[Federal Register Volume 59, Number 241 (Friday, December 16, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-30728]


[[Page Unknown]]

[Federal Register: December 16, 1994]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-59-91]
RIN 1545-AQ86

 

Debt Instruments With Original Issue Discount; Contingent 
Payments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations relating to the 
tax treatment of debt instruments that provide for one or more 
contingent payments. This document also contains proposed regulations 
that provide for the integration of a contingent payment or variable 
rate debt instrument with a related hedge and proposed amendments to 
the final original issue discount regulations that were published in 
the Federal Register on February 2, 1994. The proposed regulations in 
this document would provide needed guidance to holders and issuers of 
contingent payment debt instruments. This document also provides a 
notice of a public hearing on the proposed regulations.

DATES: Written comments must be received by Thursday, March 16, 1995. 
Requests to appear and outlines of topics to be discussed at the public 
hearing scheduled for Thursday, March 16, 1995, at 10 a.m. must be 
received by Thursday, February 23, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-59-91), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-59-91), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. A public hearing has been scheduled for Thursday, March 
16, 1995, at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations (other than 
Sec. 1.1275-6), Andrew C. Kittler, (202) 622-3940, or William E. 
Blanchard, (202) 622-3950; concerning Sec. 1.1275-6, Michael S. Novey, 
(202) 622-3900; concerning submissions and the hearing, Michael 
Slaughter, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act (44 U.S.C. 
3504(h)). Comments on the collections of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 
20224.
    The collections of information are in Secs. 1.1275-3(b)(1)(i), 
1.1275-4(b)(4)(iv), and 1.1275-6(f). This information is required by 
the IRS to determine the amount of income, deductions, gain, or loss 
attributable to a contingent payment debt instrument. This information 
will be used for audit and examination purposes. The likely respondents 
and recordkeepers are businesses and other organizations.
    Estimated total annual reporting and recordkeeping burden: 95,000 
hours.
    The estimated annual burden per respondent/recordkeeper varies from 
.3 to .5 hours, depending on individual circumstances, with an 
estimated average of .475 hours.
    Estimated number of respondents/recordkeepers: 200,000.
    Estimated annual frequency of responses: 1.

Background

    Section 1275(d) of the Internal Revenue Code of 1986 (Code) grants 
the Secretary the authority to prescribe regulations under the original 
issue discount (OID) provisions of the Code, including regulations 
relating to debt instruments that provide for contingent payments. On 
April 8, 1986, the IRS published in the Federal Register a notice of 
proposed rulemaking (51 FR 12022) relating to debt instruments with 
OID. Section 1.1275-4 of the 1986 proposed regulations provided rules 
for contingent payment debt instruments. On February 28, 1991, the IRS 
published in the Federal Register a proposed amendment to Sec. 1.1275-4 
(56 FR 8308), which would have bifurcated certain contingent payment 
debt instruments into their component parts (Sec. 1.1275-4(g)).
    On December 22, 1992, the IRS published in the Federal Register a 
notice of proposed rulemaking that substantially revised the 1986 
proposed regulations (57 FR 60750), and on February 4, 1994, the IRS 
published in the Federal Register final OID regulations (59 FR 4799). 
However, neither the 1992 proposed regulations nor the final OID 
regulations contained rules for contingent payment debt instruments 
under Sec. 1.1275-4.
    The IRS received numerous written comments on Sec. 1.1275-4, as 
originally proposed in 1986 and as amended in 1991. In addition, on 
November 17, 1986, the IRS held a public hearing to discuss the 1986 
proposed regulations, including Sec. 1.1275-4.
    Commentators criticized Sec. 1.1275-4 of the 1986 proposed 
regulations because the regulations ignored the economics of many 
contingent payment debt instruments. In particular, commentators 
believed that the 1986 proposed regulations did not reflect the 
reasonable expectations of the parties because the regulations used a 
``wait and see'' approach to the accrual of interest determined by 
reference to contingencies. The commentators noted that, with respect 
to certain contingent payment debt instruments, the 1986 proposed 
regulations resulted in a significant backloading of interest.
    Commentators also criticized the 1991 proposed amendment to 
Sec. 1.1275-4. Commentators argued that there is rarely a unique set of 
components into which a contingent payment debt instrument can be 
bifurcated. In addition, commentators questioned whether it is 
appropriate to bifurcate a contingent payment debt instrument because 
it is often unclear how the contingent components should be taxed.
    Some commentators suggested that it is preferable to determine 
interest accruals on a contingent payment debt instrument by assuming 
that the issue price of the debt instrument will bear a return at the 
applicable Federal rate (AFR) or some other specified rate. Other 
commentators suggested that it is preferable to determine interest 
accruals by constructing a projected payment schedule and accruing on 
the basis of the projections.

Explanation of Provisions

In general
    The proposed regulations in this document contain new rules for the 
treatment of contingent payment debt instruments (Sec. 1.1275-4). The 
proposed regulations provide separate rules for debt instruments that 
are issued for cash or publicly traded property and for debt 
instruments that are issued for nonpublicly traded property. The 
proposed regulations also provide special rules for tax-exempt 
obligations. Section 1.1275-4, as proposed on April 8, 1986, and 
amended on February 28, 1991, is superseded as of December 16, 1994.
    The proposed regulations provide a rule to determine the imputed 
principal amount of a contingent payment debt instrument issued for 
nonpublicly traded property. The proposed regulations also provide 
rules for the integration of certain debt instruments with related 
hedges (Sec. 1.1275-6). In addition, the proposed regulations amend the 
rules for variable rate debt instruments in Sec. 1.1275-5 of the final 
OID regulations. Finally, the proposed regulations make conforming 
changes to certain provisions of the final OID regulations, such as the 
regulations under section 483.

Section 1.1275-4  Contingent payment debt instruments.

A. Applicability
    Section 1.1275-4 of the proposed regulations generally applies to 
any debt instrument that provides for one or more contingent payments. 
The proposed regulations, however, do not apply to a debt instrument 
that has an issue price determined under section 1273(b)(4), a variable 
rate debt instrument, a debt instrument subject to Sec. 1.1272-1(c) 
(certain debt instruments that provide for alternative payment 
schedules), a debt instrument subject to section 1272(a)(6) (REMIC 
interests and certain other debt instruments that are subject to 
prepayment), or, except as provided in section 988, a debt instrument 
subject to section 988 (a debt instrument that provides for payments 
denominated in, or determined by reference to, a nonfunctional 
currency). The IRS and Treasury request comments on whether other types 
of debt instruments should be excluded from the rules of Sec. 1.1275-4, 
such as certain prepayable obligations included in a pool.
    Section 1.1275-4 of the proposed regulations applies only to a 
contingent payment debt instrument that constitutes a debt instrument 
for federal income tax purposes. No inference is intended under the 
proposed regulations as to whether a particular instrument constitutes 
a debt instrument for federal income tax purposes.
    Although the proposed regulations do not define the term contingent 
payment, the proposed regulations treat certain payments as not being 
contingent. For example, if a payment is subject to either a remote or 
incidental contingency, the payment is not a contingent payment. A 
contingency is remote if there is either a remote likelihood that the 
contingency will occur or a remote likelihood that the contingency will 
not occur. A contingency is incidental if the potential amount of the 
payment under any reasonably expected market conditions is 
insignificant relative to the total expected payments on the debt 
instrument. Under the proposed regulations, a debt instrument does not 
provide for contingent payments merely because it is convertible into 
stock of the issuer or a related party. However, if a debt instrument 
is convertible into stock of an unrelated party, the debt instrument is 
a contingent payment debt instrument.
B. The Noncontingent Bond Method
    The noncontingent bond method applies to a contingent payment debt 
instrument that has an issue price determined under Sec. 1.1273-2 or 
Sec. 1.1274-2(b)(3). For example, the noncontingent bond method 
generally applies to a contingent payment debt instrument issued for 
money or publicly traded property.
    Under the noncontingent bond method, a projected payment schedule 
is determined for a debt instrument, and interest accrues on the debt 
instrument based on this schedule. The projected payment schedule for a 
debt instrument consists of all noncontingent payments and a projected 
amount for each contingent payment. If the actual amount of a 
contingent payment differs from the projected amount of the payment, 
appropriate adjustments are taken into account to reflect this 
difference.
    Although the actual amount of a contingent payment is not fixed or 
determinable when a contingent payment debt instrument is issued, the 
noncontingent bond method, in effect, treats the projected amounts of 
contingent payments like fixed payments and requires interest accruals 
based on the projected amounts. The IRS and Treasury believe that this 
method is consistent with Congress' intent under the OID provisions to 
require a current accrual of interest on a debt instrument.
    While other methods suggested by commentators also require a 
current accrual of interest, the noncontingent bond method requires 
interest accruals based on a rate that is implicit in the debt 
instrument and provides a means of determining whether payments are 
appropriately treated as interest or principal. The IRS and Treasury 
believe that the noncontingent bond method is the most appropriate 
method for achieving this purpose. For example, methods that require 
accrual at a fixed rate for all debt instruments often will over-accrue 
or under-accrue interest on a particular debt instrument. In addition, 
the methods may not always provide an appropriate measure of the 
interest and principal components of a payment. Because of the 
inaccuracies under these methods, the IRS and Treasury rejected these 
methods.
    1. Projected payment schedule.
    The projected payment schedule for a contingent payment debt 
instrument is determined as of the debt instrument's issue date. Except 
in the case of a contingent payment that is fixed more than 6 months 
before it is due, the projected payment schedule remains fixed 
throughout the term of the debt instrument and any income, deductions, 
gain, or loss attributable to the debt instrument are based on the 
schedule.
    The projected payment schedule for a debt instrument consists of 
all noncontingent payments and a projected amount for each contingent 
payment. The proposed regulations provide rules for determining the 
projected amount of each contingent payment included in a projected 
payment schedule. Under the proposed regulations, contingent payments 
are either quotable contingent payments or nonquotable contingent 
payments.
    A quotable contingent payment is a contingent payment that is 
substantially similar to a property right for which forward price 
quotes are readily available. In general, the projected amount of a 
quotable contingent payment is the forward price of the property right. 
If a contingent payment is substantially similar to an option and 
forward price quotes are not readily available for the option, the 
projected amount of the payment is the spot price of the option on the 
issue date, if readily available, compounded at the AFR from the issue 
date to the date the payment is due.
    Under the proposed regulations, a property right includes a right, 
an obligation, or a combination of rights or obligations. For example, 
options and forward contracts are property rights. More complicated 
contingent payments are constructed from combinations of rights and 
obligations.
    A contingent payment is substantially similar to a property right 
if, under reasonably expected market conditions, the value and timing 
of the amount to be paid or received pursuant to the property right are 
expected to be substantially the same as the value and timing of the 
contingent payment. It is irrelevant for purposes of testing 
substantial similarity whether the property right must be settled in 
cash or in property or whether the credit rating of the issuer is 
different from the party giving the price quote. It is also irrelevant 
whether a property right is available in the same denomination as the 
measure of the contingent payments.
    Quotes for the substantially similar property right are readily 
available if they are readily available from brokers, traders, or 
dealers during specified time periods. Although price quotes for over-
the-counter property rights often are not widely disseminated because 
the rights may be privately tailored for a particular transaction, 
quotes for over-the-counter property rights generally will be treated 
as readily available if customers could obtain quotes from brokers, 
traders, or dealers.
    Commentators have stated that any method requiring taxpayers to 
create payment schedules using expected values would be difficult to 
apply. They have said that there is too much variation in the expected 
values of the property rights embedded in contingent payment debt 
instruments to allow for the creation of payment schedules that are not 
susceptible to abuse or to challenge upon examination on the basis of 
hindsight.
    The noncontingent bond method, however, generally sets the 
projected amounts of market-based contingent payments by using forward 
prices for the embedded property rights rather than expected values. It 
is the understanding of the IRS and Treasury that forward prices are 
available for almost all of the market-based property rights embedded 
in contingent payment debt instruments. For example, these property 
rights generally may be obtained on a separate basis for hedging 
purposes. Moreover, the IRS and Treasury understand that dealers and 
certain information services provide daily quotations of the prices of 
contingent payment debt instruments held by regulated investment 
companies to allow the companies to determine their net asset values. 
To do this, the price of the separate elements of the contingent 
payment debt instruments, including the embedded property rights, must 
be determined. Thus, the IRS and Treasury believe that, in general, it 
will not be difficult for issuers of contingent payment debt 
instruments to obtain forward price quotes for the property rights 
embedded in the debt instruments.
    The proposed regulations include a number of provisions designed to 
address other concerns with the pricing requirement. First, the pricing 
requirement only applies if quotes are readily available. Therefore, 
when it is not feasible to obtain a quote, pricing is not required.
    Second, the IRS and Treasury understand that the price a broker or 
dealer develops for any property right embedded in a contingent payment 
debt instrument when pricing the debt instrument as a whole will not 
necessarily translate into a forward price for the property right 
determined on a separate basis. For example, the price of the property 
right embedded in a contingent payment debt instrument may include 
charges for financial intermediation that would not be imposed if the 
property right were purchased separately. Thus, the rules that apply to 
an issuer who must set a projected payment schedule allow substantial 
flexibility.
    Further, the IRS and Treasury recognize that quotes for thinly 
traded property rights may vary and that the bid-ask spread may be 
substantial. The proposed regulations, therefore, provide that a 
taxpayer may use any reasonable quote to determine the projected amount 
of a payment. The proposed regulations also provide that the taxpayer 
may use bid price, ask price, or midpoint price quotes to determine the 
projected amounts of quotable contingent payments. However, the 
taxpayer must make this determination on a consistent basis. For 
example, a taxpayer cannot use ask prices to determine the projected 
amounts for some contingent payments on a debt instrument and bid 
prices to determine the projected amounts for other contingent payments 
on the instrument. Finally, if a contingent payment is equivalent to 
more than one combination of property rights, taxpayers may use any 
reasonable combination. However, it is not reasonable to construct a 
combination of property rights that contains property rights for which 
forward price quotes are unavailable if there are other possible 
combinations that consist only of property rights for which forward 
price quotes are readily available.
    A nonquotable contingent payment is any contingent payment that is 
not a quotable contingent payment. For example, contingent payments 
based on oil production or the issuer's gross receipts are generally 
nonquotable contingent payments.
    The projected amount of a nonquotable contingent payment is 
generally based on the projected yield of the contingent payment debt 
instrument. The projected yield is a reasonable rate for the debt 
instrument that, as of the issue date, reflects general market 
conditions, the credit quality of the issuer, and the terms and 
conditions of the debt instrument. For this purpose, the proposed 
regulations provide that a reasonable rate is not less than the AFR or 
the yield on the debt instrument determined without regard to the 
nonquotable contingent payments. In many cases, a reasonable rate will 
substantially exceed the AFR. Once the projected yield is determined, 
the projected amount of each nonquotable contingent payment is 
determined so that the projected payment schedule reflects the 
projected yield. The projected amount of each payment, however, must 
reasonably reflect the relative expected values of the nonquotable 
contingent payments.
    The proposed regulations provide simplifying rules to determine the 
projected payment schedule of a contingent payment debt instrument that 
would be a variable rate debt instrument except that it provides for a 
single quotable contingent payment at maturity or does not guarantee a 
sufficient return of stated principal. Under the proposed regulations, 
the projected amounts of the variable interest payments are determined 
using the rules of Sec. 1.1275-5(e), rather than the general rules for 
quotable contingent payments. For example, if the contingent payment 
debt instrument provides for stated interest at a single qualified 
floating rate and a quotable contingent payment at maturity, the 
projected amounts of the interest payments are based on the value of 
the rate as of the instrument's issue date and the projected amount of 
the contingent payment is determined under the rules for quotable 
contingent payments.
    The proposed regulations require the issuer to construct the 
projected payment schedule. If an issuer fails to produce a projected 
payment schedule as required, the issuer will be treated as failing to 
meet the recordkeeping requirements under section 6001 necessary to 
support the deduction of interest. To avoid potential audit disputes 
about the projected amount of a contingent payment, the proposed 
regulations provide that the issuer's projected payment schedule will 
be respected unless the schedule is unreasonable. A projected payment 
schedule generally will be considered unreasonable if it is set with a 
purpose to accelerate or defer interest accruals. In determining 
whether a projected payment schedule is unreasonable, consideration 
will be given to whether the interest on a contingent payment debt 
instrument determined under the schedule has a significant effect on 
the issuer's or the holder's U.S. tax liability. For example, a 
projected payment schedule prepared by an issuer that is a non-U.S. 
taxpayer will be given special scrutiny because no schedule would have 
an effect on the issuer's U.S. tax liability.
    The proposed regulations provide that all holders of a contingent 
payment debt instrument are bound by the issuer's projected payment 
schedule and that an issuer must provide the schedule to the holders. A 
holder may vary from the projected payment schedule provided by the 
issuer only if the projected payment schedule is unreasonable. If an 
issuer does not create a projected payment schedule as required or the 
issuer's schedule is unreasonable, a holder must apply the projected 
payment schedule rules to determine a reasonable projected payment 
schedule. If a holder is not using the issuer's projected payment 
schedule, the holder must explicitly disclose this fact on its timely 
filed federal income tax return and must explain why it is not using 
the issuer's schedule.
    Because the proposed regulations allow considerable flexibility, 
taxpayers may attempt to create uneconomic accruals by intentionally 
overstating or understating the projected amounts of the contingent 
payments. Taxpayers must use actual prices in setting the payment 
schedule and are given flexibility only within the range of reasonable 
prices. For example, the prices of an issuer's or a holder's hedges may 
be used to determine reasonableness. Under the rules of section 6001, 
taxpayers must maintain adequate contemporaneous records to support the 
projected payment schedule. In addition, the rules of Sec. 1.1275-2T(g) 
(the OID anti-abuse rule) apply to transactions subject to the proposed 
regulations, including transactions in which the taxpayer attempts to 
create payment schedules that cause uneconomic accruals. Attempts to 
overstate or understate the amounts of the projected payments will give 
rise to adjustments of tax liability, and, if appropriate, penalties.
    2. Adjustments.
    Under the noncontingent bond method, if the actual amount of a 
contingent payment differs from the projected amount of the payment, 
the difference results in either a positive or negative adjustment that 
must be taken into account by the taxpayer. The purpose of the 
adjustments is to correct the interest accruals that have occurred to 
date on the debt instrument. Therefore, the adjustments generally 
increase or decrease the amount of interest on a contingent payment 
debt instrument.
    If the actual amount of a contingent payment is greater than the 
projected amount of the payment, the difference is a positive 
adjustment. If the projected amount of a contingent payment is greater 
than the actual amount of the payment, the difference is a negative 
adjustment. Positive and negative adjustments for a taxable year are 
netted for each taxable year.
    A net positive adjustment for a taxable year is treated by the 
taxpayer as additional interest for the year. A net negative adjustment 
for a taxable year is taken into account as follows.
    First, a net negative adjustment for a taxable year offsets the 
interest that accrued on the debt instrument for the year based on the 
projected payment schedule.
    Second, if the net negative adjustment exceeds the amount of 
interest that accrued on the debt instrument for the taxable year, the 
excess is treated as an ordinary loss by the holder or as ordinary 
income by the issuer. However, the amount treated as ordinary loss by 
the holder is limited to the amount by which the holder's total prior 
interest inclusions on the debt instrument (including all net positive 
adjustments) exceed the total net negative adjustments on the debt 
instrument previously treated as ordinary loss by the holder. 
Similarly, the amount treated as ordinary income by the issuer is 
limited to the amount by which the issuer's total prior interest 
deductions on the debt instrument (including all net positive 
adjustments) exceed the total net negative adjustments on the debt 
instrument previously treated as ordinary income by the issuer.
    Third, because a negative adjustment adjusts interest accruals, if 
the net negative adjustment exceeds the sum of the amount of interest 
that accrued on the debt instrument for the taxable year and the amount 
treated as ordinary loss (or income) for the taxable year, the excess 
is treated as a negative adjustment that occurs on the first day of the 
succeeding taxable year. As a result, the excess offsets interest 
accruals on the debt instrument in future taxable years.
    Fourth, any unused net negative adjustment reduces the amount 
realized by the holder on the sale, exchange, or retirement of a 
contingent payment debt instrument. Similarly, any unused net negative 
adjustment is taken into account by the issuer on retirement of a 
contingent payment debt instrument as income from the discharge of 
indebtedness. The IRS and Treasury request comments on whether the 
regulations should provide specific rules governing the treatment of 
net negative adjustments determined on the occurrence of other events.
    The IRS and Treasury chose this method for taking adjustments into 
account because it provided a relatively simple method for adjusting 
the yield. However, the method may produce inappropriate results, for 
example, if there are large adjustments in the early years of a debt 
instrument. Other methods, such as a method that spreads adjustments 
over the term of the debt instrument, would produce more accurate 
results but would be more complex. The IRS and Treasury request 
comments on whether another method should be used for taking 
adjustments into account.
    3. Adjusted issue price, basis, and retirement.
    Under the noncontingent bond method, the adjusted issue price of a 
contingent payment debt instrument, adjustments to the holder's basis 
in the debt instrument, and the amount of any contingent payment 
treated as made on the scheduled retirement of the debt instrument are 
determined using the projected payment schedule rather than actual 
contingent payments. This rule is appropriate because positive or 
negative adjustments are used to take into account the difference 
between actual amounts and projected amounts of contingent payments. 
This difference would be counted twice if adjusted issue price, 
adjusted basis, and the amount deemed paid on retirement were based on 
the actual amounts of contingent payments rather than the projected 
amounts.
    4. Character on sale, exchange, or retirement.
    Under the noncontingent bond method, any gain recognized by a 
holder on the sale, exchange, or retirement of a contingent payment 
debt instrument is treated as interest income. Similarly, any loss 
recognized by a holder on the sale, exchange, or retirement of a 
contingent payment debt instrument is treated as ordinary loss to the 
extent of the holder's prior interest inclusions (reduced by prior 
ordinary losses attributable to net negative adjustments) on the 
instrument. Although this rule is inconsistent with the treatment of 
noncontingent debt instruments, the rule is necessary because of the 
treatment of net positive and net negative adjustments. The rule 
prevents a taxpayer who sells a contingent payment debt instrument 
immediately before a positive adjustment occurs from converting the 
interest income from the adjustment into capital gain or from 
converting the amount by which a negative adjustment would reduce 
interest income into capital loss. Consistent with the rule's purpose, 
the rule does not apply to a sale, exchange, or retirement that occurs 
when there are no outstanding contingent payments due on a debt 
instrument.
    5. Other special rules.
    Although most contingent payment debt instruments can be dealt with 
under the above provisions, the proposed regulations provide additional 
rules for certain other circumstances. For example, the proposed 
regulations provide rules for a holder whose basis in a contingent 
payment debt instrument is different from the debt instrument's 
adjusted issue price (e.g., a secondary market purchaser of the debt 
instrument). Under the proposed regulations, the holder continues to 
accrue interest and determine adjustments based on the original 
projected payment schedule. The holder, however, must allocate the 
difference between basis and adjusted issue price to the accruals or 
projected payments on the debt instrument over the remaining term of 
the debt instrument. Amounts allocated to a taxable year are recovered 
as if they were positive or negative adjustments, as appropriate.
    The proposed regulations require only a reasonable, rather than an 
exact, allocation of the difference between basis and adjusted issue 
price. For example, if almost all of the difference is attributable to 
changes in the expected value of a contingent payment, the holder may 
allocate the difference to the contingent payment. Similarly, a 
taxpayer may allocate a portion of the difference to accruals if the 
taxpayer determines that the portion is attributable to changes in 
interest rates. A taxpayer may make this determination by comparing 
rates on similar debt instruments, by looking to changes in standard 
interest rate indices that have occurred since the date the contingent 
payment debt instrument was issued, or by other appropriate means. The 
proposed regulations require the holder's allocation to be reasonable 
based on all the facts and circumstances.
    In the case of a contingent payment debt instrument that is 
exchange listed property (within the meaning of Sec. 1.1273-2(f)(2)), 
the proposed regulations provide a safe harbor that allows holders to 
account for the difference between the debt instrument's adjusted issue 
price and the holder's basis under the same rules that apply to 
acquisition premium on a noncontingent debt instrument under section 
1272(a)(7) and Sec. 1.1272-2.
    The IRS and Treasury recognize that the method provided in the 
proposed regulations for allocating the difference between basis and 
adjusted issue price may be difficult to apply because the difference 
may be attributable to both changes in interest rates and in the 
expected values of the contingent payments. Other methods for making 
the allocation were considered in drafting the proposed regulations, 
but were not adopted because they were not believed to be sufficiently 
accurate. The IRS and Treasury believe that contingent payment debt 
instruments (other than exchange listed debt instruments) rarely trade 
in the secondary market and, therefore, the need to make the allocation 
will occur only infrequently. The IRS and Treasury request comments on 
this issue.
    The proposed regulations also provide rules for a debt instrument 
that has a contingent payment that is fixed more than 6 months before 
the payment is due. Under the proposed regulations, an adjustment is 
made on the date the payment is fixed, and the amount of the adjustment 
is equal to the difference between the present value of the fixed 
amount and the present value of the projected amount of the contingent 
payment. The adjusted issue price is modified to reflect the adjustment 
and the projected payment schedule is changed to reflect the fixed 
payment. The IRS and Treasury are concerned about whether this method 
may produce inappropriate accelerations of income or deductions and 
request comments on whether other methods, such as a method that 
spreads the income or deductions, are more appropriate.
    In addition, the proposed regulations provide rules for debt 
instruments that have both payments that are contingent as to time and 
payments that are contingent as to amount. If a taxpayer has an option 
to put or call the debt instrument, to exchange the debt instrument for 
other property, or to extend the maturity date of the debt instrument, 
the projected payment schedule is determined by using the principles of 
Sec. 1.1272-1(c)(5). Under the proposed regulations, if an option to 
put, call, or exchange the debt instrument is assumed to be exercised 
under the principles of Sec. 1.1272-1(c)(5), it is generally reasonable 
to assume that the option is exercised immediately before it expires. 
If the option is exercised at an earlier time, the exercise is treated 
as a sale or exchange of the debt instrument.
    The proposed regulations reserve on other types of timing 
contingencies. The IRS and Treasury request comments on the appropriate 
treatment of other types of timing contingencies.

C. Method for Debt Instruments Not Subject to the Noncontingent Bond 
Method

    The proposed regulations provide a method for contingent payment 
debt instruments not subject to the noncontingent bond method. In 
general, the method applies to a debt instrument that has an issue 
price determined under Sec. 1.1274-2 (e.g., a nonpublicly traded debt 
instrument issued in a sale or exchange of nonpublicly traded 
property). The method in the proposed regulations is generally similar 
to the rules prescribed in Sec. 1.1275-4(c) of the 1986 proposed 
regulations.
    Under the proposed regulations, the payments on a contingent 
payment debt instrument (the overall debt instrument) are divided into 
two components: (1) a noncontingent component consisting of all 
noncontingent payments and the projected amounts of any quotable 
contingent payments, and (2) a contingent component consisting of all 
nonquotable contingent payments.
    The noncontingent component is treated as a separate debt 
instrument and is taxed under the general OID rules (including the 
noncontingent bond method if the separate debt instrument provides for 
quotable contingent payments). However, no interest payments on the 
separate debt instrument are qualified stated interest payments and the 
de minimis rules do not apply to the separate debt instrument. The 
issue price of the separate debt instrument is the issue price of the 
overall debt instrument. See the discussion below for the determination 
of the stated principal amount and the imputed principal amount of the 
overall debt instrument for purposes of section 1274.
    In general, a nonquotable contingent payment is not taken into 
account until the payment is made. When a nonquotable contingent 
payment (other than a contingent payment accompanied by a payment of 
adequate stated interest) is made, a portion of the payment is treated 
as principal, based on the amount determined by discounting the payment 
at the AFR from the payment date to the issue date, and the remainder 
is treated as interest. Special rules are provided if a nonquotable 
contingent payment becomes fixed more than 6 months before it is due.

D. Tax-Exempt Obligations

    The proposed regulations provide special rules for tax-exempt 
obligations. The IRS and Treasury believe that, given the limited 
exclusion provided in section 103, it is generally inappropriate to 
treat payments on a property right embedded in a tax-exempt obligation 
as interest on an obligation of a State or political subdivision (i.e., 
as tax-exempt interest). Therefore, while the noncontingent bond method 
generally applies to tax-exempt contingent payment obligations, all 
positive adjustments are treated as taxable gain from the sale or 
exchange of the obligation rather than as interest. Negative 
adjustments are treated as reducing tax-exempt interest, and, 
therefore, are generally not taken into account as deductible losses. 
If negative adjustments on a tax-exempt obligation exceed the total 
tax-exempt interest a holder receives or accrues on a tax-exempt 
obligation, the excess is treated as loss from the sale or exchange of 
the obligation. This rule is similar to the rule that applies to 
exchange gains and losses on tax-exempt obligations under Sec. 1.988-
3(c)(2). In addition, the proposed regulations provide that the 
projected yield determined for a tax-exempt obligation may not exceed 
the greater of the yield on the obligation determined without regard to 
contingent payments and the tax-exempt AFR that applies to the 
obligation. If the projected payment schedule results in a higher 
yield, projected payments must be reduced appropriately.

E. Cross Border Transactions

    The IRS and Treasury are concerned about various issues relating to 
the treatment of foreign holders of contingent payment debt 
instruments. For example, the IRS and Treasury are concerned about the 
possibility for tax avoidance that may arise when a contingent payment 
debt instrument is structured with payments that approximate the yield 
on an equity security. The IRS and Treasury invite comments on this 
issue and other issues concerning the proper taxation of foreign 
holders of contingent payment debt instruments issued by U.S. persons 
or U.S. holders of contingent payment debt instruments issued by 
foreign persons.

Section 1.1274-2  Imputed Principal Amount

    In general, the issue price of a debt instrument subject to section 
1274 is determined by reference to the instrument's imputed principal 
amount. The 1992 proposed regulations under section 1274 provided that, 
in the case of a contingent payment debt instrument, the imputed 
principal amount of the debt instrument was the present value of the 
fixed payments plus the fair market value of the contingent payments. A 
number of commentators objected to the rule, especially because of the 
difficulty in valuing the contingent payments typically provided for in 
debt instruments subject to section 1274. Other commentators objected 
to the rule's effect on the buyer's basis in the property acquired and 
the seller's amount realized on the sale or exchange. In response to 
these comments, the final OID regulations reserved on the issue to 
allow further study and to coordinate the issue with the regulations 
relating to contingent payment debt instruments.
    Under the proposed regulations, the imputed principal amount of a 
contingent payment debt instrument subject to section 1274 is the sum 
of the present values of the fixed payments and the present values of 
the projected amounts of any quotable contingent payments. Consistent 
with the treatment of the fixed payments and any quotable contingent 
payments as a separate debt instrument under Sec. 1.1275-4 of the 
proposed regulations, nonquotable contingent payments are not taken 
into account to determine the stated principal amount or the imputed 
principal amount of a contingent payment debt instrument. This rule is 
generally consistent with the 1986 proposed regulations under section 
1274.
    The proposed regulations also provide that the imputed principal 
amount of a variable rate debt instrument that provides for payments at 
a single objective rate is determined by assuming that the payments on 
the debt instrument are the same as the payments on the equivalent 
fixed rate debt instrument determined under Sec. 1.1275-5(e).
    The IRS and Treasury request comments on the effect of the proposed 
regulations on other provisions of the Code, including section 
108(e)(11), which measures the amount of discharge of indebtedness 
income in a debt-for-debt exchange by the issue price of the newly 
issued debt instrument.
Conforming Amendments to Section 483.
    The proposed regulations provide rules under section 483 for the 
treatment of contingent payments under a contract for the sale or 
exchange of property (Sec. 1.483-4). In general, the rules are the same 
as the rules for a debt instrument subject to section 1274, except that 
a taxpayer takes interest into account under its own method of 
accounting.

Section 1.1275-5  Variable Rate Debt Instruments.

    In response to comments, the proposed regulations include changes 
to the final regulations under Sec. 1.1275-5 regarding the treatment of 
variable rate debt instruments. The proposed regulations redefine an 
objective rate as a rate (other than a qualified floating rate) that is 
determined using a single fixed formula and that is based on objective 
financial or economic information. The rate, however, must not be based 
on information that is within the control of the issuer (or a related 
party) or that is, in general, unique to the circumstances of the 
issuer (or a related party), such as dividends, profits, or the value 
of the issuer's stock. The new definition of objective rate is broader 
than the definition in the final regulations and includes, for example, 
a rate based on changes in a general inflation index.
    The proposed regulations also make it clear that a variable rate 
debt instrument may not provide for any contingent payments other than 
certain variable rates of interest. Finally, the proposed regulations 
clarify the treatment of a variable rate debt instrument under 
Sec. 1.1275-5(e)(2). In general, a variable rate debt instrument 
described in Sec. 1.1275-5(e)(2) is treated like a fixed payment debt 
instrument for purposes of OID and qualified stated interest accruals. 
The changes to Sec. 1.1275-5(e)(2) clarify the final OID regulations 
and, therefore, are proposed to be effective for debt instruments 
issued on or after April 4, 1994.
    Because of the special rules for tax-exempt contingent payment 
obligations in the proposed regulations, the IRS and Treasury request 
comments on the definition of an objective rate for tax-exempt 
obligations under Sec. 1.1275-5(c)(5).

Section 1.1275-6  Integration

    Many commentators suggested that the integration of contingent 
payment debt instruments with associated hedges provides the best 
method of taxing contingent payment debt instruments that are hedged. 
The proposed regulations respond to this suggestion by providing for 
the integration of contingent or variable rate debt instruments with 
certain financial instruments (Sec. 1.1275-6). The integration rules 
are issued under the authority of section 1275(d), and until the 
proposed regulations under Sec. 1.1275-6 are finalized, the integration 
rules are not a permissible means of determining the character and 
timing of income, deductions, gains, and losses.
    The rules in the proposed regulations are modeled after the 
integration rules of section 988(d) and Sec. 1.988-5(a). The rules in 
the proposed regulations, however, have been modified to reflect the 
different policy concerns underlying the rules for taking currency gain 
or loss into account and for taking interest income or deductions into 
account. The IRS and Treasury intend to make conforming changes to 
Sec. 1.988-5(a) and request comments on the extent to which Sec. 1.988-
5(a) should be modified to conform to the proposed regulations.
    The integration rules apply to qualifying debt instruments, which 
are defined as contingent payment debt instruments, variable rate debt 
instruments, and the synthetic debt instruments that are the result of 
integration under the proposed regulations. Thus, the integration rules 
do not apply to fixed rate debt instruments.
    For a financial instrument to qualify as a hedge under the proposed 
regulations (a Sec. 1.1275-6 hedge), the combined cash flows of the 
qualifying debt instrument and the financial instrument must permit the 
calculation of a yield to maturity or must be the same as the cash 
flows on a variable rate debt instrument that pays interest at a 
qualified floating rate or rates. Thus, the proposed regulations 
generally require a perfect hedge. Section 1.1275-6 hedges, however, 
are not limited to hedging transactions as defined in Sec. 1.1221-2(b). 
For example, a Sec. 1.1275-6 hedge need not reduce risk from all of the 
operations of a business. A debt instrument held by a taxpayer cannot 
be a Sec. 1.1275-6 hedge of a debt instrument issued by the taxpayer 
and a debt instrument issued by a taxpayer cannot be a Sec. 1.1275-6 
hedge of a debt instrument held by the taxpayer. Physical assets, such 
as inventory, generally will not be treated as Sec. 1.1275-6 hedges 
because they do not provide the predictable cash flows necessary to 
create a perfect hedge. A supply or sales contract, however, may 
qualify as a Sec. 1.1275-6 hedge. Stock does not qualify as a 
Sec. 1.1275-6 hedge.
    To qualify as an integrated transaction, the taxpayer must issue or 
acquire a qualifying debt instrument, enter into a Sec. 1.1275-6 hedge, 
and meet six requirements. First, the taxpayer must satisfy the 
identification requirements of the proposed regulations, such as by 
entering a description of the qualifying debt instrument and the 
Sec. 1.1275-6 hedge in its books and records. Second, the Sec. 1.1275-6 
hedge must not be with a related party (other than a member of the same 
consolidated group making the separate-entity election under 
Sec. 1.1221-2(d)). Third, the same taxpayer must enter into the 
qualifying debt instrument and the Sec. 1.1275-6 hedge. Fourth, if the 
taxpayer is a foreign person engaged in a U.S. trade or business who 
issues or acquires the qualifying debt instrument or enters into the 
Sec. 1.1275-6 hedge through the trade or business, all items of income 
and expense associated with the debt instrument or hedge (other than 
interest expense that is subject to Sec. 1.882-5) must be effectively 
connected with the U.S. trade or business. Fifth, the qualifying debt 
instrument, any other debt instrument that is part of the same issue as 
the qualifying debt instrument, or the Sec. 1.1275-6 hedge cannot have 
been part of an integrated transaction that was previously legged out 
of by the taxpayer. Finally, the Sec. 1.1275-6 hedge must be entered 
into by the taxpayer on or after the date the taxpayer issues or 
acquires the qualifying debt instrument. If the taxpayer meets these 
requirements, the qualifying debt instrument and the Sec. 1.1275-6 
hedge are integrated and the resulting synthetic debt instrument is 
taxed accordingly.
    The Commissioner may require integration if a qualifying debt 
instrument and a financial instrument have, in substance, the same 
combined cash flows as a fixed or variable rate debt instrument. 
Therefore, even if the taxpayer fails one or more of the requirements 
for integration, the Commissioner may integrate a qualifying debt 
instrument and a financial instrument. For example, if the taxpayer 
fails to meet the identification requirements, or enters into a hedge 
with a related party, the Commissioner may integrate the transaction. 
The Commissioner also may integrate a transaction even if the hedge is 
not perfect. Thus, taxpayers may not avoid integration by altering the 
hedge so that there is a small amount of basis risk or the payments 
under the hedge do not fully match the payments on the qualifying debt 
instrument. The Commissioner will not integrate a debt instrument with 
an imperfect hedge, however, if the taxpayer retains substantial risk.
    The proposed regulations provide rules for legging into and legging 
out of an integrated transaction. Legging into an integrated 
transaction generally means entering into the hedge after the 
qualifying debt instrument is issued or acquired by the taxpayer. If a 
taxpayer legs into an integrated transaction, the qualifying debt 
instrument is subject to the separate transaction rules up to the leg-
in date, except that the day before the leg-in date is treated as the 
end of an accrual period for purposes of computing OID and interest 
accruals on the qualifying debt instrument.
    After the taxpayer legs in, the qualifying debt instrument and the 
Sec. 1.1275-6 hedge are integrated. Built-in gain or loss on the 
qualifying debt instrument is not treated as realized on the leg-in 
date (contrary to the rule for currency gain or loss in Sec. 1.988-
5(a)(6)(i)). Because the built-in gain or loss will be reflected in the 
accruals on the synthetic debt instrument, the built-in gain or loss on 
the leg-in date will be recognized over the term of the synthetic debt 
instrument.
    This approach allows taxpayers to alter the timing of income or 
deductions on a qualifying debt instrument. For example, a taxpayer 
expecting a large positive adjustment on a contingent payment debt 
instrument before the maturity date can spread the adjustment over the 
remaining term of the debt instrument by legging into an integrated 
transaction. Other approaches to legging in, however, create similar 
opportunities. For example, an approach that would mark a qualifying 
debt instrument to market and defer any built-in gain or loss would 
present even greater opportunities for deferral. Requiring mark-to-
market gain or loss to be taken into account immediately would provide 
opportunities for acceleration. The IRS and Treasury believe that 
taking the built-in gain or loss into account over the term of the 
qualifying debt instrument produces the most reasonable result. To 
prevent abuse, however, the proposed regulations include a special rule 
providing that if a taxpayer legs into an integrated transaction with a 
principal purpose of deferring or accelerating income, the Commissioner 
may treat the qualifying debt instrument as sold or otherwise 
terminated and reacquired or reissued on the leg-in date or may refuse 
to allow integration.
    Legging out of an integrated transaction generally means disposing 
of or otherwise terminating the Sec. 1.1275-6 hedge or the qualifying 
debt instrument. If the Commissioner has integrated a qualifying debt 
instrument and a financial instrument, the taxpayer is treated as 
legging out only if the taxpayer ceases to meet the requirements for 
Commissioner integration. If a taxpayer legs out, the synthetic debt 
instrument is treated as sold or otherwise disposed of for its fair 
market value and any income, deduction, gain, or loss is taken into 
account immediately. The component the taxpayer retains (either the 
Sec. 1.1275-6 hedge or the qualifying debt instrument) is treated as 
immediately reacquired for, or entered into at, its fair market value 
on the leg-out date. In order to prevent taxpayers from inappropriately 
generating tax losses by legging into and immediately legging out of an 
integrated transaction, the proposed regulations contain a wash sale 
rule that disallows losses if the taxpayer legs out within 30 days of 
legging into an integrated transaction.
    If a qualifying debt instrument and a Sec. 1.1275-6 hedge are 
integrated, the instruments are no longer subject to the rules that 
govern each instrument separately, except as specifically provided in 
the regulations or by publication in the Internal Revenue Bulletin. 
Instead, the instruments are subject to the rules that would govern the 
synthetic debt instrument. For example, the qualifying debt instrument 
and Sec. 1.1275-6 hedge are not treated as part of a straddle under 
section 1092, but the interest on the synthetic debt instrument may be 
subject to the interest capitalization rules of section 263(g).
    The issue price of the synthetic debt instrument is the adjusted 
issue price of the qualifying debt instrument. The issue date of the 
synthetic debt instrument is the date the Sec. 1.1275-6 hedge is 
acquired. The term of the synthetic debt instrument is the period from 
the issue date of the synthetic debt instrument to the maturity date of 
the qualifying debt instrument. If the synthetic debt instrument is a 
borrowing, its stated redemption price at maturity is the sum of all 
amounts paid or to be paid on the qualifying debt instrument and on the 
Sec. 1.1275-6 hedge, reduced by all amounts received or to be received 
on the hedge and any amounts that would be qualified stated interest on 
the synthetic debt instrument. If the synthetic debt instrument is a 
loan, its stated redemption price at maturity is the sum of all amounts 
received or to be received on the qualifying debt instrument and the 
Sec. 1.1275-6 hedge, reduced by all amounts paid or to be paid on the 
hedge and any amounts that would be qualified stated interest on the 
synthetic debt instrument.
    The rules for determining the stated redemption price at maturity 
are designed to cover situations where payments on the hedge move 
inversely to the payments on the qualifying debt instrument. For 
example, if a holder of a qualifying debt instrument purchases an 
option to hedge the debt instrument, the amount paid by the holder must 
be taken into account as an adjustment to the instrument's stated 
redemption price at maturity.
    Separate transaction treatment is required for certain limited 
purposes. For example, the rules of sections 871(a), 881, 1441, and 
1442 must be applied on a separate transaction basis. Similarly, any 
information reporting rules for the qualifying debt instrument continue 
to apply as if the qualifying debt instrument and the Sec. 1.1275-6 
hedge were not part of an integrated transaction. The IRS and Treasury 
request comments on whether the regulations should specifically provide 
separate transaction treatment for other purposes. The IRS and Treasury 
also request comments on whether rules similar to Sec. 1.6045-
1(d)(6)(iii) of the proposed regulations (regarding broker reporting of 
an integrated transaction under Sec. 1.988-5) should be adopted for an 
integrated transaction under Sec. 1.1275-6.
    The IRS and Treasury intend to propose rules coordinating 
Sec. 1.1275-6 with section 475. Comments are requested on this issue.

Proposed Effective Date

    In general, the proposed regulations in this document are proposed 
to be effective for debt instruments issued on or after the date that 
is 60 days after the date final regulations are published in the 
Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Thursday, March 16, 1995, 
at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue NW, Washington, DC. Because of access restrictions, 
visitors will not be admitted beyond the Internal Revenue Building 
lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit their 
written comments and an outline of the topics to be discussed (signed 
original and eight (8) copies) by Thursday, February 23, 1995.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    Several persons from the Office of Chief Counsel and the Treasury 
Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
two entries in numerical order to read as follows:

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

    Par. 2. Section 1.483-4 is added to read as follows:


Sec. 1.483-4  Contingent payments.

    (a) In general. If a contract for the sale or exchange of property 
subject to section 483 (the overall contract) provides for one or more 
contingent payments, interest under the contract is generally computed 
and accounted for under rules similar to those that would be applicable 
if the contract were a debt instrument subject to Sec. 1.1275-4(c). 
Consequently, all noncontingent payments and quotable contingent 
payments (within the meaning of Sec. 1.1275-4(b)(4)(i)) under the 
overall contract are treated as if made under a separate contract, and 
interest accruals on this separate contract are computed under rules 
similar to those contained in Sec. 1.1275-4(c)(3). Each nonquotable 
contingent payment (within the meaning of Sec. 1.1275-4(b)(4)(ii)), if 
any, under the overall contract is characterized as principal and 
interest under rules similar to those contained in Sec. 1.1275-4(c)(4). 
However, any interest, or amount treated as interest, on a contract 
subject to this section is taken into account by a taxpayer under the 
taxpayer's regular method of accounting (e.g., an accrual method or the 
cash receipts and disbursements method).
    (b) Examples. The following examples illustrate the provisions of 
paragraph (a) of this section.

    Example 1. Deferred payment sale with contingent interest--(i) 
Facts. On January 1, 1996, A sells depreciable personal property to 
B. As consideration for the sale, B issues to A a debt instrument 
with a maturity date of December 31, 2000. The debt instrument 
provides for a principal payment of $200,000 on the maturity date, 
and a payment of interest on December 31 of each year equal to a 
percentage of the total gross income derived from the property in 
that year. However, the total interest payable on the debt 
instrument over its entire term is limited to a maximum of $50,000. 
Assume that the short-term applicable Federal rate on January 1, 
1996, is 4 percent, compounded annually, and the mid-term applicable 
Federal rate on January 1, 1996, is 5 percent, compounded annually.
    (ii) Treatment of noncontingent payment as separate contract. 
Each contingent payment of interest is a nonquotable contingent 
payment (within the meaning of Sec. 1.1275-4(b)(4)(ii)). 
Accordingly, under paragraph (a) of this section, for purposes of 
applying section 483 to the debt instrument, the right to the 
noncontingent payment of $200,000 at maturity is treated as a 
separate contract. The amount of unstated interest on this separate 
contract is equal to $43,295, which is the amount by which the 
amount of this deferred payment under the contract ($200,000) 
exceeds the present value of the deferred payment ($156,705), 
calculated using the test rate of 5 percent, compounded annually 
(the mid-term applicable Federal rate on the date of the sale). The 
$200,000 payment at maturity is thus treated as consisting of a 
payment of interest of $43,295 and a payment of principal of 
$156,705. The interest is includible in A's gross income, and 
deductible by B, under their respective methods of accounting.
    (iii) Treatment of contingent payments. Assume that the amount 
of the contingent payment that is paid on December 31, 1996, is 
$20,000. Under paragraph (a) of this section, the $20,000 payment is 
treated as a payment of principal of $19,231 (the present value, as 
of the date of sale, of the $20,000 payment, calculated using a test 
rate equal to 4 percent, compounded annually) and a payment of 
interest of $769. The $769 interest payment is includible in A's 
gross income, and deductible by B, in their respective taxable years 
in which December 31, 1996 occurs. The amount treated as principal 
gives B additional basis in the property on December 31, 1996. The 
remaining contingent payments on the debt instrument are accounted 
for similarly, using a test rate of 4 percent, compounded annually, 
for the payments made on December 31, 1997, and December 31, 1998, 
and a test rate of 5 percent, compounded annually, for the payments 
made on December 31, 1999, and December 31, 2000.
    Example 2. Contingent stock payout--(i) Facts. M Corporation and 
N Corporation each owns one-half of the stock of O Corporation. On 
January 1, 1996, pursuant to a reorganization qualifying under 
section 368(a)(1)(B), M contracts to acquire the one-half interest 
of O held by N for an initial distribution on that date of 30,000 
shares of M voting stock, and a non- assignable right to receive up 
to 10,000 additional shares of M's voting stock during the next 3 
years, provided the net profits of O exceed certain amounts 
specified in the contract. No interest is provided for in the 
contract. No additional shares are received in 1996 or in 1997. In 
1998, the annual earnings of O exceed the specified amount and on 
December 31, 1998, an additional 3,000 M voting shares are 
transferred to N. Assume that the fair market value of the 3,000 
shares on December 31, 1998, is $300,000 and that the short-term 
applicable Federal rate on January 1, 1996, is 4 percent, compounded 
annually. Assume also that M and N are calendar year taxpayers.
    (ii) Allocation of interest. Assume that the right to receive 
the additional shares is a nonquotable contingent payment (within 
the meaning of Sec. 1.1275-4(b)(4)(ii)). Section 1274 does not apply 
to the right to receive the additional shares because the right is 
not a debt instrument for federal income tax purposes. As a result, 
the transfer of the 3,000 M voting shares to N is a deferred payment 
subject to section 483 and a portion of the shares is treated as 
unstated interest under that section. The amount of interest 
allocable to the shares is an amount equal to the excess of $300,000 
(the fair market value of the shares on December 31, 1998) over 
$266,699 (the present value of $300,000, determined by discounting 
the payment at the test rate of 4 percent, compounded annually, from 
December 31, 1998, to January 1, 1996). As a result, the amount of 
interest allocable to the payment of the shares is $33,301 ($300,000 
- $266,699). Both M and N take the interest into account in 1998.

    (c) Effective date. This section applies to sales and exchanges 
that occur on or after the date that is 60 days after final regulations 
are published in the Federal Register.


Sec. 1.1001-1  [Amended]

    Par. 3. In Sec. 1.1001-1, the first sentence of paragraph (g) is 
amended by adding the language ``(other than a debt instrument that 
provides for one or more contingent payments)'' immediately following 
the language ``If a debt instrument''.


Sec. 1.1272-1  [Amended]

    Par. 4. Section Sec. 1.1272-1 is amended by:
    1. Removing the language ``(or schedules)'' in the first sentence 
of paragraph (c)(1) and adding the language ``(or a reasonable number 
of schedules)'' in its place.
    2. Removing the language ``See regulations under section 1275(d)'' 
in the fourth sentence of paragraph (c)(1) and adding the language 
``See Sec. 1.1275-4'' in its place.
    Par. 5. Section 1.1274-2 is amended by revising paragraphs (f)(2) 
and (g) to read as follows:


Sec. 1.1274-2  Issue price of debt instruments to which section 1274 
applies.

* * * * *
    (f) * * *
    (2) Stated interest at an 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 
assuming that the debt instrument provides for a fixed rate that 
reflects the yield that is reasonably expected for the instrument. This 
paragraph (f)(2) is effective for debt instruments issued on or after 
the date that is 60 days after final regulations are published in the 
Federal Register.
    (g) Treatment of contingent payment debt instruments. For purposes 
of paragraph (c) of this section, the stated principal amount of a debt 
instrument that provides for one or more contingent payments is the sum 
of the noncontingent principal payments and the projected amounts of 
any quotable contingent principal payments (as determined under 
Sec. 1.1275-4(b)(4)(i)). The imputed principal amount of the debt 
instrument is the sum of the present value of each noncontingent 
payment and the present value of the projected amount of each quotable 
contingent payment. For additional rules relating to a debt instrument 
that provides for one or more contingent payments, see Sec. 1.1275-4. 
This paragraph (g) is effective for debt instruments issued on or after 
the date that is 60 days after final regulations are published in the 
Federal Register.
* * * * *
    Par. 6. In Sec. 1.1275-3, paragraph (b)(1)(i) is revised to read as 
follows:


Sec. 1.1275-3  OID information reporting requirements.

* * * * *
    (b) * * * (1) * * *
    (i) Set forth on the face of the debt instrument the issue price, 
the amount of OID, the issue date, the yield to maturity, and, in the 
case of a debt instrument subject to the rules of Sec. 1.1275-4(b), the 
projected payment schedule; or
* * * * *
    Par. 7. Section 1.1275-4 is added to read as follows:


Sec. 1.1275-4  Contingent payment debt instruments.

    (a) Applicability--(1) In general. Except as provided in paragraph 
(a)(2) of this section, this section applies to any debt instrument 
that provides for one or more contingent payments. In general, 
paragraph (b) of this section applies to a contingent payment debt 
instrument that is issued for money or publicly traded property and 
paragraph (c) of this section applies to a contingent payment debt 
instrument that is issued for nonpublicly traded property. Paragraph 
(d) of this section provides special rules for tax-exempt obligations. 
If a taxpayer holds (or issues) a contingent payment debt instrument 
that the taxpayer hedges, see Sec. 1.1275-6 for the treatment of the 
debt instrument and the hedge by the taxpayer.
    (2) Exceptions. This section does not apply to--(i) A debt 
instrument that has an issue price determined under section 1273(b)(4);
    (ii) A variable rate debt instrument (as defined in Sec. 1.1275-5);
    (iii) A debt instrument subject to Sec. 1.1272-1(c) (a debt 
instrument that provides for an alternative payment schedule (or 
schedules) applicable upon the occurrence of a contingency (or 
contingencies));
    (iv) A debt instrument subject to section 988 (except as provided 
in section 988 and the regulations thereunder); or
    (v) A debt instrument to which section 1272(a)(6) applies (certain 
interests in or mortgages held by a REMIC, and certain other debt 
instruments with payments subject to acceleration).
    (3) Insolvency and default. A payment is not contingent merely 
because of the possibility of impairment by insolvency, default, or 
similar circumstances.
    (4) Convertible debt instruments. A debt instrument does not 
provide for contingent payments merely because it provides for a right 
to convert the debt instrument into the stock of the issuer, into the 
stock or debt of a related party (within the meaning of section 267(b) 
or 707(b)(1)), or into cash or other property in an amount equal to the 
approximate value of such stock or debt.
    (5) Remote and incidental contingencies. A payment on a debt 
instrument is not a contingent payment if, as of the issue date, the 
contingency is either remote or incidental. A contingency is remote if 
there is either a remote likelihood that the contingency will occur or 
a remote likelihood that the contingency will not occur. A contingency 
is incidental if the potential amount of the payment under any 
reasonably expected market conditions is insignificant relative to the 
total expected payments on the debt instrument.
    (b) Noncontingent bond method--(1) Applicability. The noncontingent 
bond method described in paragraph (b) of this section applies to a 
contingent payment debt instrument that has an issue price determined 
under Sec. 1.1273-2 (e.g., a contingent payment debt instrument that is 
issued for money or publicly traded property). The noncontingent bond 
method also applies to a contingent payment debt instrument that has an 
issue price determined under Sec. 1.1274-2(b)(3) (a contingent payment 
debt instrument issued in a potentially abusive situation).
    (2) In general. Under the noncontingent bond method, interest on a 
debt instrument must be taken into account whether or not the amount of 
any payment is fixed or determinable in the taxable year. The amount of 
interest that is taken into account for each accrual period is 
determined by constructing a projected payment schedule for the debt 
instrument and applying rules similar to those for accruing OID on a 
noncontingent debt instrument. The projected payment schedule is 
determined as of the issue date and is based on forward prices, if 
readily available, or on the projected pattern of expected payments and 
a projected yield. If the actual amount of a contingent payment is not 
equal to the projected amount, appropriate adjustments are made to 
reflect the difference.
    (3) Description of method. The following steps describe how to 
compute the amount of income, deductions, gain, and loss under the 
noncontingent bond method.
    (i) Step one: Determine a projected payment schedule. Determine the 
projected payment schedule for the debt instrument as of the debt 
instrument's issue date under the rules of paragraph (b)(4) of this 
section.
    (ii) Step two: Determine the projected yield. Based on the issue 
price of the debt instrument and the projected payment schedule, 
determine the projected yield of the debt instrument in the manner 
described in Sec. 1.1272-1(b)(1)(i).
    (iii) Step three: Determine the daily portions of interest. 
Determine the daily portions of interest on the debt instrument for a 
taxable year as follows. The amount of interest that accrues in each 
accrual period is the product of the projected yield of the debt 
instrument (properly adjusted for the length of the accrual period) and 
the debt instrument's adjusted issue price at the beginning of the 
accrual period. See paragraph (b)(7)(ii) of this section for rules for 
determining the adjusted issue price of the debt instrument. The daily 
portions of interest are determined by allocating to each day in the 
accrual period the ratable portion of the interest that accrues in the 
accrual period. Except as modified by paragraph (b)(3)(iv) of this 
section, the daily portions of interest are includible in income by a 
holder for each day in the holder's taxable year on which the holder 
held the debt instrument, and are deductible by the issuer for each day 
during the issuer's taxable year on which the issuer was primarily 
liable on the debt instrument.
    (iv) Step four: Adjust the amount of income or deductions for 
differences between projected and actual contingent payments. Make 
appropriate adjustments to the amount of income or deductions 
attributable to the debt instrument in a taxable year for any 
differences between projected and actual contingent payments. See 
paragraph (b)(6) of this section to determine the amount of an 
adjustment and the treatment of the adjustment.
    (4) Method of determining projected payment schedule. This 
paragraph (b)(4) provides rules for determining the projected payment 
schedule for a debt instrument. The projected payment schedule includes 
each noncontingent payment and the projected amount of each contingent 
payment. The schedule is determined as of the issue date and remains 
fixed throughout the term of the debt instrument (except under special 
rules that apply to a payment that is fixed more than 6 months before 
it is due under paragraph (b)(9)(ii) of this section). Under the rules 
of section 6001, taxpayers must maintain adequate contemporaneous 
records to support the projected payment schedule.
    (i) Quotable contingent payments--(A) In general. If a right to a 
contingent payment is substantially similar to a property right for 
which forward price quotes are readily available (a quotable contingent 
payment), the projected amount of the contingent payment is equal to 
the forward price of the property right. The forward price of a 
property right is an amount one party would agree, as of the issue 
date, to pay an unrelated party for the property right on the 
settlement date (e.g., the date payments under the property right are 
to be made). For purposes of paragraph (b)(4) of this section, a 
property right includes a right, an obligation, or a combination of 
rights or obligations.
    (B) Quotes readily available. For purposes of paragraph (b)(4)(i) 
of this section, quotes are readily available for a property right if, 
at any time during the 60-day period ending 30 days after the issue 
date, one or more quotations for a price on the property right are 
readily available from brokers, traders, or dealers.
    (C) Substantially similar. A right to a contingent payment is 
substantially similar to a property right if, under reasonably expected 
market conditions, the value and timing of the amount to be paid or 
received pursuant to the property right (whether in the form of a cash 
payment or the delivery of property) are expected to be substantially 
the same as the value and timing of the contingent payment.
    (D) Special rule for contingent payments substantially similar to 
options. A right to a contingent payment that is substantially similar 
to an option or combination of options, and that is not otherwise a 
quotable contingent payment, is treated as a quotable contingent 
payment if spot price quotations for the option or options are readily 
available. The projected amount of the contingent payment is the spot 
price of the option or options on the issue date compounded at the 
applicable Federal rate for the debt instrument (within the meaning of 
Sec. 1.1274-4(b)) from the issue date to the date the payment is due.
    (E) Reasonable determination of projected amounts. The projected 
amounts of quotable contingent payments may be determined based on 
either the bid, ask, or midpoint price quotes of the substantially 
similar property rights, provided the determination is reasonable and 
is made on a consistent basis. If price quotations vary among different 
quotation sources, any reasonable quotation may be used. If a right to 
a contingent payment is substantially similar to more than one 
combination of property rights for which forward price quotes are 
readily available (or options for which spot prices are readily 
available), any reasonable combination may be used.
    (ii) Quotes not readily available. If a debt instrument provides 
for one or more contingent payments that are not described in paragraph 
(b)(4)(i) of this section (nonquotable contingent payments), the 
projected amount of each contingent payment on the debt instrument is 
determined as follows. First, determine the projected amount of each 
quotable contingent payment under paragraph (b)(4)(i) of this section. 
Second, determine the projected yield of the debt instrument. The 
projected yield is a reasonable rate for the debt instrument. A 
reasonable rate is a rate that, as of the issue date, reflects general 
market conditions, the credit quality of the issuer, and the terms and 
conditions of the debt instrument (e.g., the existence of collateral 
securing the debt instrument or the uncertainty inherent in the 
contingent payments). A reasonable rate is never less than, and may 
substantially exceed, the applicable Federal rate for the debt 
instrument (within the meaning of Sec. 1.1274-4(b)), and may not be 
less than the yield on the debt instrument based on the projected 
payment schedule set without regard to the nonquotable contingent 
payments. Third, select a projected amount for each nonquotable 
contingent payment so that the projected payment schedule results in 
the projected yield and reasonably reflects the relative expected 
values of the nonquotable contingent payments.
    (iii) Debt instruments similar to variable rate debt instruments. 
Notwithstanding paragraphs (b)(4)(i) and (ii) of this section, the 
projected payment schedules for certain debt instruments similar to 
variable rate debt instruments are determined as follows:
    (A) Single quotable contingent payment at maturity. If a debt 
instrument would qualify as a variable rate debt instrument under 
Sec. 1.1275-5 except that it provides for a single quotable contingent 
payment at maturity, the projected payment schedule is determined as 
follows. First, construct the equivalent fixed rate debt instrument for 
the debt instrument under the principles of Sec. 1.1275-5(e), 
disregarding the contingent payment at maturity. Second, determine the 
projected amount of the contingent payment at maturity in accordance 
with paragraph (b)(4)(i) of this section. Third, set the projected 
payment schedule by combining the payment schedule for the equivalent 
fixed rate debt instrument with the projected amount of the contingent 
payment.
    (B) Principal not fully guaranteed. If a debt instrument would 
qualify as a variable rate debt instrument under Sec. 1.1275-5 except 
that it does not meet the principal payment requirement of Sec. 1.1275-
5(a)(2), the projected payment schedule is determined by constructing 
the equivalent fixed rate debt instrument for the debt instrument under 
the principles of Sec. 1.1275-5(e).
    (iv) Issuer/holder consistency. The projected payment schedule used 
by the issuer to compute interest accruals and adjustments determines 
the interest accruals and adjustments of the holder. The issuer must 
provide the projected payment schedule to the holder in a manner 
consistent with the issuer disclosure rules of Sec. 1.1275-2(e). If the 
issuer does not create a projected payment schedule for a debt 
instrument or the payment schedule set by the issuer is unreasonable, 
the holder of the debt instrument must set the projected payment 
schedule under the rules of paragraph (b)(4) of this section. A holder 
that sets its own projected payment schedule must explicitly disclose 
this fact and the reason why the holder set its own schedule (e.g., why 
the projected payment schedule prepared by the issuer is unreasonable). 
Unless otherwise prescribed by the Commissioner, the disclosure must be 
made on a statement attached to the holder's timely filed federal 
income tax return for the taxable year that includes the acquisition 
date of the debt instrument.
    (v) Issuer's determination respected. The issuer's determination of 
the projected payment schedule will be respected unless the schedule is 
unreasonable. A projected payment schedule will generally be considered 
unreasonable if the schedule is set with a purpose to accelerate or 
defer interest accruals on the debt instrument. In determining whether 
a projected payment schedule is unreasonable, consideration will be 
given to whether the interest on the debt instrument determined under 
the projected payment schedule has a significant effect on the issuer's 
or holder's U.S. tax liability.
    (vi) Examples. The following examples illustrate the provisions of 
paragraph (b)(4) of this section. In each example, assume that the debt 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example 1. Contingent payment substantially similar to an 
option--(i) Facts. On January 1, 1996, W corporation issues for 
$1,000,000 a debt instrument that matures on December 31, 2000. The 
debt instrument has a stated principal amount of $1,000,000, payable 
at maturity. The debt instrument also provides for a payment at 
maturity equal to $10,000 times the increase, if any, in the value 
of a nationally known composite index of stocks from January 1, 
1996, to the maturity date.
    (ii) Projected payment schedule. Under paragraph (b)(4) of this 
section, the projected payment schedule for the debt instrument 
consists of the $1,000,000 payment at maturity plus the projected 
amount of the contingent payment at maturity. The right to the 
contingent payment is substantially similar to a long call option on 
the index that is exercisable only on December 31, 2000. Thus, if 
quotes for the forward price of the option are readily available, 
the projected amount of the contingent payment is the forward price 
of the option. If quotes for the forward price are not readily 
available and quotes for the spot price of the option are readily 
available, the projected amount of the contingent payment is the 
option's spot price on the issue date compounded at the applicable 
Federal rate for the debt instrument from the issue date to the 
maturity date.
    Example 2. Contingent payment substantially similar to a forward 
contract--(i) Facts. On January 1, 1996, X corporation issues for 
$1,000,000 a debt instrument that matures on December 31, 2005. The 
debt instrument provides for annual payments of interest at the rate 
of 6 percent and for a payment at maturity equal to $1,000,000, plus 
the excess, if any, of the price of 1,000 units of a commodity on 
the maturity date over $350,000, or less the excess, if any, of 
$350,000 over the price of 1,000 units of the commodity on the 
maturity date.
    (ii) Projected payment schedule. Under paragraph (b)(4) of this 
section, the projected payment schedule for the debt instrument 
consists of ten annual payments of $60,000 and a projected amount 
for the contingent payment at maturity. The right to the contingent 
payment is substantially similar to a right to a payment of 
$1,000,000 combined with a forward contract for the purchase of 
1,000 units of the commodity for $350,000 on December 31, 2005. 
Assume forward price quotes to purchase the commodity on December 
31, 2005, are readily available on the issue date.
    (A) Assume that on the issue date the forward price to purchase 
1,000 units of the commodity on December 31, 2005, is $350,000. The 
projected amount of the contingent payment is $1,000,000, consisting 
of the $1,000,000 base amount and no additional amount to be 
received or paid under the forward contract. Although the amount to 
be received or paid under the forward contract is projected to be 
zero, the contingency is not incidental (within the meaning of 
paragraph (a)(5) of this section) because the potential amount to be 
received or paid based on the forward contract is not insignificant 
relative to the total expected payments on the debt instrument under 
any reasonably expected market conditions.
    (B) Assume, alternatively, that on the issue date the forward 
price to purchase 1,000 units of the commodity on December 31, 2005, 
is $370,000. The projected amount of the contingent payment is 
$1,020,000, consisting of the $1,000,000 base amount plus the excess 
$20,000 of the forward price of the commodity over the purchase 
price of the commodity under the forward contract.
    (C) Assume, alternatively, that on the issue date the forward 
price to purchase 1,000 units of the commodity on December 31, 2005, 
is $330,000. The projected amount of the contingent payment is 
$980,000, consisting of the $1,000,000 base amount minus the excess 
$20,000 of the purchase price of the commodity under the forward 
contract over the forward price of the commodity.
    Example 3. Contingent payment substantially similar to a 
combination of rights--(i) Facts. Assume the same facts as in 
Example 2 of this paragraph (b)(4)(vi), except that the debt 
instrument also provides for a cap and a floor on the contingent 
payment at maturity, so that the payment may not exceed $1,300,000 
and may not be less than $700,000.
    (ii) Projected payment schedule. Under paragraph (b)(4) of this 
section, the projected payment schedule for the debt instrument 
consists of ten annual payments of $60,000 and a projected amount 
for the contingent payment at maturity. The right to the contingent 
payment is substantially similar to a right to a payment of 
$1,000,000 combined with a forward contract for the purchase of 
1,000 units of the commodity for $350,000 on December 31, 2005, and 
two options on 1,000 units of the commodity that are exercisable 
only on December 31, 2005: one a long put option with an exercise 
price of $50,000, and the other a short call option with an exercise 
price of $650,000. The projected amount of the contingent payment is 
determined by combining the forward prices of these property rights.
    Example 4. Nonquotable contingent payments--(i) Facts. On 
January 1, 1996, Y issues for $1,000,000 a debt instrument that 
matures on December 31, 1999. The debt instrument has a stated 
principal amount of $1,000,000, payable at maturity, and provides 
for payments on December 31 of each year of $20,000 plus 5 percent 
of Y's gross receipts, if any, for the year. Assume that a 
reasonable rate for the debt instrument (within the meaning of 
paragraph (b)(4)(ii) of this section) is 7.5 percent, compounded 
annually.
    (ii) Projected yield. The debt instrument provides for 
nonquotable contingent payments. Under paragraph (b)(4)(ii) of this 
section, the projected yield is 7.5 percent, compounded annually.
    (iii) Projected payment schedule. Assume that Y anticipates that 
it will have no gross receipts in 1996, but that it will have gross 
receipts in later years, and those gross receipts will grow each 
year for the next three years. Based on its business projections, Y 
believes that it is not unreasonable to expect that its gross 
receipts in 1998 and each year thereafter will grow by between 6 
percent and 13 percent over the prior year. Thus, Y must take these 
expectations into account in establishing a projected payment 
schedule for the debt instrument that results in a yield of 7.5 
percent, compounded annually. Accordingly, Y could reasonably set 
the following projected payment schedule for the debt instrument:

------------------------------------------------------------------------
                                              Noncontingent   Contingent
                    Date                         payment       payment  
------------------------------------------------------------------------
12/31/1996..................................       $20,000            $0
12/31/1997..................................        20,000        70,000
12/31/1998..................................        20,000        75,600
12/31/1999..................................     1,020,000        83,850
------------------------------------------------------------------------

    Example 5. Debt instrument that provides for a variable rate of 
interest and a single quotable contingent payment at maturity--(i) 
Facts. On January 1, 1996, W corporation issues for $1,000,000 a 
debt instrument that matures on December 31, 2000. The debt 
instrument has a stated principal amount of $1,000,000, payable at 
maturity. The debt instrument also provides for semiannual payments 
of interest and a payment at maturity equal to $5,000 times the 
increase, if any, in the value of a nationally known composite index 
of stocks from January 1, 1996, to the maturity date. The rate of 
interest on the debt instrument is the value of 6-month LIBOR on the 
payment date. On the issue date, the value of 6-month LIBOR is 4 
percent, compounded semiannually. Assume that the payment at 
maturity based on the index is a quotable contingent payment.
    (ii) Projected payment schedule. Because the debt instrument 
would qualify as a variable rate debt instrument under Sec. 1.1275-5 
except that it provides for a single quotable contingent payment at 
maturity, paragraph (b)(4)(iii) of this section applies to the debt 
instrument. Under paragraph (b)(4)(iii)(A) of this section, the 
projected payment schedule is determined by first constructing the 
equivalent fixed rate debt instrument for the debt instrument. Under 
Sec. 1.1275-5(e), the equivalent fixed rate debt instrument is a 5-
year debt instrument that provides for semiannual payments of 
interest at 4 percent, compounded semiannually. Next, the projected 
amount of the contingent payment is determined in accordance with 
paragraph (b)(4)(i) of this section. The right to the contingent 
payment based on the stock index is substantially similar to a long 
call option on the index that is exercisable only on December 31, 
2000. Thus, the projected amount of the contingent payment is the 
forward price of the option, assuming quotes for the forward price 
of the option are readily available. Finally, the projected payment 
schedule is determined, consisting of 10 semiannual payments of 
interest at 4 percent and a payment at maturity equal to $1,000,000 
plus the forward price of the option on the index.

    (5) Qualified stated interest. No amounts payable on a debt 
instrument to which paragraph (b) of this section applies constitute 
qualified stated interest within the meaning of Sec. 1.1273-1(c).
    (6) Adjustments under the noncontingent bond method. This paragraph 
(b)(6) provides rules for the treatment of positive and negative 
adjustments under the noncontingent bond method.
    (i) Determination of positive and negative adjustments. If the 
amount of a contingent payment is more than the projected amount of the 
contingent payment, the difference is a positive adjustment on the date 
of the payment. If the amount of a contingent payment is less than the 
projected amount of the contingent payment, the difference is a 
negative adjustment on the date of the projected payment.
    (ii) Treatment of net positive adjustment. The amount, if any, by 
which total positive adjustments on a debt instrument in a taxable year 
exceed the total negative adjustments on the debt instrument in the 
taxable year is a net positive adjustment. A net positive adjustment is 
treated as additional interest for the taxable year.
    (iii) Treatment of net negative adjustment. The amount, if any, by 
which total negative adjustments on a debt instrument in a taxable year 
exceed the total positive adjustments on the debt instrument in the 
taxable year is a net negative adjustment. A taxpayer's net negative 
adjustment on a debt instrument for a taxable year is treated as 
follows:
    (A) Reduction of interest accruals. A net negative adjustment first 
reduces interest for the taxable year that the taxpayer would otherwise 
account for on the debt instrument under paragraph (b)(3)(iii) of this 
section.
    (B) Ordinary income or loss. If the net negative adjustment exceeds 
the interest for the taxable year that the taxpayer would otherwise 
account for on the debt instrument under paragraph (b)(3)(iii) of this 
section, the excess is treated as ordinary loss by a holder and 
ordinary income by an issuer. However, the amount treated as ordinary 
loss by a holder is limited to the amount by which the holder's total 
interest inclusions on the debt instrument exceed the total amount of 
the holder's net negative adjustments treated as ordinary loss on the 
debt instrument in prior taxable years. The amount treated as ordinary 
income by an issuer is limited to the amount by which the issuer's 
total interest deductions on the debt instrument exceed the total 
amount of the issuer's net negative adjustments treated as ordinary 
income on the debt instrument in prior taxable years.
    (C) Carryforward. If the net negative adjustment exceeds the sum of 
the amounts treated by the taxpayer as a reduction of interest and as 
ordinary income or loss (as the case may be) on the debt instrument for 
the taxable year, the excess is a negative adjustment carryforward for 
the taxable year.
    (1) In general. Except as provided in paragraph (b)(6)(iii)(C)(2) 
of this section, a negative adjustment carryforward on a debt 
instrument for a taxable year is treated as a negative adjustment on 
the debt instrument on the first day of the succeeding taxable year.
    (2) In year of sale, exchange, or retirement. Any negative 
adjustment carryforward on a debt instrument for a taxable year in 
which the debt instrument is sold, exchanged, or retired reduces the 
amount realized by the holder on the sale, exchange, or retirement. Any 
negative adjustment carryforward for a taxable year in which the debt 
instrument is retired is taken into account by the issuer as income 
from the discharge of indebtedness under section 61(a)(12).
    (iv) Cross references. If a holder has a basis in a debt instrument 
that is different than the debt instrument's adjusted issue price, the 
holder may have additional positive or negative adjustments under 
paragraph (b)(9)(i) of this section. If the amount of a contingent 
payment is fixed more than 6 months before the date it is due, the 
amount and timing of the adjustment are determined under paragraph 
(b)(9)(ii) of this section. If all the remaining contingent payments on 
a debt instrument become fixed substantially contemporaneously, the 
timing of the adjustment is determined under paragraph (b)(9)(v) of 
this section.
    (v) Examples. The following examples illustrate the provisions of 
paragraph (b)(6) of this section. In each example, assume that the debt 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example 1. Net negative adjustment--(i) Facts. On June 13, 1996, 
Z, a calendar year taxpayer, purchases a debt instrument at original 
issue for $1,044. Assume that the debt instrument is subject to 
paragraph (b) of this section. The projected payment schedule 
provides for projected payments of $100 on December 31, 1996, and 
$1,100 on December 31, 1997. Based on the projected payment 
schedule, Z's total daily portions of interest would be $56 for 1996 
and $100 for 1997.
    (ii) Adjustment in 1996. Assume that the payment actually made 
on December 31, 1996, is $25, rather than the projected $100. Under 
paragraph (b)(6)(i) of this section, Z has a negative adjustment of 
$75 on December 31, 1996, attributable to the difference between the 
amount of the actual payment and the amount of the projected 
payment. Because Z has no positive adjustments for 1996, Z has a net 
negative adjustment of $75 on the debt instrument for 1996. This net 
negative adjustment reduces to zero the $56 total daily portions of 
interest Z would otherwise include in income in 1996. Accordingly, Z 
has no interest income on the debt instrument for 1996. Because Z 
has no interest inclusions on the debt instrument for prior taxable 
years, the remaining $19 of the net negative adjustment is a 
negative adjustment carryforward for 1996 that results in a negative 
adjustment of $19 on January 1, 1997.
    (iii) Adjustments in 1997. Assume that the payment actually made 
on December 31, 1997, is $1,150, rather than the projected $1,100. 
Under paragraph (b)(6)(i) of this section, Z has a positive 
adjustment of $50 on December 31, 1997, attributable to the 
difference between the amount of the actual payment and the amount 
of the projected payment. Because Z also has a negative adjustment 
of $19 on January 1, 1997, Z has a net positive adjustment of $31 on 
the debt instrument for 1997 (the excess of the $50 positive 
adjustment over the $19 negative adjustment). Therefore, Z has $131 
of interest income on the debt instrument for 1997 (the net positive 
adjustment plus the $100 total daily portions of interest that are 
taken into account by Z in that year).
    Example 2. Net negative adjustment at maturity--(i) Facts. 
Assume the same facts as in Example 1 of this paragraph (b)(6)(v), 
except that the payment actually made on December 31, 1997, is 
$1,010, rather than the projected $1,100.
    (ii) Adjustments in 1997. Under paragraph (b)(6)(i) of this 
section, Z has a negative adjustment of $90 on December 31, 1997, 
attributable to the difference between the amount of the actual 
payment and the amount of the projected payment. In addition, Z has 
a negative adjustment of $19 on January 1, 1997. Because Z has no 
positive adjustments in 1997, Z has a net negative adjustment of 
$109 for 1997. This net negative adjustment reduces to zero the $100 
total daily portions of interest Z would otherwise include in income 
for 1997. Therefore, Z has no interest income on the debt instrument 
for 1997. Because Z has no interest inclusions on the debt 
instrument for prior taxable years, the remaining $9 of the net 
negative adjustment constitutes a negative adjustment carryforward 
for 1997 that reduces the amount realized by Z on retirement of the 
debt instrument.

    (7) Adjusted issue price, adjusted basis, and retirement--(i) In 
general. Paragraph (b)(7) of this section provides rules under the 
noncontingent bond method to determine the adjusted issue price of a 
debt instrument, the holder's basis in a debt instrument, and the 
amount of any contingent payment made on a scheduled retirement. 
Paragraph (b)(7) of this section also provides rules for an unscheduled 
retirement. In general, because any difference between the actual 
amount of a contingent payment and the projected amount of the payment 
is taken into account as an adjustment to income or deduction, the 
projected payments are treated as the actual payments for purposes of 
making adjustments to issue price and basis and determining the amount 
of any contingent payment made on a scheduled retirement. Except as 
provided in paragraph (b)(7)(iv) of this section, positive and negative 
adjustments are not taken into account for purposes of paragraph (b)(7) 
of this section.
    (ii) Definition of adjusted issue price. The adjusted issue price 
of a debt instrument is equal to the debt instrument's issue price, 
increased by the interest previously accrued on the debt instrument 
under paragraph (b)(3)(iii) of this section (determined without regard 
to any adjustments taken into account under paragraph (b)(3)(iv) of 
this section), and decreased by the amount of any noncontingent payment 
and the projected amount of any contingent payment previously made on 
the debt instrument. See paragraph (b)(9)(ii) of this section for 
special rules that apply when a contingent payment is fixed more than 6 
months before it is due.
    (iii) Adjustments to basis. A holder's basis in a debt instrument 
is increased by the interest previously accrued by the holder on the 
debt instrument under paragraph (b)(3)(iii) of this section (determined 
without regard to any adjustments taken into account under paragraph 
(b)(3)(iv) of this section), and decreased by the amount of any 
noncontingent payment and the projected amount of any contingent 
payment previously made on the debt instrument to the holder. See 
paragraphs (b)(9)(i) and (ii) of this section for special rules that 
apply when basis is different than adjusted issue price or a contingent 
payment is fixed more than 6 months before it is due.
    (iv) Amount realized on a scheduled retirement. For purposes of 
determining the amount realized by a holder and the repurchase price 
paid by the issuer on the scheduled retirement of a debt instrument, a 
holder is treated as receiving, and the issuer is treated as paying, 
the projected amount of any contingent payment due at maturity. The 
amount realized on a scheduled retirement of a debt instrument and the 
issuer's repurchase price on the retirement, however, may be reduced 
under paragraph (b)(6)(iii)(C)(2) of this section (regarding the 
treatment of negative adjustment carryforwards determined in the 
taxable year of the retirement).
    (v) Unscheduled retirements. An unscheduled retirement of a debt 
instrument (or the receipt of a pro-rata prepayment that is treated as 
a retirement of a portion of a debt instrument under Sec. 1.1275-2(f)) 
is treated as a sale or exchange of the debt instrument (or a pro rata 
portion of the debt instrument) by the holder to the issuer for the 
amount paid by the issuer to the holder.
    (vi) Examples. The following examples illustrate the provisions of 
paragraph (b)(7) of this section. In each example, assume that the debt 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example 1. Adjusted issue price, adjusted basis, and 
retirement--(i) Facts. Assume the same facts as in Example 1 of 
paragraph (b)(6)(v) of this section.
    (ii) Adjustment to issue price and basis. Based on the projected 
payment schedule, Z's total daily portions of interest on the debt 
instrument would be $56 for 1996. Therefore, the adjusted issue 
price of the debt instrument and Z's adjusted basis in the debt 
instrument are increased by this amount ($56), despite the fact 
that, under paragraph (b)(6)(iii) of this section, Z has a net 
negative adjustment for 1996 of $75 that reduces to zero the $56 
total daily portions of interest otherwise accounted for by Z in 
that year. In addition, the adjusted issue price of the debt 
instrument and Z's adjusted basis in the debt instrument are 
decreased on December 31, 1996, by the projected amount of the 
payment on that date ($100). Thus, on January 1, 1997, Z's adjusted 
basis in the debt instrument and the adjusted issue price of the 
debt instrument are $1,000.
    (iii) Retirement. Based on the projected payment schedule, Z's 
adjusted basis in the debt instrument immediately before the payment 
at maturity is $1,100. Even though Z receives $1,150 at maturity, 
for purposes of determining the amount realized by Z on retirement 
of the debt instrument, Z is treated as receiving the projected 
amount of the contingent payment on December 31, 1997. Therefore, Z 
is treated as receiving $1,100 on December 31, 1997. Because Z's 
adjusted basis in the debt instrument immediately before its 
retirement is $1,100, Z recognizes no gain or loss on the 
retirement. Z, however, does include $131 as interest income on the 
debt instrument in 1997. See Example 1 of paragraph (b)(6)(v) of 
this section.
    Example 2. Negative adjustment carryforward for year of sale--
(i) Facts. Assume the same facts as in Example 1 of paragraph 
(b)(6)(v) of this section, except that Z sells the debt instrument 
on January 1, 1997, for $1,075.
    (ii) Gain on sale. On the date the debt instrument is sold, Z's 
adjusted basis in the debt instrument is $1,000. Because Z has a 
negative adjustment on the debt instrument on January 1, 1997, of 
$19 under paragraph (b)(6)(iii)(C)(1) of this section, and has no 
positive adjustments on the debt instrument in 1997, Z has a net 
negative adjustment for 1997 of $19. Because Z has included no 
interest on the debt instrument in income in 1997 or previous years, 
the entire $19 net negative adjustment constitutes a negative 
adjustment carryforward for the taxable year of the sale. Under 
paragraph (b)(6)(iii)(C)(2) of this section, the $19 negative 
adjustment carryforward reduces the amount realized by Z on the sale 
of the debt instrument from $1,075 to $1,056. Thus, Z has a gain on 
the sale of $56.
    Example 3. Negative adjustment carryforward for year of 
retirement--(i) Facts. Assume the same facts as in Example 1 of 
paragraph (b)(6)(v) of this section, except that the payment 
actually made on December 31, 1997, is $1,010, rather than the 
projected $1,100. Thus, Z will have a $9 negative adjustment 
carryforward for 1997, the year of retirement. See Example 2 of 
paragraph (b)(6)(v) of this section.
    (ii) Loss on retirement. Immediately before the payment at 
maturity, Z's adjusted basis in the debt instrument is $1,100. Under 
paragraph (b)(7)(iv) of this section, Z is treated as receiving the 
projected amount of the contingent payment, or $1,100, as the 
payment at maturity. Under paragraph (b)(6)(iii)(C)(2) of this 
section, however, this amount is reduced by any negative adjustment 
carryforward determined for the taxable year of retirement to 
calculate the amount Z realizes on retirement of the debt 
instrument. Thus, Z has a loss of $9 on the retirement of the debt 
instrument, equal to the amount by which Z's adjusted basis in the 
debt instrument ($1,100) exceeds the amount Z realizes on the 
retirement of the debt instrument ($1,100 minus the $9 negative 
adjustment carryforward).

    (8) Character on sale, exchange, or retirement--(i) Gain. Any gain 
recognized by a holder on the sale, exchange, or retirement of a debt 
instrument is interest income.
    (ii) Loss. Any loss recognized by a holder on the sale, exchange, 
or retirement of the debt instrument is ordinary loss to the extent 
that the holder's total interest inclusions on the debt instrument 
exceed the total net negative adjustments on the debt instrument the 
holder took into account as ordinary loss. Any additional loss is 
treated as loss from the sale, exchange, or retirement of the debt 
instrument.
    (iii) Special rule if there are no remaining contingent payments on 
the debt instrument. Notwithstanding paragraphs (b)(8)(i) and (ii) of 
this section, if, at the time of the sale, exchange, or retirement of 
the debt instrument, there are no remaining contingent payments due on 
the debt instrument, any gain or loss recognized by the holder on the 
debt instrument is gain or loss from the sale, exchange, or retirement 
of the debt instrument.
    (iv) Fixed but deferred payments. For purposes of paragraph (b)(8) 
of this section, a contingent payment that is fixed within the 6-month 
period ending on the due date of the payment is treated as a contingent 
payment even after the payment is fixed. See paragraph (b)(9)(ii) of 
this section, under which a contingent payment that is fixed more than 
6 months before it is due is not treated as a contingent payment after 
it is fixed.
    (v) Examples. The following examples illustrate the provisions of 
paragraph (b)(8) of this section. In each example, assume that the debt 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example 1. Gain on sale--(i) Facts. On January 1, 1997, D, a 
calendar year taxpayer, sells a debt instrument that is subject to 
paragraph (b) of this section for $1,350. On that date, D has an 
adjusted basis in the debt instrument of $1,200. In addition, D has 
a negative adjustment carryforward of $50 for 1996 that results in a 
negative adjustment of $50 on January 1, 1997, under paragraph 
(b)(6)(iii)(C)(1) of this section. D has no positive adjustments on 
the debt instrument on January 1, 1997.
    (ii) Character of gain. Under paragraph (b)(6) of this section, 
the $50 negative adjustment on January 1, 1997, results in a 
negative adjustment carryforward for 1997, the taxable year of the 
sale of the debt instrument. Under paragraph (b)(6)(iii)(C)(2) of 
this section, the negative adjustment carryforward reduces the 
amount realized by D on the sale of the debt instrument from $1,350 
to $1,300. As a result, D realizes a $100 gain on the sale of the 
debt instrument, equal to the $1,300 amount realized minus D's 
$1,200 adjusted basis in the debt instrument. Under paragraph 
(b)(8)(i) of this section, the gain is interest income to D.
    Example 2. Ordinary loss on sale--(i) Facts. On January 1, 1996, 
E, a calendar year taxpayer, purchases a debt instrument at original 
issue for $1,000. The debt instrument is a capital asset in the 
hands of E. The debt instrument provides for a payment of $1,000 at 
maturity on December 31, 2001, and for quotable contingent payments 
on December 31, 1997, 1999, and 2001. The projected payment schedule 
provides for projected payments of $275 on December 31, 1997, $200 
on December 31, 1999, and $1,127 on December 31, 2001. Thus, the 
projected yield on the debt instrument is 10 percent, compounded 
annually. Based on the projected payment schedule, the total daily 
portions of interest would be $100 for 1996, $110 for 1997, and 
$93.50 for 1998.
    (ii) Adjustment for 1997. Assume that the payment actually made 
on December 31, 1997, is $150, rather than the projected $275. Under 
paragraph (b)(6)(i) of this section, E has a negative adjustment of 
$125 on December 31, 1997. Because E has no positive adjustments for 
1997, E has a net negative adjustment of $125 on the debt instrument 
for 1997. This net negative adjustment reduces to zero the $110 
total daily portions of interest E would otherwise include in income 
in 1997. Accordingly, E has no interest income on the debt 
instrument for 1997. Because E had $100 of interest inclusions for 
1996, the remaining $15 of the net negative adjustment is an 
ordinary loss to E for 1997.
    (iii) Determination of amount and character of loss on sale. 
Assume that E sells the debt instrument for $950 on December 31, 
1998. On that date, E has an adjusted basis in the debt instrument 
of $1,028.50 ($1,000 original basis, plus total daily portions of 
$100 for 1996, $110 for 1997, and $93.50 for 1998, minus the $275 
projected amount of the December 31, 1997 payment). As a result, E 
realizes a $78.50 loss on the sale of the debt instrument (the 
difference between the sales price and E's adjusted basis in the 
debt instrument). The total amount of E's interest inclusions on the 
debt instrument as of December 31, 1998 ($100 in 1996 and $93.50 in 
1998) exceeds the total amount of net negative adjustments on the 
debt instrument E treated as ordinary loss as of that date ($15 in 
1997) by more than $78.50. Therefore, under paragraph (b)(8)(ii) of 
this section, the $78.50 loss on the debt instrument is treated as 
an ordinary loss by E.
    Example 3. Loss on sale of a debt instrument--(i) Facts. Assume 
the same facts as in Example 2 of this paragraph (b)(8)(v), except 
that the payment actually made on December 31, 1997, is $0, rather 
than the projected $275.
    (ii) Adjustment for 1997. Under paragraph (b)(6)(i) of this 
section, E has a negative adjustment of $275 on December 31, 1997. 
Because E has no positive adjustments for 1997, E has a net negative 
adjustment of $275 on the debt instrument for 1997. This net 
negative adjustment reduces to zero the $110 total daily portions of 
interest E would otherwise include in income in 1997. Accordingly, E 
has no interest income on the debt instrument for 1997. Because E 
had $100 of interest inclusions for 1996, $100 of the remaining $165 
net negative adjustment is treated by E as an ordinary loss for 
1997. The remaining $65 of the net negative adjustment is a negative 
adjustment carryforward for 1997 that results in a negative 
adjustment of $65 on January 1, 1998.
    (iii) Determination of amount and character of loss on sale. 
Assume that E sells the debt instrument for $900 on January 1, 1998. 
On that date, E has an adjusted basis in the debt instrument of $935 
($1,000 original basis, plus total daily portions of $100 for 1996 
and $110 for 1997, minus the $275 projected amount of the December 
31, 1997 payment). Because E has no other adjustments for 1998, and 
E's interest inclusions on the debt instrument in prior taxable 
years do not exceed the total net negative adjustments E treated as 
ordinary loss in those years, the $65 negative adjustment on January 
1, 1998, results in a negative adjustment carryforward of $65 for 
1998. Under paragraph (b)(6)(iii)(C)(2) of this section, the $65 
negative adjustment carryforward reduces the amount E realizes on 
the sale of the debt instrument from $900 to $835. As a result, E 
realizes a $100 loss on the sale of the debt instrument (the 
difference between the amount realized and E's adjusted basis in the 
debt instrument). Because E's total interest inclusions on the debt 
instrument do not exceed the total net negative adjustments E 
treated as ordinary loss on the debt instrument, E's loss on the 
sale of the debt instrument is treated as a capital loss.

    (9) Operating rules. The rules of this paragraph (b)(9) 
notwithstanding any other rule of this paragraph (b).
    (i) Basis different than adjusted issue price. This paragraph 
(b)(9)(i) provides rules for a holder whose basis in a debt instrument 
is different than the adjusted issue price of the debt instrument 
(e.g., a subsequent holder that purchases the debt instrument for more 
or less than the instrument's adjusted issue price).
    (A) General rule. A holder whose basis in a debt instrument is 
different than the adjusted issue price of the debt instrument accrues 
interest under paragraph (b)(3)(iii) of this section and makes 
adjustments under paragraph (b)(3)(iv) of this section based on the 
projected payment schedule determined as of the issue date of the debt 
instrument. However, upon acquiring the debt instrument, the holder 
must reasonably allocate any difference between the adjusted issue 
price and the basis to daily portions of interest or projected payments 
over the remaining term of the debt instrument. Allocations are taken 
into account under paragraphs (b)(9)(i)(B) and (C) of this section.
    (B) Basis greater than adjusted issue price. If a holder's basis in 
a debt instrument exceeds the debt instrument's adjusted issue price, 
the amount allocated to a daily portion of interest or to a projected 
payment is treated as a negative adjustment on the date the daily 
portion accrues or the payment is made. The holder's adjusted basis in 
the debt instrument is reduced by the amount the holder treats as a 
negative adjustment under this paragraph (b)(9)(i)(B).
    (C) Basis less than adjusted issue price. If a holder's basis in a 
debt instrument is less than the debt instrument's adjusted issue 
price, the amount allocated to a daily portion of interest or to a 
projected payment is treated as a positive adjustment on the date the 
daily portion accrues or the payment is made. The holder's adjusted 
basis in the debt instrument is increased by the amount the holder 
treats as a positive adjustment under this paragraph (b)(9)(i)(C).
    (D) Premium and discount rules do not apply. The rules for accruing 
premium and discount in sections 171, 1272(a)(7), 1276, and 1281 do not 
apply. Other rules of those sections continue to apply to the extent 
relevant.
    (E) Safe harbor for exchange listed debt instruments. If a 
contingent payment debt instrument is exchange listed property (within 
the meaning of Sec. 1.1273-2(f)(2)), it is reasonable for a holder of 
the debt instrument to allocate any difference between the holder's 
basis and the adjusted issue price of the debt instrument pro-rata to 
daily portions of interest (as determined under paragraph (b)(3)(iii) 
of this section) over the remaining term of the debt instrument.
    (F) Examples. The following examples illustrate the provisions of 
paragraph (b)(9)(i) of this section. In each example, assume that the 
debt instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes. In addition, assume that each debt instrument is not exchange 
listed property.

    Example 1. Basis greater than adjusted issue price--(i) Facts. 
On July 1, 1997, Z purchases for $1,405 a debt instrument that 
matures on December 31, 1998, and promises to pay on the maturity 
date $1,000 plus the increase, if any, in the price of a specified 
amount of a commodity from the issue date to the maturity date. The 
debt instrument was originally issued on January 1, 1996, for an 
issue price of $1,000. Z is a calendar year taxpayer. The projected 
payment schedule for the debt instrument (determined as of the issue 
date) provides for a single payment at maturity of $1,350. Thus, the 
debt instrument has a projected yield of 10.25 percent, compounded 
semiannually. At the time of the purchase, the debt instrument has 
an adjusted issue price of $1,162, assuming semiannual accrual 
periods ending on December 31 and June 30 of each year. The increase 
in the value of the debt instrument over its adjusted issue price is 
due to an increase in the expected amount of the contingent payment 
and not to a decrease in market interest rates.
    (ii) Allocation of the difference between basis and adjusted 
issue price. Z's basis in the debt instrument on July 1, 1997, is 
$1,405. Under paragraph (b)(9)(i)(B) of this section, Z allocates 
the $243 difference between basis ($1,405) and adjusted issue price 
($1,162) to the contingent payment at maturity. Z's allocation of 
the difference between basis and adjusted issue price is reasonable 
because the increase in the value of the debt instrument over its 
adjusted issue price is due to an increase in the expected amount of 
the contingent payment.
    (iii) Treatment of debt instrument for 1997. Based on the 
projected payment schedule, $60 of interest accrues on the debt 
instrument from July 1, 1997 to December 31, 1997 (the product of 
the debt instrument's adjusted issue price on July 1, 1997 ($1,162) 
and the projected yield properly adjusted for the length of the 
accrual period (10.25 percent/2)). Z has no net negative or positive 
adjustments for 1997. Thus, Z includes in income $60 of total daily 
portions of interest for 1997. On December 31, 1997, Z's adjusted 
basis in the debt instrument is $1,465 ($1,405 original basis, plus 
total daily portions of $60 for 1997).
    (iv) Effect of allocation to contingent payment at maturity. 
Assume that the payment actually made on December 31, 1998, is 
$1,400, rather than the projected $1,350. Under paragraph (b)(6)(i) 
of this section, Z has a positive adjustment of $50 on December 31, 
1998. Under paragraph (b)(9)(i)(B) of this section, Z has a negative 
adjustment of $243 on December 31, 1998. As a result, Z has a net 
negative adjustment of $193 for 1998. This net negative adjustment 
reduces to zero the $128 total daily portions of interest Z would 
otherwise include in income in 1998. Accordingly, Z has no interest 
income on the debt instrument for 1998. Because Z had $60 of 
interest inclusions for 1997, $60 of the remaining $65 net negative 
adjustment is treated by Z as an ordinary loss for 1998. The 
remaining $5 of the net negative adjustment is a negative adjustment 
carryforward for 1998 that reduces the amount realized by Z on the 
retirement of the debt instrument from $1,350 to $1,345.
    (v) Loss at maturity. On December 31, 1998, Z's basis in the 
debt instrument is $1,350 ($1,405 original basis, plus total daily 
portions of $60 for 1997 and $128 for 1998, minus the negative 
adjustment of $243). As a result, Z realizes a loss of $5 on the 
retirement of the debt instrument (the difference between the amount 
realized ($1,345) and Z's adjusted basis in the debt instrument 
($1,350)). Under paragraph (b)(8)(ii) of this section, the $5 loss 
is treated as loss from the retirement of the debt instrument. 
Consequently, Z realizes a total loss of $65 on the debt instrument 
for 1998 (a $60 ordinary loss and a $5 loss on the retirement of the 
debt instrument).
    Example 2. Basis less than adjusted issue price--(i) Facts. On 
January 1, 1998, Y purchases for $910 a debt instrument that pays 7 
percent interest semiannually on June 30 and December 31 of each 
year, and that promises to pay on December 31, 2000, $1,000 plus or 
minus $10 times the positive or negative difference, if any, between 
a specified amount and the value of an index on December 31, 2000. 
However, the payment on December 31, 2000, may not be less than 
$650. The debt instrument was originally issued on January 1, 1996, 
for an issue price of $1,000. Y is a calendar year taxpayer. The 
projected payment schedule for the debt instrument provides for 
semiannual payments of $35 and a contingent payment at maturity of 
$1,175. On January 1, 1998, the debt instrument has an adjusted 
issue price of $1,060, assuming semiannual accrual periods ending on 
December 31 and June 30 of each year. Since the time the debt 
instrument was issued, market rates of interest on similar debt 
instruments have increased from approximately 10 percent to 
approximately 13 percent. In addition, because of a decrease in the 
relevant index, the expected value of the contingent payment has 
declined by about 9 percent.
    (ii) Allocation of the difference between basis and adjusted 
issue price. Y's basis in the debt instrument on January 1, 1998, is 
$910. Under paragraph (b)(9)(i)(B) of this section, Y must allocate 
the $150 difference between basis ($910) and adjusted issue price 
($1,060) to daily portions of interest or to projected payments. 
These amounts will be positive adjustments taken into account at the 
time the daily portions accrue or the payments are made.
    (A) Based on forward prices on January 1, 1998, Y determines 
that approximately $105 of the difference between basis and adjusted 
issue price is allocable to the contingent payment. Y allocates the 
remaining $45 to daily portions of interest on a pro-rata basis. 
This allocation is reasonable.
    (B) Assume alternatively that, based on yields of comparable 
debt instruments and its purchase price for the debt instrument, Y 
determines that approximately $49 of the difference between basis 
and adjusted issue price is allocable to daily portions of interest 
as follows: $13.32 to the daily portions of interest for the taxable 
year ending December 31, 1998; $16.15 to the daily portions of 
interest for the taxable year ending December 31, 1999; and $19.53 
to the daily portions of interest for the taxable year ending 
December 31, 2000. Y allocates the remaining $101 to the contingent 
payment at maturity. This allocation is reasonable.
    Example 3. Secondary holder sells debt instrument--(i) Facts. 
Assume the same facts as in Example 2 of this paragraph (b)(9)(i)(F) 
and that Y allocates $49 to daily portions of interest and $101 to 
the contingent payment at maturity, on the same basis as in 
paragraph (ii)(B) of Example 2 of this paragraph (b)(9)(i)(F). In 
1998, Y has a total of $104.68 of daily portions of interest, 
receives two semiannual payments of $35, and has a positive 
adjustment of $13.32 from the allocation. Thus, Y has $118 of 
interest income on the debt instrument for 1998 ($104.68 of interest 
and a $13.32 net positive adjustment). On December 31, 1998, Y has 
an adjusted basis of $958 in the debt instrument ($910 original 
basis, plus $104.68 total daily portions for 1998 and the $13.32 
positive adjustment, minus $70 interest payments for 1998), and the 
debt instrument has an adjusted issue price of $1,094.68 ($1,060 
adjusted issue price on January 1, 1998, plus $104.68 total daily 
portions for 1998, minus $70 interest payments for 1998).
    (ii) Sale of debt instrument. Assume that Y sells the debt 
instrument for $950 on January 15, 1999. In 1999, Y has total daily 
portions of interest on the debt instrument (using a semiannual 
accrual period ending June 30) of $4.47 and positive adjustments 
allocable to the total daily portions of interest in 1999 of $0.64. 
Therefore, Y has $5.11 of interest income on the debt instrument for 
1999. On January 15, 1999, Y has an adjusted basis in the debt 
instrument of $963.11. As a result, Y realizes a $13.11 loss on the 
sale of the debt instrument. Under paragraph (b)(8)(ii) of this 
section, the loss is an ordinary loss.

    (ii) Fixed but deferred contingent payments. This paragraph 
(b)(9)(ii) provides rules for computing interest accruals and 
adjustments under paragraph (b)(3) of this section when the amount of a 
contingent payment becomes fixed more than 6 months before the payment 
is due. For purposes of the preceding sentence, a payment is treated as 
a fixed payment if all remaining contingencies with respect to the 
payment are remote or incidental.
    (A) Determining adjustments. The amount of the adjustment 
attributable to the payment is equal to the difference between the 
present value of the amount that is fixed and the present value of the 
projected amount of the contingent payment. The present value of each 
amount is determined by discounting the amount from the date the 
payment is due to the date the payment becomes fixed, using a discount 
rate equal to the projected yield on the debt instrument. The 
adjustment is treated as a positive or negative adjustment, as 
appropriate, on the date the contingent payment becomes fixed. See 
paragraph (b)(9)(v) of this section to determine the timing of the 
adjustment if all remaining contingent payments on the debt instrument 
become fixed substantially contemporaneously.
    (B) Payment schedule. For purposes of paragraph (b) of this 
section, the contingent payment is no longer treated as a contingent 
payment after the date the amount of the payment becomes fixed. On the 
date the contingent payment becomes fixed, the projected payment 
schedule for the debt instrument is modified prospectively to reflect 
the fixed amount of the payment. Therefore, no adjustment is made under 
paragraph (b)(3)(iv) of this section when the contingent payment is 
actually made.
    (C) Accrual period. Notwithstanding the determination under 
Sec. 1.1272-1(b)(1)(ii) of accrual periods for the debt instrument, an 
accrual period ends on the day the contingent payment becomes fixed, 
and a new accrual period begins on the day after the day the contingent 
payment becomes fixed.
    (D) Basis and adjusted issue price. The amount of any positive 
adjustment on a debt instrument determined under paragraph 
(b)(9)(ii)(A) of this section increases the adjusted issue price of the 
instrument and the holder's adjusted basis in the instrument. The 
amount of any negative adjustment on a debt instrument determined under 
paragraph (b)(9)(ii)(A) of this section decreases the adjusted issue 
price of the instrument and the holder's adjusted basis in the 
instrument.
    (E) Special rule for certain contingent interest payments. 
Notwithstanding paragraphs (b)(9)(ii) (A), (B), (C), and (D) of this 
section, this paragraph (b)(9)(ii)(E) applies to contingent stated 
interest payments that are adjusted to compensate for contingencies 
regarding the reasonableness of the debt instrument's stated rate of 
interest. For example, this paragraph (b)(9)(ii)(E) applies to a debt 
instrument that provides for an increase in the stated rate of interest 
if the credit quality of the issuer or liquidity of the debt instrument 
deteriorates. Contingent stated interest payments of this type are 
recognized over the period to which they relate in a reasonable manner.
    (F) Example. The following example illustrates the provisions of 
paragraph (b)(9)(ii) of this section. In this example, assume that the 
debt instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example. Fixed but deferred payments--(i) Facts. On January 1, 
1996, B, a calendar year taxpayer, purchases a debt instrument at 
original issue for $1,000. The debt instrument matures on December 
31, 2001, and provides for a payment of $1,000 at maturity. In 
addition, on December 31, 1998, and December 31, 2001, the debt 
instrument provides for payments equal to the excess of the average 
daily value of an index for the 6-month period ending on September 
30 of the preceding year over a specified amount. The two contingent 
payments are substantially similar to options on the index. Assume 
that the two contingent payments are quotable contingent payments, 
and that, on the issue date, the forward price of the option that is 
exercisable on December 31, 1998, is $250 and the forward price of 
the option that is exercisable on December 31, 2001, is $440. Assume 
that B uses annual accrual periods.
    (ii) Interest accrual for 1996. Under paragraph (b)(4) of this 
section, the debt instrument's projected payment schedule consists 
of a payment of $250 on December 31, 1998, and a payment of $1,440 
on December 31, 2001. Thus, the debt instrument's projected yield is 
10 percent, compounded annually. B includes a total of $100 of daily 
portions of interest in income in 1996. B's adjusted basis in the 
debt instrument and the debt instrument's adjusted issue price on 
December 31, 1996, is $1,100.
    (iii) Interest accrual for 1997--(A) Adjustment. Based on the 
projected payment schedule, B would include $110 of total daily 
portions of interest in income in 1997. However, assume that on 
September 30, 1997, the payment due on December 31, 1998, fixes at 
$300, rather than the projected $250. Thus, on September 30, 1997, B 
has an adjustment equal to the difference between the present value 
of the $300 fixed amount and the present value of the $250 projected 
amount of the contingent payment. The present values of the two 
payments are determined by discounting each payment from the date 
the payment is due (December 31, 1998) to the date the payment 
becomes fixed (September 30, 1997), using a discount rate equal to 
10 percent, compounded annually. The present value of the fixed 
payment is $266.30 and the present value of the projected amount of 
the contingent payment is $221.91. Thus, on September 30, 1997, B 
has a positive adjustment of $44.39 ($266.30-$221.91).
    (B) Effect of adjustment. Under paragraph (b)(9)(ii)(C) of this 
section, B's accrual period ends on September 30, 1997. The daily 
portions of interest on the debt instrument for the period from 
January 1, 1997 to September 30, 1997 total $81.49. The adjusted 
issue price of the debt instrument and B's adjusted basis in the 
debt instrument are thus increased over this period by $125.88 (the 
sum of the daily portions of interest of $81.49 and the positive 
adjustment of $44.39 made at the end of the period) to $1,225.88. 
For purposes of all future accrual periods, including the new 
accrual period from October 1, 1997, to December 31, 1997, the debt 
instrument's projected payment schedule is modified to reflect a 
fixed payment of $300 on December 31, 1998. Based on the new 
adjusted issue price of the debt instrument and the new projected 
payment schedule, the projected yield on the debt instrument does 
not change.
    (C) Interest accrual for 1997. Based on the modified projected 
payment schedule, $29.55 of interest accrues during the accrual 
period that ends on December 31, 1997. Because B has no other 
adjustments during 1997, the $44.39 positive adjustment on September 
30, 1997, results in a net positive adjustment for 1997, which is 
additional interest for that year. Thus, B includes $155.43 ($81.49 
+ $29.55 + $44.39) of interest in income in 1997. B's adjusted basis 
in the debt instrument and the debt instrument's adjusted issue 
price on December 31, 1997, is $1,255.43 ($1,225.88 from the end of 
the prior accrual period plus $29.55 total daily portions for the 
current accrual period).
    (iv) Interest accrual for 1998. In 1998, B has no adjustments 
and, based on the modified projected payment schedule, includes 
$125.54 total daily portions of interest in income (rather than $121 
as under the original projected payment schedule). On December 31, 
1998, B's adjusted basis in the debt instrument and the adjusted 
issue price of the debt instrument are increased by the $125.54 
total daily portions of interest included in income under the 
modified projected payment schedule, and reduced by $300, the amount 
of the fixed payment on December 31, 1998, that is reflected on the 
modified projected payment schedule.

    (iii) Timing contingencies. This paragraph (b)(9)(iii) provides 
rules for debt instruments that have both payments that are contingent 
as to time and payments that are contingent as to amount.
    (A) Treatment of certain options. If a taxpayer has an option to 
put or call the debt instrument, to exchange the debt instrument for 
other property, or to extend the maturity date of the debt instrument, 
the projected payment schedule is determined by using the principles of 
Sec. 1.1272-1(c)(5). If an option to put, call, or exchange the debt 
instrument is assumed to be exercised under the principles of 
Sec. 1.1272-1(c)(5), it is generally reasonable to assume that the 
option is exercised immediately before it expires. If the option is 
exercised at an earlier time, the exercise is treated as a sale or 
exchange of the debt instrument.
    (B) Other timing contingencies. [Reserved]
    (iv) Allocation of deductions. For purposes of Sec. 1.861-8, any 
amount treated as an ordinary loss under paragraph (b)(6)(iii)(B) or 
(b)(8)(ii) of this section is considered a deduction that is definitely 
related to the class of gross income to which interest on the relevant 
debt instrument belongs. Any other deduction or loss relating to the 
debt instrument will be subject to the general rules of Sec. 1.861-8.
    (v) Special rule when all contingent payments become fixed. 
Notwithstanding any other provision of this section, if all the 
remaining contingent payments on a debt instrument become fixed 
substantially contemporaneously, any positive or negative adjustment on 
the instrument is spread over the remaining term of the instrument in a 
reasonable manner. For purposes of the preceding sentence, a payment is 
treated as a fixed payment if all remaining contingencies with respect 
to the payment are remote or incidental.
    (c) Method for debt instruments not subject to the noncontingent 
bond method--(1) Applicability. Paragraph (c) of this section applies 
to a contingent payment debt instrument that has an issue price 
determined under Sec. 1.1274-2 (other than a debt instrument issued in 
a potentially abusive situation). For example, paragraph (c) of this 
section generally applies to a contingent payment debt instrument that 
is issued for nonpublicly traded property.
    (2) Separation into components. In the case of a debt instrument 
subject to paragraph (c) of this section (the overall debt instrument), 
the noncontingent payments and any quotable contingent payments (as 
defined in paragraph (b)(4)(i) of this section) are subject to the 
rules in paragraph (c)(3) of this section, and the nonquotable 
contingent payments (as defined in paragraph (b)(4)(ii) of this 
section) are accounted for separately under the rules in paragraph 
(c)(4) of this section.
    (3) Treatment of noncontingent and quotable contingent payments. 
The noncontingent payments and any quotable contingent payments are 
treated as a separate debt instrument. The issue price of the separate 
debt instrument is the issue price of the overall debt instrument, 
determined under Sec. 1.1274-2. No interest payments on the separate 
debt instrument are qualified stated interest payments (within the 
meaning of Sec. 1.1273-1(c)) and the de minimis rules of section 
1273(a)(3) and Sec. 1.1273-1(d) do not apply to the separate debt 
instrument. If the separate debt instrument provides for a quotable 
contingent payment, the rules of paragraph (b) of this section apply to 
the instrument, notwithstanding paragraph (b)(1) of this section.
    (4) Treatment of nonquotable contingent payments--(i) In general. 
Except as provided in paragraph (c)(4)(iii) of this section, the 
portion of a nonquotable contingent payment treated as interest under 
paragraph (c)(4)(ii)(B) of this section is includible in gross income 
by the holder and deductible from gross income by the issuer in their 
respective taxable years in which the amount of the payment becomes 
fixed.
    (ii) Recharacterization of certain nonquotable contingent 
payments--(A) Amount treated as principal. In general, a nonquotable 
contingent payment is treated as a payment of principal in an amount 
equal to the present value of the payment, determined by discounting 
the payment at the test rate from the date that the amount of the 
payment becomes fixed to the issue date. However, a nonquotable 
contingent payment accompanied by a payment of adequate stated interest 
is treated entirely as a payment of principal.
    (B) Amount treated as interest. If the total amount of a 
nonquotable contingent payment exceeds the amount of the payment 
treated as principal under paragraph (c)(4)(ii)(A) of this section, the 
excess is treated as a payment of interest.
    (C) Test rate. The test rate used for purposes of paragraph 
(c)(4)(ii)(A) of this section is the rate that would be the test rate 
for the overall debt instrument under Sec. 1.1274-4 if the term of the 
overall debt instrument began on the issue date of the overall debt 
instrument and ended on the date the contingent payment is fixed.
    (iii) Certain delayed contingent payments--(A) Deemed issuance of 
separate debt instrument. If a nonquotable contingent payment becomes 
fixed more than 6 months before the payment is due, the issuer and 
holder are treated as if the issuer had issued a separate debt 
instrument on the date the amount of the payment becomes fixed, 
maturing on the date that the payment is due. This separate debt 
instrument is treated as a debt instrument to which section 1274 
applies. The stated principal amount of this separate debt instrument 
is the amount of the payment that becomes fixed. An amount equal to the 
issue price of this debt instrument is characterized as interest or 
principal under the rules of paragraph (c)(4)(ii) of this section and 
accounted for under paragraph (c)(4)(i) of this section, as if this 
amount had been paid by the issuer to the holder on the date that the 
amount of the payment becomes fixed. To determine the issue price of 
the separate debt instrument, all payments under the separate debt 
instrument are discounted at the test rate from the maturity date of 
the separate debt instrument to the date that the amount of the payment 
becomes fixed. The amount of a contingent payment is treated as fixed 
even if, once fixed, the payment is payable in the future together with 
interest that is subject to further contingencies.
    (B) Test rate. In applying section 1274 to a separate debt 
instrument described in paragraph (c)(4)(iii)(A) of this section, the 
test rate for the separate debt instrument is the rate that would be 
the test rate for the overall debt instrument under Sec. 1.1274-4 if 
the term of the overall debt instrument began on the issue date of the 
overall debt instrument and ended on the date the contingent payment is 
due.
    (5) Gain on sale, exchange, or retirement. Any gain recognized by a 
holder on the sale, exchange, or retirement of a debt instrument 
subject to paragraph (c) of this section is interest income. The 
preceding sentence does not apply, however, if, at the time of the 
sale, exchange, or retirement, there are no remaining contingent 
payments on the debt instrument. For purposes of the preceding 
sentence, if a contingent payment becomes fixed more than 6 months 
before it is due, it is no longer treated as a contingent payment after 
the date it is fixed.
    (6) Examples. The following examples illustrate the provisions of 
paragraph (c) of this section. In each example, assume that the 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the debt 
instrument constitutes a debt instrument for federal income tax 
purposes.

    Example 1. Nonquotable contingent interest payments--(i) Facts. 
A owns Blackacre, unencumbered depreciable real estate. On January 
1, 1996, A sells Blackacre to B. As consideration for the sale, B 
makes a downpayment of $1,000,000 and issues to A a debt instrument 
that matures on December 31, 2000. The debt instrument provides for 
a payment of principal at maturity of $5,000,000 and a contingent 
payment of interest on December 31 of each year equal to a fixed 
percentage of the gross rents B receives from Blackacre in that 
year. Assume that the contingent interest payments are nonquotable 
contingent payments and that the debt instrument is not issued in a 
potentially abusive situation. Assume also that on January 1, 1996, 
the short-term applicable Federal rate is 5 percent, compounded 
annually, and the mid-term applicable Federal rate is 6 percent, 
compounded annually.
    (ii) Determination of issue price. Under Sec. 1.1274-2(g), the 
stated principal amount of the debt instrument is $5,000,000. The 
imputed principal amount of the debt instrument is $3,736,291, which 
is the present value, as of the issue date, of the $5,000,000 
noncontingent payment due at maturity, calculated using a discount 
rate equal to the mid-term applicable Federal rate. Therefore, under 
Sec. 1.1274-2(c), the issue price of the debt instrument is 
$3,736,291. Under Sec. 1.1012-1(g), B's basis in Blackacre on 
January 1, 1996, is $4,736,291 ($1,000,000 down payment plus the 
$3,736,291 issue price of the debt instrument).
    (iii) Noncontingent payment treated as separate debt instrument. 
Under paragraph (c)(3) of this section, the right to the 
noncontingent payment of principal at maturity is treated as a 
separate debt instrument. The issue price of this separate debt 
instrument is $3,736,291 (the issue price of the overall debt 
instrument). The separate debt instrument has a stated redemption 
price at maturity of $5,000,000 and, therefore, OID of $1,263,709.
    (iv) Treatment of contingent payments. Assume that the amount of 
contingent interest that is fixed and payable on December 31, 1996, 
is $200,000. Under paragraph (c)(4)(ii)(A) of this section, this 
payment is treated as consisting of a payment of principal of 
$190,476, which is the present value of the payment, determined by 
discounting the payment at the test rate of 5 percent, compounded 
annually, from the date the payment becomes fixed to the issue date. 
Under paragraph (c)(4)(ii)(B) of this section, the remainder of the 
$200,000 payment, $9,524, is treated as interest. The additional 
amount treated as principal gives B additional basis in Blackacre on 
December 31, 1996. The portion of the payment treated as interest is 
includible in gross income by A and deductible by B in their 
respective taxable years in which December 31, 1996 occurs. The 
remaining contingent payments on the debt instrument are accounted 
for similarly, using a test rate of 5 percent, compounded annually, 
for the contingent payments due on December 31, 1997, and December 
31, 1998, and a test rate of 6 percent, compounded annually, for the 
contingent payments due on December 31, 1999, and December 31, 2000.
    Example 2. Fixed but deferred payment--(i) Facts. The facts are 
the same as in Example 1 of this paragraph (c)(6), except that the 
contingent payment of interest that is fixed on December 31, 1996, 
is not payable until December 31, 2000, the maturity date.
    (ii) Determination of issue price. The determination of the 
issue price of the debt instrument, and B's initial basis in 
Blackacre, is made in a manner the same as that described in 
paragraph (ii) of Example 1 of this paragraph (c)(6). Accordingly, 
the issue price of the debt instrument is $3,736,291.
    (iii) Treatment of noncontingent payment. The right to the 
noncontingent payment of principal is treated as a separate debt 
instrument in a manner the same as that described in paragraph (iii) 
of Example 1 of this paragraph (c)(6).
    (iv) Treatment of contingent payments. Assume that the amount of 
the payment that becomes fixed on December 31, 1996, is $200,000. 
Because this amount is not payable until December 31, 2000 (the 
maturity date), under paragraph (c)(4)(iii) of this section, a 
separate debt instrument to which section 1274 applies is treated as 
issued by B on December 31, 1996 (the date the payment is fixed). 
The maturity date of this separate debt instrument is December 31, 
2000 (the date on which the payment is due). The stated principal 
amount of this separate debt instrument is $200,000, the amount of 
the payment that becomes fixed. The imputed principal amount of the 
separate debt instrument is $158,419, which is the present value, as 
of December 31, 1996, of the $200,000 payment, computed using a 
discount rate equal to the test rate of the overall debt instrument 
(6 percent, compounded annually). An amount equal to the issue price 
of the separate debt instrument is treated as an amount paid on 
December 31, 1996, and characterized as interest and principal under 
the rules of paragraph (c)(4)(ii) of this section. The amount of the 
deemed payment characterized as principal is equal to $150,875, 
which is the present value, as of January 1, 1996 (the issue date of 
the overall debt instrument) of the deemed payment, computed using a 
discount rate of 5 percent, compounded annually. The amount of the 
deemed payment characterized as interest is $7,544 
($158,419-$150,875) which is includible in gross income by A and 
deductible by B in their respective taxable years in which December 
31, 1996 occurs. The contingent payments made on December 31, 1997, 
December 31, 1998, December 31, 1999, and December 31, 2000, are 
treated in a manner the same as that described in paragraph (iv) of 
Example 1 of this paragraph (c)(6).

    (d) Rules for tax-exempt obligations--(1) Applicability. This 
paragraph (d) provides rules for tax-exempt obligations (as defined in 
section 1275(a)(3)) subject to this section.
    (2) Noncontingent bond method generally applicable--(i) In general. 
Except as modified by this paragraph (d), the rules of paragraph (b) of 
this section apply to tax-exempt obligations.
    (ii) Daily portions. The daily portions of interest determined 
under paragraph (b)(3)(iii) of this section are not included in gross 
income by the holder.
    (iii) Modification to projected payment schedule. The yield on a 
tax-exempt obligation may not exceed the greater of the yield on the 
obligation determined without regard to the contingent payments, and 
the tax-exempt applicable Federal rate, as determined for purposes of 
section 1288(b)(1), that applies to the obligation. If the projected 
yield determined under paragraph (b)(2)(ii) of this section exceeds the 
yield determined under the preceding sentence, appropriate adjustments 
must be made to the projected payment schedule to create a projected 
yield that meets this requirement.
    (iv) Positive adjustments. Positive adjustments on a tax-exempt 
obligation are taken into account under this paragraph (d)(2)(iv) 
rather than under paragraph (b)(6) of this section. A positive 
adjustment on a tax-exempt obligation is treated as taxable gain to the 
holder from the sale or exchange of the obligation in the taxable year 
of the adjustment.
    (v) Negative adjustments. Negative adjustments on a tax-exempt 
obligation are taken into account under this paragraph (d)(2)(v) rather 
than under paragraph (b)(6) of this section.
    (A) Reduction of interest accruals. Total negative adjustments for 
a taxable year first reduce the tax-exempt interest the holder would 
otherwise account for on the tax-exempt obligation for the taxable year 
under paragraph (b)(3)(iii) of this section.
    (B) Reduction of other tax-exempt interest for taxable year. If the 
total negative adjustments on the tax-exempt obligation for a taxable 
year exceed the tax-exempt interest for the taxable year that the 
holder would otherwise account for on the tax-exempt obligation under 
paragraph (b)(3)(iii) of this section, the excess is treated as a 
reduction of the holder's other tax-exempt interest income for the 
taxable year. However, the amount treated as a reduction is limited to 
the amount by which the total tax-exempt interest the holder accounted 
for on the tax-exempt obligation in prior taxable years exceeds the 
amount of the holder's total negative adjustments on the tax-exempt 
obligation that reduced other tax-exempt interest under this paragraph 
(d)(2)(v)(B) in prior taxable years.
    (C) Carryforward of negative adjustment. If the total negative 
adjustments on the tax-exempt obligation for a taxable year exceed the 
sum of the amounts treated as a reduction of tax-exempt interest under 
paragraphs (d)(2)(v)(A) and (B) of this section, the excess is a 
negative adjustment carryforward for the taxable year.
    (1) In general. Except as provided in paragraph (d)(2)(v)(C)(2) of 
this section, a negative adjustment carryforward on a tax-exempt 
obligation for a taxable year is treated as a negative adjustment on 
the tax-exempt obligation on the first day of the succeeding taxable 
year.
    (2) In year of sale, exchange, or retirement. Any negative 
adjustment carryforward on a tax-exempt obligation for a taxable year 
in which the debt instrument is sold, exchanged, or retired reduces the 
amount realized by the holder on the sale, exchange, or retirement.
    (vi) Gains. Notwithstanding paragraph (b)(8) of this section, any 
gain recognized on the sale, exchange, or retirement of a tax-exempt 
obligation is gain from the sale or exchange of the obligation.
    (vii) Losses--(A) Reduction of tax-exempt interest income. 
Notwithstanding paragraph (b)(8) of this section, any loss recognized 
on the sale, exchange, or retirement of a tax-exempt obligation is 
treated as a reduction of the holder's tax-exempt interest income for 
the taxable year of the sale, exchange, or retirement. However, the 
amount treated as a reduction of tax- exempt interest income by the 
holder is limited to the amount by which the holder's total tax-exempt 
interest on the obligation exceeds the holder's total negative 
adjustments on the obligation that were treated as reductions of tax-
exempt interest income under paragraph (d)(2)(v)(B) of this section. If 
the amount that would reduce tax-exempt interest income measured under 
the preceding sentence exceeds the holder's total tax-exempt interest 
income for the taxable year, the excess is carried forward to reduce 
the holder's tax-exempt interest income in subsequent taxable years.
    (B) Treatment of excess losses. If the loss recognized by a holder 
on the sale, exchange, or retirement of a tax-exempt obligation exceeds 
the amount measured under paragraph (d)(2)(vii)(A) of this section, the 
excess is treated as loss from the sale or exchange of the tax-exempt 
obligation.
    (e) Timing of income and deductions from notional principal 
contracts. For the rules governing the timing of income and deductions 
with respect to notional principal contracts characterized as including 
a loan, see Sec. 1.446-3.
    (f) Effective date. This section is effective for debt instruments 
issued on or after the date that is 60 days after final regulations are 
published in the Federal Register.
    Par. 8. Section 1.1275-5 is amended by:
    1. Revising paragraph (a)(1).
    2. Adding the word ``only'' immediately following the parenthetical 
in the introductory language of paragraph (a)(3)(i).
    3. Removing the language ``less than 1 year'' in the first sentence 
of paragraph (a)(3)(ii) and adding the language ``1 year or less'' in 
its place.
    4. Adding paragraph (a)(5).
    5. Revising paragraph (c)(1).
    6. Revising the text of paragraph (d) preceding the examples, 
revising Examples 4 through 6, and adding Example 10.
    7. Revising paragraph (e)(2).
    8. Revising the text of paragraph (e)(3)(v) preceding the examples 
and revising Example 3.
    The revisions and additions 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. A variable rate debt instrument is a 
debt instrument that meets the conditions described in paragraphs (a) 
(2), (3), (4), and (5) of this section. If a debt instrument that 
provides for a variable rate of interest does not qualify as a variable 
rate debt instrument, the debt instrument is a contingent payment debt 
instrument. See Sec. 1.1275-4 for the treatment of a contingent payment 
debt instrument. If a taxpayer holds (or issues) a variable rate debt 
instrument that the taxpayer hedges, see Sec. 1.1275-6 for the 
treatment of the debt instrument and the hedge by the taxpayer.
* * * * *
    (5) No contingent principal payments. The debt instrument must not 
provide for any principal payments that are contingent (within the 
meaning of Sec. 1.1275-4(a)).
* * * * *
    (c) Objective rate--(1) In general--(i) Debt instruments issued on 
or after the date that is 60 days after final regulations are published 
in the Federal Register--(A) In general. Except as provided in 
paragraph (c)(1)(i)(B) of this section, for debt instruments issued on 
or after the date that is 60 days after final regulations are published 
in the Federal Register, an objective rate is a rate (other than a 
qualified floating rate) that is determined using a single fixed 
formula and that is based on objective financial or economic 
information. For example, an objective rate generally includes a rate 
that is based on one or more qualified floating rates or on the yield 
of actively traded personal property (within the meaning of section 
1092(d)(1)).
    (B) Exception. For purposes of paragraph (c)(1)(i)(A) of this 
section, an objective rate does not include a rate based on information 
that is within the control of the issuer (or a related party within the 
meaning of section 267(b) or 707(b)(1)) or that is unique to the 
circumstances of the issuer (or a related party within the meaning of 
section 267(b) or 707(b)(1)), such as dividends, profits, or the value 
of the issuer's stock. However, a rate does not fail to be an objective 
rate merely because it is based on the credit quality of the issuer.
    (ii) Debt instruments issued after April 3, 1994, and before the 
date that is 60 days after final regulations are published in the 
Federal Register. For debt instruments issued after April 3, 1994, and 
before the date that is 60 days after final regulations are published 
in the Federal Register, 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--
    (A) One or more qualified floating rates;
    (B) 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;
    (C) 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
    (D) A combination of rates described in paragraphs (c)(1)(ii)(A), 
(B), and (C) of this section.
* * * * *
    (d) Examples. The following examples illustrate the rules of 
paragraphs (b) and (c) of this section. For purposes of these examples, 
assume that the debt instrument is not a tax-exempt obligation. In 
addition, unless otherwise provided, assume that the rate is not 
reasonably expected to result in a significant front-loading or back-
loading of interest and that the rate is not based on objective 
financial or economic information that is within the control of the 
issuer (or a related party) or that is unique to the circumstances of 
the issuer (or a related party).
* * * * *
    Example 4. Rate based on changes in the value of a commodity 
index. X issues a debt instrument that provides for annual interest 
payments at the end of each year at a rate equal to the percentage 
increase, if any, in the value of an index for the year immediately 
preceding the payment. The index is based on the prices of several 
actively traded commodities. Variations in the value of this 
interest rate cannot reasonably be expected to measure 
contemporaneous variations in the cost of newly borrowed funds. 
Accordingly, the rate is not a qualified floating rate. However, 
because the rate is based on objective financial information, 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. Although the rate would be an objective 
rate under paragraph (c)(1)(i) of this section, the rate is not an 
objective rate because it is reasonably expected that the average 
value of the rate during the first half of the instrument's term 
will be significantly less than the average value of the rate during 
the final half of the instrument's term.
    Example 6. Rate based on issuer's profits. 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 
based on objective financial information that is unique to the 
issuer's circumstances, the rate is not an objective rate.
* * * * *
    Example 10. Rate based on an inflation index. On January 1, 
1996, X issues a debt instrument that provides for annual interest 
payments at the end of each year at a rate equal to 400 basis points 
(4 percent) plus the annual percentage change in a general inflation 
index (e.g., the Consumer Price Index, U.S. City Average, All Items, 
for all Urban Consumers, seasonally unadjusted). Variations in the 
value of this interest rate cannot reasonably be expected to measure 
contemporaneous variations in the cost of newly borrowed funds. 
Accordingly, the rate is not a qualified floating rate. However, 
because the rate is based on objective economic information, the 
rate is an objective rate.

    (e) ***
    (2) Variable rate debt instrument that provides for annual payments 
of interest at a single variable rate. If a variable rate debt 
instrument provides for stated interest at a single qualified floating 
rate 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;
    (ii) The amount of qualified stated interest and the amount of OID, 
if any, that accrues during an accrual period is determined under the 
rules applicable to fixed rate debt instruments by assuming that the 
variable rate is a fixed rate equal to--
    (A) In the case of a qualified floating rate or qualified inverse 
floating rate, the value, as of the issue date, of the qualified 
floating rate or qualified inverse floating rate; or
    (B) In the case of an objective rate (other than a qualified 
inverse floating rate), a fixed rate that reflects the yield that is 
reasonably expected for the debt instrument; and
    (iii) Qualified stated interest allocable to an accrual period is 
increased (or decreased) if the interest actually paid during an 
accrual period exceeds (or is less than) the interest assumed to be 
paid during the accrual period under paragraph (e)(2)(ii) of this 
section.
    (3) ***
    (v) Examples. The following examples illustrate the rules in 
paragraphs (e) (2) and (3) of this section.
* * * * *
    Example 3. 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) Accrual of OID and qualified stated interest. Under 
paragraph (e)(2) of this section, the variable rate debt instrument 
is treated as a 2-year debt instrument that has an issue price of 
$90,000, a stated principal amount of $100,000, and interest 
payments of $5,000 at the end of each year. The debt instrument has 
$10,000 of OID and the annual interest payments of $5,000 are 
qualified stated interest payments. Under Sec. 1.1272-1, the debt 
instrument has a yield of 10.82 percent, compounded annually. The 
amount of OID allocable to the first annual accrual period (assuming 
Z uses annual accrual periods) is $4,743.25 
(($90,000 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)(2)(iii) of this section, the $2,000 difference 
between the $7,000 interest payment actually made at maturity and 
the $5,000 interest payment assumed to be made at maturity under the 
equivalent fixed rate debt instrument is treated as additional 
qualified stated interest for the period.
* * * * *
    Par. 9. Section 1.1275-6 is added to read as follows:


Sec. 1.1275-6  Integration of qualifying debt instruments.

    (a) In general. This section generally provides for the integration 
of a qualifying debt instrument with a hedge or combination of hedges 
if the combined cash flows of the components are substantially 
equivalent to the cash flows on a fixed or variable rate debt 
instrument. The integrated transaction is generally subject to the 
rules of this section rather than the rules each component of the 
transaction would be subject to on a separate basis. The purpose of 
this section is to permit a more appropriate determination of the 
character and timing of income, deductions, gains, or losses than would 
be permitted by a separate accounting for the components. The rules of 
this section must be interpreted consistently with this purpose. The 
rules of this section affect only the taxpayer who holds (or issues) 
the qualifying debt instrument and enters into the hedge.
    (b) Definitions--(1) Qualifying debt instrument--(i) In general. A 
qualifying debt instrument is a debt instrument subject to either 
Sec. 1.1275-4 (relating to contingent payment debt instruments) or 
Sec. 1.1275-5 (relating to variable rate debt instruments), or is an 
integrated transaction as defined in paragraph (c) of this section. 
However, a tax-exempt obligation, as defined in section 1275(a)(3), is 
not a qualifying debt instrument.
    (ii) Special rule if all payments on a debt instrument are 
proportionally hedged. If a debt instrument is a qualifying debt 
instrument and all principal and interest payments under the instrument 
are hedged in the same proportion, then, for purposes of this section, 
the portion of the instrument that is hedged is treated as a qualifying 
debt instrument.
    (2) Section 1.1275-6 hedge--(i) In general. A Sec. 1.1275-6 hedge 
is any financial instrument (as defined in paragraph (b)(3) of this 
section) such that the combined cash flows of the financial instrument 
and the qualifying debt instrument permit the calculation of a yield to 
maturity (under the principles of section 1272), or the right to the 
combined cash flows would qualify as a variable rate debt instrument 
under Sec. 1.1275-5 that pays interest at a qualified floating rate or 
rates (except for the requirement that the interest payments be stated 
as interest). A financial instrument that hedges currency risk, 
however, is not a Sec. 1.1275-6 hedge.
    (ii) Limitation. A taxpayer cannot treat a debt instrument it 
issues as a Sec. 1.1275-6 hedge of a debt instrument it holds and a 
taxpayer cannot treat a debt instrument it holds as a Sec. 1.1275-6 
hedge of a debt instrument it issues.
    (3) Financial instrument. For purposes of this section, a financial 
instrument is a spot, forward, or futures contract, an option, a 
notional principal contract, a debt instrument, or a similar 
instrument, or combination or series of financial instruments. Stock, 
however, is not a financial instrument for purposes of this section.
    (4) Synthetic debt instrument. The synthetic debt instrument is the 
hypothetical debt instrument with the same cash flows as the combined 
cash flows of the qualifying debt instrument and the Sec. 1.1275-6 
hedge.
    (c) Integrated transaction--(1) Integration by taxpayer. Except as 
otherwise provided in this section, a qualifying debt instrument and a 
Sec. 1.1275-6 hedge are an integrated transaction if all of the 
following requirements are satisfied--
    (i) The taxpayer satisfies the identification requirements of 
paragraph (f) of this section on or before the date the taxpayer enters 
into the Sec. 1.1275-6 hedge.
    (ii) None of the parties to the Sec. 1.1275-6 hedge are related 
within the meaning of section 267(b) or 707(b)(1) (other than parties 
that have made a separate-entity election under Sec. 1.1221-2(d)).
    (iii) Both the qualifying debt instrument and the Sec. 1.1275-6 
hedge are entered into by the same individual, partnership, trust, 
estate, or corporation (regardless of whether the corporation is a 
member of an affiliated group of corporations that files a consolidated 
return).
    (iv) With respect to a foreign person engaged in a U.S. trade or 
business that issues or acquires a qualifying debt instrument or enters 
into a Sec. 1.1275-6 hedge through the trade or business, all items of 
income and expense associated with the qualifying debt instrument and 
the Sec. 1.1275-6 hedge (other than interest expense that is subject to 
Sec. 1.882-5) would have been effectively connected with the U.S. trade 
or business throughout the term of the synthetic debt instrument had 
this section not applied.
    (v) The qualifying debt instrument, any other debt instrument that 
is part of the same issue as the qualifying debt instrument, or the 
Sec. 1.1275-6 hedge cannot have been part of an integrated transaction 
entered into by the taxpayer that has been terminated under the legging 
out rules of paragraph (d)(2) of this section.
    (vi) The Sec. 1.1275-6 hedge is entered into on or after the date 
the qualifying debt instrument is issued or acquired.
    (2) Integration by Commissioner. The Commissioner may treat a 
qualifying debt instrument and a financial instrument (whether entered 
into by the taxpayer or by a related party) as an integrated 
transaction if the combined cash flows on the qualifying debt 
instrument and financial instrument are substantially the same as the 
combined cash flows required for the financial instrument to be a 
Sec. 1.1275-6 hedge. The circumstances under which the Commissioner may 
require integration include, but are not limited to, the following:
    (i) A taxpayer fails to identify a qualifying debt instrument and 
the Sec. 1.1275-6 hedge under paragraph (f) of this section.
    (ii) A taxpayer issues or acquires a qualifying debt instrument and 
a related party (within the meaning of section 267(b) or 707(b)(1)) 
enters into the Sec. 1.1275-6 hedge.
    (iii) A taxpayer issues or acquires a qualifying debt instrument 
and enters into the Sec. 1.1275-6 hedge with a related party (within 
the meaning of section 267(b) or 707(b)(1)).
    (iv) The taxpayer legs out of an integrated transaction and 
subsequently enters into a new Sec. 1.1275-6 hedge with respect to the 
same qualifying debt instrument or other debt instrument that is part 
of the same issue.
    (d) Special rules for legging into and legging out of an integrated 
transaction--(1) Legging into--(i) Definition. Legging into an 
integrated transaction under this section means that a Sec. 1.1275-6 
hedge is entered into after the date the qualifying debt instrument is 
issued by the taxpayer or acquired by the taxpayer, and the 
requirements of paragraph (c)(1) of this section are satisfied on the 
date the Sec. 1.1275-6 hedge is entered into (the leg-in date).
    (ii) Treatment. If a taxpayer legs into an integrated transaction, 
the taxpayer treats the qualifying debt instrument under the applicable 
rules for accruing interest and OID up to the leg-in date, except that 
the day before the leg-in date is treated as the end of an accrual 
period. As of the leg-in date, the qualifying debt instrument is 
subject to the rules of paragraph (g) of this section.
    (iii) Anti-abuse rule. If a taxpayer legs into an integrated 
transaction with a principal purpose of deferring or accelerating 
income or deductions on the qualifying debt instrument, the 
Commissioner may--
    (A) Treat the qualifying debt instrument as sold for its fair 
market value on the leg-in date; or
    (B) Refuse to allow the taxpayer to integrate the qualifying debt 
instrument and the Sec. 1.1275-6 hedge.
    (2) Legging out--(i) Definition--(A) Legging out if the taxpayer 
has integrated. If a taxpayer has integrated a qualifying debt 
instrument and a Sec. 1.1275-6 hedge under paragraph (c)(1) of this 
section, legging out means that, prior to the maturity of the synthetic 
debt instrument, the taxpayer disposes of or otherwise terminates all 
or a part of the qualifying debt instrument or Sec. 1.1275-6 hedge, the 
Sec. 1.1275-6 hedge ceases to meet the requirements for a Sec. 1.1275-6 
hedge, or the taxpayer fails to meet any requirement of paragraph 
(c)(1) of this section. If the taxpayer fails to meet the requirements 
of paragraph (c)(1) of this section but meets the requirements of 
paragraph (c)(2) of this section, the Commissioner may treat the 
taxpayer as not legging out. A taxpayer that disposes of or terminates 
both the qualifying debt instrument and the Sec. 1.1275-6 hedge on the 
same day is considered to have disposed of or otherwise terminated the 
synthetic debt instrument rather than to have legged out.
    (B) Legging out if the Commissioner has integrated. If the 
Commissioner has integrated a qualifying debt instrument and a 
financial instrument under paragraph (c)(2) of this section, legging 
out means that, prior to the maturity of the synthetic debt instrument, 
the requirements for Commissioner integration under paragraph (c)(2) of 
this section are not met or the taxpayer fails to meet the requirements 
for taxpayer integration under paragraph (c)(1) of this section and the 
Commissioner agrees to allow the taxpayer to be treated as legging out. 
A taxpayer that disposes of or terminates both the qualifying debt 
instrument and the financial instrument on the same day is considered 
to have disposed of or otherwise terminated the synthetic debt 
instrument rather than to have legged out.
    (ii) Operating rules. If a taxpayer legs out (or is treated as 
legging out) of an integrated transaction, the following rules apply--
    (A) The transaction is treated as an integrated transaction during 
the time the requirements of paragraph (c)(1) or (2) of this section, 
as appropriate, are satisfied.
    (B) If the Sec. 1.1275-6 hedge is disposed of or otherwise 
terminated, the synthetic debt instrument is treated as sold or 
otherwise terminated for its fair market value on the leg-out date and, 
except as provided in paragraph (d)(2)(ii)(D) of this section, any 
income, deduction, gain, or loss is realized and recognized on the leg-
out date. Appropriate adjustments are made as of the leg-out date to 
reflect any difference between the fair market value of the qualifying 
debt instrument and the adjusted issue price of the qualifying debt 
instrument. For example, if a qualifying debt instrument is subject to 
Sec. 1.1275-4, a holder must use the principles of Sec. 1.1275-
4(b)(9)(i) to compute interest accruals on the instrument after the 
leg-out date.
    (C) If the qualifying debt instrument is disposed of or otherwise 
terminated, the synthetic debt instrument is treated as sold for its 
fair market value on the leg-out date and the Sec. 1.1275-6 hedge is 
treated as entered into at its fair market value immediately after the 
taxpayer legs out.
    (D) If a taxpayer legs out of an integrated transaction by 
disposing of or otherwise terminating a Sec. 1.1275-6 hedge within 30 
days of legging into the integrated transaction, then any loss or 
deduction determined under paragraph (d)(2)(ii)(B) of this section is 
not allowed. Appropriate adjustments are made to the qualifying debt 
instrument to take into account any disallowed loss.
    (e) Transactions part of a straddle. At the discretion of the 
Commissioner, a transaction may not be integrated under paragraph 
(c)(1) of this section if, prior to the time the integrated transaction 
is identified, the qualifying debt instrument is part of a straddle as 
defined in section 1092(c).
    (f) Identification requirements--(1) Identification by taxpayer. 
For each integrated transaction, a taxpayer must enter and retain as 
part of its books and records the following information--
    (i) The date the qualifying debt instrument was issued or acquired 
by the taxpayer and the date the Sec. 1.1275-6 hedge was entered into 
by the taxpayer;
    (ii) A description of the qualifying debt instrument and the 
Sec. 1.1275-6 hedge; and
    (iii) A summary of the cash flows and accruals resulting from 
treating the qualifying debt instrument and the Sec. 1.1275-6 hedge as 
an integrated transaction (i.e., the cash flows and accruals on the 
synthetic debt instrument).
    (2) Identification by trustee on behalf of beneficiary. A trustee 
of a trust that enters into a synthetic debt instrument may satisfy the 
identification requirements described in paragraph (f)(1) of this 
section on behalf of a beneficiary of the trust.
    (g) Taxation of integrated transactions--(1) General rule. An 
integrated transaction is generally treated as a single transaction by 
the taxpayer during the period that the transaction qualifies as an 
integrated transaction. Except as provided in paragraph (g)(12) of this 
section, while a qualifying debt instrument and a Sec. 1.1275-6 hedge 
are part of an integrated transaction, neither the qualifying debt 
instrument nor the Sec. 1.1275-6 hedge is subject to the rules that 
would apply on a separate basis to the debt instrument and the 
Sec. 1.1275-6 hedge, including sections 263(g), 475, 1092, 1256, or 
1258, or Secs. 1.446- 3, 1.446-4, or 1.1221-2. The rules that would 
govern the treatment of the synthetic debt instrument generally govern 
the treatment of the integrated transaction. For example, the 
integrated transaction may be subject to section 263(g) or, if the 
synthetic debt instrument would be part of a straddle, section 1092. 
Generally, the synthetic debt instrument is subject to sections 163(e), 
1271 through 1275, and 1286 with terms as follows.
    (2) Issue date. The issue date of the synthetic debt instrument is 
the date the Sec. 1.1275-6 hedge is entered into by the taxpayer.
    (3) Term. The term of the synthetic debt instrument is the period 
beginning on the issue date of the synthetic debt instrument and ending 
on the maturity date of the qualifying debt instrument.
    (4) Issue price. The issue price of the synthetic debt instrument 
is the adjusted issue price of the qualifying debt instrument on the 
issue date of the synthetic debt instrument.
    (5) Adjusted issue price. In general, the adjusted issue price of 
the synthetic debt instrument is determined under the principles of 
Sec. 1.1275-1(c).
    (6) Qualified stated interest. Qualified stated interest payments 
on the synthetic debt instrument are payments that would be treated as 
qualified stated interest under the principles of Sec. 1.1273-1(c) if 
the payments were stated as interest.
    (7) Stated redemption price at maturity--(i) Synthetic debt 
instruments that are borrowings. If the synthetic debt instrument is a 
borrowing, the instrument's stated redemption price at maturity is the 
sum of all amounts paid or to be paid on the qualifying debt instrument 
and the Sec. 1.1275-6 hedge, reduced by any amounts received or to be 
received on the Sec. 1.1275-6 hedge and any amounts treated as 
qualified stated interest on the synthetic debt instrument under 
paragraph (g)(6) of this section.
    (ii) Synthetic debt instruments that are loans. If the synthetic 
debt instrument is a loan, the instrument's stated redemption price at 
maturity is the sum of all amounts received or to be received on the 
qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by any 
amounts paid or to be paid on the Sec. 1.1275-6 hedge and any amounts 
treated as qualified stated interest on the synthetic debt instrument 
under paragraph (g)(6) of this section.
    (8) Source of interest income and allocation of expense. The source 
of interest income from the synthetic debt instrument is determined by 
reference to the source of income of the qualifying debt instrument 
under sections 861(a)(1) and 862(a)(1). For purposes of section 904, 
the character of interest from the synthetic debt instrument is 
determined by reference to the character of the interest income from 
the qualifying debt instrument. Interest expense is allocated and 
apportioned under regulations under section 861 or under Sec. 1.882-5.
    (9) Effectively connected income. Interest income of a foreign 
person resulting from a synthetic debt instrument entered into by the 
foreign person that satisfies the requirements of paragraph (c)(1)(iv) 
of this section is treated as effectively connected with a U.S. trade 
or business. Interest expense of a foreign person resulting from an 
integrated transaction entered into by the foreign person that 
satisfies the requirements of paragraph (c)(1)(iv) of this section is 
allocated and apportioned under Sec. 1.882-5.
    (10) Not a short-term obligation. If the synthetic debt instrument 
has a term of one year or less, the synthetic debt instrument is not 
treated as a short-term obligation for purposes of section 
1272(a)(2)(C).
    (11) Special rules for integration by the Commissioner. If the 
Commissioner requires integration, appropriate adjustments are made to 
the treatment of the synthetic debt instrument, and, if necessary, the 
qualifying debt instrument and financial instrument. For example, the 
Commissioner may treat a financial instrument that is not a 
Sec. 1.1275-6 hedge as a Sec. 1.1275-6 hedge when applying the rules of 
this section. The issue date of the synthetic debt instrument is the 
date determined appropriate by the Commissioner to require integration.
    (12) Retention of separate transaction rules for certain purposes. 
This paragraph (g)(12) provides for the retention of separate 
transaction rules for certain purposes. In addition, the Commissioner 
may require use of separate transaction rules for any aspect of an 
integrated transaction by publication in the Internal Revenue Bulletin 
(see Sec. 601.601(d)(2)(ii) of this chapter).
    (i) Foreign persons that enter into integrated transactions giving 
rise to U.S. source income not effectively connected with a U.S. trade 
or business. If a foreign person enters into an integrated transaction 
that gives rise to U.S. source interest income (determined under the 
source rules for the synthetic debt instrument) not effectively 
connected with a U.S. trade or business of the foreign person, 
paragraph (g) of this section does not apply for purposes of sections 
871(a), 881, 1441, 1442, and 6049. These sections of the Internal 
Revenue Code are applied to the qualifying debt instrument and the 
Sec. 1.1275-6 hedge on a separate basis. For example, if a U.S. 
corporation issues a qualifying debt instrument and enters into a 
notional principal contract that is a Sec. 1.1275-6 hedge, the source 
of interest on the qualifying debt instrument is determined under 
section 861. In general, the interest constitutes U.S. source interest 
that is subject to withholding tax to the extent provided in sections 
871, 881, 1441, and 1442. The source of payments on the notional 
principal contract is determined under Sec. 1.863-7 and, to the extent 
paid to a non-U.S. person who is not engaged in a U.S. trade or 
business, constitutes non-U.S. source income that is not subject to 
U.S. withholding tax.
    (ii) Relationship between issuer and holder. Because the rules of 
this section affect only the taxpayer holding or issuing the qualifying 
debt instrument (i.e., either the issuer or a particular holder), any 
provisions of the Internal Revenue Code or regulations that govern the 
relationship between the issuer and holder of the qualifying debt 
instrument are applied on a separate basis. For example, taxpayers must 
comply with any reporting or disclosure requirements on any qualifying 
debt instrument as if it were not part of an integrated transaction. 
Thus, if required under Sec. 1.1275-4(b)(4), an issuer of a contingent 
payment debt instrument subject to integrated treatment must provide 
the projected payment schedule to holders.
    (h) Examples. The following examples illustrate the provisions of 
this section. In each example, assume that the qualifying debt 
instrument is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the debt instrument 
constitutes a debt instrument for federal income tax purposes.

    Example 1. Issuer hedge--(i) Facts. On January 1, 1997, V, a 
domestic corporation, issues a 5-year debt instrument for $1,000. 
The debt instrument provides for annual payments of interest at a 
rate equal to the value of 1-year LIBOR and a principal payment of 
$1,000 at maturity. On the same day, V enters into a 5-year interest 
rate swap agreement with an unrelated party. Under the swap, V pays 
6 percent and receives 1-year LIBOR on a notional principal amount 
of $1,000. The payments on the swap are fixed and made on the same 
days as the payments on the debt instrument. Also on January 1, 
1997, V identifies the debt instrument and the swap as an integrated 
transaction in accordance with the requirements of paragraph (f) of 
this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument because it is a variable rate debt 
instrument. The swap is a Sec. 1.1275-6 hedge because it is a 
financial instrument and a yield to maturity on the combined cash 
flows of the swap and the debt instrument can be calculated. V has 
met the identification requirements, and the other requirements of 
paragraph (c)(1) of this section are satisfied. Therefore, the 
transaction is an integrated transaction under this section.
    (iii) Treatment of the synthetic debt instrument. The synthetic 
debt instrument is a 5-year debt instrument that has an issue price 
of $1,000 and provides for annual interest payments of $60 and a 
principal payment of $1,000 at maturity. Under paragraph (g)(6) of 
this section, the annual interest payments on the synthetic debt 
instrument are treated as qualified stated interest payments. Under 
paragraph (g)(7)(i) of this section, the synthetic debt instrument 
has a stated redemption price at maturity of $1,000 (the sum of all 
amounts to be paid on the qualifying debt instrument and the swap, 
reduced by amounts to be received on the swap and the annual 
interest payments on the synthetic debt instrument). Therefore, the 
synthetic debt instrument has no OID.
    Example 2. Issuer hedge with an option--(i) Facts. On January 1, 
1996, W corporation issues for $1,000 a debt instrument that matures 
on December 31, 1998. The debt instrument has a stated principal 
amount of $1,000 payable at maturity. The debt instrument also 
provides for a payment at maturity equal to $10 times the increase, 
if any, in the value of a nationally known composite index of stocks 
from January 1, 1996, to the maturity date. On January 1, 1996, W 
also purchases from an unrelated party an option that pays $10 times 
the increase, if any, in the stock index from January 1, 1996, to 
December 31, 1998. W pays $250 for the option. W identifies the debt 
instrument and option as an integrated transaction in accordance 
with the requirements of paragraph (f) of this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument because it is a contingent payment debt 
instrument. The option is a Sec. 1.1275-6 hedge because it is a 
financial instrument and a yield to maturity on the combined cash 
flows of the option and the debt instrument can be calculated. W has 
met the identification requirements, and the other requirements of 
paragraph (c)(1) of this section are satisfied. Therefore, the 
transaction is an integrated transaction under this section.
    (iii) Treatment of the synthetic debt instrument. The synthetic 
debt instrument is a 3-year debt instrument with an issue price of 
$1,000 that provides for a payment immediately after issuance of 
$250 and a payment of $1,000 at maturity. The synthetic debt 
instrument has a stated redemption price at maturity of $1,250 and, 
therefore, has OID of $250. The $250 payment reduces the adjusted 
issue price of the synthetic debt instrument to $750 immediately 
after it is issued. Therefore, the OID allocable to the first 
accrual period is based on the $750 adjusted issue price. See 
Sec. 1.1272-1(b).
    Example 3. Hedge with prepaid swap--(i) Facts. On January 1, 
1996, H purchases for 1,000 a 5-year debt instrument 
that provides for semiannual payments based on 6-month pound LIBOR 
and a payment of the 1,000 principal at maturity. On the 
same day, H enters into a swap with an unrelated third party under 
which H receives 10 percent, in pounds, semiannually and pays 6-
month pound LIBOR semiannually on a notional principal amount of 
1,000. Payments on the swap are fixed and made on the 
same date that H receives payments on the debt instrument. H also 
makes a 162 prepayment on the swap. H identifies the 
swap and the debt instrument as an integrated transaction under 
paragraph (f) of this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument because it is a variable rate debt 
instrument. The swap is a Sec. 1.1275-6 hedge because it is a 
financial instrument and a yield to maturity on the combined cash 
flows of the swap and the debt instrument can be calculated. 
Although the debt instrument is denominated in pounds, the swap 
hedges only interest rate risk, not currency risk. See Sec. 1.988-
5(a) for the treatment of a debt instrument and a swap if the swap 
hedges currency risk.
    (iii) Treatment of the synthetic debt instrument. The synthetic 
debt instrument is a 5-year debt instrument that has an issue price 
of 1,000 and provides for semiannual interest payments 
of 50 and a principal payment of 1,000 at 
maturity. Under paragraph (g)(6) of this section, the semiannual 
interest payments are treated as qualified stated interest payments. 
Under paragraph (g)(7)(ii) of this section, the synthetic debt 
instrument's stated redemption price at maturity is 838 
(the sum of all amounts to be received on the qualifying debt 
instrument and the Sec. 1.1275-6 hedge, reduced by all amounts to be 
paid on the Sec. 1.1275-6 hedge and the semiannual interest payments 
on the synthetic debt instrument). Because the issue price of the 
synthetic debt instrument exceeds the instrument's stated redemption 
price at maturity, the synthetic debt instrument does not have OID. 
The synthetic debt instrument, however, does have 162 of 
amortizable bond premium. The 162 prepayment on the 
Sec. 1.1275-6 hedge made by H on January 1, 1996, increases the 
adjusted issue price of the synthetic debt instrument to 
1,162 immediately after it is issued.
    Example 4. Legging into an integrated transaction by a holder--
(i) Facts. On January 1, 1996, X corporation purchases for 
$1,000,000 a debt instrument that matures on December 31, 2005. The 
debt instrument provides for annual payments of interest at the rate 
of 6 percent and for a payment at maturity equal to $1,000,000, 
increased by the excess, if any, of the price of 1,000 units of a 
commodity on December 31, 2005, over $350,000, and decreased by the 
excess, if any, of $350,000 over the price of 1,000 units of a 
commodity on that date. Assume that on the issue date the forward 
price of the commodity on December 31, 2005, is $370,000. The 
projected amount of the payment at maturity, determined under 
Sec. 1.1275-4(b)(4), therefore, is $1,020,000. On January 1, 1999, X 
enters into a cash settled forward contract with an unrelated party 
to sell 1,000 units of the commodity on December 31, 2005, for 
$450,000. Also on January 1, 1999, X identifies the transaction as 
an integrated transaction in accordance with the requirements of 
paragraph (f) of this section.
    (ii) Eligibility for integration. X meets the requirements for 
integration as of January 1, 1999. Therefore, X legged into an 
integrated transaction on that date. Prior to that date, X treats 
the debt instrument under the applicable rules of Sec. 1.1275-4.
    (iii) Treatment of the synthetic debt instrument. As of January 
1, 1999, the debt instrument and the forward contract are treated as 
an integrated transaction. The issue price of the synthetic debt 
instrument is equal to the adjusted issue price of the qualifying 
debt instrument on the leg-in date, $1,004,804 (assuming one year 
accrual periods). The term of the synthetic debt instrument is from 
January 1, 1999 to December 31, 2005. The synthetic debt instrument 
provides for annual interest payments of $60,000 and a principal 
payment at maturity of $1,100,000 ($1,000,000 + $450,000 - 
$350,000). Under paragraph (g)(6) of this section, the annual 
interest payments are treated as qualified stated interest payments. 
Under paragraph (g)(7)(ii) of this section, the synthetic debt 
instrument's stated redemption price at maturity is $1,100,000 (the 
sum of all amounts to be received on the qualifying debt instrument 
and the Sec. 1.1275-6 hedge, reduced by all amounts to be paid on 
the Sec. 1.1275-6 hedge and the annual interest payments on the 
synthetic debt instrument).
    Example 5. Abusive leg-in--(i) Facts. On January 1, 1996, Y 
corporation purchases for $1,000,000 a debt instrument that matures 
on December 31, 2000. The debt instrument provides for annual 
payments of interest at the rate of 6 percent, a payment on December 
31, 1998 of the increase, if any, in the price of a commodity from 
January 1, 1996 to December 31, 1998, and a payment at maturity of 
$1,000,000 and the increase, if any, in the price of the commodity 
from December 31, 1998 to maturity. Because the debt instrument is a 
contingent payment debt instrument subject to Sec. 1.1275-4, Y 
accrues interest based on the projected payment schedule.
    (ii) Leg-in. By December 1998, the price of the commodity has 
substantially increased and Y expects a positive adjustment on 
December 31, 1998. On December 20, 1998, Y enters into an agreement 
to exchange the two commodity based payments on the debt instrument 
for two payments on the same dates of $100,000 each. Y identifies 
the transaction as an integrated transaction in accordance with the 
requirements of paragraph (f) of this section. Y disposes of the 
hedge on January 15, 1999.
    (iii) Treatment. The legging into an integrated transaction has 
the effect of deferring the positive adjustment from 1998 to 1999. 
Because Y legged into the integrated transaction with a principal 
purpose to defer the positive adjustment, the Commissioner may treat 
the debt instrument as sold for its fair market value on the leg-in 
date, December 20, 1998, or refuse to allow integration.
    Example 6. Integration of offsetting debt instruments--(i) 
Facts. On January 1, 1996, Z issues two 10-year debt instruments. 
The first, Issue 1, has an issue price of $1,000, pays interest 
annually at 6 percent, and, at maturity, pays $1,000, increased by 
$1 times the increase, if any, in the value of the S&P 100 Index 
over the term of the instrument and reduced by $1 times the 
decrease, if any, in the value of the S&P 100 Index over the term of 
the instrument. However, the amount paid at maturity may not be less 
than $500 or more than $1,500. The second, Issue 2, has an issue 
price of $1,000, pays interest annually at 8 percent, and, at 
maturity, pays $1,000, reduced by $1 times the increase, if any, in 
the value of the S&P 100 Index over the term of the instrument and 
increased by $1 times the decrease, if any, in the value of the S&P 
100 Index over the term of the instrument. The amount paid at 
maturity may not be less than $500 or more than $1,500. As of 
January 1, 1996, Z identifies Issue 1 as the qualifying debt 
instrument, Issue 2 as a Sec. 1.1275-6 hedge, and otherwise meets 
the identification requirements of paragraph (f) of this section.
    (ii) Eligibility for integration. Both Issue 1 and Issue 2 are 
qualifying debt instruments. Z has met the identification 
requirements by identifying Issue 1 as the qualifying debt 
instrument and Issue 2 as the Sec. 1.1275-6 hedge. The other 
requirements of paragraph (c)(1) of this section are satisfied. 
Therefore, the transaction is an integrated transaction under this 
section.
    (iii) Treatment of the synthetic debt instrument. The synthetic 
debt instrument has an issue price of $1,000, provides for a payment 
at maturity of $2,000, and, in addition, provides for annual 
payments of $140, which are treated as qualified stated interest 
payments under paragraph (g)(6) of this section. The synthetic debt 
instrument has a stated redemption price at maturity of $1,000 
(equal to $2,000 to be paid on the qualifying debt instrument and 
Sec. 1.1275-6 hedge, reduced by the $1,000 received on the 
Sec. 1.1275-6 hedge). As a result, the synthetic debt instrument has 
no OID. The payment of $1,000 received by Z on the Sec. 1.1275-6 
hedge on January 1, 1996, increases the synthetic debt instrument's 
adjusted issue price to $2,000 immediately after it is issued.

    (i) [Reserved]
    (j) Effective date. This section is effective for qualifying 
debt instruments issued on or after the date that is 60 days after 
final regulations are published in the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 94-30728 Filed 12-15-94; 8:45 am]
BILLING CODE 4830-01-U