(g)(2) and that the stated redemption price at maturity of the
debt instrument is $100,000.
(ii) Payment results in OID. Under paragraph (g)(2)(i) of this
section, the issue price of B's debt instrument evidencing the loan
is $96,000. Because the amount of OID on the debt instrument
($4,000) is more than a de minimis amount of OID, A accounts for the
OID under Sec. 1.1272-1. B accounts for the OID under Sec. 1.163-7.
Example 2. Payments from borrower to lender in a section 1274
transaction--(i) Facts. A sells property to B for $1,000,000 in a
transaction that is not a potentially abusive situation (within the
meaning of Sec. 1.1274-3). In consideration for the property, B
gives A $300,000 and issues a 5-year debt instrument that has a
stated principal amount of $700,000, payable at maturity, and that
calls for semiannual payments of interest at a rate of 8.5 percent.
In addition to the cash downpayment, B pays A $14,000 designated as
points on the loan. Assume that the points are not deductible under
section 461(g)(2).
(ii) Issue price. Under paragraph (g)(2)(ii) of this section,
the stated principal amount of B's debt instrument is -$686,000
($700,000 minus $14,000). Assuming a test rate of 9 percent,
compounded semiannually, the imputed principal amount of B's debt
instrument under Sec. 1.1274-2(c)(1) is $686,153. Under Sec. 1.1274-
2(b)(1), the issue price of B's debt instrument is the stated
principal amount of $686,000. Because the amount of OID on the debt
instrument ($700,000-$686,000, or $14,000) is more than a de minimis
amount of OID, A accounts for the OID under Sec. 1.1272-1 and B
accounts for the OID under Sec. 1.163-7. B's basis in the property
purchased is $1,000,000 ($686,000 debt instrument plus $314,000 cash
payments).
Example 3. Payments between lender and third party (seller-paid
points)--(i) Facts. A sells real property to B for $500,000 in a
transaction that is not a potentially abusive situation (within the
meaning of Sec. 1.1274-3). B makes a cash down payment of $100,000
and borrows $400,000 of the purchase price from a lender, L,
repayable in annual installments over a term of 15 years calling for
interest at a rate of 9 percent, compounded annually. As part of the
transaction, A makes a payment of $8,000 to L to facilitate the loan
to B.
(ii) Payment results in a de minimis amount of OID. Under the
provisions of paragraphs (g)(2)(i) and (g)(4) of this section, B is
treated as having made an $8,000 payment directly to L and a payment
of only $492,000 to A for the property. Thus, B's basis in the
property is $492,000. The payment to L reduces the issue price of
B's debt instrument to $392,000, resulting in $8,000 of OID
($400,000-$392,000). Because the amount of OID is de minimis under
Sec. 1.1273-1(d), L accounts for the de minimis OID under
Sec. 1.1273-1(d)(5). But see Sec. 1.1272-3 (election to treat de
minimis OID as OID). B accounts for the de minimis OID under
Sec. 1.163-7.
(h) Investment units--(1) In general. Under section 1273(c)(2), an
investment unit is treated as if the investment unit were a debt
instrument. The issue price of the investment unit is determined under
paragraph (a)(1), (b)(1), or (c)(1) of this section, if applicable. The
issue price of the investment unit is then allocated between the debt
instrument and the property right (or rights) that comprise the unit
based on their relative fair market values. If paragraphs (a)(1),
(b)(1), and (c)(1) of this section are not applicable, however, the
issue price of the debt instrument that is part of the investment unit
is determined under section 1273(b)(4) or 1274, whichever is
applicable.
(2) Consistent allocation by holders and issuer. The issuer's
allocation of the issue price of the investment unit is binding on all
holders of the investment unit. However, the issuer's determination is
not binding on a holder that explicitly discloses that its allocation
is different from the issuer's allocation. Unless otherwise provided 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 investment unit. See
Sec. 1.1275-2(e) for rules relating to the issuer's obligation to
disclose certain information to holders.
(i) [Reserved]
(j) Convertible debt instruments. The issue price of a debt
instrument includes any amount paid for an option to convert the
instrument into stock (or another debt instrument) of either the issuer
or 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 instrument).
(k) Below-market loans subject to section 7872(b). The issue price
of a below-market loan subject to section 7872(b) (a term loan other
than a gift loan) is the issue price determined under this section,
reduced by the excess amount determined under section 7872(b)(1).
(l) [Reserved]
(m) Treatment of amounts representing pre-issuance accrued
interest--(1) Applicability. Paragraph (m)(2) of this section provides
an alternative to the general rule of this section for determining the
issue price of a debt instrument if--
(i) A portion of the initial purchase price of the instrument is
allocable to interest that has accrued prior to the issue date (pre-
issuance accrued interest); and
(ii) The instrument provides for a payment of stated interest on
the first payment date within 1 year of the issue date that equals or
exceeds the amount of the pre-issuance accrued interest.
(2) Exclusion of pre-issuance accrued interest from issue price. If
a debt instrument meets the requirements of paragraph (m)(1) of this
section, the instrument's issue price may be computed by subtracting
from the issue price (as otherwise computed under this section) the
amount of pre-issuance accrued interest. If the issue price of the debt
instrument is computed in this manner, a portion of the stated interest
payable on the first payment date must be treated as a return of the
excluded pre-issuance accrued interest, rather than as an amount
payable on the instrument.
(3) Example. The following example illustrates the rule of
paragraph (m) of this section.
Example. (i) Facts. On January 15, 1995, A purchases at original
issue, for $1,005, B corporation's debt instrument. The debt
instrument provides for a payment of principal of $1,000 on January
1, 2005, and provides for semiannual interest payments of $60 on
January 1 and July 1 of each year, beginning on July 1, 1995.
(ii) Determination of pre-issuance accrued interest. Under
paragraphs (m)(1) and (m)(2) of this section, $5 of the $1,005
initial purchase price of the debt instrument is allocable to pre-
issuance accrued interest. Accordingly, the debt instrument's issue
price may be computed by subtracting the amount of pre-issuance
accrued interest ($5) from the issue price otherwise computed under
this section ($1,005), resulting in an issue price of $1,000. If the
issue price is computed in this manner, $5 of the $60 payment made
on July 1, 1995, must be treated as a repayment by B of the pre-
issuance accrued interest.
Sec. 1.1274-1 Debt instruments to which section 1274 applies.
(a) In general. Subject to the exceptions and limitations in
paragraph (b) of this section, section 1274 and this section apply to
any debt instrument issued in consideration for the sale or exchange of
property. For purposes of section 1274, property includes debt
instruments and investment units, but does not include money, services,
or the right to use property. For the treatment of certain obligations
given in exchange for services or the use of property, see sections 404
and 467. For purposes of this paragraph (a), money includes functional
currency and, in certain circumstances, nonfunctional currency. See
Sec. 1.988-2(b)(2) for circumstances when nonfunctional currency is
treated as money rather than as property.
(b) Exceptions--(1) Debt instrument with adequate stated interest
and no OID. Section 1274 does not apply to a debt instrument if--
(i) All interest payable on the instrument is qualified stated
interest;
(ii) The stated rate of interest is at least equal to the test rate
of interest (as defined in Sec. 1.1274-4);
(iii) The debt instrument is not issued in a potentially abusive
situation (as defined in Sec. 1.1274-3); and
(iv) No payment from the buyer-borrower to the seller-lender
designated as points or interest is made at the time of issuance of the
debt instrument.
(2) Exceptions under sections 1274(c)(1)(B), 1274(c)(3), 1274A(c),
and 1275(b)(1)--(i) In general. Sections 1274(c)(1)(B), 1274(c)(3),
1274A(c), and 1275(b)(1) describe certain transactions to which section
1274 does not apply. This paragraph (b)(2) provides certain rules to be
used in applying those exceptions.
(ii) Special rules for certain exceptions under section
1274(c)(3)--(A) Determination of sales price for certain sales of
farms. For purposes of section 1274(c)(3)(A), the determination as to
whether the sales price cannot exceed $1,000,000 is made without regard
to any other exception to, or limitation on, the applicability of
section 1274 (e.g., without regard to the special rules regarding sales
of principal residences and land transfers between related persons). In
addition, the sales price is determined without regard to section 1274
and without regard to any stated interest. The sales price includes the
amount of any liability included in the amount realized from the sale
or exchange. See Sec. 1.1001-2.
(B) Sales involving total payments of $250,000 or less. Under
section 1274(c)(3)(C), the determination of the amount of payments due
under all debt instruments and the amount of other consideration to be
received is made as of the date of the sale or exchange or, if earlier,
the contract date. If the precise amount due under any debt instrument
or the precise amount of any other consideration to be received cannot
be determined as of that date, section 1274(c)(3)(C) applies only if it
can be determined that the maximum of the aggregate amount of payments
due under the debt instruments and other consideration to be received
cannot exceed $250,000. For purposes of section 1274(c)(3)(C), if a
liability is assumed or property is taken subject to a liability, the
aggregate amount of payments due includes the outstanding principal
balance or adjusted issue price (in the case of an obligation
originally issued at a discount) of the obligation.
(C) Coordination with section 1273 and Sec. 1.1273-2. In accordance
with section 1274(c)(3)(D), section 1274 and this section do not apply
if the issue price of a debt instrument issued in consideration for the
sale or exchange of property is determined under paragraph (a)(1),
(b)(1), or (c)(1) of Sec. 1.1273-2.
(3) Other exceptions to section 1274--(i) Holders of certain below-
market instruments. Section 1274 does not apply to any holder of a debt
instrument that is issued in consideration for the sale or exchange of
personal use property (within the meaning of section 1275(b)(3)) in the
hands of the issuer and that evidences a below-market loan described in
section 7872(c)(1).
(ii) Transactions involving certain demand loans. Section 1274 does
not apply to any debt instrument that evidences a demand loan that is a
below-market loan described in section 7872(c)(1).
(iii) Certain transfers subject to section 1041. Section 1274 does
not apply to any debt instrument issued in consideration for a transfer
of property subject to section 1041 (relating to transfers of property
between spouses or incident to divorce).
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Single stated rate paid semiannually. A debt
instrument issued in consideration for the sale of nonpublicly
traded property in a transaction that is not a potentially abusive
situation calls for the payment of a principal amount of $1,000,000
at the end of a 10-year term and 20 semiannual interest payments of
$60,000. Assume that the test rate of interest is 12 percent,
compounded semiannually. The debt instrument is not subject to
section 1274 because it provides for interest equal to the test rate
and all interest payable on the instrument is qualified stated
interest.
Example 2. Sale of farm for debt instrument with contingent
interest--(i) Facts. On July 1, 1995, A, an individual, sells to B
land used as a farm within the meaning of section 6420(c)(2). As
partial consideration for the sale, B issues a debt instrument
calling for a single $500,000 payment due in 10 years unless profits
from the land in each of the 10 years preceding maturity of the debt
instrument exceed a specified amount, in which case B is to make a
payment of $1,200,000. The debt instrument does not provide for
interest.
(ii) Total payments may exceed $1,000,000. Even though the total
payments ultimately payable under the contract may be less than
$1,000,000, at the time of the sale or exchange it cannot be
determined that the sales price cannot exceed $1,000,000. Thus, the
sale of the land used as a farm is not an excepted transaction
described in section 1274(c)(3)(A).
Example 3. Sale between related parties subject to section
483(e)--(i) Facts. On July 1, 1995, A, an individual, sells land
(not used as a farm within the meaning of section 6420(c)(2)) to A's
child B for $650,000. In consideration for the sale, B issues a 10-
year debt instrument to A that calls for a payment of $650,000. No
other consideration is given. The debt instrument does not provide
for interest.
(ii) Treatment of debt instrument. For purposes of section
483(e), the $650,000 debt instrument is treated as two separate debt
instruments: a $500,000 debt instrument and a $150,000 debt
instrument. The $500,000 debt instrument is subject to section
483(e), and accordingly is covered by the exception from section
1274 described in section 1274(c)(3)(F). Because the amount of the
payments due as consideration for the sale exceeds $250,000,
however, the $150,000 debt instrument is subject to section 1274.
Sec. 1.1274-2 Issue price of debt instruments to which section 1274
applies.
(a) In general. If section 1274 applies to a debt instrument,
section 1274 and this section determine the issue price of the debt
instrument. For rules relating to the determination of the amount and
timing of OID to be included in income, see section 1272 and the
regulations thereunder.
(b) Issue price--(1) Debt instruments that provide for adequate
stated interest; stated principal amount. The issue price of a debt
instrument that provides for adequate stated interest is the stated
principal amount of the debt instrument. For purposes of section 1274,
the stated principal amount of a debt instrument is the aggregate
amount of all payments due under the debt instrument, excluding any
amount of stated interest. Under Sec. 1.1273-2(g)(2)(ii), however, the
stated principal amount of a debt instrument is reduced by any payment
from the buyer- borrower to the seller-lender that is designated as
interest or points. See Example 2 of Sec. 1.1273-2(g)(5).
(2) Debt instruments that do not provide for adequate stated
interest; imputed principal amount. The issue price of a debt
instrument that does not provide for adequate stated interest is the
imputed principal amount of the debt instrument.
(3) Debt instruments issued in a potentially abusive situation;
fair market value. Notwithstanding paragraphs (b)(1) and (b)(2) of this
section, in the case of a debt instrument issued in a potentially
abusive situation (as defined in Sec. 1.1274-3), the issue price of the
debt instrument is the fair market value of the property received in
exchange for the debt instrument, reduced by the fair market value of
any consideration other than the debt instrument issued in
consideration for the sale or exchange.
(c) Determination of whether a debt instrument provides for
adequate stated interest--(1) In general. A debt instrument provides
for adequate stated interest if its stated principal amount is less
than or equal to its imputed principal amount. Imputed principal amount
means the sum of the present values, as of the issue date, of all
payments, including payments of stated interest, due under the debt
instrument (determined by using a discount rate equal to the test rate
of interest as determined under Sec. 1.1274-4). If a debt instrument
has a single fixed rate of interest that is paid or compounded at least
annually, and that rate is equal to or greater than the test rate, the
debt instrument has adequate stated interest.
(2) Determination of present value. The present value of a payment
is determined by discounting the payment from the date it becomes due
to the date of the sale or exchange at the test rate of interest. To
determine present value, a compounding period must be selected, and the
test rate must be based on the same compounding period.
(d) Treatment of certain options. This paragraph (d) provides rules
for determining the issue price of a debt instrument to which section
1274 applies (other than a debt instrument issued in a potentially
abusive situation) that is subject to one or more options described in
both paragraphs (c)(1) and (c)(5) of Sec. 1.1272-1. Under this
paragraph (d), an issuer will be deemed to exercise or not exercise an
option or combination of options in a manner that minimizes the
instrument's imputed principal amount, and a holder will be deemed to
exercise or not exercise an option or combination of options in a
manner that maximizes the instrument's imputed principal amount. If
both the issuer and the holder have options, the rules of this
paragraph (d) are applied to the options in the order that they may be
exercised. Thus, the deemed exercise of one option may eliminate other
options that are later in time. See Sec. 1.1272-1(c)(5) to determine
the debt instrument's yield and maturity for purposes of determining
the accrual of OID with respect to the instrument.
(e) Mandatory sinking funds. In determining the issue price of a
debt instrument to which section 1274 applies (other than a debt
instrument issued in a potentially abusive situation) and that is
subject to a mandatory sinking fund provision described in Sec. 1.1272-
1(c)(3)(ii), the mandatory sinking fund provision is ignored.
(f) Treatment of variable rate debt instruments--(1) Stated
interest at a qualified floating rate--(i) In general. For purposes of
paragraph (c) of this section, the imputed principal amount of a
variable rate debt instrument (within the meaning of Sec. 1.1275-5(a))
that provides for stated interest at a qualified floating rate (or
rates) is determined by assuming that the instrument provides for a
fixed rate of interest for each accrual period to which a qualified
floating rate applies. For purposes of the preceding sentence, the
assumed fixed rate in each accrual period is the greater of--
(A) The value of the applicable qualified floating rate as of the
first date on which there is a binding written contract that
substantially sets forth the terms under which the sale or exchange is
ultimately consummated; or
(B) The value of the applicable qualified floating rate as of the
date on which the sale or exchange occurs.
(ii) Interest rate restrictions. Notwithstanding paragraph
(f)(1)(i) of this section, if, as a result of interest rate
restrictions (such as an interest rate cap), the expected yield of the
debt instrument taking the restrictions into account is significantly
less than the expected yield of the debt instrument without regard to
the restrictions, the interest payments on the debt instrument (other
than any fixed interest payments) are treated as contingent payments.
Reasonably symmetric interest rate caps and floors, or reasonably
symmetric governors, that are fixed throughout the term of the debt
instrument do not result in the debt instrument being subject to this
rule.
(2) Stated interest at a single objective rate. For purposes of
paragraph (c) of this section, the imputed principal amount of a
variable rate debt instrument (within the meaning of Sec. 1.1275-5(a))
that provides for stated interest at a single objective rate is
determined by treating the interest payments as contingent payments.
(g) Contingent payments. [Reserved]
(h) Examples. The following examples illustrate the rules of this
section. Each example assumes a 30-day month, 360-day year. In
addition, each example assumes that the debt instrument is not a
qualified debt instrument (as defined in section 1274A(b)) and is not
issued in a potentially abusive situation.
Example 1. Debt instrument without a fixed rate over its entire
term--(i) Facts. On January 1, 1995, A sells nonpublicly traded
property to B for a stated purchase price of $3,500,000. In
consideration for the sale, B makes a down payment of $500,000 and
issues a 10-year debt instrument with a stated principal amount of
$3,000,000, payable at maturity. The debt instrument calls for no
interest in the first 2 years and interest at a rate of 15 percent
payable annually over the remaining 8 years of the debt instrument.
The first interest payment of $450,000 is due on December 31, 1997,
and the last interest payment is due on December 31, 2004, together
with the $3,000,000 payment of principal. Assume that the test rate
of interest applicable to the debt instrument is 10.5 percent,
compounded annually.
(ii) Applicability of section 1274. Because the debt instrument
does not provide for any interest during the first 2 years, none of
the interest on the debt instrument is qualified stated interest.
Therefore, the issue price of the debt instrument is determined
under section 1274. See Sec. 1.1274-1(b)(1). If the debt instrument
has adequate stated interest, the issue price of the instrument is
its stated principal amount. Otherwise, the issue price of the debt
instrument is its imputed principal amount. The debt instrument has
adequate stated interest only if the stated principal amount is less
than or equal to the imputed principal amount.
(iii) Determination of imputed principal amount. To compute the
imputed principal amount of the debt instrument, all payments due
under the debt instrument are discounted back to the issue date at
10.5 percent, compounded annually, as follows:
(A) The present value of the $3,000,000 principal payment
payable on December 31, 2004, is $1,105,346.59, determined as
follows:
TR02FE94.000
(B) The present value of the eight interest payments of $450,000
as of January 1, 1997, is $2,357,634.55, determined as follows:
TR02FE94.001
(C) The present value of this interim amount as of January 1,
1995, is $1,930,865.09, determined as follows:
TR02FE94.002
(iv) Determination of issue price. The debt instrument's imputed
principal amount (that is, the present value of all payments due
under the debt instrument) is $3,036,211.68
($1,105,346.59+$1,930,865.09). Because the stated principal amount
($3,000,000) is less than the imputed principal amount, the debt
instrument provides for adequate stated interest. Therefore, the
issue price of the debt instrument is its stated principal amount
($3,000,000).
Example 2. Debt instrument subject to issuer call option--(i)
Facts. On January 1, 1995, in partial consideration for the sale of
nonpublicly traded property, H corporation issues to G a 10-year
debt instrument, maturing on January 1, 2005, with a stated
principal amount of $10,000,000, payable on that date. The debt
instrument provides for annual payments of interest of 8 percent for
the first 5 years and 14 percent for the final 5 years, payable on
January 1 of each year, beginning on January 1, 1996. In addition
the debt instrument provides H with the unconditional option to call
(prepay) the debt instrument at the end of 5 years for its stated
principal amount of $10,000,000. Assume that the Federal mid-term
and long-term rates applicable to the sale based on annual
compounding are 9 percent and 10 percent, respectively.
(ii) Option presumed exercised. Assuming exercise of the call
option, the imputed principal amount as determined under paragraph
(d) of this section is $9,611,034.87 (the present value of all of
the payments due within a 5-year term discounted at a test rate of 9
percent, compounded annually). Assuming nonexercise of the call
option, the imputed principal amount is $10,183,354.78 (the present
value of all of the payments due within a 10-year term discounted at
a test rate of 10 percent, compounded annually). For purposes of
determining the imputed principal amount, the option is presumed
exercised because the imputed principal amount, assuming exercise of
the option, is less than the imputed principal amount, assuming the
option is not exercised. Because the option is presumed exercised,
the debt instrument fails to provide for adequate stated interest
because the imputed principal amount ($9,611,034.87) is less than
the stated principal amount ($10,000,000). Thus, the issue price of
the debt instrument is $9,611,034.87.
Example 3. Variable rate debt instrument with a single rate over
its entire term--(i) Facts. On January 1, 1995, A sells B
nonpublicly traded property. In partial consideration for the sale,
B issues a debt instrument in the principal amount of $1,000,000,
payable in 5 years. The debt instrument calls for interest payable
monthly at a rate of 1 percentage point above the average prime
lending rate of a major bank for the month preceding the month of
the interest payment. Assume that the test rate of interest
applicable to the debt instrument is 10.5 percent, compounded
monthly. Assume also that 1 percentage point above the prime lending
rate of the designated bank on the date of the sale is 12.5 percent,
compounded monthly, which is greater than 1 percentage point above
the prime lending rate of the designated bank on the first date on
which there is a binding written contract that substantially sets
forth the terms under which the sale is consummated.
(ii) Debt instrument has adequate stated interest. The debt
instrument is a variable rate debt instrument (within the meaning of
Sec. 1.1275-5) that provides for stated interest at a qualified
floating rate. Under paragraph (f)(1)(i) of this section, the debt
instrument is treated as if it provided for a fixed rate of interest
equal to 12.5 percent, compounded monthly. Because the test rate of
interest is 10.5 percent, compounded monthly, the debt instrument
provides for adequate stated interest.
Example 4. Debt instrument with a capped variable rate. On July
1, 1995, A sells nonpublicly traded property to B in return for a
debt instrument with a stated principal amount of $10,000,000,
payable on July 1, 2005. Interest is payable on July 1 of each year,
beginning on July 1, 1996, at the Federal short-term rate for June
of the same year. The debt instrument provides, however, that the
interest rate cannot rise above 8.5 percent, compounded annually.
Assume that, as of the date the test rate of interest for the debt
instrument is determined, the Federal short-term rate is 8 percent,
compounded annually. Assume further that, as a result of the
interest rate cap of 8.5 percent, compounded annually, the expected
yield of the debt instrument is significantly less than the expected
yield of the debt instrument if it did not include the interest rate
cap. Under paragraph (f)(1)(ii) of this section, the variable
payments are treated as contingent payments for purposes of this
section.
Sec. 1.1274-3 Potentially abusive situations defined.
(a) In general. For purposes of section 1274, a potentially abusive
situation means---
(1) A tax shelter (as defined in section 6662(d)(2)(C)(ii)); or
(2) Any other situation involving--
(i) A recent sales transaction;
(ii) Nonrecourse financing;
(iii) Financing with a term in excess of the useful life of the
property; or
(iv) A debt instrument with clearly excessive interest.
(b) Operating rules--(1) Debt instrument exchanged for nonrecourse
financing. Nonrecourse financing does not include an exchange of a
nonrecourse debt instrument for an outstanding recourse or nonrecourse
debt instrument.
(2) Nonrecourse debt with substantial down payment. Nonrecourse
financing does not include a sale or exchange of a real property
interest financed by a nonrecourse debt instrument if, in addition to
the nonrecourse debt instrument, the purchaser makes a down payment in
money that equals or exceeds 20 percent of the total stated purchase
price of the real property interest. For purposes of the preceding
sentence, a real property interest means any interest, other than an
interest solely as a creditor, in real property.
(3) Clearly excessive interest. Interest on a debt instrument is
clearly excessive if the interest, in light of the terms of the debt
instrument and the creditworthiness of the borrower, is clearly greater
than the arm's length amount of interest that would have been charged
in a cash lending transaction between the same two parties.
(c) Other situations to be specified by Commissioner. The
Commissioner may designate in the Internal Revenue Bulletin situations
that, although described in paragraph (a)(2) of this section, will not
be treated as potentially abusive because they do not have the effect
of significantly misstating basis or amount realized (see
Sec. 601.601(d)(2)(ii) of this chapter).
(d) Consistency rule. The issuer's determination that the debt
instrument is or is not issued in a potentially abusive situation is
binding on all holders of the debt instrument. However, the issuer's
determination is not binding on a holder who explicitly discloses a
position that is inconsistent with 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 Sec. 1.1275-2(e) for rules relating to the
issuer's obligation to disclose certain information to holders.
Secs. 1.1274-3T and 1.1274-6T [Removed]
Par. 10. Sections 1.1274-3T and 1.1274-6T are removed as of April
4, 1994.
Par. 11. Sections 1.1274-4 and 1.1274-5 are added to read as
follows:
Sec. 1.1274-4 Test rate.
(a) Determination of test rate of interest--(1) In general--(i)
Test rate is the 3-month rate. Except as provided in paragraph (a)(2)
of this section, the test rate of interest for a debt instrument issued
in consideration for the sale or exchange of property is the 3-month
rate.
(ii) The 3-month rate. Except as provided in paragraph (a)(1)(iii)
of this section, the 3-month rate is the lower of--
(A) The lowest applicable Federal rate (based on the appropriate
compounding period) in effect during the 3-month period ending with the
first month in which there is a binding written contract that
substantially sets forth the terms under which the sale or exchange is
ultimately consummated; or
(B) The lowest applicable Federal rate (based on the appropriate
compounding period) in effect during the 3-month period ending with the
month in which the sale or exchange occurs.
(iii) Special rule if there is no binding written contract. If
there is no binding written contract that substantially sets forth the
terms under which the sale or exchange is ultimately consummated, the
3-month rate is the lowest applicable Federal rate (based on the
appropriate compounding period) in effect during the 3-month period
ending with the month in which the sale or exchange occurs.
(2) Test rate for certain debt instruments--(i) Sale-leaseback
transactions. Under section 1274(e) (relating to certain sale-leaseback
transactions), the test rate is 110 percent of the 3-month rate
determined under paragraph (a)(1) of this section. For purposes of
section 1274(e)(3), related party means a person related to the
transferor within the meaning of section 267(b) or 707(b)(1).
(ii) Qualified debt instrument. Under section 1274A(a), the test
rate for a qualified debt instrument is no greater than 9 percent,
compounded semiannually, or an equivalent rate based on an appropriate
compounding period.
(iii) Alternative test rate for short-term obligations--(A)
Requirements. This paragraph (a)(2)(iii)(A) provides an alternative
test rate under section 1274(d)(1)(D) for a debt instrument with a
maturity of 1 year or less. This alternative test rate applies,
however, only if the debt instrument provides for adequate stated
interest using the alternative test rate, the issuer provides on the
face of the debt instrument that the instrument qualifies as having
adequate stated interest under section 1274(d)(1)(D), and the issuer
and holder treat or agree to treat the instrument as having adequate
stated interest.
(B) Alternative test rate. For purposes of paragraph
(a)(2)(iii)(A), the alternative test rate is the market yield on U.S.
Treasury bills with the same maturity date as the debt instrument. If
the same maturity date is not available, the market yield on U.S.
Treasury bills that mature in the same week or month as the debt
instrument is used. The alternative test rate is determined as of the
date on which there is a binding written contract that substantially
sets forth the terms under which the sale or exchange is ultimately
consummated or as of the date of the sale or exchange, whichever date
results in a lower rate. If there is no binding written contract,
however, the alternative test rate is determined as of the date of the
sale or exchange.
(b) Applicable Federal rate. Except as otherwise provided in this
section, the applicable Federal rate for a debt instrument is based on
the term of the instrument (i.e., short-term, mid-term, or long-term).
See section 1274(d)(1). The Internal Revenue Service publishes the
applicable Federal rates for each month in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter). The applicable
Federal rates are based on the yield to maturity of outstanding
marketable obligations of the United States of similar maturities
during the one month period ending on the 14th day of the month
preceding the month for which the rates are applicable.
(c) Special rules to determine the term of a debt instrument for
purposes of determining the applicable Federal rate--(1) Installment
obligation. If a debt instrument is an installment obligation (as
defined in Sec. 1.1273-1(e)(1)), the term of the instrument is the
instrument's weighted average maturity (as defined in Sec. 1.1273-
1(e)(3)).
(2) Certain variable rate debt instruments--(i) In general. Except
as otherwise provided in paragraph (c)(2)(ii) of this section, if a
variable rate debt instrument (as defined in Sec. 1.1275-5(a)) provides
for stated interest at a qualified floating rate (or rates), the term
of the instrument is determined by reference to the longest interval
between interest adjustment dates, or, if the variable rate debt
instrument provides for a fixed rate, the interval between the issue
date and the last day on which the fixed rate applies, if this interval
is longer.
(ii) Restrictions on adjustments. If, due to significant
restrictions on variations in a qualified floating rate or the use of
certain formulae pursuant to Sec. 1.1275-5(b)(2) (e.g., 15 percent of
1-year LIBOR, plus 800 basis points), the rate in substance resembles a
fixed rate, the applicable Federal rate is determined by reference to
the term of the debt instrument.
(3) Counting of either the issue date or the maturity date. The
term of a debt instrument includes either the issue date or the
maturity date, but not both dates.
(4) Certain debt instruments that provide for principal payments
uncertain as to time. If a debt instrument provides for principal
payments that are fixed in total amount but uncertain as to time, the
term of the instrument is determined by reference to the latest
possible date on which a principal payment can be made or, in the case
of an installment obligation, by reference to the longest weighted
average maturity under any possible payment schedule.
(d) Foreign currency loans. If all of the payments of a debt
instrument are denominated in, or determined by reference to, a
currency other than the U.S. dollar, the applicable Federal rate for
the debt instrument is a foreign currency rate of interest that is
analogous to the applicable Federal rate described in this section. For
this purpose, an analogous rate of interest is a rate based on yields
(with the appropriate compounding period) of the highest grade of
outstanding marketable obligations denominated in such currency
(excluding any obligations that benefit from special tax exemptions or
preferential tax rates not available to debt instruments generally)
with due consideration given to the maturities of the obligations.
(e) Examples. The following examples illustrate the rules of this
section.
Example 1. Variable rate debt instrument that limits the amount
of increase and decrease in the rate--(i) Facts. On July 1, 1996, A
sells nonpublicly traded property to B in return for a 5-year debt
instrument that provides for interest to be paid on July 1 of each
year, beginning on July 1, 1997, based on the prime rate of a local
bank on that date. However, the interest rate cannot increase or
decrease from one year to the next by more than .25 percentage
points (25 basis points).
(ii) Significant restriction. The debt instrument is a variable
rate debt instrument (as defined in Sec. 1.1275-5) that provides for
stated interest at a qualified floating rate. Assume that based on
all the facts and circumstances, the restriction is a significant
restriction on the variations in the rate of interest. Under
paragraph (c)(2)(ii) of this section, the applicable Federal rate is
determined by reference to the term of the debt instrument, and the
applicable Federal rate is the Federal mid-term rate.
Example 2. Installment obligation--(i) Facts. On January 1,
1996, A sells nonpublicly traded property to B in exchange for a
debt instrument that calls for a payment of $500,000 on January 1,
2001, and a payment of $1,000,000 on January 1, 2006. The debt
instrument does not provide for any stated interest.
(ii) Determination of term. The debt instrument is an
installment obligation. Under paragraph (c)(1) of this section, the
term of the debt instrument is its weighted average maturity (as
defined in Sec. 1.1273-1(e)(3)). The debt instrument's weighted
average maturity is 8.33 years, which is the sum of (A) the ratio of
the first payment to total payments (500,000/1,500,000), multiplied
by the number of complete years from the issue date until the
payment is due (5 years), and (B) the ratio of the second payment to
total payments (1,000,000/1,500,000), multiplied by the number of
complete years from the issue date until the second payment is due
(10 years).
(iii) Applicable Federal rate. Based on the calculation in
paragraph (ii) of this example, the term of the debt instrument is
treated as 8.33 years. Consequently, the applicable Federal rate is
the Federal mid-term rate.
Sec. 1.1274-5 Assumptions.
(a) In general. Section 1274 does not apply to a debt instrument if
the debt instrument is assumed, or property is taken subject to the
debt instrument, in connection with a sale or exchange of property,
unless the terms of the debt instrument, as part of the sale or
exchange, are modified in a manner that would constitute an exchange
under section 1001.
(b) Modifications of debt instruments--(1) In general. Except as
provided in paragraph (b)(2) of this section, if a debt instrument is
assumed, or property is taken subject to a debt instrument, in
connection with a sale or exchange of property, the terms of the debt
instrument are modified as part of the sale or exchange, and the
modification triggers an exchange under section 1001, the modification
is treated as a separate transaction taking place immediately before
the sale or exchange and is attributed to the seller of the property.
For purposes of this paragraph (b), a debt instrument is not considered
to be modified as part of the sale or exchange unless the seller knew
or had reason to know about the modification.
(2) Election to treat buyer as modifying the debt instrument--(i)
In general. Rather than having the rules in paragraph (b)(1) of this
section apply, the seller and buyer may jointly elect to treat the
transaction as one in which the buyer first assumed the original
(unmodified) debt instrument and then subsequently modified the debt
instrument. For this purpose, the modification is treated as a separate
transaction taking place immediately after the sale or exchange.
(ii) Time and manner of making the election. The buyer and seller
make the election under paragraph (b)(2)(i) of this section by jointly
signing a statement that includes the names, addresses, and taxpayer
identification numbers of the seller and buyer, and a clear indication
that the election is being made under paragraph (b)(2)(i) of this
section. Both the buyer and the seller must sign this statement not
later than the earlier of the last day (including extensions) for
filing the Federal income tax return of the buyer or seller for the
taxable year in which the sale or exchange of the property occurs. The
buyer and seller should attach this signed statement (or a copy
thereof) to their timely filed Federal income tax returns.
(c) Wraparound indebtedness. For purposes of paragraph (a) of this
section, the issuance of wraparound indebtedness is not considered an
assumption.
(d) Consideration attributable to assumed debt. If, as part of the
consideration for the sale or exchange of property, the buyer assumes,
or takes the property subject to, an indebtedness that was issued with
OID (including a debt instrument issued in a prior sale or exchange to
which section 1274 applied), the portion of the buyer's basis in the
property and the seller's amount realized attributable to the debt
instrument equals the adjusted issue price of the debt instrument as of
the date of the sale or exchange.
Par. 12. Sections 1.1274A-1, 1.1275-1 and 1.1275-2 are added to
read as follows:
Sec. 1.1274A-1 Special rules for certain transactions where stated
principal amount does not exceed $2,800,000.
(a) In general. Section 1274A allows the use of a lower test rate
for purposes of sections 483 and 1274 in the case of a qualified debt
instrument (as defined in section 1274A(b)) and, if elected by the
borrower and the lender, the use of the cash receipts and disbursements
method of accounting for interest on a cash method debt instrument (as
defined in section 1274A(c)(2)). This section provides special rules
for qualified debt instruments and cash method debt instruments.
(b) Rules for both qualified and cash method debt instruments--(1)
Sale-leaseback transactions. A debt instrument issued in a sale-
leaseback transaction (within the meaning of section 1274(e)) cannot be
either a qualified debt instrument or a cash method debt instrument.
(2) Debt instruments calling for contingent payments. A debt
instrument that provides for contingent payments cannot be a qualified
debt instrument unless it can be determined at the time of the sale or
exchange that the maximum stated principal amount due under the debt
instrument cannot exceed the amount specified in section 1274A(b).
Similarly, a debt instrument that provides for contingent payments
cannot be a cash method debt instrument unless it can be determined at
the time of the sale or exchange that the maximum stated principal
amount due under the debt instrument cannot exceed the amount specified
in section 1274A(c)(2)(A).
(3) Aggregation of transactions--(i) General rule. The aggregation
rules of section 1274A(d)(1) are applied using a facts and
circumstances test.
(ii) Examples. The following examples illustrate the application of
section 1274A(d)(1) and paragraph (b)(3)(i) of this section.
Example 1. Aggregation of two sales to a single person. In two
transactions evidenced by separate sales agreements, A sells
undivided half interests in Blackacre to B. The sales are pursuant
to a plan for the sale of a 100 percent interest in Blackacre to B.
These sales or exchanges are part of a series of related
transactions and, thus, are treated as a single sale for purposes of
section 1274A.
Example 2. Aggregation of two purchases by unrelated
individuals. Pursuant to a plan, unrelated individuals X and Y
purchase undivided half interests in Blackacre from A and
subsequently contribute these interests to a partnership in exchange
for equal interests in the partnership. These purchases are treated
as part of the same transaction and, thus, are treated as a single
sale for purposes of section 1274A.
Example 3. Aggregation of sales made pursuant to a tender offer.
Fifteen unrelated individuals own all of the stock of X Corporation.
Y Corporation makes a tender offer to these 15 shareholders. The
terms offered to each shareholder are identical. Shareholders
holding a majority of the shares of X Corporation elect to tender
their shares pursuant to Y Corporation's offer. These sales are part
of the same transaction and, thus, are treated as a single sale for
purposes of section 1274A.
Example 4. No aggregation for separate sales of similar property
to unrelated persons. Pursuant to a newspaper advertisement, X
Corporation offers for sale similar condominiums in a single
building. The prices of the units vary due to a variety of factors,
but the financing terms offered by X Corporation to all buyers are
identical. The units are purchased by unrelated buyers who decided
whether to purchase units in the building at the price and on the
terms offered by X Corporation, without regard to the actions of
other buyers. Because each buyer acts individually, the sales are
not part of the same transaction or a series of related transactions
and, thus, are treated as separate sales.
(4) Inflation adjustment of dollar amounts. Under section
1274A(d)(2), the dollar amounts specified in sections 1274A(b) and
1274A(c)(2)(A) are adjusted for inflation. The dollar amounts, adjusted
for inflation, are published in the Internal Revenue Bulletin (see
Sec. 601.601(d)(2)(ii) of this chapter).
(c) Rules for cash method debt instruments--(1) Time and manner of
making cash method election. The borrower and lender make the election
described in section 1274A(c)(2)(D) by jointly signing a statement that
includes the names, addresses, and taxpayer identification numbers of
the borrower and lender, a clear indication that an election is being
made under section 1274A(c)(2), and a declaration that the debt
instrument with respect to which the election is being made fulfills
the requirements of a cash method debt instrument. Both the borrower
and the lender must sign this statement not later than the earlier of
the last day (including extensions) for filing the Federal income tax
return of the borrower or lender for the taxable year in which the debt
instrument is issued. The borrower and lender should attach this signed
statement (or a copy thereof) to their timely filed Federal income tax
returns.
(2) Successors of electing parties. Except as otherwise provided in
this paragraph (c)(2), the cash method election under section 1274A(c)
applies to any successor of the electing lender or borrower. Thus, for
any period after the transfer of a cash method debt instrument, the
successor takes into account the interest (including unstated interest)
on the instrument under the cash receipts and disbursements method of
accounting. Nevertheless, if the lender (or any successor thereof)
transfers the cash method debt instrument to a taxpayer who uses an
accrual method of accounting, section 1272 rather than section 1274A(c)
applies to the successor of the lender with respect to the debt
instrument for any period after the date of the transfer. The borrower
(or any successor thereof), however, remains on the cash receipts and
disbursements method of accounting with respect to the cash method debt
instrument.
(3) Modified debt instrument. In the case of a debt instrument
issued in a debt-for-debt exchange that qualifies as an exchange under
section 1001, the debt instrument is eligible for the election to be a
cash method debt instrument if the other prerequisites to making the
election in section 1274A(c) are met. However, if a principal purpose
of the modification is to defer interest income or deductions through
the use of the election, then the debt instrument is not eligible for
the election.
(4) Debt incurred or continued to purchase or carry a cash method
debt instrument. If a debt instrument is incurred or continued to
purchase or carry a cash method debt instrument, rules similar to those
under section 1277 apply to determine the timing of the interest
deductions for the debt instrument. For purposes of the preceding
sentence, rules similar to those under section 265(a)(2) apply to
determine whether a debt instrument is incurred or continued to
purchase or carry a cash method debt instrument.
Sec. 1.1275-1 Definitions.
(a) Applicability. The definitions contained in this section apply
for purposes of sections 163(e) and 1271 through 1275 and the
regulations thereunder.
(b) Adjusted issue price--(1) In general. The adjusted issue price
of a debt instrument at the beginning of the first accrual period is
the issue price. Thereafter, the adjusted issue price of the debt
instrument is the issue price of the debt instrument--
(i) Increased by the amount of OID previously includible in the
gross income of any holder (determined without regard to section
1272(a)(7) and section 1272(c)(1)); and
(ii) Decreased by the amount of any payment previously made on the
debt instrument other than a payment of qualified stated interest. See
Sec. 1.1275-2(f) for rules regarding adjustments to adjusted issue
price on a pro rata prepayment.
(2) Adjusted issue price for subsequent holders. For purposes of
calculating OID accruals, acquisition premium, or market discount, a
holder (other than a purchaser at original issuance) determines
adjusted issue price in any manner consistent with the regulations
under sections 1271 through 1275.
(c) OID. OID means original issue discount (as defined in section
1273(a) and Sec. 1.1273-1).
(d) Debt instrument. Except as provided in section 1275(a)(1)(B)
(relating to certain annuity contracts), debt instrument means any
instrument or contractual arrangement that constitutes indebtedness
under general principles of Federal income tax law (including, for
example, a certificate of deposit or a loan). Nothing in the
regulations under sections 163(e), 483, and 1271 through 1275, however,
shall influence whether an instrument constitutes indebtedness for
Federal income tax purposes.
(e) Tax-exempt obligations. For purposes of section 1275(a)(3)(B),
exempt from tax means exempt from Federal income tax.
(f) Issue. Two or more debt instruments are part of the same issue
if they have the same credit and payment terms and are sold reasonably
close in time either pursuant to a common plan or as part of a single
transaction or a series of related transactions. See Sec. 1.1275-
2(d)(2) for special rules relating to reopenings of Treasury
securities.
(g) Debt instruments issued by a natural person. If an entity is a
primary obligor under a debt instrument, the debt instrument is
considered to be issued by the entity and not by a natural person even
if a natural person is a co-maker and is jointly liable for the debt
instrument's repayment. A debt instrument issued by a partnership is
considered to be issued by the partnership as an entity even if the
partnership is composed entirely of natural persons.
(h) Publicly offered debt instrument. A debt instrument is publicly
offered if it is part of an issue of debt instruments the initial
offering of which--
(1) Is registered with the Securities and Exchange Commission; or
(2) Would be required to be registered under the Securities Act of
1933 (15 U.S.C. 77a et seq.) but for an exemption from registration--
(i) Under section 3 of the Securities Act of 1933 (relating to
exempted securities);
(ii) Under any law (other than the Securities Act of 1933) because
of the identity of the issuer or the nature of the security; or
(iii) Because the issue is intended for distribution to persons who
are not United States persons.
Sec. 1.1275-2 Special rules relating to debt instruments.
(a) Payment ordering rule--(1) In general. Except as provided in
paragraph (a)(2) of this section, each payment under a debt instrument
is treated first as a payment of OID to the extent of the OID that has
accrued as of the date the payment is due and has not been allocated to
prior payments, and second as a payment of principal. Thus, no portion
of any payment is treated as prepaid interest.
(2) Exceptions. The rule in paragraph (a)(1) of this section does
not apply to--
(i) A payment of qualified stated interest;
(ii) A payment of points deductible under section 461(g)(2), in the
case of the issuer;
(iii) A pro rata prepayment described in paragraph (f)(2) of this
section; or
(iv) A payment of additional interest or a similar charge provided
with respect to amounts that are not paid when due.
(b) Debt instruments distributed by corporations with respect to
stock--(1) Treatment of distribution. For purposes of determining the
issue price of a debt instrument distributed by a corporation with
respect to its stock, the instrument is treated as issued by the
corporation for property. See section 1275(a)(4). Thus, under section
1273(b)(3), the issue price of a distributed debt instrument that is
traded on an established market is its fair market value. The issue
price of a distributed debt instrument that is not traded on an
established market is determined under section 1274 or section
1273(b)(4).
(2) Issue date. The issue date of a debt instrument distributed by
a corporation with respect to its stock is the date of the
distribution.
(c) Aggregation of debt instruments--(1) General rule. Except as
provided in paragraph (c)(2) of this section, debt instruments issued
in connection with the same transaction or related transactions
(determined based on all the facts and circumstances) are treated as a
single debt instrument for purposes of sections 1271 through 1275 and
the regulations thereunder. This rule ordinarily applies only to debt
instruments of a single issuer that are issued to a single holder. The
Commissioner may, however, aggregate debt instruments that are issued
by more than one issuer or that are issued to more than one holder if
the debt instruments are issued in an arrangement that is designed to
avoid the aggregation rule (e.g., debt instruments issued by or to
related parties or debt instruments originally issued to different
holders with the understanding that the debt instruments will be
transferred to a single holder).
(2) Exception if separate issue price established. Paragraph (c)(1)
of this section does not apply to a debt instrument if--
(i) The debt instrument is part of an issue a substantial portion
of which is traded on an established market within the meaning of
Sec. 1.1273-2(f); or
(ii) The debt instrument is part of an issue a substantial portion
of which is issued for money (or for property traded on an established
market within the meaning of Sec. 1.1273-2(f)) to parties who are not
related to the issuer or holder and who do not purchase other debt
instruments of the same issuer in connection with the same transaction
or related transactions.
(3) Special rule for debt instruments that provide for the issuance
of additional debt instruments. If, under the terms of a debt
instrument (the original debt instrument), the holder may receive one
or more additional debt instruments of the issuer, the additional debt
instrument or instruments are aggregated with the original debt
instrument. Thus, the payments made pursuant to an additional debt
instrument are treated as made on the original debt instrument, and the
distribution by the issuer of the additional debt instrument is not
considered to be a payment made on the original debt instrument. This
paragraph (c)(3) applies regardless of whether the right to receive an
additional debt instrument is fixed as of the issue date or is
contingent upon subsequent events. See Sec. 1.1272-1(c) for the
treatment of certain rights to issue additional debt instruments in
lieu of cash payments.
(4) Examples. The following examples illustrate the rules set forth
in paragraphs (c)(1) and (c)(2) of this section.
Example 1. Exception for debt instruments issued separately to
other purchasers. On January 1, 1995, Corporation M issues two
series of bonds, Series A and Series B. The two series are sold for
cash and have different terms. Although some holders purchase bonds
from both series, a substantial portion of the bonds is issued to
different holders. H purchases bonds from both series. Under the
exception in paragraph (c)(2)(ii) of this section, the Series A and
Series B bonds purchased by H are not aggregated.
Example 2. Tiered REMICs. Z forms a dual tier real estate
mortgage investment conduit (REMIC). In the dual tier structure, Z
forms REMIC A to acquire a pool of real estate mortgages and to
issue a residual interest and several classes of regular interests.
Contemporaneously, Z forms REMIC B to acquire as qualified mortgages
all of the regular interests in REMIC A. REMIC B issues several
classes of regular interests and a residual interest, and Z sells
all of those interests to unrelated parties in a public offering.
Under the general rule set out in paragraph (c)(1) of this section,
all of the regular interests issued by REMIC A and held by REMIC B
are treated as a single debt instrument for purposes of sections
1271 through 1275.
(d) Special rules for Treasury securities--(1) Issue price and
issue date. The issue price of an issue of Treasury securities is the
average price of the debt instruments sold. The issue date of an issue
of Treasury securities is the first settlement date on which a
substantial amount of the securities in the issue is sold.
(2) Reopenings of Treasury securities--(i) Treatment of additional
Treasury securities. Additional Treasury securities issued in a
qualified reopening are part of the same issue as the original Treasury
securities and have the same issue date as the original Treasury
securities. The issue price of both the original Treasury securities
and the additional Treasury securities is the average price at which
the original Treasury securities were sold. This paragraph (d)(2)
applies to qualified reopenings that occur on or after March 25, 1992.
(ii) Definitions--(A) Additional Treasury securities. Additional
Treasury securities are Treasury securities with terms that are in all
respects identical to the terms of the original Treasury securities and
that are issued (without regard to paragraph (d)(2)(i) of this section)
not more than 12 months after the original Treasury securities were
first issued to the public.
(B) Original Treasury securities. Original Treasury securities are
securities comprising any issue of outstanding Treasury securities.
(C) Qualified reopening. A qualified reopening is a reopening of
Treasury securities intended to alleviate an acute, protracted shortage
of the original Treasury securities.
(e) Disclosure of certain information to holders. Certain
provisions of the regulations under section 163(e) and sections 1271
through 1275 provide that the issuer's determination of an item
controls the holder's treatment of the item. In such a case, the issuer
must provide the relevant information to the holder in a reasonable
manner. For example, the issuer may provide the name or title and
either the address or telephone number of a representative of the
issuer who will make available to holders upon request the information
required for holders to comply with these provisions of the
regulations.
(f) Treatment of pro rata prepayments--(1) Treatment as retirement
of separate debt instrument. A pro rata prepayment is treated as a
payment in retirement of a portion of a debt instrument, which may
result in a gain or loss to the holder. Generally, the gain or loss is
calculated by assuming that the original debt instrument consists of
two instruments, one that is retired and one that remains outstanding.
The adjusted issue price, holder's adjusted basis, and accrued but
unpaid OID of the original debt instrument, determined immediately
before the pro rata prepayment, are allocated between these two
instruments based on the portion of the instrument that is treated as
retired by the pro rata prepayment.
(2) Definition of pro rata prepayment. For purposes of paragraph
(f)(1) of this section, a pro rata prepayment is a payment on a debt
instrument made prior to maturity that--
(i) Is not made pursuant to the instrument's payment schedule
(including a payment schedule determined under Sec. 1.1272-1(c)); and
(ii) Results in a substantially pro rata reduction of each payment
remaining to be paid on the instrument.
(g) Anti-abuse rule. [Reserved]
Par. 13. In Sec. 1.1275-3, the section heading and paragraphs (a)
and (b) are revised to read as follows:
Sec. 1.1275-3 OID information reporting requirements.
(a) In general. This section provides legending and information
reporting requirements intended to facilitate the reporting of OID.
(b) Information required to be set forth on face of debt
instruments that are not publicly offered--(1) In general. Except as
provided in paragraph (b)(4) or paragraph (d) of this section, this
paragraph (b) applies to any debt instrument that is not publicly
offered (within the meaning of Sec. 1.1275-1(h)), is issued in physical
form, and has OID. The issuer of any such debt instrument must legend
the instrument by stating on the face of the instrument that the debt
instrument was issued with OID. In addition, the issuer must either--
(i) Set forth on the face of the debt instrument the issue price,
the amount of OID, the issue date, and the yield to maturity; or
(ii) Provide the name or title and either the address or telephone
number of a representative of the issuer who will, beginning no later
than 10 days after the issue date, promptly make available to holders
upon request the information described in paragraph (b)(1)(i) of this
section.
(2) Time for legending. An issuer may satisfy the requirements of
this paragraph (b) by legending the debt instrument when it is first
issued in physical form. Legending is not required, however, before the
first holder of the debt instrument disposes of the instrument.
(3) Legend must survive reissuance upon transfer. Any new physical
security that is issued (for example, upon registration of transfer of
ownership) must contain any required legend.
(4) Exceptions. Paragraph (b)(1) of this section does not apply to
debt instruments described in section 1272(a)(2) (relating to debt
instruments not subject to the periodic OID inclusion rules), debt
instruments issued by natural persons (as defined in Sec. 1.6049-
4(f)(2)), REMIC regular interests or other debt instruments subject to
section 1272(a)(6), or stripped bonds and coupons within the meaning of
section 1286.
* * * * *
Sec. 1.1275-3T [Removed]
Par. 14. Section 1.1275-3T is removed as of February 2, 1994.
Par. 15. Section 1.1275-5 is added to read as follows:
Sec. 1.1275-5 Variable rate debt instruments.
(a) Applicability--(1) In general. This section provides rules for
variable rate debt instruments. For purposes of section 163(e) and
sections 1271 through 1275, a variable rate debt instrument is a debt
instrument that meets the conditions described in paragraphs (a)(2),
(a)(3), and (a)(4) of this section.
(2) Principal payments. The issue price of the debt instrument must
not exceed the total noncontingent principal payments by more than an
amount equal to the lesser of--
(i) .015 multiplied by the product of the total noncontingent
principal payments and the number of complete years to maturity from
the issue date (or, in the case of an installment obligation, the
weighted average maturity as defined in Sec. 1.1273-1(e)(3)); or
(ii) 15 percent of the total noncontingent principal payments.
(3) Stated interest--(i) General rule. The debt instrument must
provide for stated interest (compounded or paid at least annually) at--
(A) One or more qualified floating rates;
(B) A single fixed rate and one or more qualified floating rates;
(C) A single objective rate; or
(D) A single fixed rate and a single objective rate that is a
qualified inverse floating rate.
(ii) Certain debt instruments bearing interest at a fixed rate for
an initial period. If interest on a debt instrument is stated at a
fixed rate for an initial period of less than 1 year followed by a
variable rate that is either a qualified floating rate or an objective
rate for a subsequent period, and the value of the variable rate on the
issue date is intended to approximate the fixed rate, the fixed rate
and the variable rate together constitute a single qualified floating
rate or objective rate. A fixed rate and a variable rate will be
conclusively presumed to meet the requirements of the preceding
sentence if the value of the variable rate on the issue date does not
differ from the value of the fixed rate by more than .25 percentage
points (25 basis points).
(4) Current value. The debt instrument must provide that a
qualified floating rate or objective rate in effect at any time during
the term of the instrument is set at a current value of that rate. A
current value is the value of the rate on any day that is no earlier
than 3 months prior to the first day on which that value is in effect
and no later than 1 year following that first day.
(b) Qualified floating rate--(1) In general. A variable rate is a
qualified floating rate if variations in the value of the rate can
reasonably be expected to measure contemporaneous variations in the
cost of newly borrowed funds in the currency in which the debt
instrument is denominated. The rate may measure contemporaneous
variations in borrowing costs for the issuer of the debt instrument or
for issuers in general. Except as provided in paragraph (b)(2) of this
section, a multiple of a qualified floating rate is not a qualified
floating rate. If a debt instrument provides for two or more qualified
floating rates that can reasonably be expected to have approximately
the same values throughout the term of the instrument, the qualified
floating rates together constitute a single qualified floating rate.
Two or more qualified floating rates will be conclusively presumed to
meet the requirements of the preceding sentence if the values of all
rates on the issue date are within .25 percentage points (25 basis
points) of each other.
(2) Certain rates based on a qualified floating rate. 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 zero
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 zero but not more than 1.35, increased or decreased by a fixed
rate.
(3) Restrictions on the stated rate of interest. A variable rate is
not a qualified floating rate if it is subject to a restriction or
restrictions on the maximum stated interest rate (cap), a restriction
or restrictions on the minimum stated interest rate (floor), a
restriction or restrictions on the amount of increase or decrease in
the stated interest rate (governor), or other similar restrictions.
Notwithstanding the preceding sentence, the following restrictions will
not cause a variable rate to fail to be a qualified floating rate--
(i) A cap, floor, or governor that is fixed throughout the term of
the debt instrument;
(ii) A cap or similar restriction that is not reasonably expected
as of the issue date to cause the yield on the debt instrument to be
significantly less than the expected yield determined without the cap;
(iii) A floor or similar restriction that is not reasonably
expected as of the issue date to cause the yield on the debt instrument
to be significantly more than the expected yield determined without the
floor; or
(iv) A governor or similar restriction that is not reasonably
expected as of the issue date to cause the yield on the debt instrument
to be significantly more or significantly less than the expected yield
determined without the governor.
(c) Objective rate--(1) In general. 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--
(i) One or more qualified floating rates;
(ii) One or more rates where each rate would be a qualified
floating rate for a debt instrument denominated in a currency other
than the currency in which the debt instrument is denominated;
(iii) The yield or changes in the price of one or more items of
personal property (other than stock or debt of the issuer or a related
party within the meaning of section 267(b) or 707(b)(1)), provided each
item of property is actively traded within the meaning of section
1092(d)(1) (determined without regard to section 1092(d)(3)); or
(iv) A combination of rates described in paragraphs (c)(1)(i),
(c)(1)(ii), and (c)(1)(iii) of this section.
(2) Other objective rates to be specified by Commissioner. The
Commissioner may designate in the Internal Revenue Bulletin variable
rates other than those described in paragraph (c)(1) of this section
that will be treated as objective rates (see Sec. 601.601(d)(2)(ii) of
this chapter).
(3) Qualified inverse floating rate. An objective rate described in
paragraph (c)(1) of this section is a qualified inverse floating rate
if--
(i) The rate is equal to a fixed rate minus a qualified floating
rate; and
(ii) The variations in the rate can reasonably be expected to
inversely reflect contemporaneous variations in the cost of newly
borrowed funds (disregarding any restrictions on the rate that are
described in paragraphs (b)(3)(i), (b)(3)(ii), (b)(3)(iii), and
(b)(3)(iv) of this section).
(4) Significant front-loading or back-loading of interest.
Notwithstanding paragraph (c)(1) of this section, a variable rate of
interest on a debt instrument is not an objective rate if it is
reasonably expected that the average value of the rate during the first
half of the instrument's term will be either significantly less than or
significantly greater than the average value of the rate during the
final half of the instrument's term.
(5) Tax-exempt debt. Notwithstanding paragraph (c)(1) of this
section, in the case of any 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.
(d) Examples. The following examples illustrate the rules of
paragraphs (b) and (c) of this section. For purposes of these examples,
assume that paragraphs (c)(4) and (c)(5) of this section do not apply.
Example 1. Rate based on LIBOR. X issues a debt instrument that
provides for annual payments of interest at a rate equal to the
value of the 1-year London Interbank Offered Rate (LIBOR) at the end
of each year. Variations in the value of 1-year LIBOR over the term
of the debt instrument can reasonably be expected to measure
contemporaneous variations in the cost of newly borrowed funds over
that term. Accordingly, the rate is a qualified floating rate.
Example 2. Rate increased by a fixed amount. X issues a debt
instrument that provides for annual payments of interest at a rate
equal to 200 basis points (2 percent) plus the current value, at the
end of each year, of the average yield on 1-year Treasury securities
as published in Federal Reserve bulletins. Variations in the value
of this interest rate can reasonably be expected to measure
contemporaneous variations in the cost of newly borrowed funds.
Accordingly, the rate is a qualified floating rate.
Example 3. Rate based on commercial paper rate. X issues a debt
instrument that provides for a rate of interest that is periodically
adjusted to equal the current interest rate of Bank's commercial
paper. Variations in the value of this interest rate can reasonably
be expected to measure contemporaneous variations in the cost of
newly borrowed funds. Accordingly, the rate is a qualified floating
rate.
Example 4. Rate based on changes in the value of a commodity
index. 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 changes in the prices of actively
traded property, the rate is an objective rate.
Example 5. Rate based on a percentage of S&P 500 Index. 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. In addition, because the interest rate is
based on the value of the S&P 500 Index rather than on changes in
that value, the rate is not an objective rate.
Example 6. Rate based on issuer's profits. Z issues a debt
instrument that provides for annual interest payments equal to 20
percent of Z's net 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 stated rate is
neither based on the yield or changes in the price of actively
traded property nor based on a qualified floating rate, the rate is
not an objective rate.
Example 7. Rate based on a multiple of an interest index. 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 stated rate is based on a qualified floating rate 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. 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 French franc
LIBOR is a qualified floating rate for a debt instrument denominated
in French francs, the rate is an objective rate.
Example 9. Qualified inverse floating rate. 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 the cost of newly
borrowed funds, it is a qualified inverse floating rate. However, if
the value of 1-year LIBOR on the issue date was 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 the cost of newly borrowed
funds.
(e) Qualified stated interest and OID with respect to a variable
rate debt instrument--(1) In general. This paragraph (e) provides rules
to determine the amount and accrual of OID and qualified stated
interest on a variable rate debt instrument. In general, the rules
convert the debt instrument into a fixed rate debt instrument and then
apply the general OID rules to the debt instrument. The issue price of
a variable rate debt instrument, however, is not determined under this
paragraph (e). See Secs. 1.1273-2 and 1.1274-2 to determine the issue
price of a variable rate debt instrument.
(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 or objective rate that is unconditionally payable in cash or in
property (other than debt instruments of the issuer), or that will be
constructively received under section 451, at least annually--
(i) All stated interest with respect to the debt instrument is
qualified stated interest; and
(ii) The amount of OID, if any, 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.
(3) All other variable rate debt instruments except for those that
provide for a fixed rate. If a variable rate debt instrument is not
described in paragraph (e)(2) of this section and does not provide for
interest payable at a fixed rate (other than an initial fixed rate
described in paragraph (a)(3)(ii) of this section), the amount of
interest and OID accruals for the instrument are determined under this
paragraph (e)(3).
(i) Step one: Determine the fixed rate substitute for each variable
rate provided under the debt instrument--(A) Qualified floating rate.
The fixed rate substitute for each qualified floating rate provided for
in the debt instrument is the value of each rate as of the issue date.
If, however, a variable rate debt instrument provides for two or more
qualified floating rates with different intervals between interest
adjustment dates, the fixed rate substitutes for the rates must be
based on intervals that are equal in length. For example, if a 4-year
debt instrument provides for 24 monthly interest payments based on the
value of the 30-day commercial paper rate on each payment date followed
by 8 quarterly interest payments based on the value of quarterly LIBOR
on each payment date, the fixed rate substitutes may be based on the
values, as of the issue date, of the 90-day commercial paper rate and
quarterly LIBOR. Alternatively, the fixed rate substitutes may be based
on the values, as of the issue date, of the 30-day commercial paper
rate and monthly LIBOR.
(B) Qualified inverse floating rate. The fixed rate substitute for
a qualified inverse floating rate is the value of the qualified inverse
floating rate as of the issue date.
(C) Objective rate. The fixed rate substitute for an objective rate
(other than a qualified inverse floating rate) is a fixed rate that
reflects the yield that is reasonably expected for the debt instrument.
(ii) Step two: Construct the equivalent fixed rate debt instrument.
The equivalent fixed rate debt instrument has terms that are identical
to those provided under the variable rate debt instrument, except that
the equivalent fixed rate debt instrument provides for the fixed rate
substitutes (determined in paragraph (e)(3)(i) of this section) in lieu
of the qualified floating rates or objective rate provided under the
variable rate debt instrument.
(iii) Step three: Determine the amount of qualified stated interest
and OID with respect to the equivalent fixed rate debt instrument. The
amount of qualified stated interest and OID, if any, are determined for
the equivalent fixed rate debt instrument under the rules applicable to
fixed rate debt instruments and are taken into account as if the holder
held the equivalent fixed rate debt instrument.
(iv) Step four: Make appropriate adjustments for actual variable
rates. Qualified stated interest or OID allocable to an accrual period
must be increased (or decreased) if the interest actually accrued or
paid during an accrual period exceeds (or is less than) the interest
assumed to be accrued or paid during the accrual period under the
equivalent fixed rate debt instrument. This increase or decrease is an
adjustment to qualified stated interest for the accrual period if the
equivalent fixed rate debt instrument (as determined under paragraph
(e)(3)(ii) of this section) provides for qualified stated interest and
the increase or decrease is reflected in the amount actually paid
during the accrual period. Otherwise, this increase or decrease is an
adjustment to OID for the accrual period.
(v) Examples. The following examples illustrate the rules in
paragraph (e)(3) of this section.
Example 1. Equivalent fixed rate debt instrument--(i) Facts. X
purchases at original issue a 6-year variable rate debt instrument
that provides for semiannual payments of interest. For the first 3
years, the rate of interest is the value of 6-month LIBOR on the
payment date. For the final 3 years, the rate is the value of the 6-
month T-bill rate on the payment date. On the issue date, the value
of 6-month LIBOR is 3 percent, compounded semiannually, and the 6-
month T-bill rate is 2 percent, compounded semiannually.
(ii) Determination of equivalent fixed rate debt instrument.
Under paragraph (e)(3)(i) of this section, the fixed rate substitute
for 6-month LIBOR is 3 percent, compounded semiannually, and the
fixed rate substitute for the 6-month T-bill rate is 2 percent,
compounded semiannually. Under paragraph (e)(3)(ii) of this section,
the equivalent fixed rate debt instrument is a 6-year debt
instrument that provides for semiannual payments of interest at 3
percent, compounded semiannually, for the first 3 years followed by
2 percent, compounded semiannually, for the final 3 years.
Example 2. Equivalent fixed rate debt instrument with de minimis
OID--(i) Facts. Y purchases at original issue, for $100,000, a 4-
year variable rate debt instrument that has a stated principal
amount of $100,000, payable at maturity. The debt instrument
provides for monthly payments of interest at the end of each month.
For the first year, the interest rate is the monthly commercial
paper rate and for the last 3 years, the interest rate is the
monthly commercial paper rate plus 100 basis points. On the issue
date, the monthly commercial paper rate is 3 percent, compounded
monthly.
(ii) Equivalent fixed rate debt instrument. Under paragraph
(e)(3)(ii) of this section, the equivalent fixed rate debt
instrument for the variable rate debt instrument is a 4-year debt
instrument that has an issue price and stated principal amount of
$100,000. The equivalent fixed rate debt instrument provides for
monthly payments of interest at 3 percent, compounded monthly, for
the first year ($250 per month) and monthly payments of interest at
4 percent, compounded monthly, for the last 3 years ($333.33 per
month).
(iii) De minimis OID. Under Sec. 1.1273-1(a), because a portion
(100 basis points) of each interest payment in the final 3 years is
not a qualified stated interest payment, the equivalent fixed rate
debt instrument has OID of $2,999.88 ($102,999.88 -$100,000).
However, under Sec. 1.1273-1(d)(4) (the de minimis rule relating to
teaser rates and interest holidays), the stated redemption price at
maturity of the equivalent fixed rate debt instrument is $100,999.96
($100,000 (issue price) plus $999.96 (the greater of the amount of
foregone interest ($999.96) and the amount equal to the excess of
the instrument's stated principal amount over its issue price ($0)).
Thus, the equivalent fixed rate debt instrument is treated as having
OID of $999.96 ($100,999.96 -$100,000). Because this amount is less
than the de minimis amount of $1,010 (0.0025 multiplied by
$100,999.96 multiplied by 4 complete years to maturity), the
equivalent fixed rate debt instrument has de minimis OID. Therefore,
the variable rate debt instrument has zero OID and all stated
interest payments are qualified stated interest payments.
Example 3. Adjustment to qualified stated interest for actual
payment of interest--(i) Facts. On January 1, 1995, Z purchases at
original issue, for $90,000, a variable rate debt instrument that
matures on January 1, 1997, and has a stated principal amount of
$100,000, payable at maturity. The debt instrument provides for
annual payments of interest on January 1 of each year, beginning on
January 1, 1996. The amount of interest payable is the value of
annual LIBOR on the payment date. The value of annual LIBOR on
January 1, 1995, and January 1, 1996, is 5 percent, compounded
annually. The value of annual LIBOR on January 1, 1997, is 7
percent, compounded annually.
(ii) Equivalent fixed rate debt instrument. Under paragraph
(e)(3)(ii) of this section, the equivalent fixed rate debt
instrument for the variable rate debt instrument is a 2-year debt
instrument that has an issue price of $90,000 and a stated principal
amount of $100,000. The equivalent fixed rate debt instrument
provides for interest payments of $5,000 at the end of each year.
(iii) Accrual of OID and qualified stated interest. Under
Sec. 1.1273-1, the equivalent fixed rate debt instrument has $10,000
of OID and the annual interest payments of $5,000 are qualified
stated interest payments. Under Sec. 1.1272-1, the equivalent fixed
rate 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 x .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)(3)(iv) 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.
(4) Variable rate debt instrument that provides for a single fixed
rate--(i) General rule. If a variable rate debt instrument provides for
stated interest either at one or more qualified floating rates or at a
qualified inverse floating rate and in addition provides for stated
interest at a single fixed rate (other than an initial fixed rate
described in paragraph (a)(3)(ii) of this section), the amount of
interest and OID are determined using the method of paragraph (e)(3) of
this section, as modified by this paragraph (e)(4). For purposes of
paragraphs (e)(3)(i) through (e)(3)(iii) of this section, the variable
rate debt instrument is treated as if it provided for a qualified
floating rate (or a qualified inverse floating rate, if the debt
instrument provides for a qualified inverse floating rate), rather than
the fixed rate. The qualified floating rate (or qualified inverse
floating rate) replacing the fixed rate must be such that the fair
market value of the variable rate debt instrument as of the issue date
would be approximately the same as the fair market value of an
otherwise identical debt instrument that provides for the qualified
floating rate (or qualified inverse floating rate) rather than the
fixed rate.
(ii) Example. The following example illustrates the rule in
paragraph (e)(4)(i) of this section.
Example. Variable rate debt instrument that provides for a
single fixed rate--(i) Facts. On January 1, 1995, X purchases at
original issue, for $100,000, a variable rate debt instrument that
matures on January 1, 2001, and that has a stated principal amount
of $100,000. The debt instrument provides for payments of interest
on January 1 of each year, beginning on January 1, 1996. For the
first 4 years, the interest rate is 4 percent, compounded annually,
and for the last 2 years the interest rate is the value of 1-year
LIBOR, as of the payment date, plus 200 basis points. On January 1,
1995, the value of 1-year LIBOR is 2 percent, compounded annually.
In addition, assume that on January 1, 1995, the variable rate debt
instrument has approximately the same fair market value as an
otherwise identical debt instrument that provides for an interest
rate equal to the value of 1-year LIBOR, as of the payment date, for
the first 4 years.
(ii) Equivalent fixed rate debt instrument. Under paragraph
(e)(4)(i) of this section, for purposes of paragraphs (e)(3)(i)
through (e)(3)(iii) of this section, the variable rate debt
instrument is treated as if it provided for an interest rate equal
to the value of 1-year LIBOR, as of the payment date, for the first
4 years. Under paragraph (e)(3)(ii) of this section, the equivalent
fixed rate debt instrument for the variable rate debt instrument is
a 6-year debt instrument that has an issue price and stated
principal amount of $100,000. The equivalent fixed rate debt
instrument provides for interest payments of $2,000 for the first 4
years and $4,000 for the last 2 years.
(iii) Accrual of OID and qualified stated interest. Under
Sec. 1.1273-1, the equivalent fixed rate debt instrument has OID of
$4,000 because a portion (200 basis points) of each interest payment
in the last 2 years is not a qualified stated interest payment. The
$4,000 of OID is allocable over the 6-year term of the debt
instrument under Sec. 1.1272-1. Under paragraph (e)(3)(iv) of this
section, the difference between the $4,000 payment made in the first
4 years and the $2,000 payment assumed to be made on the equivalent
fixed rate debt instrument in those years is an adjustment to
qualified stated interest. In addition, any difference between the
amount actually paid in each of the last 2 years and the $4,000
payment assumed to be made on the equivalent fixed rate debt
instrument is an adjustment to qualified stated interest.
(f) Special rule for certain reset bonds. Notwithstanding paragraph
(e) of this section, this paragraph (f) provides a special rule for a
variable rate debt instrument that provides for stated interest at a
fixed rate for an initial interval, and provides that on the date
immediately following the end of the initial interval (the effective
date) the stated interest rate will be a rate determined under a
procedure (such as an auction procedure) so that the fair market value
of the instrument on the effective date will be a fixed amount (the
reset value). Solely for purposes of calculating the accrual of OID,
the variable rate debt instrument is treated as--
(i) Maturing on the date immediately preceding the effective date
for an amount equal to the reset value; and
(ii) Reissued on the effective date for an amount equal to the
reset value.
Sec. 1.1275-6T [Removed]
Par. 16. Section 1.1275-6T is removed as of February 2, 1994.
Sec. 1.6050H-2T [Removed]
Par. 17. Section 1.6050H-2T is removed as of February 2, 1994.
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(c) is amended as follows:
1. Removing the following entries from the table:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control
number
------------------------------------------------------------------------
*****
1.1274-3T................................................. 1545-0887
1.1275-3.................................................. 1545-0887
1.1275-3T................................................. 1545-0887
*****
------------------------------------------------------------------------
2. Adding entries in numerical order to the table to read as
follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control
number
------------------------------------------------------------------------
*****
1.1272-1(c)(4)............................................ 1545-1353
1.1272-3.................................................. 1545-1353
1.1273-2(h)(2)............................................ 1545-1353
1.1274-3(d)............................................... 1545-1353
1.1274-5(b)............................................... 1545-1353
1.1274A-1(c).............................................. 1545-1353
1.1275-3(b)............................................... 1545-1353
1.1275-3(c)............................................... 1545-0887
*****
------------------------------------------------------------------------
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: January 14, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-2073 Filed 1-27-94; 11:10 am]
BILLING CODE 4830-01-U