[Federal Register Volume 61, Number 116 (Friday, June 14, 1996)]
[Rules and Regulations]
[Pages 30133-30160]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-14918]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8674]
RIN 1545-AQ86; 1545-AS35


Debt Instruments With Original Issue Discount; Contingent 
Payments; Anti-Abuse Rule

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the tax 
treatment of debt instruments that provide for one or more contingent 
payments. This document also contains final regulations that treat a 
debt instrument and a related hedge as an integrated transaction. In 
addition, this document contains amendments to the original issue 
discount regulations, and finalizes the anti-abuse rule relating to 
those regulations. The final regulations in this document provide 
needed guidance to holders and issuers of contingent payment debt 
instruments.

DATES: Except as noted below, the regulations are effective August 13, 
1996. The amendments to Sec. 1.1275-5 are effective June 14, 1996, 
except for paragraphs (a)(6), (b)(2), and (c)(1), which are effective 
August 13, 1996. The removal of Sec. 1.483-2T is effective June 14, 
1996. The removal of Sec. 1.1275-2T is effective August 13, 1996.
    For dates of applicability of these regulations, see Effective 
Dates under Supplementary Information.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations (other than 
Sec. 1.1275-6), William E. Blanchard, (202) 622-3950, or Jeffrey W. 
Maddrey, (202) 622-3940; or concerning Sec. 1.1275-6, Michael S. Novey, 
(202) 622-3900 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

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

[[Page 30134]]

of any internal revenue law. Generally, tax returns and tax return 
information are confidential, as required by 26 U.S.C. 6103.

Background

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

Explanation of Provisions

Section 1.1275-4  Contingent Payment Debt Instruments

A. Noncontingent Bond Method
    Under the noncontingent bond method in the proposed regulations, a 
taxpayer computes interest accruals on a contingent payment debt 
instrument by setting a payment schedule as of the issue date and 
applying the OID rules to the payment schedule. The payment schedule 
consists of all fixed payments on the debt instrument and a projected 
amount for each contingent payment. For market-based contingencies 
(i.e., contingencies for which price quotes are readily available), the 
projected amount is the forward price of the contingency. For other 
contingencies, the issuer first determines a reasonable yield for the 
debt instrument and then sets projected amounts equal to the relative 
expected payments on the contingencies so that the payment schedule 
produces the reasonable yield. These rules were designed to produce a 
yield similar to the yield the issuer would obtain on a fixed rate debt 
instrument.
    Commentators suggested that the regulations could be simplified if 
they used the same basic methodology for both market-based and non-
market-based contingencies. In addition, commentators suggested that 
forward price quotes would be variable or manipulable and that 
taxpayers will set more appropriate payment schedules if they first 
determine yield and then set the payment schedule to fit the yield.
    The final regulations adopt these suggestions and generally conform 
the treatment of debt instruments that provide for either market-based 
or non-market-based contingent payments. Thus, for any contingent 
payment debt instrument subject to the noncontingent bond method, a 
taxpayer first determines the yield on the instrument and then sets the 
payment schedule to fit the yield. The yield is determined by the yield 
at which the issuer would issue a fixed rate debt instrument with terms 
and conditions similar to the contingent payment debt instrument (the 
comparable yield). Relevant terms and conditions include the level of 
subordination, term, timing of payments, and general market conditions. 
For example, if a hedge is available such that the issuer or holder 
could integrate the debt instrument and the hedge into a synthetic 
fixed-rate debt instrument under the rules of Sec. 1.1275-6, the 
comparable yield is the yield that the synthetic fixed-rate debt 
instrument would have. If a Sec. 1.1275-6 hedge (or the substantial 
equivalent) is not available, but similar fixed rate debt instruments 
of the issuer trade at a price that reflects a spread above a benchmark 
rate, the comparable yield is the sum of the value of the benchmark 
rate on the issue date and the spread. In all cases, the yield must be 
a reasonable yield for the issuer and may not be less than the 
applicable Federal rate (AFR).
    Once the comparable yield is determined, the payment schedule is 
set to produce the comparable yield. The final regulations retain the 
general approach of the proposed regulations in determining the payment 
schedule. Thus, for market-based payments, the projected payment is the 
forward price of the payment. For non-market-based payments, the 
projected payment is the expected amount of the payment as of the issue 
date.
    Commentators were concerned that a taxpayer could overstate the 
yield on a contingent payment debt instrument and, therefore, claim 
excess interest deductions during the term of the instrument. They were 
particularly concerned about a long-term debt instrument that has non-
market-based payments because the taxpayer's determination would be 
hard to verify and any excess interest deductions would not be 
recaptured for a long time.
    The final regulations address this concern by providing that the 
comparable yield for a debt instrument is presumed to be the AFR if the 
instrument provides for a non-market-based payment and is part of an 
issue that is marketed or sold in substantial part to tax-exempt 
investors or other investors for whom the treatment of the debt 
instrument is not expected to have a substantial effect on their U.S. 
tax liability. A taxpayer may overcome this presumption only with clear 
and convincing evidence that the comparable yield for the debt 
instrument should be a specific yield that is higher than the AFR. 
Appraisals and other valuations of nonpublicly traded property cannot 
be used to overcome the presumption, nor can references to general 
market rates. An issuer may, for example, overcome the presumption by 
showing that recently issued similar debt instruments of the issuer 
trade at a price that reflects a specific yield.
    One commentator suggested that the use of the term projected 
payment schedule caused securities law problems because the issuer 
could be seen as making representations to the holder about the 
expected payments. The comparable yield and projected payment schedule 
determined under these regulations are for tax purposes only and are 
not assurances by the

[[Page 30135]]

issuer with respect to the payments. The final regulations retain the 
term projected payment schedule, but an issuer may use a different term 
to describe the payment schedule (e.g., payment schedule determined 
under Sec. 1.1275-4) if the language used by the issuer is clear.
    Under the proposed regulations, projected payments rather than 
actual payments are used to determine the adjusted issue price of a 
debt instrument, the holder's basis in a debt instrument, and the 
amount of any contingent payment treated as made on the scheduled 
retirement of a debt instrument. One commentator questioned the use of 
projected payments to make these determinations. The approach in the 
proposed regulations is appropriate, however, because a positive or 
negative adjustment is used to take into account the difference between 
the actual amount and the projected amount of a contingent payment. 
This difference would be counted twice if the adjusted issue price, the 
holder's basis, and the amount deemed paid on retirement were based on 
the actual amount rather than the projected amount of a contingent 
payment. Thus, the approach used in the proposed regulations is 
retained in the final regulations.
B. Tax-Exempt Obligations
    In response to comments, the rules contained in Sec. 1.1275-4(d) 
relating to tax-exempt contingent payment obligations have been 
revised. Under the proposed regulations, tax-exempt obligations are 
generally subject to the noncontingent bond method, with the following 
modifications: (1) The yield on which interest accruals are based may 
not exceed the greater of the yield on the obligation, determined 
without regard to the non-market-based contingent payments, and the 
tax-exempt AFR that applies to the obligation; (2) Positive adjustments 
are treated as gain from the sale or exchange of the obligation rather 
than as interest; and (3) Negative adjustments reduce the amount of 
tax-exempt interest, and, therefore, are generally not taken into 
account as deductible losses. These modifications to the noncontingent 
bond method for tax-exempt obligations were added because the IRS and 
Treasury believe that when a property right is embedded in a tax-exempt 
obligation it is generally inappropriate to treat payments on the right 
as interest on an obligation of a state or political subdivision.
    Several commentators suggested that the proposed regulations 
relating to tax-exempt obligations are overly restrictive. These 
commentators questioned the reason for limiting the rate of accrual to 
the tax-exempt AFR and characterizing positive adjustments as taxable 
gain rather than interest. They also questioned the fairness of 
treating negative adjustments as nondeductible adjustments to tax-
exempt interest when positive adjustments are treated as taxable gain. 
Some of the commentators suggested that, at a minimum, the interest 
limitations should not apply to contingent obligations that pay 
interest based on interest rate formulas that reflect the cost of funds 
rather than changes in the value of embedded property rights. Finally, 
commentators noted that programs involving municipal refinancings of 
real estate projects (for example, low-income multi-family housing 
projects) would be jeopardized by the proposed regulations because 
payments on tax-exempt obligations issued to finance these projects are 
in certain cases contingent in part on the revenues or appreciation in 
value of the project.
    The IRS and Treasury continue to believe that gain from a property 
right should not be recharacterized as tax-exempt interest merely 
because the property right is embedded in a tax- exempt obligation. The 
IRS and Treasury nevertheless recognize that certain types of 
traditional tax-exempt financings should not be subject to the interest 
limitations of the proposed regulations (e.g., financings on which 
interest is computed in a manner that relates to the cost of funds). 
Accordingly, Sec. 1.1275-4(d) has been revised to include a category of 
tax-exempt obligations that will be subject to the noncontingent bond 
method without the tax-exempt interest limitations contained in the 
proposed regulations. This category of tax-exempt obligations includes 
(1) obligations that would qualify as variable rate debt instruments 
(VRDIs) except for the failure to meet certain of the technical 
requirements of the VRDI definition (such as the cap and floor 
limitations, or the requirement that interest be paid or compounded at 
least annually), and (2) certain obligations issued to refinance an 
obligation, the proceeds of which were used to finance a project.
    For other tax-exempt obligations, the interest restrictions of the 
proposed regulations are adopted in final form. Section 1.1275-4(d) has 
been revised, however, to provide that a negative adjustment is treated 
as a taxable loss from the sale or exchange of the obligation, rather 
than as a nondeductible adjustment to tax-exempt interest.
C. Prepaid Tuition Plans
    A number of commentators asked whether contracts issued under 
state-sponsored prepaid tuition plans are subject to Sec. 1.1275-4. 
Although the terms of the contracts vary, the contracts generally are 
issued pursuant to a plan created by a state to enable the participants 
in the plan to save for post- secondary education for themselves or 
other designated beneficiaries. In addition, the plans generally 
provide protection against increases in the costs of higher education 
or otherwise subsidize these costs, often by providing for contingent 
payments that are linked to the future costs of post-secondary 
education.
    The commentators argue that Sec. 1.1275-4 does not apply to the 
contracts because the contracts are not debt instruments for federal 
income tax purposes. In addition, the commentators argue that, even if 
the contracts are debt instruments, the noncontingent bond method would 
be unduly burdensome and inappropriate for contracts of this type.
    The final regulations under Sec. 1.1275-4 do not affect the 
treatment of contracts issued pursuant to state-sponsored prepaid 
tuition plans, whether or not the contracts are debt instruments. The 
final regulations, like the proposed regulations, only apply to debt 
instruments. Thus, the final regulations do not apply to contracts 
issued pursuant to a plan created by a state to enable participants to 
save for post-secondary education if the contracts are not debt 
instruments. In addition, the final regulations provide an exception 
for any debt instrument issued pursuant to a state-sponsored prepaid 
tuition plan.
    This exception applies to a contract issued pursuant to a plan or 
arrangement if: The plan or arrangement is created by a state statute; 
the plan or arrangement has a primary objective of enabling the 
participants to pay for the costs of post-secondary education for 
themselves or their designated beneficiaries; and the contingencies 
under the contract are related to such purpose. These characteristics 
are intended to describe all existing state-sponsored prepaid tuition 
plans. Therefore, the final regulations do not change the tax treatment 
of a contract issued pursuant to these plans. As a result, if the 
contract is a debt instrument, the contingent payments on the contract 
are not taken into account by an individual until the payments are 
made.
    The exception in the final regulations is intended to apply only to 
the existing

[[Page 30136]]

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

Other Amendments to the OID Regulations

A. Alternative Payment Schedules Under Sec. 1.1272-1(c)
    Section 1.1272-1(c) provides rules to determine the yield and 
maturity of certain debt instruments that provide for one or more 
alternative payment schedules applicable upon the occurrence of a 
contingency (or contingencies), provided that the timing and amounts of 
the payments that comprise each payment schedule are known as of the 
issue date. Under these rules, the yield and maturity of a debt 
instrument are generally determined by assuming that the payments will 
be made under the payment schedule most likely to occur (based on all 
the facts and circumstances as of the issue date). Special rules are 
provided for unconditional options and mandatory sinking funds.
    The general rules in Sec. 1.1272-1(c) produce a reasonable result 
when a debt instrument has one stated payment schedule that is very 
likely to occur and one or more alternative payment schedules that are 
unlikely to occur. In this case, adherence to the stated payment 
schedule will result in accruals on the debt instrument that reasonably 
reflect the expected return on the instrument. The rules can lead to 
unreasonable results, however, if a debt instrument provides for a 
stated payment schedule and one or more alternative payment schedules 
that differ significantly and that have a comparable likelihood of 
occurring. In this case, the accruals based on the payment schedule 
identified as most likely to occur could differ significantly from the 
expected return on the debt instrument, which would reflect all the 
payment schedules and their relative probabilities of occurrence.
    Because the general rules of Sec. 1.1272-1(c) could produce 
unreasonable results, these rules have been modified. Under the final 
regulations, if a single payment schedule is significantly more likely 
than not to occur, the yield and maturity of the debt instrument are 
calculated based on that payment schedule. As a result, any other debt 
instrument that provides for an alternative payment schedule (other 
than because of an unconditional option or mandatory sinking fund) will 
generally be subject to the rules in Sec. 1.1275-4 for contingent 
payment debt instruments. The final regulations generally retain the 
rules for mandatory sinking funds and unconditional options.
B. Remote and Incidental Contingencies
    The proposed regulations provide that a payment subject to a remote 
or incidental contingency is not considered a contingent payment for 
purposes of Sec. 1.1275-4. In response to a comment, the rule relating 
to remote and incidental contingencies has been broadened, through the 
addition of new Sec. 1.1275-2(h), to provide that remote and incidental 
contingencies are generally ignored for purposes of sections 163(e) 
(other than section 163(e)(5)) and 1271 through 1275 and the 
regulations thereunder. Thus, for example, if an otherwise fixed 
payment debt instrument provides for an additional payment that will be 
made upon the occurrence of a contingency and there is a remote 
likelihood that the contingency will occur, the contingent payment is 
ignored for purposes of computing OID accruals on the instrument. If 
the contingency occurs, however, then, solely for purposes of sections 
1272 and 1273, the debt instrument is treated as reissued. Therefore, 
OID on the debt instrument is redetermined.
C. Definition of Qualified Stated Interest
    The addition of the rules for remote or incidental contingencies 
and the changes to the rules for alternative payment schedules allow 
simplification of the definition of qualified stated interest. Under 
Sec. 1.1273-1(c), as published in the Federal Register on February 2, 
1994, qualified stated interest must be unconditionally payable in cash 
or property at least annually at a single fixed rate. Interest is 
unconditionally payable only if late payment (other than a late payment 
that occurs within a reasonable grace period) or nonpayment is expected 
to be penalized or reasonable remedies exist to compel payment.
    This definition of unconditionally payable can be read to conflict 
with the alternative payment schedule rules. For example, if a debt 
instrument has two alternative payment schedules, one schedule can be 
stated as the required payment schedule and the other schedule can be 
stated as a penalty if the required payments are not made. The required 
payments might then be treated as unconditionally payable and, 
therefore, as being qualified stated interest even if they would not be 
qualified stated interest if treated under the alternative payment 
schedule rules. Under this treatment, if a payment is not made, the 
reissuance rules of the alternative payment schedule regime do not 
apply. Holders can thus argue that no OID would accrue with respect to 
the debt instrument even though OID would accrue if the instrument were 
treated as having an alternative payment schedule and holders fully 
expect any unmade payment to be made in the future.
    The remote or incidental rules in Sec. 1.1275-2(h) provide a better 
mechanism for determining whether a payment is qualified stated 
interest and determining the treatment if no payment is made. Thus, the 
final regulations modify the definition of unconditionally payable so 
that interest is unconditionally payable only if reasonable legal 
remedies exist to compel payment or the debt instrument otherwise 
provides terms and

[[Page 30137]]

conditions that make the likelihood of late payment (other than a late 
payment that occurs within a reasonable grace period) or nonpayment 
remote. If the payment is not made (other than because of insolvency, 
default, or similar circumstances), the final regulations require a 
deemed reissuance for OID purposes, which ensures that OID will accrue. 
This approach should simplify the treatment of many debt instruments 
and yet ensure that OID accrues in appropriate circumstances.
D. OID Anti-Abuse Rule
    On February 2, 1994, the IRS published in the Federal Register 
temporary and proposed regulations that contained an anti-abuse rule 
for purposes of the OID regulations (Sec. 1.1275-2T (59 FR 4831); 
Sec. 1.1275-2(g) (59 FR 4878)). Under the anti-abuse rule, the 
Commissioner can apply or depart from the regulations under section 
163(e) or sections 1271 through 1275 as necessary to achieve a 
reasonable result if a principal purpose in structuring a debt 
instrument or engaging in a transaction is to achieve a result under 
the regulations that is unreasonable in light of the applicable 
statutes. This rule is adopted as a final regulation with some 
clarifying changes and the addition of an example to illustrate its 
application to certain contingent payment debt instruments.
E. Determination of Issue Price Under Section 1274
    Under the proposed regulations, the issue price of a contingent 
payment debt instrument that is subject to section 1274 (i.e., a debt 
instrument issued in exchange for nonpublicly traded property) is 
determined without taking into account the instrument's contingent 
payments. Thus, the issue price of the debt instrument (and the buyer's 
initial basis in the property) is limited to an amount determined by 
taking into account only the noncontingent payments. The buyer's basis 
in the property, however, is increased by the amount of a contingent 
payment treated as principal. This approach was adopted primarily 
because it is inappropriate to allow a buyer a basis in property that 
reflects anticipated contingent payments that are uncertain in amount. 
In addition, this approach limits the ability of the buyer to overstate 
interest deductions over the term of the debt instrument. The approach 
of the proposed regulations has been adopted in the final regulations 
for taxable debt instruments subject to section 1274. See Sec. 1.1274-
2(g).
    It is not appropriate, however, to apply this approach to tax-
exempt contingent payment obligations subject to section 1274. Because 
the present value of projected contingent payments generally is not 
included in the issue price of a taxable debt instrument subject to 
section 1274, the instrument is accounted for under Sec. 1.1275-4(c). 
This regime is not appropriate for tax-exempt obligations because it 
does not distinguish between tax-exempt interest and gain attributable 
to an embedded property right. Thus, in order to permit tax-exempt 
obligations to be subject to the noncontingent bond method under 
Sec. 1.1275-4(b), the final regulations provide special rules to 
determine the issue price of a tax-exempt contingent payment obligation 
subject to section 1274.
    Under these rules, the issue price of a tax-exempt contingent 
payment obligation subject to section 1274 is equal to the fair market 
value of the obligation on the issue date (or, in the case of an 
obligation that provides for interest-based or revenue-based payments, 
the greater of the obligation's fair market value or stated principal 
amount). In addition, the obligation is subject to the rules of 
Sec. 1.1275-4(d) (the noncontingent bond method for tax-exempt 
contingent payment obligations) rather than Sec. 1.1275-4(c). However, 
to ensure that the buyer's basis is the same as if the buyer had issued 
a taxable debt instrument, the final regulations limit the buyer's 
basis to the present value of the fixed payments.

Section 1.1275-6  Integration Rules

    Commentators generally approved of the integration rules in the 
proposed regulations, and those rules are adopted with only two 
significant changes.
    First, the final regulations allow (but do not require) the 
integration of a hedge with a fixed rate debt instrument. For example, 
a taxpayer may integrate a fixed rate debt instrument and a swap into a 
VRDI. Although the hedging transaction regulations (Sec. 1.446-4) cover 
many of these transactions, the integration rules provide more certain 
treatment. The final regulations, however, do not allow the 
Commissioner to integrate a hedge with either a fixed rate debt 
instrument or a VRDI that provides for interest at a qualified floating 
rate. In these cases, treating the hedge and the debt instrument 
separately is a longstanding rule that generally clearly reflects 
income.
    Second, in limited circumstances, the final regulations allow a 
hedge to be entered into prior to the date the taxpayer issues or 
acquires the debt instrument. In these circumstances, however, the 
taxpayer must identify the hedge as part of an integrated transaction 
on the day the hedge is entered into by the taxpayer. Under the final 
regulations, if the hedging transaction has not yet had any cash flows 
(including amounts paid to enter into or purchase the hedge), the 
integration rules work appropriately so that any built-in gain or loss 
on the hedge at the time of integration is included over the term of 
the synthetic debt instrument. Thus, the final regulations put no 
restriction on the time the hedging transaction has to be entered into 
in this case. If there have been cash flows on the hedge, the final 
regulations require the hedge to be entered into no earlier than a date 
that is substantially contemporaneous with the date on which the debt 
instrument is acquired. This approach should allow commercially 
reasonable transactions to be integrated without the need to create 
complex rules to determine the treatment of prior cash flows on the 
hedging transaction.
    The rules for remote and incidental contingencies in Sec. 1.1275-
2(h) apply for purposes of the integration rules. Thus, if there is an 
incidental mismatch between a Sec. 1.1275-6 hedge and a qualifying debt 
instrument, a taxpayer may still integrate the hedge and the 
instrument. The mismatch is dealt with according to the rules for 
incidental contingencies.
    The final regulations also clarify the timing of income, 
deductions, gains, and losses from a hedge of a contingent payment debt 
instrument not subject to integration. Under Sec. 1.446-4, the income, 
deductions, gains, and losses must match the income, deductions, gains, 
and losses from the debt instrument. The final regulations clarify that 
gain or loss realized on a transaction that hedges a contingent payment 
on a debt instrument subject to Sec. 1.1275-4(c) is taken into account 
when the contingent payment is taken into account under Sec. 1.1275-
4(c). This treatment does not allow the taxpayer to change the timing 
of the income, deductions, gains, and losses from the debt instrument.

Effective Dates

    In general, the final regulations apply to debt instruments issued 
on or after August 13, 1996. Section 1.1275-6 applies to a qualifying 
debt instrument issued on or after August 13, 1996. Section 1.1275-6 
also applies to a qualifying debt instrument acquired by the taxpayer 
on or after August 13, 1996, if the qualifying debt instrument is a 
fixed rate debt instrument or a VRDI or if the qualifying debt 
instrument and the Sec. 1.1275-6 hedge are acquired by the

[[Page 30138]]

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

Debt Instruments Issued Before the Effective Date of the Final 
Regulations

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

Consent To Change Accounting Method

    The Commissioner grants consent for a taxpayer to change its method 
of accounting to follow the final regulations in this document. This 
consent is granted, however, only for a change for the first taxable 
year in which the taxpayer must account for a debt instrument under the 
final regulations. The change is made on a cut-off basis (i.e., the new 
method only applies to debt instruments issued on or after August 13, 
1996. Therefore, no items of income or deduction are omitted or 
duplicated, and no adjustment under section 481 is allowed.

Special Analyses

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

Drafting Information

    Several persons from the Office of Chief Counsel and the Treasury 
Department, including Andrew C. Kittler, formerly of the Office of the 
Assistant Chief Counsel (Financial Institutions and Products), 
participated in developing these regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for Sec. 1.1275-2T and 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 1.163-7 is amended by adding a sentence at the end 
of paragraph (a) to read as follows:


Sec. 1.163-7   Deduction for OID on certain debt instruments.

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


Sec. 1.446-4   Hedging transactions.

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


Sec. 1.483-2T   [Removed]

    Par. 4. Section 1.483-2T is removed effective June 14, 1996.
    Par. 5. Section 1.483-4 is added to read as follows:


Sec. 1.483-4   Contingent payments.

    (a) In general. This section applies to a contract for the sale or 
exchange of property (the overall contract) if the contract provides 
for one or more contingent payments and the contract is subject to 
section 483. This section applies even if the contract provides for 
adequate stated interest under Sec. 1.483-2. If this section applies to 
a contract, interest under the contract is generally computed and 
accounted for using rules similar to those that would apply if the 
contract were a debt instrument subject to Sec. 1.1275-4(c). 
Consequently, all noncontingent payments under the overall contract are 
treated as if made under a separate contract, and interest accruals on 
this separate contract are computed under rules similar to those 
contained in Sec. 1.1275-4(c)(3). Each contingent payment under the 
overall contract is characterized as principal and interest under rules 
similar to those contained in 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 December 31, 1996, A sells depreciable personal property 
to B. As consideration for the sale, B issues to A a debt instrument 
with a maturity date of December 31, 2001. The debt instrument 
provides for a principal payment of $200,000 on the maturity date, 
and a payment of interest on December 31 of each year, beginning in 
1997, equal to a percentage of the total gross income derived from 
the property in that year. However, the total interest payable on 
the debt instrument over its entire term is limited to a maximum of 
$50,000. Assume that on December 31, 1996, the short-term applicable 
Federal rate is 4 percent, compounded annually, and the mid-term 
applicable Federal rate is 5 percent, compounded annually.
    (ii) Treatment of noncontingent payment as separate contract. 
Each payment of interest is a contingent payment. Accordingly, under 
paragraph (a) of this section, for purposes of applying section 483 
to the debt instrument, the right to the noncontingent payment of 
$200,000 is treated as a separate contract. The amount of unstated 
interest on this separate contract is equal to $43,295, which is the 
amount by which the payment ($200,000) exceeds the present value of 
the payment ($156,705), calculated using the test rate of 5 percent, 
compounded annually. The $200,000 payment is thus treated as 
consisting of a

[[Page 30139]]

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

    (c) Effective date. This section applies to sales and exchanges 
that occur on or after August 13, 1996.
    Par. 6. Section 1.1001-1 is amended by revising paragraph (g) to 
read as follows:


Sec. 1.1001-1   Computation of gain or loss.

* * * * *
    (g) Debt instruments issued in exchange for property--(1) In 
general. If a debt instrument is issued in exchange for property, the 
amount realized attributable to the debt instrument is the issue price 
of the debt instrument as determined under Sec. 1.1273-2 or 
Sec. 1.1274-2, whichever is applicable. If, however, the issue price of 
the debt instrument is determined under section 1273(b)(4), the amount 
realized attributable to the debt instrument is its stated principal 
amount reduced by any unstated interest (as determined under section 
483).
    (2) Certain debt instruments that provide for contingent payments--
(i) In general. Paragraph (g)(1) of this section does not apply to a 
debt instrument subject to either Sec. 1.483-4 or Sec. 1.1275-4(c) 
(certain contingent payment debt instruments issued for nonpublicly 
traded property).
    (ii) Special rule to determine amount realized. If a debt 
instrument subject to Sec. 1.1275-4(c) is issued in exchange for 
property, and the income from the exchange is not reported under the 
installment method of section 453, the amount realized attributable to 
the debt instrument is the issue price of the debt instrument as 
determined under Sec. 1.1274-2(g), increased by the fair market value 
of the contingent payments payable on the debt instrument. If a debt 
instrument subject to Sec. 1.483-4 is issued in exchange for property, 
and the income from the exchange is not reported under the installment 
method of section 453, the amount realized attributable to the debt 
instrument is its stated principal amount, reduced by any unstated 
interest (as determined under section 483), and increased by the fair 
market value of the contingent payments payable on the debt instrument. 
This paragraph (g)(2)(ii), however, does not apply to a debt instrument 
if the fair market value of the contingent payments is not reasonably 
ascertainable. Only in rare and extraordinary cases will the fair 
market value of the contingent payments be treated as not reasonably 
ascertainable.
    (3) Coordination with section 453. If a debt instrument is issued 
in exchange for property, and the income from the exchange is not 
reported under the installment method of section 453, this paragraph 
(g) applies rather than Sec. 15a.453-1(d)(2) to determine the 
taxpayer's amount realized attributable to the debt instrument.
    (4) Effective date. This paragraph (g) applies to sales or 
exchanges that occur on or after August 13, 1996.
    Par. 7. Section 1.1012-1 is amended by revising paragraph (g) to 
read as follows:


Sec. 1.1012-1  Basis of property.

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

[[Page 30140]]

    9. Adding entries for Sec. 1.1275-6.
    The revisions and additions read as follows:


Sec. 1.1271-0  Original issue discount; effective date; table of 
contents.

* * * * *
    (b) * * *
* * * * *

Sec. 1.1272-1  Current Inclusion of OID in Income

* * * * *
    (c) * * *
    (2) Payment schedule that is significantly more likely than not 
to occur.
    (3) Mandatory sinking fund provision.
    (4) Consistency rule. [Reserved]
* * * * *
    (7) Effective date.
    (d) Certain debt instruments that provide for a fixed yield.
* * * * *

Sec. 1.1274-2  Issue Price of Debt Instruments to Which Section 
1274 Applies

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

Sec. 1.1275-2  Special Rules Relating to Debt Instruments

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

Sec. 1.1275-4  Contingent Payment Debt Instruments

    (a) Applicability.
    (1) In general.
    (2) Exceptions.
    (3) Insolvency and default.
    (4) Convertible debt instruments.
    (5) Remote and incidental contingencies.
    (b) Noncontingent bond method.
    (1) Applicability.
    (2) In general.
    (3) Description of method.
    (4) Comparable yield and projected payment schedule.
    (5) Qualified stated interest.
    (6) Adjustments.
    (7) Adjusted issue price, adjusted basis, and retirement.
    (8) Character on sale, exchange, or retirement.
    (9) Operating rules.
    (c) Method for debt instruments not subject to the noncontingent 
bond method.
    (1) Applicability.
    (2) Separation into components.
    (3) Treatment of noncontingent payments.
    (4) Treatment of contingent payments.
    (5) Basis different from adjusted issue price.
    (6) Treatment of a holder on sale, exchange, or retirement.
    (7) Examples.
    (d) Rules for tax-exempt obligations.
    (1) In general.
    (2) Certain tax-exempt obligations with interest-based or 
revenue-based payments
    (3) All other tax-exempt obligations.
    (4) Basis different from adjusted issue price.
    (e) Amounts treated as interest under this section.
    (f) Effective date.

Sec. 1.1275-5  Variable Rate Debt Instruments

    (a) * * *
    (5) No contingent principal payments.
    (6) Special rule for debt instruments issued for nonpublicly 
traded property.
* * * * *
    (c) * * *
    (1) Definition.
* * * * *
    (5) Tax-exempt obligations.
* * * * *

Sec. 1.1275-6  Integration of Qualifying Debt Instruments

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

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


Sec. 1.1272-1  Current inclusion of OID in income.

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

[[Page 30141]]

    (3) Mandatory sinking fund provision. Notwithstanding paragraph 
(c)(2) of this section, if a debt instrument is subject to a mandatory 
sinking fund provision, the provision is ignored for purposes of 
computing the yield and maturity of the debt instrument if the use and 
terms of the provision meet reasonable commercial standards. For 
purposes of the preceding sentence, a mandatory sinking fund provision 
is a provision that meets the following requirements:
    (i) The provision requires the issuer to redeem a certain amount of 
debt instruments in an issue prior to maturity.
    (ii) The debt instruments actually redeemed are chosen by lot or 
purchased by the issuer either in the open market or pursuant to an 
offer made to all holders (with any proration determined by lot).
    (iii) On the issue date, the specific debt instruments that will be 
redeemed on any date prior to maturity cannot be identified.
    (4) Consistency rule. [Reserved]
    (5) Treatment of certain options. Notwithstanding paragraphs (c) 
(2) and (3) of this section, the rules of this paragraph (c)(5) 
determine the yield and maturity of a debt instrument that provides the 
holder or issuer with an unconditional option or options, exercisable 
on one or more dates during the term of the debt instrument, that, if 
exercised, require payments to be made on the debt instrument under an 
alternative payment schedule or schedules (e.g., an option to extend or 
an option to call a debt instrument at a fixed premium). Under this 
paragraph (c)(5), an issuer is deemed to exercise or not exercise an 
option or combination of options in a manner that minimizes the yield 
on the debt instrument, and a holder is deemed to exercise or not 
exercise an option or combination of options in a manner that maximizes 
the yield on the debt instrument. If both the issuer and the holder 
have options, the rules of this paragraph (c)(5) are applied to the 
options in the order that they may be exercised. See paragraph (j) 
Example 5 through Example 8 of this section.
    (6) Subsequent adjustments. If a contingency described in this 
paragraph (c) (including the exercise of an option described in 
paragraph (c)(5) of this section) actually occurs or does not occur, 
contrary to the assumption made pursuant to this paragraph (c) (a 
change in circumstances), then, solely for purposes of sections 1272 
and 1273, the debt instrument is treated as retired and then reissued 
on the date of the change in circumstances for an amount equal to its 
adjusted issue price on that date. See paragraph (j) Example 5 and 
Example 7 of this section. If, however, the change in circumstances 
results in a substantially contemporaneous pro-rata prepayment as 
defined in Sec. 1.1275-2(f)(2), the pro-rata prepayment is treated as a 
payment in retirement of a portion of the debt instrument, which may 
result in gain or loss to the holder. See paragraph (j) Example 6 and 
Example 8 of this section.
    (7) Effective date. This paragraph (c) applies to debt instruments 
issued on or after August 13, 1996.
    (d) Certain debt instruments that provide for a fixed yield. If a 
debt instrument provides for one or more contingent payments but all 
possible payment schedules under the terms of the instrument result in 
the same fixed yield, the yield of the debt instrument is the fixed 
yield. For example, the yield of a debt instrument with principal 
payments that are fixed in total amount but that are uncertain as to 
time (such as a demand loan) is the stated interest rate if the issue 
price of the instrument is equal to the stated principal amount and 
interest is paid or compounded at a fixed rate over the entire term of 
the instrument. This paragraph (d) applies to debt instruments issued 
on or after August 13, 1996.
* * * * *
    (f) * * *
    (2) * * * For purposes of the preceding sentence, the last possible 
date that the debt instrument could be outstanding is determined 
without regard to Sec. 1.1275-2(h) (relating to payments subject to 
remote or incidental contingencies).
* * * * *
    Par. 10. Section 1.1273-1 is amended by:
    1. Removing the language ``principal payments uncertain as to 
time'' in the fourth sentence of paragraph (a) and adding the language 
``a fixed yield'' in its place.
    2. Revising paragraph (c)(1)(ii).
    3. Revising paragraph (f) Example 4.
    The revisions read as follows:


Sec. 1.1273-1  Definition of OID.

* * * * *
    (c) * * * (1) * * *
    (ii) Unconditionally payable. Interest is unconditionally payable 
only if reasonable legal remedies exist to compel timely payment or the 
debt instrument otherwise provides terms and conditions that make the 
likelihood of late payment (other than a late payment that occurs 
within a reasonable grace period) or nonpayment a remote contingency 
(within the meaning of Sec. 1.1275-2(h)). For purposes of the preceding 
sentence, remedies or other terms and conditions are not taken into 
account if the lending transaction does not reflect arm's length 
dealing and the holder does not intend to enforce the remedies or other 
terms and conditions. For purposes of determining whether interest is 
unconditionally payable, the possibility of nonpayment due to default, 
insolvency, or similar circumstances, or due to the exercise of a 
conversion option described in Sec. 1.1272-1(e) is ignored. This 
paragraph (c)(1)(ii) applies to debt instruments issued on or after 
August 13, 1996.
* * * * *
    (f) * * *

    Example 4. Qualified stated interest on a debt instrument that 
is subject to an option--(i) Facts. On January 1, 1997, A issues, 
for $100,000, a 10-year debt instrument that provides for a $100,000 
principal payment at maturity and for annual interest payments of 
$10,000. Under the terms of the debt instrument, A has the option, 
exercisable on January 1, 2002, to lower the annual interest 
payments to $8,000. In addition, the debt instrument gives the 
holder an unconditional right to put the debt instrument back to A, 
exercisable on January 1, 2002, in return for $100,000.
    (ii) Amount of qualified stated interest. Under paragraph (c)(2) 
of this section, the debt instrument provides for qualified stated 
interest to the extent of the lowest fixed rate at which qualified 
stated interest would be payable under any payment schedule. If the 
payment schedule determined by assuming that the issuer's option 
will be exercised and the put option will not be exercised were 
treated as the debt instrument's sole payment schedule, only $8,000 
of each annual interest payment would be qualified stated interest. 
Under any other payment schedule, the debt instrument would provide 
for annual qualified stated interest payments of $10,000. 
Accordingly, only $8,000 of each annual interest payment is 
qualified stated interest. Any excess of each annual interest 
payment over $8,000 is included in the debt instrument's stated 
redemption price at maturity.
* * * * *
    Par. 11. Section 1.1274-2 is amended by:
    1. Removing the language ``Sec. 1.1272-1(c)(3)(ii)'' from paragraph 
(e) and adding the language ``Sec. 1.1272-1(c)(3)'' in its place.
    2. Revising paragraph (g).
    3. Adding and reserving paragraph (i) and adding paragraph (j).
    The revisions and additions read as follows:


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

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

[[Page 30142]]

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


Sec. 1.1275-2  Special rules relating to debt instruments.

* * * * *
    (g) Anti-abuse rule--(1) In general. If a principal purpose in 
structuring a debt instrument or engaging in a transaction is to 
achieve a result that is unreasonable in light of the purposes of 
section 163(e), sections 1271 through 1275, or any related section of 
the Code, the Commissioner can apply or depart from the regulations 
under the applicable sections as necessary or appropriate to achieve a 
reasonable result. For example, if this paragraph (g) applies to a debt 
instrument that provides for a contingent payment, the Commissioner can 
treat the contingency as if it were a separate position.
    (2) Unreasonable result. Whether a result is unreasonable is 
determined based on all the facts and circumstances. In making this 
determination, a significant fact is whether the treatment of the debt 
instrument is expected to have a substantial effect on the issuer's or 
a holder's U.S. tax liability. In the case of a contingent payment debt 
instrument, another significant fact is whether the result is 
obtainable without the application of Sec. 1.1275-4 and any related 
provisions (e.g., if the debt instrument and the contingency were 
entered into separately). A result will not be considered unreasonable, 
however, in the absence of an expected substantial effect on the 
present value of a taxpayer's tax liability.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph (g):

    Example 1. A issues a current-pay, increasing-rate note that 
provides for an early call option. Although the option is deemed 
exercised on the call date under Sec. 1.1272-1(c)(5), the option is 
not expected to be exercised by A. In addition, a principal purpose 
of including the option in the terms of the note is to limit the 
amount of interest income includible by the holder in the period 
prior to the call date by virtue of the option rules in Sec. 1.1272-
1(c)(5). Moreover, the application of the option rules is expected 
to substantially reduce the present value of the holder's tax 
liability. Based on these facts, the application of Sec. 1.1272-
1(c)(5) produces an unreasonable result. Therefore, under this 
paragraph (g), the Commissioner can apply the regulations (in whole 
or in part) to the note without regard to Sec. 1.1272-1(c)(5).
    Example 2. C, a foreign corporation not subject to U.S. 
taxation, issues to a U.S. holder a debt instrument that provides 
for a contingent payment. The debt instrument is issued for cash and 
is subject to the noncontingent bond method in Sec. 1.1275-4(b). Six 
months after issuance, C and the holder modify the debt instrument 
so that there is a deemed reissuance of the instrument under section 
1001. The new debt instrument is subject to the rules of 
Sec. 1.1275-4(c) rather than Sec. 1.1275-4(b). The application of 
Sec. 1.1275-4(c) is expected to substantially reduce the present 
value of the holder's tax liability as compared to the application 
of Sec. 1.1275-4(b). In addition, a principal purpose of the 
modification is to substantially reduce the present value of the 
holder's tax liability through the application of Sec. 1.1275-4(c). 
Based on these facts, the application of Sec. 1.1275-4(c) produces 
an unreasonable result. Therefore, under this paragraph (g), the 
Commissioner can apply the noncontingent bond method to the modified 
debt instrument.
    Example 3. D issues a convertible debt instrument rather than an 
economically equivalent investment unit consisting of a debt 
instrument and a warrant. The convertible debt instrument is issued 
at par and provides for annual payments of interest. D issues the 
convertible debt instrument rather than the investment unit so that 
the debt instrument would not have OID. See Sec. 1.1273-2(j). In 
general, this is a reasonable result in light of the purposes of the 
applicable statutes. Therefore, the Commissioner generally will not 
use the authority under this paragraph (g) to depart from the 
application of Sec. 1.1273-2(j) in this case.

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

[[Page 30143]]

occurs prior to the date the payment is made.
    (ii) Contingency relating to time. A contingency relating to the 
timing of a payment is incidental if, under all reasonably expected 
market conditions, the potential difference in the timing of the 
payment (from the earliest date to the latest date) is insignificant. 
If a payment on a debt instrument is subject to an incidental 
contingency described in this paragraph (h)(3)(ii), the payment is 
treated as made on the earliest date that the payment could be made 
pursuant to the contingency. If the payment is not made on this date, a 
taxpayer makes appropriate adjustments to take into account the delay 
in payment. However, see paragraph (h)(6)(i)(C) of this section for the 
treatment of the debt instrument if the delay is not insignificant.
    (4) Aggregation rule. For purposes of paragraph (h)(2) of this 
section, if a debt instrument provides for multiple contingencies each 
of which has a remote likelihood of occurring but, when all of the 
contingencies are considered together, there is a greater than remote 
likelihood that at least one of the contingencies will occur, none of 
the contingencies is treated as a remote contingency. For purposes of 
paragraph (h)(3)(i) of this section, if a debt instrument provides for 
multiple contingencies each of which is incidental but the potential 
total amount of all of the payments subject to the contingencies is 
not, under reasonably expected market conditions, insignificant 
relative to the total expected amount of the remaining payments on the 
debt instrument, none of the contingencies is treated as incidental.
    (5) Consistency rule. For purposes of paragraphs (h)(2) and (3) of 
this section, the issuer's determination that a contingency is either 
remote or incidental is binding on all holders. However, the issuer's 
determination is not binding on a holder that explicitly discloses that 
its determination is different from the issuer's determination. Unless 
otherwise prescribed by the Commissioner, the disclosure must be made 
on a statement attached to the holder's timely filed federal income tax 
return for the taxable year that includes the acquisition date of the 
debt instrument. See Sec. 1.1275-2(e) for rules relating to the 
issuer's obligation to disclose certain information to holders.
    (6) Subsequent adjustments--(i) Applicability. This paragraph 
(h)(6) applies to a debt instrument when there is a change in 
circumstances. For purposes of the preceding sentence, there is a 
change in circumstances if--
    (A) A remote contingency actually occurs or does not occur, 
contrary to the assumption made in paragraph (h)(2) of this section;
    (B) A payment subject to an incidental contingency described in 
paragraph (h)(3)(i) of this section becomes fixed in an amount that is 
not insignificant relative to the total expected amount of the 
remaining payments on the debt instrument; or
    (C) A payment subject to an incidental contingency described in 
paragraph (h)(3)(ii) of this section becomes fixed such that the 
difference between the assumed payment date and the due date of the 
payment is not insignificant.
    (ii) In general. If a change in circumstances occurs, solely for 
purposes of sections 1272 and 1273, the debt instrument is treated as 
retired and then reissued on the date of the change in circumstances 
for an amount equal to the instrument's adjusted issue price on that 
date.
    (iii) Contingent payment debt instruments. Notwithstanding 
paragraph (h)(6)(ii) of this section, in the case of a contingent 
payment debt instrument subject to Sec. 1.1275-4, if a change in 
circumstances occurs, no retirement or reissuance is treated as 
occurring, but any payment that is fixed as a result of the change in 
circumstances is governed by the rules in Sec. 1.1275-4 that apply when 
the amount of a contingent payment becomes fixed.
    (7) Effective date. This paragraph (h) applies to debt instruments 
issued on or after August 13, 1996.
    (i) [Reserved]
    (j) Treatment of certain modifications. If the terms of a debt 
instrument are modified to defer one or more payments, and the 
modification does not cause an exchange under section 1001, then, 
solely for purposes of sections 1272 and 1273, the debt instrument is 
treated as retired and then reissued on the date of the modification 
for an amount equal to the instrument's adjusted issue price on that 
date. This paragraph (j) applies to debt instruments issued on or after 
August 13, 1996.


Sec. 1.1275-2T  [Removed]

    Par. 13. Section 1.1275-2T is removed effective August 13, 1996.
    Par. 14. 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 
comparable yield and projected payment schedule; or
* * * * *
    Par. 15. 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. 
See Sec. 1.1275-6 for a taxpayer's treatment of a contingent payment 
debt instrument and a hedge.
    (2) Exceptions. This section does not apply to--
    (i) A debt instrument that has an issue price determined under 
section 1273(b)(4) (e.g., a debt instrument subject to section 483);
    (ii) A variable rate debt instrument (as defined in Sec. 1.1275-5);
    (iii) A debt instrument subject to Sec. 1.1272-1(c) (a debt 
instrument that provides for certain contingencies) or Sec. 1.1272-1(d) 
(a debt instrument that provides for a fixed yield);
    (iv) A debt instrument subject to section 988 (except as provided 
in section 988 and the regulations thereunder);
    (v) A debt instrument to which section 1272(a)(6) applies (certain 
interests in or mortgages held by a REMIC, and certain other debt 
instruments with payments subject to acceleration);
    (vi) A debt instrument (other than a tax-exempt obligation) 
described in section 1272(a)(2) (e.g., U.S. savings bonds, certain 
loans between natural persons, and short-term taxable obligations); or
    (vii) A debt instrument issued pursuant to a plan or arrangement 
if--
    (A) The plan or arrangement is created by a state statute;
    (B) A primary objective of the plan or arrangement is to enable the 
participants to pay for the costs of post-secondary education for 
themselves or their designated beneficiaries; and
    (C) Contingent payments on the debt instrument are related to such 
objective.

[[Page 30144]]

    (3) Insolvency and default. A payment is not contingent merely 
because of the possibility of impairment by insolvency, default, or 
similar circumstances.
    (4) Convertible debt instruments. A debt instrument does not 
provide for contingent payments merely because it provides for an 
option to convert the debt instrument into the stock of the issuer, 
into the stock or debt of a related party (within the meaning of 
section 267(b) or 707(b)(1)), or into cash or other property in an 
amount equal to the approximate value of such stock or debt.
    (5) Remote and incidental contingencies. A payment is not a 
contingent payment merely because of a contingency that, as of the 
issue date, is either remote or incidental. See Sec. 1.1275-2(h) for 
the treatment of remote and incidental contingencies.
    (b) Noncontingent bond method--(1) Applicability. The noncontingent 
bond method described in this paragraph (b) applies to a contingent 
payment debt instrument that has an issue price determined under 
Sec. 1.1273-2 (e.g., a contingent payment debt instrument that is 
issued for money or publicly traded property).
    (2) In general. Under the noncontingent bond method, interest on a 
debt instrument must be taken into account whether or not the amount of 
any payment is fixed or determinable in the taxable year. The amount of 
interest that is taken into account for each accrual period is 
determined by constructing a projected payment schedule for the debt 
instrument and applying rules similar to those for accruing OID on a 
noncontingent debt instrument. If the actual amount of a contingent 
payment is not equal to the projected amount, appropriate adjustments 
are made to reflect the difference.
    (3) Description of method. The following steps describe how to 
compute the amount of income, deductions, gain, and loss under the 
noncontingent bond method:
    (i) Step one: Determine the comparable yield. Determine the 
comparable yield for the debt instrument under the rules of paragraph 
(b)(4) of this section. The comparable yield is determined as of the 
debt instrument's issue date.
    (ii) Step two: Determine the projected payment schedule. Determine 
the projected payment schedule for the debt instrument under the rules 
of paragraph (b)(4) of this section. The projected payment schedule is 
determined as of the issue date and remains fixed throughout the term 
of the debt instrument (except under paragraph (b)(9)(ii) of this 
section, which applies to a payment that is fixed more than 6 months 
before it is due).
    (iii) Step three: Determine the daily portions of interest. 
Determine the daily portions of interest on the debt instrument for a 
taxable year as follows. The amount of interest that accrues in each 
accrual period is the product of the comparable yield of the debt 
instrument (properly adjusted for the length of the accrual period) and 
the debt instrument's adjusted issue price at the beginning of the 
accrual period. See paragraph (b)(7)(ii) of this section to determine 
the adjusted issue price of the debt instrument. The daily portions of 
interest are determined by allocating to each day in the accrual period 
the ratable portion of the interest that accrues in the accrual period. 
Except as modified by paragraph (b)(3)(iv) of this section, the daily 
portions of interest are includible in income by a holder for each day 
in the holder's taxable year on which the holder held the debt 
instrument and are deductible by the issuer for each day during the 
issuer's taxable year on which the issuer was primarily liable on the 
debt instrument.
    (iv) Step four: Adjust the amount of income or deductions for 
differences between projected and actual contingent payments. Make 
appropriate adjustments to the amount of income or deductions 
attributable to the debt instrument in a taxable year for any 
differences between projected and actual contingent payments. See 
paragraph (b)(6) of this section to determine the amount of an 
adjustment and the treatment of the adjustment.
    (4) Comparable yield and projected payment schedule. This paragraph 
(b)(4) provides rules for determining the comparable yield and 
projected payment schedule for a debt instrument. The comparable yield 
and projected payment schedule must be supported by contemporaneous 
documentation showing that both are reasonable, are based on reliable, 
complete, and accurate data, and are made in good faith.
    (i) Comparable yield--(A) In general. Except as provided in 
paragraph (b)(4)(i)(B) of this section, the comparable yield for a debt 
instrument is the yield at which the issuer would issue a fixed rate 
debt instrument with terms and conditions similar to those of the 
contingent payment debt instrument (the comparable fixed rate debt 
instrument), including the level of subordination, term, timing of 
payments, and general market conditions. For example, if a Sec. 1.1275-
6 hedge (or the substantial equivalent) is available, the comparable 
yield is the yield on the synthetic fixed rate debt instrument that 
would result if the issuer entered into the Sec. 1.1275-6 hedge. If a 
Sec. 1.1275-6 hedge (or the substantial equivalent) is not available, 
but similar fixed rate debt instruments of the issuer trade at a price 
that reflects a spread above a benchmark rate, the comparable yield is 
the sum of the value of the benchmark rate on the issue date and the 
spread. In determining the comparable yield, no adjustments are made 
for the riskiness of the contingencies or the liquidity of the debt 
instrument. The comparable yield must be a reasonable yield for the 
issuer and must not be less than the applicable Federal rate (based on 
the overall maturity of the debt instrument).
    (B) Presumption for certain debt instruments. This paragraph 
(b)(4)(i)(B) applies to a debt instrument if the instrument provides 
for one or more contingent payments not based on market information and 
the instrument is part of an issue that is marketed or sold in 
substantial part to persons for whom the inclusion of interest under 
this paragraph (b) is not expected to have a substantial effect on 
their U.S. tax liability. If this paragraph (b)(4)(i)(B) applies to a 
debt instrument, the instrument's comparable yield is presumed to be 
the applicable Federal rate (based on the overall maturity of the debt 
instrument). A taxpayer may overcome this presumption only with clear 
and convincing evidence that the comparable yield for the debt 
instrument should be a specific yield (determined using the principles 
in paragraph (b)(4)(i)(A) of this section) that is higher than the 
applicable Federal rate. The presumption may not be overcome with 
appraisals or other valuations of nonpublicly traded property. Evidence 
used to overcome the presumption must be specific to the issuer and 
must not be based on comparable issuers or general market conditions.
    (ii) Projected payment schedule. The projected payment schedule for 
a debt instrument includes each noncontingent payment and an amount for 
each contingent payment determined as follows:
    (A) Market-based payments. If a contingent payment is based on 
market information (a market-based payment), the amount of the 
projected payment is the forward price of the contingent payment. The 
forward price of a contingent payment is the amount one party would 
agree, as of the issue date, to pay an unrelated party for the right to 
the contingent payment on the settlement date (e.g., the date the 
contingent payment is made). For example, if the right to a contingent

[[Page 30145]]

payment is substantially similar to an exchange-traded option, the 
forward price is the spot price of the option (the option premium) 
compounded at the applicable Federal rate from the issue date to the 
date the contingent payment is due.
    (B) Other payments. If a contingent payment is not based on market 
information (a non-market-based payment), the amount of the projected 
payment is the expected value of the contingent payment as of the issue 
date.
    (C) Adjustments to the projected payment schedule. The projected 
payment schedule must produce the comparable yield. If the projected 
payment schedule does not produce the comparable yield, the schedule 
must be adjusted consistent with the principles of this paragraph 
(b)(4) to produce the comparable yield. For example, the adjusted 
amounts of non-market-based payments must reasonably reflect the 
relative expected values of the payments and must not be set to 
accelerate or defer income or deductions. If the debt instrument 
contains both market-based and non-market-based payments, adjustments 
are generally made first to the non-market-based payments because more 
objective information is available for the market-based payments.
    (iii) Market information. For purposes of this paragraph (b), 
market information is any information on which an objective rate can be 
based under Sec. 1.1275-5(c)(1) or (2).
    (iv) Issuer/holder consistency. The issuer's projected payment 
schedule is used to determine the holder's interest accruals and 
adjustments. The issuer must provide the projected payment schedule to 
the holder in a manner consistent with the issuer disclosure rules of 
Sec. 1.1275-2(e). If the issuer does not create a projected payment 
schedule for a debt instrument or the issuer's projected payment 
schedule is unreasonable, the holder of the debt instrument must 
determine the comparable yield and projected payment schedule for the 
debt instrument under the rules of this paragraph (b)(4). A holder that 
determines its own projected payment schedule must explicitly disclose 
this fact and the reason why the holder set its own schedule (e.g., why 
the issuer's projected payment schedule is unreasonable). Unless 
otherwise prescribed by the Commissioner, the disclosure must be made 
on a statement attached to the holder's timely filed federal income tax 
return for the taxable year that includes the acquisition date of the 
debt instrument.
    (v) Issuer's determination respected--(A) In general. If the issuer 
maintains the contemporaneous documentation required by this paragraph 
(b)(4), the issuer's determination of the comparable yield and 
projected payment schedule will be respected unless either is 
unreasonable.
    (B) Unreasonable determination. For purposes of paragraph 
(b)(4)(v)(A) of this section, a comparable yield or projected payment 
schedule generally will be considered unreasonable if it is set with a 
purpose to overstate, understate, accelerate, or defer interest 
accruals on the debt instrument. In a determination of whether a 
comparable yield or projected payment schedule is unreasonable, 
consideration will be given to whether the treatment of the debt 
instrument under this section is expected to have a substantial effect 
on the issuer's or holder's U.S. tax liability. For example, if a 
taxable issuer markets a debt instrument to a holder not subject to 
U.S. taxation, the comparable yield will be given close scrutiny and 
will not be respected unless contemporaneous documentation shows that 
the yield is not too high.
    (C) Exception. Paragraph (b)(4)(v)(A) of this section does not 
apply to a debt instrument subject to paragraph (b)(4)(i)(B) of this 
section (concerning a yield presumption for certain debt instruments 
that provide for non-market-based payments).
    (vi) Examples. The following examples illustrate the provisions of 
this paragraph (b)(4). In each example, assume that the instrument 
described is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the instrument is a debt 
instrument for federal income tax purposes.

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

[[Page 30146]]

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

------------------------------------------------------------------------
                                               Noncontingent  Contingent
                     Date                         payment       payment 
------------------------------------------------------------------------
12/31/1997...................................       $20,000            0
12/31/1998...................................        20,000       70,000
12/31/1999...................................        20,000       75,600
12/31/2000...................................     1,020,000       83,850
------------------------------------------------------------------------

    (5) Qualified stated interest. No amounts payable on a debt 
instrument to which this paragraph (b) applies are qualified stated 
interest within the meaning of Sec. 1.1273-1(c).
    (6) Adjustments. This paragraph (b)(6) provides rules for the 
treatment of positive and negative adjustments under the noncontingent 
bond method. A taxpayer takes into account only those adjustments that 
occur during a taxable year while the debt instrument is held by the 
taxpayer or while the taxpayer is primarily liable on the debt 
instrument.
    (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 payment (or on the scheduled 
date of the payment if the amount of the payment is zero).
    (ii) Treatment of net positive adjustments. 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 adjustments. The amount, if any, by 
which total negative adjustments on a debt instrument in a taxable year 
exceed the total positive adjustments on the debt instrument in the 
taxable year is a net negative adjustment. A taxpayer's net negative 
adjustment on a debt instrument for a taxable year is treated as 
follows:
    (A) Reduction of interest accruals. A net negative adjustment first 
reduces interest for the taxable year that the taxpayer would otherwise 
account for on the debt instrument under paragraph (b)(3)(iii) of this 
section.
    (B) Ordinary income or loss. If the net negative adjustment exceeds 
the interest for the taxable year that the taxpayer would otherwise 
account for on the debt instrument under paragraph (b)(3)(iii) of this 
section, the excess is treated as ordinary loss by a holder and 
ordinary income by an issuer. However, the amount treated as ordinary 
loss by a holder is limited to the amount by 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. In general, a taxpayer treats a negative adjustment 
carryforward for a taxable year as a negative adjustment on the debt 
instrument on the first day of the succeeding taxable year. However, if 
a holder of a debt instrument has a negative adjustment carryforward on 
the debt instrument in a taxable year in which the debt instrument is 
sold, exchanged, or retired, the negative adjustment carryforward 
reduces the holder's amount realized on the sale, exchange, or 
retirement. If an issuer of a debt instrument has a negative adjustment 
carryforward on the debt instrument for a taxable year in which the 
debt instrument is retired, the issuer takes the negative adjustment 
carryforward into account as ordinary income.
    (D) Treatment under section 67. A net negative adjustment is not 
subject to section 67 (the 2-percent floor on miscellaneous itemized 
deductions).
    (iv) Cross-references. If a holder has a basis in a debt instrument 
that is different from the debt instrument's adjusted issue price, the 
holder may have additional positive or negative adjustments under 
paragraph (b)(9)(i) of this section. If the amount of a contingent 
payment is fixed more than 6 months before the date it is due, the 
amount and timing of the adjustment are determined under paragraph 
(b)(9)(ii) of this section.
    (7) Adjusted issue price, adjusted basis, and retirement--(i) In 
general. If a debt instrument is subject to the noncontingent bond 
method, this paragraph (b)(7) provides rules to determine the adjusted 
issue price of the debt instrument, the holder's basis in the debt 
instrument, and the treatment of any scheduled or unscheduled 
retirements. In general, because any difference between the actual 
amount of a contingent payment and the projected amount of the payment 
is taken into account as an adjustment to income or deduction, the 
projected payments are treated as the actual payments for purposes of 
making adjustments to issue price and basis and determining the amount 
of any contingent payment made on a scheduled retirement.
    (ii) Definition of adjusted issue price. The adjusted issue price 
of a debt instrument is equal to the debt instrument's issue price, 
increased by the interest previously accrued on the debt instrument 
under paragraph (b)(3)(iii) of this section (determined without regard 
to any adjustments taken into account under paragraph (b)(3)(iv) of 
this section), and decreased by the amount of any noncontingent payment 
and the projected amount of any contingent payment previously made on 
the debt instrument. See paragraph (b)(9)(ii) of this section for 
special rules that apply when a contingent payment is fixed more than 6 
months before it is due.
    (iii) Adjustments to basis. A holder's basis in a debt instrument 
is increased by the interest previously accrued by the holder on the 
debt instrument under paragraph (b)(3)(iii) of this section (determined 
without regard to any adjustments taken into account under paragraph 
(b)(3)(iv) of this section), and decreased by the amount of any 
noncontingent payment and the

[[Page 30147]]

projected amount of any contingent payment previously made on the debt 
instrument to the holder. See paragraph (b)(9)(i) of this section for 
special rules that apply when basis is different from adjusted issue 
price and paragraph (b)(9)(ii) of this section for special rules that 
apply when a contingent payment is fixed more than 6 months before it 
is due.
    (iv) Scheduled retirements. For purposes of determining the amount 
realized by a holder and the repurchase price paid by the issuer on the 
scheduled retirement of a debt instrument, a holder is treated as 
receiving, and the issuer is treated as paying, the projected amount of 
any contingent payment due at maturity. If the amount paid or received 
is different from the projected amount, see paragraph (b)(6) of this 
section for the treatment of the difference by the taxpayer. Under 
paragraph (b)(6)(iii)(C) of this section, the amount realized by a 
holder on the retirement of a debt instrument is reduced by any 
negative adjustment carryforward determined in the taxable year of the 
retirement.
    (v) Unscheduled retirements. An unscheduled retirement of a debt 
instrument (or the receipt of a pro-rata prepayment that is treated as 
a retirement of a portion of a debt instrument under Sec. 1.1275-2(f)) 
is treated as a repurchase of the debt instrument (or a pro-rata 
portion of the debt instrument) by the issuer from the holder for the 
amount paid by the issuer to the holder.
    (vi) Examples. The following examples illustrate the provisions of 
paragraphs (b) (6) and (7) of this section. In each example, assume 
that the instrument described is a debt instrument for federal income 
tax purposes. No inference is intended, however, as to whether the 
instrument is a debt instrument for federal income tax purposes.

    Example 1. Treatment of positive and negative adjustments--(i) 
Facts. On December 31, 1996, Z, a calendar year taxpayer, purchases 
a debt instrument subject to this paragraph (b) at original issue 
for $1,000. The debt instrument's comparable yield is 10 percent, 
compounded annually, and the projected payment schedule provides for 
payments of $500 on December 31, 1997 (consisting of a noncontingent 
payment of $375 and a projected amount of $125) and $660 on December 
31, 1998 (consisting of a noncontingent payment of $600 and a 
projected amount of $60). The debt instrument is a capital asset in 
the hands of Z.
    (ii) Adjustment in 1997. Based on the projected payment 
schedule, Z's total daily portions of interest on the debt 
instrument are $100 for 1997 (issue price of $1,000 x 10 percent). 
Assume that the payment actually made on December 31, 1997, is $375, 
rather than the projected $500. Under paragraph (b)(6)(i) of this 
section, Z has a negative adjustment of $125 on December 31, 1997, 
attributable to the difference between the amount of the actual 
payment and the amount of the projected payment. Because Z has no 
positive adjustments for 1997, Z has a net negative adjustment of 
$125 on the debt instrument for 1997. This net negative adjustment 
reduces to zero the $100 total daily portions of interest Z would 
otherwise include in income in 1997. Accordingly, Z has no interest 
income on the debt instrument for 1997. Because Z had no interest 
inclusions on the debt instrument for prior taxable years, the 
remaining $25 of the net negative adjustment is a negative 
adjustment carryforward for 1997 that results in a negative 
adjustment of $25 on January 1, 1998.
    (iii) Adjustment to issue price and basis. Z's total daily 
portions of interest on the debt instrument are $100 for 1997. The 
adjusted issue price of the debt instrument and Z's adjusted basis 
in the debt instrument are increased by this amount, despite the 
fact that Z does not include this amount in income because of the 
net negative adjustment for 1997. In addition, the adjusted issue 
price of the debt instrument and Z's adjusted basis in the debt 
instrument are decreased on December 31, 1997, by the projected 
amount of the payment on that date ($500). Thus, on January 1, 1998, 
Z's adjusted basis in the debt instrument and the adjusted issue 
price of the debt instrument are $600.
    (iv) Adjustments in 1998. Based on the projected payment 
schedule, Z's total daily portions of interest are $60 for 1998 
(adjusted issue price of $600 x 10 percent). Assume that the payment 
actually made on December 31, 1998, is $700, rather than the 
projected $660. Under paragraph (b)(6)(i) of this section, Z has a 
positive adjustment of $40 on December 31, 1998, attributable to the 
difference between the amount of the actual payment and the amount 
of the projected payment. Because Z also has a negative adjustment 
of $25 on January 1, 1998, Z has a net positive adjustment of $15 on 
the debt instrument for 1998 (the excess of the $40 positive 
adjustment over the $25 negative adjustment). As a result, Z has $75 
of interest income on the debt instrument for 1998 (the $15 net 
positive adjustment plus the $60 total daily portions of interest 
that are taken into account by Z in that year).
    (v) Retirement. Based on the projected payment schedule, Z's 
adjusted basis in the debt instrument immediately before the payment 
at maturity is $660 ($600 plus $60 total daily portions of interest 
for 1998). Even though Z receives $700 at maturity, for purposes of 
determining the amount realized by Z on retirement of the debt 
instrument, Z is treated as receiving the projected amount of the 
contingent payment on December 31, 1998. Therefore, Z is treated as 
receiving $660 on December 31, 1998. Because Z's adjusted basis in 
the debt instrument immediately before its retirement is $660, Z 
recognizes no gain or loss on the retirement.
    Example 2. Negative adjustment carryforward for year of sale--
(i) Facts. Assume the same facts as in Example 1 of this paragraph 
(b)(7)(vi), except that Z sells the debt instrument on January 1, 
1998, for $630.
    (ii) Gain on sale. On the date the debt instrument is sold, Z's 
adjusted basis in the debt instrument is $600. Because Z has a 
negative adjustment of $25 on the debt instrument on January 1, 
1998, and has no positive adjustments on the debt instrument in 
1998, Z has a net negative adjustment for 1998 of $25. Because Z has 
not included in income any interest on the debt instrument, the 
entire $25 net negative adjustment is a negative adjustment 
carryforward for the taxable year of the sale. Under paragraph 
(b)(6)(iii)(C) of this section, the $25 negative adjustment 
carryforward reduces the amount realized by Z on the sale of the 
debt instrument from $630 to $605. Thus, Z has a gain on the sale of 
$5 ($605-$600). Under paragraph (b)(8)(i) of this section, the gain 
is treated as interest income.
    Example 3. Negative adjustment carryforward for year of 
retirement--(i) Facts. Assume the same facts as in Example 1 of this 
paragraph (b)(7)(vi), except that the payment actually made on 
December 31, 1998, is $615, rather than the projected $660.
    (ii) Adjustments in 1998. Under paragraph (b)(6)(i) of this 
section, Z has a negative adjustment of $45 on December 31, 1998, 
attributable to the difference between the amount of the actual 
payment and the amount of the projected payment. In addition, Z has 
a negative adjustment of $25 on January 1, 1998. See Example 1(ii) 
of this paragraph (b)(7)(vi). Because Z has no positive adjustments 
in 1998, Z has a net negative adjustment of $70 for 1998. This net 
negative adjustment reduces to zero the $60 total daily portions of 
interest Z would otherwise include in income for 1998. Therefore, Z 
has no interest income on the debt instrument for 1998. Because Z 
had no interest inclusions on the debt instrument for 1997, the 
remaining $10 of the net negative adjustment is a negative 
adjustment carryforward for 1998 that reduces the amount realized by 
Z on retirement of the debt instrument.
    (iii) Loss on retirement. Immediately before the payment at 
maturity, Z's adjusted basis in the debt instrument is $660. Under 
paragraph (b)(7)(iv) of this section, Z is treated as receiving the 
projected amount of the contingent payment, or $660, as the payment 
at maturity. Under paragraph (b)(6)(iii)(C) of this section, 
however, this amount is reduced by any negative adjustment 
carryforward determined for the taxable year of retirement to 
calculate the amount Z realizes on retirement of the debt 
instrument. Thus, Z has a loss of $10 on the retirement of the debt 
instrument, equal to the amount by which Z's adjusted basis in the 
debt instrument ($660) exceeds the amount Z realizes on the 
retirement of the debt instrument ($660 minus the $10 negative 
adjustment carryforward). Under paragraph (b)(8)(ii) of this 
section, the loss is a capital loss.

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

[[Page 30148]]

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

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

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

[[Page 30149]]

and the adjusted issue price of the debt instrument pro-rata to daily 
portions of interest (as determined under paragraph (b)(3)(iii) of this 
section) over the remaining term of the debt instrument. A pro-rata 
allocation is not reasonable, however, to the extent the holder's yield 
on the debt instrument, determined after taking into account the 
amounts allocated under this paragraph (b)(9)(i)(E), is less than the 
applicable Federal rate for the instrument. For purposes of the 
preceding sentence, the applicable Federal rate for the debt instrument 
is determined as if the purchase date were the issue date and the 
remaining term of the instrument were the term of the instrument.
    (F) Examples. The following examples illustrate the provisions of 
this paragraph (b)(9)(i). In each example, assume that the instrument 
described is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the instrument is a debt 
instrument for federal income tax purposes. In addition, assume that 
each instrument is not exchange listed property.

    Example 1. Basis greater than adjusted issue price--(i) Facts. 
On July 1, 1998, Z purchases for $1,405 a debt instrument that 
matures on December 31, 1999, and promises to pay on the maturity 
date $1,000 plus the increase, if any, in the price of a specified 
amount of a commodity from the issue date to the maturity date. The 
debt instrument was originally issued on December 31, 1996, for an 
issue price of $1,000. The comparable yield for the debt instrument 
is 10.25 percent, compounded semiannually, and the projected payment 
schedule for the debt instrument (determined as of the issue date) 
provides for a single payment at maturity of $1,350. At the time of 
the purchase, the debt instrument has an adjusted issue price of 
$1,162, assuming semiannual accrual periods ending on December 31 
and June 30 of each year. The increase in the value of the debt 
instrument over its adjusted issue price is due to an increase in 
the expected amount of the contingent payment and not to a decrease 
in market interest rates. The debt instrument is a capital asset in 
the hands of Z. Z is a calendar year taxpayer.
    (ii) Allocation of the difference between basis and adjusted 
issue price. Z's basis in the debt instrument on July 1, 1998, is 
$1,405. Under paragraph (b)(9)(i)(A) of this section, Z allocates 
the $243 difference between basis ($1,405) and adjusted issue price 
($1,162) to the contingent payment at maturity. Z's allocation of 
the difference between basis and adjusted issue price is reasonable 
because the increase in the value of the debt instrument over its 
adjusted issue price is due to an increase in the expected amount of 
the contingent payment.
    (iii) Treatment of debt instrument for 1998. Based on the 
projected payment schedule, $60 of interest accrues on the debt 
instrument from July 1, 1998 to December 31, 1998 (the product of 
the debt instrument's adjusted issue price on July 1, 1998 ($1,162) 
and the comparable yield properly adjusted for the length of the 
accrual period (10.25 percent/2)). Z has no net negative or positive 
adjustments for 1998. Thus, Z includes in income $60 of total daily 
portions of interest for 1998. On December 31, 1998, Z's adjusted 
basis in the debt instrument is $1,465 ($1,405 original basis, plus 
total daily portions of $60 for 1998).
    (iv) Effect of allocation to contingent payment at maturity. 
Assume that the payment actually made on December 31, 1999, is 
$1,400, rather than the projected $1,350. Thus, under paragraph 
(b)(6)(i) of this section, Z has a positive adjustment of $50 on 
December 31, 1999. In addition, under paragraph (b)(9)(i)(B) of this 
section, Z has a negative adjustment of $243 on December 31, 1999, 
which is attributable to the difference between Z's basis in the 
debt instrument on July 1, 1998, and the instrument's adjusted issue 
price on that date. As a result, Z has a net negative adjustment of 
$193 for 1999. This net negative adjustment reduces to zero the $128 
total daily portions of interest Z would otherwise include in income 
in 1999. Accordingly, Z has no interest income on the debt 
instrument for 1999. Because Z had $60 of interest inclusions for 
1998, $60 of the remaining $65 net negative adjustment is treated by 
Z as an ordinary loss for 1999. The remaining $5 of the net negative 
adjustment is a negative adjustment carryforward for 1999 that 
reduces the amount realized by Z on the retirement of the debt 
instrument from $1,350 to $1,345.
    (v) Loss at maturity. On December 31, 1999, Z's basis in the 
debt instrument is $1,350 ($1,405 original basis, plus total daily 
portions of $60 for 1998 and $128 for 1999, minus the negative 
adjustment of $243). As a result, Z realizes a loss of $5 on the 
retirement of the debt instrument (the difference between the amount 
realized on the retirement ($1,345) and Z's adjusted basis in the 
debt instrument ($1,350)). Under paragraph (b)(8)(ii) of this 
section, the $5 loss is treated as loss from the retirement of the 
debt instrument. Consequently, Z realizes a total loss of $65 on the 
debt instrument for 1999 (a $60 ordinary loss and a $5 capital 
loss).
    Example 2. Basis less than adjusted issue price--(i) Facts. On 
January 1, 1999, Y purchases for $910 a debt instrument that pays 7 
percent interest semiannually on June 30 and December 31 of each 
year, and that promises to pay on December 31, 2001, $1,000 plus or 
minus $10 times the positive or negative difference, if any, between 
a specified amount and the value of an index on December 31, 2001. 
However, the payment on December 31, 2001, may not be less than 
$650. The debt instrument was originally issued on December 31, 
1996, for an issue price of $1,000. The comparable yield for the 
debt instrument is 9.80 percent, compounded semiannually, and the 
projected payment schedule for the debt instrument (determined as of 
the issue date) provides for semiannual payments of $35 and a 
contingent payment at maturity of $1,175. On January 1, 1999, the 
debt instrument has an adjusted issue price of $1,060, assuming 
semiannual accrual periods ending on December 31 and June 30 of each 
year. Y is a calendar year taxpayer.
    (ii) Allocation of the difference between basis and adjusted 
issue price. Y's basis in the debt instrument on January 1, 1999, is 
$910. Under paragraph (b)(9)(i)(A) of this section, Y must allocate 
the $150 difference between basis ($910) and adjusted issue price 
($1,060) to daily portions of interest or to projected payments. 
These amounts will be positive adjustments taken into account at the 
time the daily portions accrue or the payments are made.
    (A) Assume that, because of a decrease in the relevant index, 
the expected value of the payment at maturity has declined by about 
9 percent. Based on forward prices on January 1, 1999, Y determines 
that approximately $105 of the difference between basis and adjusted 
issue price is allocable to the contingent payment. Y allocates the 
remaining $45 to daily portions of interest on a pro-rata basis 
(i.e., the amount allocated to an accrual period equals the product 
of $45 and a fraction, the numerator of which is the total daily 
portions for the accrual period and the denominator of which is the 
total daily portions remaining on the debt instrument on January 1, 
1999). This allocation is reasonable.
    (B) Assume alternatively that, based on yields of comparable 
debt instruments and its purchase price for the debt instrument, Y 
determines that an appropriate yield for the debt instrument is 13 
percent, compounded semiannually. Based on this determination, Y 
allocates $55.75 of the difference between basis and adjusted issue 
price to daily portions of interest as follows: $15.19 to the daily 
portions of interest for the taxable year ending December 31, 1999; 
$18.40 to the daily portions of interest for the taxable year ending 
December 31, 2000; and $22.16 to the daily portions of interest for 
the taxable year ending December 31, 2001. Y allocates the remaining 
$94.25 to the contingent payment at maturity. This allocation is 
reasonable.

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

[[Page 30150]]

payment becomes fixed, using a discount rate equal to the comparable 
yield on the debt instrument. The adjustment is treated as a positive 
or negative adjustment, as appropriate, on the date the contingent 
payment becomes fixed. See paragraph (b)(9)(ii)(G) of this section to 
determine the timing of the adjustment if all remaining contingent 
payments on the debt instrument become fixed substantially 
contemporaneously.
    (B) Payment schedule. The contingent payment is no longer treated 
as a contingent payment after the date the amount of the payment 
becomes fixed. On the date the contingent payment becomes fixed, the 
projected payment schedule for the debt instrument is modified 
prospectively to reflect the fixed amount of the payment. Therefore, no 
adjustment is made under paragraph (b)(3)(iv) of this section when the 
contingent payment is actually made.
    (C) Accrual period. Notwithstanding the determination under 
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) Adjustments to basis and adjusted issue price. The amount of 
any positive adjustment on a debt instrument determined under paragraph 
(b)(9)(ii)(A) of this section increases the adjusted issue price of the 
instrument and the holder's adjusted basis in the instrument. 
Similarly, the amount of any negative adjustment on a debt instrument 
determined under paragraph (b)(9)(ii)(A) of this section decreases the 
adjusted issue price of the instrument and the holder's adjusted basis 
in the instrument.
    (E) Basis different from adjusted issue price. If a holder's basis 
in a debt instrument exceeds the debt instrument's adjusted issue 
price, the amount allocated to a projected payment under paragraph 
(b)(9)(i) of this section is treated as a negative adjustment on the 
date the payment becomes fixed. If a holder's basis in a debt 
instrument is less than the debt instrument's adjusted issue price, the 
amount allocated to a projected payment under paragraph (b)(9)(i) of 
this section is treated as a positive adjustment on the date the 
payment becomes fixed.
    (F) Special rule for certain contingent interest payments. 
Notwithstanding paragraph (b)(9)(ii)(A) of this section, this paragraph 
(b)(9)(ii)(F) applies to contingent stated interest payments that are 
adjusted to compensate for contingencies regarding the reasonableness 
of the debt instrument's stated rate of interest. For example, this 
paragraph (b)(9)(ii)(F) applies to a debt instrument that provides for 
an increase in the stated rate of interest if the credit quality of the 
issuer or liquidity of the debt instrument deteriorates. Contingent 
stated interest payments of this type are recognized over the period to 
which they relate in a reasonable manner.
    (G) Special rule when all contingent payments become fixed. 
Notwithstanding paragraph (b)(9)(ii)(A) of this section, if all the 
remaining contingent payments on a debt instrument become fixed 
substantially contemporaneously, any positive or negative adjustments 
on the instrument are taken into account in a reasonable manner over 
the period to which they relate. For purposes of the preceding 
sentence, a payment is treated as a fixed payment if all remaining 
contingencies with respect to the payment are remote or incidental 
(within the meaning of Sec. 1.1275-2(h)).
    (H) Example. The following example illustrates the provisions of 
this paragraph (b)(9)(ii). In this example, assume that the instrument 
described is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the instrument is a debt 
instrument for federal income tax purposes.

    Example. Fixed but deferred payments--(i) Facts. On December 31, 
1996, B, a calendar year taxpayer, purchases a debt instrument at 
original issue for $1,000. The debt instrument matures on December 
31, 2002, and provides for a payment of $1,000 at maturity. In 
addition, on December 31, 1999, and December 31, 2002, the debt 
instrument provides for payments equal to the excess of the average 
daily value of an index for the 6-month period ending on September 
30 of the preceding year over a specified amount. The debt 
instrument's comparable yield is 10 percent, compounded annually, 
and the instrument's projected payment schedule consists of a 
payment of $250 on December 31, 1999, and a payment of $1,439 on 
December 31, 2002. B uses annual accrual periods.
    (ii) Interest accrual for 1997. Based on the projected payment 
schedule, B includes a total of $100 of daily portions of interest 
in income in 1997. B's adjusted basis in the debt instrument and the 
debt instrument's adjusted issue price on December 31, 1997, is 
$1,100.
    (iii) Interest accrual for 1998--(A) Adjustment. Based on the 
projected payment schedule, B would include $110 of total daily 
portions of interest in income in 1998. However, assume that on 
September 30, 1998, the payment due on December 31, 1999, fixes at 
$300, rather than the projected $250. Thus, on September 30, 1998, B 
has an adjustment equal to the difference between the present value 
of the $300 fixed amount and the present value of the $250 projected 
amount of the contingent payment. The present values of the two 
payments are determined by discounting each payment from the date 
the payment is due (December 31, 1999) to the date the payment 
becomes fixed (September 30, 1998), using a discount rate equal to 
10 percent, compounded annually. The present value of the fixed 
payment is $266.30 and the present value of the projected amount of 
the contingent payment is $221.91. Thus, on September 30, 1998, B 
has a positive adjustment of $44.39 ($266.30-$221.91).
    (B) Effect of adjustment. Under paragraph (b)(9)(ii)(C) of this 
section, B's accrual period ends on September 30, 1998. The daily 
portions of interest on the debt instrument for the period from 
January 1, 1998 to September 30, 1998 total $81.51. The adjusted 
issue price of the debt instrument and B's adjusted basis in the 
debt instrument are thus increased over this period by $125.90 (the 
sum of the daily portions of interest of $81.51 and the positive 
adjustment of $44.39 made at the end of the period) to $1,225.90. 
For purposes of all future accrual periods, including the new 
accrual period from October 1, 1998, to December 31, 1998, the debt 
instrument's projected payment schedule is modified to reflect a 
fixed payment of $300 on December 31, 1999. Based on the new 
adjusted issue price of the debt instrument and the new projected 
payment schedule, the yield on the debt instrument does not change.
    (C) Interest accrual for 1998. Based on the modified projected 
payment schedule, $29.56 of interest accrues during the accrual 
period that ends on December 31, 1998. Because B has no other 
adjustments during 1998, the $44.39 positive adjustment on September 
30, 1998, results in a net positive adjustment for 1998, which is 
additional interest for that year. Thus, B includes $155.46 
($81.51+$29.56+$44.39) of interest in income in 1998. B's adjusted 
basis in the debt instrument and the debt instrument's adjusted 
issue price on December 31, 1998, is $1,255.46 ($1,225.90 from the 
end of the prior accrual period plus $29.56 total daily portions for 
the current accrual period).

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

[[Page 30151]]

income to which income from such debt instrument belongs. Accordingly, 
if a U.S. person holds a debt instrument issued by a related controlled 
foreign corporation and, pursuant to section 904(d)(3) and the 
regulations thereunder, any interest accrued by such U.S. person with 
respect to such debt instrument would be treated as foreign source 
general limitation income, any deductions relating to a net negative 
adjustment will reduce the U.S. person's foreign source general 
limitation income. The holder shall apply the general rules relating to 
allocation and apportionment of deductions to any other deduction or 
loss realized by the holder with respect to the debt instrument.
    (B) Investments in United States real property. Notwithstanding 
paragraph (b)(8)(i) of this section, gain on the sale, exchange, or 
retirement of a debt instrument that is a United States real property 
interest is treated as gain for purposes of sections 897, 1445, and 
6039C.
    (v) Coordination with subchapter M and related provisions. For 
purposes of sections 852(c)(2) and 4982 and Sec. 1.852-11, any positive 
adjustment, negative adjustment, income, or loss on a debt instrument 
that occurs after October 31 of a taxable year is treated in the same 
manner as foreign currency gain or loss that is attributable to a 
section 988 transaction.
    (vi) Coordination with section 1092. A holder treats a negative 
adjustment and an issuer treats a positive adjustment as a loss with 
respect to a position in a straddle if the debt instrument is a 
position in a straddle and the contingency (or any portion of the 
contingency) to which the adjustment relates would be part of the 
straddle if entered into as a separate position.
    (c) Method for debt instruments not subject to the noncontingent 
bond method--(1) Applicability. This paragraph (c) applies to a 
contingent payment debt instrument (other than a tax-exempt obligation) 
that has an issue price determined under Sec. 1.1274-2. For example, 
this paragraph (c) generally applies to a contingent payment debt 
instrument that is issued for nonpublicly traded property.
    (2) Separation into components. If paragraph (c) of this section 
applies to a debt instrument (the overall debt instrument), the 
noncontingent payments are subject to the rules in paragraph (c)(3) of 
this section, and the contingent payments are accounted for separately 
under the rules in paragraph (c)(4) of this section.
    (3) Treatment of noncontingent payments. The noncontingent payments 
are treated as a separate debt instrument. The issue price of the 
separate debt instrument is the issue price of the overall debt 
instrument, determined under Sec. 1.1274-2(g). 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.
    (4) Treatment of contingent payments--(i) In general. Except as 
provided in paragraph (c)(4)(iii) of this section, the portion of a 
contingent payment treated as interest under paragraph (c)(4)(ii) of 
this section is includible in gross income by the holder and deductible 
from gross income by the issuer in their respective taxable years in 
which the payment is made.
    (ii) Characterization of contingent payments as principal and 
interest--(A) General rule. A contingent payment is treated as a 
payment of principal in an amount equal to the present value of the 
payment, determined by discounting the payment at the test rate from 
the date the payment is made to the issue date. The amount of the 
payment in excess of the amount treated as principal under the 
preceding sentence is treated as a payment of interest.
    (B) Test rate. The test rate used for purposes of paragraph 
(c)(4)(ii)(A) of this section is the rate that would be the test rate 
for the overall debt instrument under 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 made. 
However, in the case of a contingent payment that consists of a payment 
of stated principal accompanied by a payment of stated interest at a 
rate that exceeds the test rate determined under the preceding 
sentence, the test rate is the stated interest rate.
    (iii) Certain delayed contingent payments--(A) General rule. 
Notwithstanding paragraph (c)(4)(ii) of this section, if a contingent 
payment becomes fixed more than 6 months before the payment is due, the 
issuer and holder are treated as if the issuer had issued a separate 
debt instrument on the date the payment becomes fixed, maturing on the 
date the payment is due. This separate debt instrument is treated as a 
debt instrument to which section 1274 applies. The stated principal 
amount of this separate debt instrument is the amount of the payment 
that becomes fixed. An amount equal to the issue price of this debt 
instrument is characterized as interest or principal under the rules of 
paragraph (c)(4)(ii) of this section and accounted for as if this 
amount had been paid by the issuer to the holder on the date that the 
amount of the payment becomes fixed. To determine the issue price of 
the separate debt instrument, the payment is discounted at the test 
rate from the maturity date of the separate debt instrument to the date 
that the amount of the payment becomes fixed.
    (B) Test rate. The test rate used for purposes of paragraph 
(c)(4)(iii)(A) of this section is determined in the same manner as the 
test rate under paragraph (c)(4)(ii)(B) of this section is determined 
except that the date the contingent payment is due is used rather than 
the date the contingent payment is made.
    (5) Basis different from adjusted issue price. This paragraph 
(c)(5) provides rules for a holder whose basis in a debt instrument is 
different from the instrument's adjusted issue price (e.g., a 
subsequent holder). This paragraph (c)(5), however, does not apply if 
the holder is reporting income under the installment method of section 
453.
    (i) Allocation of basis. The holder must allocate basis to the 
noncontingent component (i.e., the right to the noncontingent payments) 
and to any separate debt instruments described in paragraph (c)(4)(iii) 
of this section in an amount up to the total of the adjusted issue 
price of the noncontingent component and the adjusted issue prices of 
the separate debt instruments. The holder must allocate the remaining 
basis, if any, to the contingent component (i.e., the right to the 
contingent payments).
    (ii) Noncontingent component. Any difference between the holder's 
basis in the noncontingent component and the adjusted issue price of 
the noncontingent component, and any difference between the holder's 
basis in a separate debt instrument and the adjusted issue price of the 
separate debt instrument, is taken into account under the rules for 
market discount, premium, and acquisition premium that apply to a 
noncontingent debt instrument.
    (iii) Contingent component. Amounts received by the holder that are 
treated as principal payments under paragraph (c)(4)(ii) of this 
section reduce the holder's basis in the contingent component. If the 
holder's basis in the contingent component is reduced to zero, any 
additional principal payments on the contingent component are treated 
as gain from the sale or exchange of the debt instrument. Any basis 
remaining on the contingent component on the date the final contingent 
payment is made increases the holder's adjusted basis in the 
noncontingent component

[[Page 30152]]

(or, if there are no remaining noncontingent payments, is treated as 
loss from the sale or exchange of the debt instrument).
    (6) Treatment of a holder on sale, exchange, or retirement. This 
paragraph (c)(6) provides rules for the treatment of a holder on the 
sale, exchange, or retirement of a debt instrument subject to this 
paragraph (c). Under this paragraph (c)(6), the holder must allocate 
the amount received from the sale, exchange, or retirement of a debt 
instrument first to the noncontingent component and to any separate 
debt instruments described in paragraph (c)(4)(iii) of this section in 
an amount up to the total of the adjusted issue price of the 
noncontingent component and the adjusted issue prices of the separate 
debt instruments. The holder must allocate the remaining amount 
received, if any, to the contingent component.
    (i) Amount allocated to the noncontingent component. The amount 
allocated to the noncontingent component and any separate debt 
instruments is treated as an amount realized from the sale, exchange, 
or retirement of the noncontingent component or separate debt 
instrument.
    (ii) Amount allocated to the contingent component. The amount 
allocated to the contingent component is treated as a contingent 
payment that is made on the date of the sale, exchange, or retirement 
and is characterized as interest and principal under the rules of 
paragraph (c)(4)(ii) of this section.
    (7) Examples. The following examples illustrate the provisions of 
this paragraph (c). In each example, assume that the instrument 
described is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the instrument is a debt 
instrument for federal income tax purposes.

    Example 1. Contingent interest payments--(i) Facts. A owns 
Blackacre, unencumbered depreciable real estate. On January 1, 1997, 
A sells Blackacre to B. As consideration for the sale, B makes a 
downpayment of $1,000,000 and issues to A a debt instrument that 
matures on December 31, 2001. The debt instrument provides for a 
payment of principal at maturity of $5,000,000 and a contingent 
payment of interest on December 31 of each year equal to a fixed 
percentage of the gross rents B receives from Blackacre in that 
year. Assume that the debt instrument is not issued in a potentially 
abusive situation. Assume also that on January 1, 1997, the short-
term applicable Federal rate is 5 percent, compounded annually, and 
the mid-term applicable Federal rate is 6 percent, compounded 
annually.
    (ii) Determination of issue price. Under Sec. 1.1274-2(g), the 
issue price of the debt instrument is $3,736,291, which is the 
present value, as of the issue date, of the $5,000,000 noncontingent 
payment due at maturity, calculated using a discount rate equal to 
the mid-term applicable Federal rate. Under Sec. 1.1012-1(g)(1), B's 
basis in Blackacre on January 1, 1997, is $4,736,291 ($1,000,000 
down payment plus the $3,736,291 issue price of the debt 
instrument).
    (iii) Noncontingent payment treated as separate debt instrument. 
Under paragraph (c)(3) of this section, the right to the 
noncontingent payment of principal at maturity is treated as a 
separate debt instrument. The issue price of this separate debt 
instrument is $3,736,291 (the issue price of the overall debt 
instrument). The separate debt instrument has a stated redemption 
price at maturity of $5,000,000 and, therefore, OID of $1,263,709.
    (iv) Treatment of contingent payments. Assume that the amount of 
contingent interest that is fixed and paid on December 31, 1997, is 
$200,000. Under paragraph (c)(4)(ii) of this section, this payment 
is treated as consisting of a payment of principal of $190,476, 
which is the present value of the payment, determined by discounting 
the payment at the test rate of 5 percent, compounded annually, from 
the date the payment is made to the issue date. The remainder of the 
$200,000 payment ($9,524) is treated as interest. The additional 
amount treated as principal gives B additional basis in Blackacre on 
December 31, 1997. The portion of the payment treated as interest is 
includible in gross income by A and deductible by B in their 
respective taxable years in which December 31, 1997 occurs. The 
remaining contingent payments on the debt instrument are accounted 
for similarly, using a test rate of 5 percent, compounded annually, 
for the contingent payments due on December 31, 1998, and December 
31, 1999, and a test rate of 6 percent, compounded annually, for the 
contingent payments due on December 31, 2000, and December 31, 2001.
    Example 2. Fixed but deferred payment--(i) Facts. The facts are 
the same as in paragraph (c)(7) Example 1 of this section, except 
that the contingent payment of interest that is fixed on December 
31, 1997, is not payable until December 31, 2001, the maturity date.
    (ii) Treatment of deferred contingent payment. Assume that the 
amount of the payment that becomes fixed on December 31, 1997, is 
$200,000. Because this amount is not payable until December 31, 
2001, under paragraph (c)(4)(iii) of this section, a separate debt 
instrument to which section 1274 applies is treated as issued by B 
on December 31, 1997 (the date the payment is fixed). The maturity 
date of this separate debt instrument is December 31, 2001 (the date 
on which the payment is due). The stated principal amount of this 
separate debt instrument is $200,000, the amount of the payment that 
becomes fixed. The imputed principal amount of the separate debt 
instrument is $158,419, which is the present value, as of December 
31, 1997, of the $200,000 payment, computed using a discount rate 
equal to the test rate of the overall debt instrument (6 percent, 
compounded annually). An amount equal to the issue price of the 
separate debt instrument is treated as an amount paid on December 
31, 1997, and characterized as interest and principal under the 
rules of paragraph (c)(4)(ii) of this section. The amount of the 
deemed payment characterized as principal is equal to $150,875, 
which is the present value, as of January 1, 1997 (the issue date of 
the overall debt instrument), of the deemed payment, computed using 
a discount rate of 5 percent, compounded annually. The amount of the 
deemed payment characterized as interest is $7,544 ($158,419 
-$150,875), which is includible in gross income by A and deductible 
by B in their respective taxable years in which December 31, 1997 
occurs.

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

[[Page 30153]]

obligation), the proceeds of which were used to finance a project or 
enterprise; and
    (B) Would otherwise qualify as a variable rate debt instrument 
under Sec. 1.1275-5 except that it provides for stated interest 
payments at least annually based on a single fixed percentage of the 
revenue, value, change in value, or other similar measure of the 
performance of the refinanced project or enterprise.
    (iv) Modifications to the noncontingent bond method. If a tax-
exempt obligation is subject to this paragraph (d)(2), the following 
modifications to the noncontingent bond method described in paragraph 
(b) of this section apply to the obligation.
    (A) Daily portions and net positive adjustments. The daily portions 
of interest determined under paragraph (b)(3)(iii) of this section and 
any net positive adjustment on the obligation are interest for purposes 
of section 103.
    (B) Net negative adjustments. A net negative adjustment for a 
taxable year reduces the amount of tax-exempt interest the holder would 
otherwise account for on the obligation for the taxable year under 
paragraph (b)(3)(iii) of this section. If the net negative adjustment 
exceeds this amount, the excess is a nondeductible, noncapitalizable 
loss. If a regulated investment company (RIC) within the meaning of 
section 851 has a net negative adjustment in a taxable year that would 
be a nondeductible, noncapitalizable loss under the prior sentence, the 
RIC must use this loss to reduce its tax-exempt interest income on 
other tax-exempt obligations held during the taxable year.
    (C) Gains. Any gain recognized on the sale, exchange, or retirement 
of the obligation is gain from the sale or exchange of the obligation.
    (D) Losses. Any loss recognized on the sale, exchange, or 
retirement of the obligation is treated the same as a net negative 
adjustment under paragraph (d)(2)(iv)(B) of this section.
    (E) Special rule for losses and net negative adjustments. 
Notwithstanding paragraphs (d)(2)(iv) (B) and (D) of this section, on 
the sale, exchange, or retirement of the obligation, the holder may 
claim a loss from the sale or exchange of the obligation to the extent 
the holder has not received in cash or property the sum of its original 
investment in the obligation and any amounts included in income under 
paragraph (d)(4)(ii) of this section.
    (3) All other tax-exempt obligations--(i) Applicability. This 
paragraph (d)(3) applies to a tax-exempt obligation that is not subject 
to paragraph (d)(2) of this section.
    (ii) Modifications to the noncontingent bond method. If a tax-
exempt obligation is subject to this paragraph (d)(3), the following 
modifications to the noncontingent bond method described in paragraph 
(b) of this section apply to the obligation.
    (A) Modification to projected payment schedule. The comparable 
yield for the obligation is the greater of the obligation's yield, 
determined without regard to the contingent payments, and the tax-
exempt applicable Federal rate that applies to the obligation. The 
Internal Revenue Service publishes the tax-exempt applicable Federal 
rate for each month in the Internal Revenue Bulletin (see 
Sec. 601.601(d)(2)(ii) of this chapter).
    (B) Daily portions. The daily portions of interest determined under 
paragraph (b)(3)(iii) of this section are interest for purposes of 
section 103.
    (C) Adjustments. A net positive adjustment on the obligation is 
treated as gain to the holder from the sale or exchange of the 
obligation in the taxable year of the adjustment. A net negative 
adjustment on the obligation is treated as a loss to the holder from 
the sale or exchange of the obligation in the taxable year of the 
adjustment.
    (D) Gains and losses. Any gain or loss recognized on the sale, 
exchange, or retirement of the obligation is gain or loss from the sale 
or exchange of the obligation.
    (4) Basis different from adjusted issue price. This paragraph 
(d)(4) provides rules for a holder whose basis in a tax-exempt 
obligation is different from the adjusted issue price of the 
obligation. The rules of paragraph (b)(9)(i) of this section do not 
apply to tax-exempt obligations.
    (i) Basis greater than adjusted issue price. If the holder's basis 
in the obligation exceeds the obligation's adjusted issue price, the 
holder, upon acquiring the obligation, must allocate this difference to 
daily portions of interest on a yield to maturity basis over the 
remaining term of the obligation. The amount allocated to a daily 
portion of interest is not deductible by the holder. However, the 
holder's basis in the obligation is reduced by the amount allocated to 
a daily portion of interest on the date the daily portion accrues.
    (ii) Basis less than adjusted issue price. If the holder's basis in 
the obligation is less than the obligation's adjusted issue price, the 
holder, upon acquiring the obligation, must allocate this difference to 
daily portions of interest on a yield to maturity basis over the 
remaining term of the obligation. The amount allocated to a daily 
portion of interest is includible in income by the holder as ordinary 
income on the date the daily portion accrues. The holder's adjusted 
basis in the obligation is increased by the amount includible in income 
by the holder under this paragraph (d)(4)(ii) on the date the daily 
portion accrues.
    (iii) Premium and discount rules do not apply. The rules for 
accruing premium and discount in sections 171, 1276, and 1288 do not 
apply. Other rules of those sections continue to apply to the extent 
relevant.
    (e) Amounts treated as interest under this section. Amounts treated 
as interest under this section are treated as OID for all purposes of 
the Internal Revenue Code.
    (f) Effective date. This section applies to debt instruments issued 
on or after August 13, 1996.
    Par. 16. Section 1.1275-5 is amended by:
    1. Revising paragraph (a)(1).
    2. Removing the language ``The debt instrument must provide for 
stated interest'' from the introductory language of paragraph (a)(3)(i) 
and adding the language ``The debt instrument must not provide for any 
stated interest other than stated interest'' in its place.
    3. Removing the language ``less than 1 year'' from the first 
sentence of paragraph (a)(3)(ii) and adding the language ``1 year or 
less'' in its place.
    4. Adding paragraphs (a)(5) and (a)(6).
    5. Revising paragraph (b)(2).
    6. Revising paragraphs (c)(1) and (c)(5).
    7. Removing the language ``cost of newly borrowed funds'' from 
paragraph (c)(3)(ii) and adding the language ``qualified floating 
rate'' in its place.
    8. Revising paragraph (d) introductory text; revising Examples 4 
through 9; and adding Example 10.
    9. Revising paragraph (e)(2).
    10. Revising paragraph (e)(3)(v) introductory text; revising 
Example 3 (ii); and removing Example 3 (iii).
    The revisions and additions read as follows:


Sec. 1.1275-5  Variable rate debt instruments.

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

[[Page 30154]]

treatment of a contingent payment debt instrument. See Sec. 1.1275-6 
for a taxpayer's treatment of a variable rate debt instrument and a 
hedge.
* * * * *
    (5) No contingent principal payments. Except as provided in 
paragraph (a)(2) of this section, the debt instrument must not provide 
for any principal payments that are contingent (within the meaning of 
Sec. 1.1275-4(a)).
    (6) Special rule for debt instruments issued for nonpublicly traded 
property. A debt instrument (other than a tax-exempt obligation) that 
would otherwise qualify as a variable rate debt instrument under this 
section is not a variable rate debt instrument if section 1274 applies 
to the instrument and any stated interest payments on the instrument 
are treated as contingent payments under Sec. 1.1274-2. This paragraph 
(a)(6) applies to debt instruments issued on or after August 13, 1996.
    (b) * * *
    (2) Certain rates based on a qualified floating rate. For a debt 
instrument issued on or after August 13, 1996, a variable rate is a 
qualified floating rate if it is equal to either--
    (i) The product of a qualified floating rate described in paragraph 
(b)(1) of this section and a fixed multiple that is greater than .65 
but not more than 1.35; or
    (ii) The product of a qualified floating rate described in 
paragraph (b)(1) of this section and a fixed multiple that is greater 
than .65 but not more than 1.35, increased or decreased by a fixed 
rate.
* * * * *
    (c) Objective rate--(1) Definition--(i) In general. For debt 
instruments issued on or after August 13, 1996, an objective rate is a 
rate (other than a qualified floating rate) that is determined using a 
single fixed formula and that is based on objective financial or 
economic information. For example, an objective rate generally includes 
a rate that is based on one or more qualified floating rates or on the 
yield of actively traded personal property (within the meaning of 
section 1092(d)(1)).
    (ii) Exception. For purposes of paragraph (c)(1)(i) of this 
section, an objective rate does not include a rate based on information 
that is within the control of the issuer (or a related party within the 
meaning of section 267(b) or 707(b)(1)) or that is unique to the 
circumstances of the issuer (or a related party within the meaning of 
section 267(b) or 707(b)(1)), such as dividends, profits, or the value 
of the issuer's stock. However, a rate does not fail to be an objective 
rate merely because it is based on the credit quality of the issuer.
* * * * *
    (5) Tax-exempt obligations. Notwithstanding paragraph (c)(1) of 
this section, in the case of a tax-exempt obligation (within the 
meaning of section 1275(a)(3)), a variable rate is an objective rate 
only if it is a qualified inverse floating rate or a qualified 
inflation rate. A rate is a qualified inflation rate if the rate 
measures contemporaneous changes in inflation based on a general 
inflation index.
    (d) Examples. The following examples illustrate the rules of 
paragraphs (b) and (c) of this section. For purposes of these examples, 
assume that the debt instrument is not a tax-exempt obligation. In 
addition, unless otherwise provided, assume that the rate is not 
reasonably expected to result in a significant front-loading or back-
loading of interest and that the rate is not based on objective 
financial or economic information that is within the control of the 
issuer (or a related party) or that is unique to the circumstances of 
the issuer (or a related party).
* * * * *

    Example 4. Rate based on changes in the value of a commodity 
index. On January 1, 1997, X issues a debt instrument that provides 
for annual interest payments at the end of each year at a rate equal 
to the percentage increase, if any, in the value of an index for the 
year immediately preceding the payment. The index is based on the 
prices of several actively traded commodities. Variations in the 
value of this interest rate cannot reasonably be expected to measure 
contemporaneous variations in the cost of newly borrowed funds. 
Accordingly, the rate is not a qualified floating rate. However, 
because the rate is based on objective financial information using a 
single fixed formula, the rate is an objective rate.
    Example 5. Rate based on a percentage of S&P 500 Index. On 
January 1, 1997, X issues a debt instrument that provides for annual 
interest payments at the end of each year based on a fixed 
percentage of the value of the S&P 500 Index. Variations in the 
value of this interest rate cannot reasonably be expected to measure 
contemporaneous variations in the cost of newly borrowed funds and, 
therefore, the rate is not a qualified floating rate. Although the 
rate is described in paragraph (c)(1)(i) of this section, the rate 
is not an objective rate because, based on historical data, it is 
reasonably expected that the average value of the rate during the 
first half of the instrument's term will be significantly less than 
the average value of the rate during the final half of the 
instrument's term.
    Example 6. Rate based on issuer's profits. On January 1, 1997, Z 
issues a debt instrument that provides for annual interest payments 
equal to 1 percent of Z's gross profits earned during the year 
immediately preceding the payment. Variations in the value of this 
interest rate cannot reasonably be expected to measure 
contemporaneous variations in the cost of newly borrowed funds. 
Accordingly, the rate is not a qualified floating rate. In addition, 
because the rate is based on information that is unique to the 
issuer's circumstances, the rate is not an objective rate.
    Example 7. Rate based on a multiple of an interest index. On 
January 1, 1997, Z issues a debt instrument with annual interest 
payments at a rate equal to two times the value of 1-year LIBOR as 
of the payment date. Because the rate is a multiple greater than 
1.35 times a qualified floating rate, the rate is not a qualified 
floating rate. However, because the rate is based on objective 
financial information using a single fixed formula, the rate is an 
objective rate.
    Example 8. Variable rate based on the cost of borrowed funds in 
a foreign currency. On January 1, 1997, Y issues a 5-year dollar 
denominated debt instrument that provides for annual interest 
payments at a rate equal to the value of 1-year French franc LIBOR 
as of the payment date. Variations in the value of French franc 
LIBOR do not measure contemporaneous changes in the cost of newly 
borrowed funds in dollars. As a result, the rate is not a qualified 
floating rate for an instrument denominated in dollars. However, 
because the rate is based on objective financial information using a 
single fixed formula, the rate is an objective rate.
    Example 9. Qualified inverse floating rate. On January 1, 1997, 
X issues a debt instrument that provides for annual interest 
payments at the end of each year at a rate equal to 12 percent minus 
the value of 1-year LIBOR as of the payment date. On the issue date, 
the value of 1-year LIBOR is 6 percent. Because the rate can 
reasonably be expected to inversely reflect contemporaneous 
variations in 1-year LIBOR, it is a qualified inverse floating rate. 
However, if the value of 1-year LIBOR on the issue date were 11 
percent rather than 6 percent, the rate would not be a qualified 
inverse floating rate because the rate could not reasonably be 
expected to inversely reflect contemporaneous variations in 1-year 
LIBOR.
    Example 10. Rate based on an inflation index. On January 1, 
1997, X issues a debt instrument that provides for annual interest 
payments at the end of each year at a rate equal to 400 basis points 
(4 percent) plus the annual percentage change in a general inflation 
index (e.g., the Consumer Price Index, U.S. City Average, All Items, 
for all Urban Consumers, seasonally unadjusted). The rate, however, 
may not be less than zero. Variations in the value of this interest 
rate cannot reasonably be expected to measure contemporaneous 
variations in the cost of newly borrowed funds. Accordingly, the 
rate is not a qualified floating rate. However, because the rate is 
based on objective economic information using a single fixed 
formula, the rate is an objective rate.

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

[[Page 30155]]

or objective rate and the interest is unconditionally payable in cash 
or in property (other than debt instruments of the issuer), or will be 
constructively received under section 451, at least annually, the 
following rules apply to the instrument:
    (i) All stated interest with respect to the debt instrument is 
qualified stated interest.
    (ii) The amount of qualified stated interest and the amount of OID, 
if any, that accrues during an accrual period is determined under the 
rules applicable to fixed rate debt instruments by assuming that the 
variable rate is a fixed rate equal to--
    (A) In the case of a qualified floating rate or qualified inverse 
floating rate, the value, as of the issue date, of the qualified 
floating rate or qualified inverse floating rate; or
    (B) In the case of an objective rate (other than a qualified 
inverse floating rate), a fixed rate that reflects the yield that is 
reasonably expected for the debt instrument.
    (iii) The qualified stated interest allocable to an accrual period 
is increased (or decreased) if the interest actually paid during an 
accrual period exceeds (or is less than) the interest assumed to be 
paid during the accrual period under paragraph (e)(2)(ii) of this 
section.
    (3) * * *
    (v) Examples. The following examples illustrate the rules in 
paragraphs (e) (2) and (3) of this section:
* * * * *
    Example 3. * * *

    (ii) Accrual of OID and qualified stated interest. Under 
paragraph (e)(2) of this section, the variable rate debt instrument 
is treated as a 2-year debt instrument that has an issue price of 
$90,000, a stated principal amount of $100,000, and interest 
payments of $5,000 at the end of each year. The debt instrument has 
$10,000 of OID and the annual interest payments of $5,000 are 
qualified stated interest payments. Under 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. 17. 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 to which each component of 
the transaction would be subject on a separate basis. The purpose of 
this section is to permit a more appropriate determination of the 
character and timing of income, deductions, gains, or losses than would 
be permitted by separate treatment of the components. The rules of this 
section affect only the taxpayer who holds (or issues) the qualifying 
debt instrument and enters into the hedge.
    (b) Definitions--(1) Qualifying debt instrument. A qualifying debt 
instrument is any debt instrument (including an integrated transaction 
as defined in paragraph (c) of this section) other than--
    (i) A tax-exempt obligation as defined in section 1275(a)(3);
    (ii) A debt instrument to which section 1272(a)(6) applies (certain 
interests in or mortgages held by a REMIC, and certain other debt 
instruments with payments subject to acceleration); or
    (iii) A debt instrument that is subject to Sec. 1.483-4 or 
Sec. 1.1275-4(c) (certain contingent payment debt instruments issued 
for nonpublicly traded property).
    (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) if the combined cash flows of the financial instrument and the 
qualifying debt instrument permit the calculation of a yield to 
maturity (under the principles of section 1272), or the right to the 
combined cash flows would qualify under Sec. 1.1275-5 as a variable 
rate debt instrument that pays interest at a qualified floating rate or 
rates (except for the requirement that the interest payments be stated 
as interest). A financial instrument is not a Sec. 1.1275-6 hedge, 
however, if the resulting synthetic debt instrument does not have the 
same term as the remaining term of the qualifying debt instrument. A 
financial instrument that hedges currency risk is not a Sec. 1.1275-6 
hedge.
    (ii) Limitations--(A) A debt instrument issued by a taxpayer and a 
debt instrument held by the taxpayer cannot be part of the same 
integrated transaction.
    (B) A debt instrument can be a Sec. 1.1275-6 hedge only if it is 
issued substantially contemporaneously with, and has the same maturity 
(including rights to accelerate or delay payments) as, the qualifying 
debt instrument.
    (3) Financial instrument. For purposes of this section, a financial 
instrument is a spot, forward, or futures contract, an option, a 
notional principal contract, a debt instrument, or a similar 
instrument, or combination or series of financial instruments. Stock is 
not a financial instrument for purposes of this section.
    (4) Synthetic debt instrument. The synthetic debt instrument is the 
hypothetical debt instrument with the same cash flows as the combined 
cash flows of the qualifying debt instrument and the 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 (e) 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), or, if the parties 
are related, the party providing the hedge uses, for federal income tax 
purposes, a mark-to-market method of accounting for the hedge and all 
similar or related transactions.
    (iii) Both the qualifying debt instrument and the 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) If the taxpayer is a foreign person engaged in a U.S. trade or 
business and the taxpayer issues or acquires a qualifying debt 
instrument, or enters into a 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 qualifying debt instrument had this section not applied.
    (v) Neither the qualifying debt instrument, nor any other debt 
instrument that is part of the same issue as the qualifying debt 
instrument, nor the Sec. 1.1275-6 hedge was, with respect

[[Page 30156]]

to the taxpayer, part of an integrated transaction that was terminated 
or otherwise legged out of within the 30 days immediately preceding the 
date that would be the issue date of the synthetic debt instrument.
    (vi) The qualifying debt instrument is issued or acquired by the 
taxpayer on or before the date of the first payment on the Sec. 1.1275-
6 hedge, whether made or received by the taxpayer (including a payment 
made to purchase the hedge). If the qualifying debt instrument is 
issued or acquired by the taxpayer after, but substantially 
contemporaneously with, the date of the first payment on the 
Sec. 1.1275-6 hedge, the qualifying debt instrument is treated, solely 
for purposes of this paragraph (c)(1)(vi), as meeting the requirements 
of the preceding sentence.
    (vii) Neither the Sec. 1.1275-6 hedge nor the qualifying debt 
instrument was, with respect to the taxpayer, part of a straddle (as 
defined in section 1092(c)) prior to the issue date of the synthetic 
debt instrument.
    (2) Integration by Commissioner. The Commissioner may treat a 
qualifying debt instrument and a financial instrument (whether entered 
into by the taxpayer or by a related party) as an integrated 
transaction if the combined cash flows on the qualifying debt 
instrument and financial instrument are substantially the same as the 
combined cash flows required for the financial instrument to be a 
Sec. 1.1275-6 hedge. The Commissioner, however, may not integrate a 
transaction unless the qualifying debt instrument either is subject to 
Sec. 1.1275-4 or is subject to Sec. 1.1275-5 and pays interest at an 
objective rate. The circumstances under which the Commissioner may 
require integration include, but are not limited to, the following:
    (i) A taxpayer fails to identify a qualifying debt instrument and 
the Sec. 1.1275-6 hedge under paragraph (e) of this section.
    (ii) A taxpayer issues or acquires a qualifying debt instrument and 
a related party (within the meaning of section 267(b) or 707(b)(1)) 
enters into the 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 within 
30 days enters into a new Sec. 1.1275-6 hedge with respect to the same 
qualifying debt instrument or another debt instrument that is part of 
the same issue.
    (d) Special rules for legging into and legging out of an integrated 
transaction--(1) Legging into--(i) Definition. Legging into an 
integrated transaction under this section means that a Sec. 1.1275-6 
hedge is entered into after the date the qualifying debt instrument is 
issued or acquired by the taxpayer, and the requirements of paragraph 
(c)(1) of this section are satisfied on the date the 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 taking interest and OID into account up to the leg-in date, 
except that the day before the leg-in date is treated as the end of an 
accrual period. As of the leg-in date, the qualifying debt instrument 
is subject to the rules of paragraph (f) of this section.
    (iii) Anti-abuse rule. If a taxpayer legs into an integrated 
transaction with a principal purpose of deferring or accelerating 
income or deductions on the qualifying debt instrument, the 
Commissioner may--
    (A) Treat the qualifying debt instrument as sold for its fair 
market value on the leg-in date; or
    (B) Refuse to allow the taxpayer to integrate the qualifying debt 
instrument and the 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 Sec. 1.1275-6 hedge ceases to meet the 
requirements for a Sec. 1.1275-6 hedge, the taxpayer fails to meet any 
requirement of paragraph (c)(1) of this section, or the taxpayer 
disposes of or otherwise terminates all or a part of the qualifying 
debt instrument or Sec. 1.1275-6 hedge. If the taxpayer fails to meet 
the requirements of paragraph (c)(1) of this section but meets the 
requirements of paragraph (c)(2) of this section, the Commissioner may 
treat the taxpayer as not legging out.
    (B) Legging out if the Commissioner has integrated. If the 
Commissioner has integrated a qualifying debt instrument and a 
financial instrument under paragraph (c)(2) of this section, legging 
out means that, prior to the maturity of the synthetic debt instrument, 
the requirements for Commissioner integration under paragraph (c)(2) of 
this section are not met or the taxpayer fails to meet the requirements 
for taxpayer integration under paragraph (c)(1) of this section and the 
Commissioner agrees to allow the taxpayer to be treated as legging out.
    (C) Exception for certain nonrecognition transactions. If, in a 
single nonrecognition transaction, a taxpayer disposes of, or ceases to 
be primarily liable on, the qualifying debt instrument and the 
Sec. 1.1275-6 hedge, the taxpayer is not treated as legging out. 
Instead, the integrated transaction is treated under the rules 
governing the nonrecognition transaction. For example, if a holder of 
an integrated transaction is acquired in a reorganization under section 
368(a)(1)(A), the holder is treated as disposing of the synthetic debt 
instrument in the reorganization rather than legging out. If the 
successor holder is not eligible for integrated treatment, the 
successor is treated as legging out.
    (ii) Operating rules. If a taxpayer legs out (or is treated as 
legging out) of an integrated transaction, the following rules apply:
    (A) The transaction is treated as an integrated transaction during 
the time the requirements of paragraph (c)(1) or (2) of this section, 
as appropriate, are satisfied.
    (B) Immediately before the taxpayer legs out, the taxpayer is 
treated as selling or otherwise terminating the synthetic debt 
instrument for its fair market value and, except as provided in 
paragraph (d)(2)(ii)(D) of this section, any income, deduction, gain, 
or loss is realized and recognized at that time.
    (C) If, immediately after the taxpayer legs out, the taxpayer holds 
or remains primarily liable on the qualifying debt instrument, 
adjustments are made to reflect any difference between the fair market 
value of the qualifying debt instrument and the adjusted issue price of 
the qualifying debt instrument. If, immediately after the taxpayer legs 
out, the taxpayer is a party to a Sec. 1.1275-6 hedge, the Sec. 1.1275-
6 hedge is treated as entered into at its fair market value.
    (D) If a taxpayer legs out of an integrated transaction by 
disposing of or otherwise terminating a 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 for any disallowed loss. The adjustments are taken into 
account on a yield to maturity basis over the remaining term of the 
qualifying debt instrument.
    (E) If a holder of a debt instrument subject to Sec. 1.1275-4 legs 
into an integrated transaction with respect to the instrument and 
subsequently legs out of the integrated transaction, any gain 
recognized under paragraph (d)(2)(ii)(B) or (C) of this section is

[[Page 30157]]

treated as interest income to the extent determined under the 
principles of Sec. 1.1275-4(b)(8)(iii)(B) (rules for determining the 
character of gain on the sale of a debt instrument all of the payments 
on which have been fixed). If the synthetic debt instrument would 
qualify as a variable rate debt instrument, the equivalent fixed rate 
debt instrument determined under Sec. 1.1275-5(e) is used for this 
purpose.
    (e) Identification requirements. For each integrated transaction, a 
taxpayer must enter and retain as part of its books and records the 
following information--
    (1) The date the qualifying debt instrument was issued or acquired 
(or is expected to be issued or acquired) by the taxpayer and the date 
the Sec. 1.1275-6 hedge was entered into by the taxpayer;
    (2) A description of the qualifying debt instrument and the 
Sec. 1.1275-6 hedge; and
    (3) 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).
    (f) Taxation of integrated transactions--(1) General rule. An 
integrated transaction is generally treated as a single transaction by 
the taxpayer during the period that the transaction qualifies as an 
integrated transaction. Except as provided in paragraph (f)(12) of this 
section, while a qualifying debt instrument and a 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 section 1092 or Sec. 1.446-4. The rules 
that would govern the treatment of the synthetic debt instrument 
generally govern the treatment of the integrated transaction. For 
example, the integrated transaction may be subject to section 263(g) 
or, if the synthetic debt instrument would be part of a straddle, 
section 1092. Generally, the synthetic debt instrument is subject to 
sections 163(e) and 1271 through 1275, with terms as set forth in 
paragraphs (f)(2) through (13) of this section.
    (2) Issue date. The issue date of the synthetic debt instrument is 
the first date on which the taxpayer entered into all of the components 
of the synthetic debt instrument.
    (3) Term. The term of the synthetic debt instrument is the period 
beginning on the issue date of the synthetic debt instrument and ending 
on the maturity date of the qualifying debt instrument.
    (4) Issue price. The issue price of the synthetic debt instrument 
is the adjusted issue price of the qualifying debt instrument on the 
issue date of the synthetic debt instrument. If, as a result of 
entering into the Sec. 1.1275-6 hedge, the taxpayer pays or receives 
one or more payments that are substantially contemporaneous with the 
issue date of the synthetic debt instrument, the payments reduce or 
increase the issue price as appropriate.
    (5) Adjusted issue price. In general, the adjusted issue price of 
the synthetic debt instrument is determined under the principles of 
Sec. 1.1275-1(b).
    (6) Qualified stated interest. No amounts payable on the synthetic 
debt instrument are qualified stated interest within the meaning of 
Sec. 1.1273-1(c).
    (7) Stated redemption price at maturity--(i) Synthetic debt 
instruments that are borrowings. In general, if the synthetic debt 
instrument is a borrowing, the instrument's stated redemption price at 
maturity is the sum of all amounts paid or to be paid on the qualifying 
debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts 
received or to be received on the Sec. 1.1275-6 hedge.
    (ii) Synthetic debt instruments that are held by the taxpayer. In 
general, if the synthetic debt instrument is held by the taxpayer, the 
instrument's stated redemption price at maturity is the sum of all 
amounts received or to be received by the taxpayer on the qualifying 
debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts 
paid or to be paid by the taxpayer on the Sec. 1.1275-6 hedge.
    (iii) Certain amounts ignored. For purposes of this paragraph 
(f)(7), if an amount paid or received on the Sec. 1.1275-6 hedge is 
taken into account under paragraph (f)(4) of this section to determine 
the issue price of the synthetic debt instrument, the amount is not 
taken into account to determine the synthetic debt instrument's stated 
redemption price at maturity.
    (8) Source of interest income and allocation of expense. The source 
of interest income from the synthetic debt instrument is determined by 
reference to the source of income of the qualifying debt instrument 
under sections 861(a)(1) and 862(a)(1). For purposes of section 904, 
the character of interest from the synthetic debt instrument is 
determined by reference to the character of the interest income from 
the qualifying debt instrument. Interest expense is allocated and 
apportioned under regulations under section 861 or under Sec. 1.882-5.
    (9) Effectively connected income. If the requirements of paragraph 
(c)(1)(iv) of this section are satisfied, any interest income resulting 
from the synthetic debt instrument entered into by the foreign person 
is treated as effectively connected with a U.S. trade or business, and 
any interest expense resulting from the synthetic debt instrument 
entered into by the foreign person is allocated and apportioned under 
Sec. 1.882-5.
    (10) Not a short-term obligation. For purposes of section 
1272(a)(2)(C), a synthetic debt instrument is not treated as a short-
term obligation.
    (11) Special rules in the event of integration by the Commissioner. 
If the Commissioner requires integration, appropriate adjustments are 
made to the treatment of the synthetic debt instrument, and, if 
necessary, the qualifying debt instrument and financial instrument. For 
example, the Commissioner may treat a financial instrument that is not 
a 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 (f)(12) provides for the retention of separate 
transaction rules for certain purposes. In addition, by publication in 
the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this 
chapter), the Commissioner may require use of separate transaction 
rules for any aspect of an integrated transaction.
    (i) Foreign persons that enter into integrated transactions giving 
rise to U.S. source income not effectively connected with a U.S. trade 
or business. If a foreign person enters into an integrated transaction 
that gives rise to U.S. source interest income (determined under the 
source rules for the synthetic debt instrument) not effectively 
connected with a U.S. trade or business of the foreign person, 
paragraph (f) of this section does not apply for purposes of sections 
871(a), 881, 1441, 1442, and 6049. These sections of the Internal 
Revenue Code are applied to the qualifying debt instrument and the 
Sec. 1.1275-6 hedge on a separate basis.
    (ii) Relationship between taxpayer and other persons. Because the 
rules of this section affect only the taxpayer that enters into an 
integrated transaction (i.e., either the issuer or a particular holder 
of a qualifying debt instrument), any provisions of the Internal 
Revenue Code or regulations that govern the relationship between the 
taxpayer and any other person are applied on a separate basis. For 
example, taxpayers

[[Page 30158]]

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. Similarly, if a 
U.S. corporation enters into an integrated transaction that includes a 
notional principal contract, the source of any payment received by the 
counterparty on the notional principal contract is determined under 
Sec. 1.863-7 as if the contract were not part of an integrated 
transaction, and, if received by a foreign person who is not engaged in 
a U.S. trade or business, the payment is non-U.S. source income that is 
not subject to U.S. withholding tax.
    (13) Coordination with consolidated return rules. If a taxpayer 
enters into a Sec. 1.1275-6 hedge with a member of the same 
consolidated group (the counterparty) and the Sec. 1.1275-6 hedge is 
part of an integrated transaction for the taxpayer, the Sec. 1.1275-6 
hedge is not treated as an intercompany transaction for purposes of 
Sec. 1.1502-13. If the taxpayer legs out of integrated treatment, the 
taxpayer and the counterparty are each treated as disposing of its 
position in the Sec. 1.1275-6 hedge under the principles of paragraph 
(d)(2) of this section. If the Sec. 1.1275-6 hedge remains in existence 
after the leg-out date, the Sec. 1.1275-6 hedge is treated under the 
rules that would otherwise apply to the transaction (including 
Sec. 1.1502-13 if the transaction is between members).
    (g) Predecessors and successors. For purposes of this section, any 
reference to a taxpayer, holder, issuer, or person includes, where 
appropriate, a reference to a predecessor or successor. For purposes of 
the preceding sentence, a predecessor is a transferor of an asset or 
liability (including an integrated transaction) to a transferee (the 
successor) in a nonrecognition transaction. Appropriate adjustments, if 
necessary, are made in the application of this section to predecessors 
and successors.
    (h) Examples. The following examples illustrate the provisions of 
this section. In each example, assume that the qualifying debt 
instrument is a debt instrument for federal income tax purposes. No 
inference is intended, however, as to whether the debt instrument is a 
debt instrument for federal income tax purposes.

    Example 1. Issuer hedge--(i) Facts. On January 1, 1997, V, a 
domestic corporation, issues a 5-year debt instrument for $1,000. 
The debt instrument provides for annual payments of interest at a 
rate equal to the value of 1-year LIBOR and a principal payment of 
$1,000 at maturity. On the same day, V enters into a 5-year interest 
rate swap agreement with an unrelated party. Under the swap, V pays 
6 percent and receives 1-year LIBOR on a notional principal amount 
of $1,000. The payments on the swap are fixed and made on the same 
days as the payments on the debt instrument. On January 1, 1997, V 
identifies the debt instrument and the swap as an integrated 
transaction in accordance with the requirements of paragraph (e) of 
this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument. The swap is a 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 (f)(6) of 
this section, no amounts payable on the synthetic debt instrument 
are qualified stated interest. Thus, under paragraph (f)(7)(i) of 
this section, the synthetic debt instrument has a stated redemption 
price at maturity of $1,300 (the sum of all amounts to be paid on 
the qualifying debt instrument and the swap, reduced by amounts to 
be received on the swap). The synthetic debt instrument, therefore, 
has $300 of OID.
    Example 2. Issuer hedge with an option--(i) Facts. On December 
31, 1996, W, a domestic corporation, issues for $1,000 a debt 
instrument that matures on December 31, 1999. The debt instrument 
has a stated principal amount of $1,000 payable at maturity. The 
debt instrument also provides for a payment at maturity equal to $10 
times the increase, if any, in the value of a nationally known 
composite index of stocks from December 31, 1996, to the maturity 
date. On December 31, 1996, W purchases from an unrelated party an 
option that pays $10 times the increase, if any, in the stock index 
from December 31, 1996, to December 31, 1999. W pays $250 for the 
option. On December 31, 1996, W identifies the debt instrument and 
option as an integrated transaction in accordance with the 
requirements of paragraph (e) of this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument. The option is a 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. Under 
paragraph (f)(4) of this section, the issue price of the synthetic 
debt instrument is equal to the issue price of the debt instrument 
($1,000) reduced by the payment for the option ($250). As a result, 
the synthetic debt instrument is a 3-year debt instrument with an 
issue price of $750. Under paragraph (f)(7) of this section, the 
synthetic debt instrument has a stated redemption price at maturity 
of $1,000 (the $250 payment for the option is not taken into 
account). The synthetic debt instrument, therefore, has $250 of OID.
    Example 3. Hedge with prepaid swap--(i) Facts. On January 1, 
1997, H purchases for 1,000 a 5-year debt instrument 
that provides for semiannual payments based on 6-month pound LIBOR 
and a payment of the 1,000 principal at maturity. On the 
same day, H enters into a swap with an unrelated third party under 
which H receives semiannual payments, in pounds, of 10 percent, 
compounded semiannually, and makes semiannual payments, in pounds, 
of 6-month pound LIBOR on a notional principal amount of 
1,000. Payments on the swap are fixed and made on the 
same dates as the payments on the debt instrument. H also makes a 
162 prepayment on the swap. On January 1, 1997, H 
identifies the swap and the debt instrument as an integrated 
transaction in accordance with the requirements of paragraph (e) of 
this section.
    (ii) Eligibility for integration. The debt instrument is a 
qualifying debt instrument. The swap is a 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. 
Therefore, the transaction is an integrated transaction under this 
section. 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. Under 
paragraph (f)(4) of this section, the issue price of the synthetic 
debt instrument is equal to the issue price of the debt instrument 
(1,000) increased by the prepayment on the swap 
(162). As a result, the synthetic debt instrument is a 
5-year debt instrument that has an issue price of 1,162 
and provides for semiannual interest payments of 50 and 
a principal payment of 1,000 at maturity. Under 
paragraph (f)(6) of this section, no amounts payable on the 
synthetic debt instrument are qualified stated interest. Thus, under 
paragraph (f)(7)(ii) of this section, the synthetic debt 
instrument's stated redemption price at maturity is 
1,500 (the sum of all amounts to be received on the 
qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by 
all amounts to be paid on the Sec. 1.1275-6 hedge other than the 
162 prepayment for the swap). The synthetic debt 
instrument, therefore, has 338 of OID.
    Example 4. Legging into an integrated transaction by a holder--
(i) Facts. On December 31, 1996, X corporation purchases for 
$1,000,000 a debt instrument that matures on December 31, 2006. The 
debt instrument provides for annual payments of interest at the rate 
of 6 percent and for a payment at maturity equal to $1,000,000, 
increased by the excess, if any, of the price of 1,000 units of a 
commodity on December 31, 2006, over

[[Page 30159]]

$350,000, and decreased by the excess, if any, of $350,000 over the 
price of 1,000 units of the commodity on that date. The projected 
amount of the payment at maturity determined under Sec. 1.1275-
4(b)(4) is $1,020,000. On December 31, 1999, X enters into a cash-
settled forward contract with an unrelated party to sell 1,000 units 
of the commodity on December 31, 2006, for $450,000. On December 31, 
1999, X also identifies the debt instrument and the forward contract 
as an integrated transaction in accordance with the requirements of 
paragraph (e) of this section.
    (ii) Eligibility for integration. X meets the requirements for 
integration as of December 31, 1999. Therefore, X legged into an 
integrated transaction on that date. Prior to that date, X treats 
the debt instrument under the applicable rules of Sec. 1.1275-4.
    (iii) Treatment of the synthetic debt instrument. As of December 
31, 1999, the debt instrument and the forward contract are treated 
as an integrated transaction. The issue price of the synthetic debt 
instrument is equal to the adjusted issue price of the qualifying 
debt instrument on the leg-in date, $1,004,804 (assuming one year 
accrual periods). The term of the synthetic debt instrument is from 
December 31, 1999, to December 31, 2006. The synthetic debt 
instrument provides for annual interest payments of $60,000 and a 
principal payment at maturity of $1,100,000 ($1,000,000 + $450,000 - 
$350,000). Under paragraph (f)(6) of this section, no amounts 
payable on the synthetic debt instrument are qualified stated 
interest. Thus, under paragraph (f)(7)(ii) of this section, the 
synthetic debt instrument's stated redemption price at maturity is 
$1,520,000 (the sum of all amounts to be received by X on the 
qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by 
all amounts to be paid by X on the Sec. 1.1275-6 hedge). The 
synthetic debt instrument, therefore, has $515,196 of OID.
    Example 5. Abusive leg-in--(i) Facts. On January 1, 1997, Y 
corporation purchases for $1,000,000 a debt instrument that matures 
on December 31, 2001. The debt instrument provides for annual 
payments of interest at the rate of 6 percent, a payment on December 
31, 1999, of the increase, if any, in the price of a commodity from 
January 1, 1997, to December 31, 1999, and a payment at maturity of 
$1,000,000 and the increase, if any, in the price of the commodity 
from December 31, 1999 to maturity. Because the debt instrument is a 
contingent payment debt instrument subject to Sec. 1.1275-4, Y 
accrues interest based on the projected payment schedule.
    (ii) Leg-in. By late 1999, the price of the commodity has 
substantially increased, and Y expects a positive adjustment on 
December 31, 1999. In late 1999, Y enters into an agreement to 
exchange the two commodity based payments on the debt instrument for 
two payments on the same dates of $100,000 each. Y identifies the 
transaction as an integrated transaction in accordance with the 
requirements of paragraph (e) of this section. Y disposes of the 
hedge in early 2000.
    (iii) Treatment. The legging into an integrated transaction has 
the effect of deferring the positive adjustment from 1999 to 2000. 
Because Y legged into the integrated transaction with a principal 
purpose to defer the positive adjustment, the Commissioner may treat 
the debt instrument as sold for its fair market value on the leg-in 
date or refuse to allow integration.
    Example 6. Integration of offsetting debt instruments--(i) 
Facts. On January 1, 1997, Z issues two 10-year debt instruments. 
The first, Issue 1, has an issue price of $1,000, pays interest 
annually at 6 percent, and, at maturity, pays $1,000, increased by 
$1 times the increase, if any, in the value of the S&P 100 Index 
over the term of the instrument and reduced by $1 times the 
decrease, if any, in the value of the S&P 100 Index over the term of 
the instrument. However, the amount paid at maturity may not be less 
than $500 or more than $1,500. The second, Issue 2, has an issue 
price of $1,000, pays interest annually at 8 percent, and, at 
maturity, pays $1,000, reduced by $1 times the increase, if any, in 
the value of the S&P 100 Index over the term of the instrument and 
increased by $1 times the decrease, if any, in the value of the S&P 
100 Index over the term of the instrument. The amount paid at 
maturity may not be less than $500 or more than $1,500. On January 
1, 1997, Z identifies Issue 1 as the qualifying debt instrument, 
Issue 2 as a Sec. 1.1275-6 hedge, and otherwise meets the 
identification requirements of paragraph (e) of this section.
    (ii) Eligibility for integration. Both Issue 1 and Issue 2 are 
qualifying debt instruments. Z has met the identification 
requirements by identifying Issue 1 as the qualifying debt 
instrument and Issue 2 as the 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 $2,000, provides for a payment 
at maturity of $2,000, and, in addition, provides for annual 
payments of $140. Under paragraph (f)(6) of this section, no amounts 
payable on the synthetic debt instrument are qualified stated 
interest. Thus, under paragraph (f)(7)(i) of this section, the 
synthetic debt instrument's stated redemption price at maturity is 
$3,400 (the sum of all amounts to be paid on the qualifying debt 
instrument and the Sec. 1.1275-6 hedge, reduced by amounts to be 
received on the Sec. 1.1275-6 hedge other than the $1,000 payment 
received on the issue date). The synthetic debt instrument, 
therefore, has $1,400 of OID.
    Example 7. Integrated transaction entered into by a foreign 
person--(i) Facts. X, a foreign person, enters into an integrated 
transaction by purchasing a qualifying debt instrument that pays 
U.S. source interest and entering into a notional principal contract 
with a U.S. corporation. Neither the income from the qualifying debt 
instrument nor the income from the notional principal contract is 
effectively connected with a U.S. trade or business. The notional 
principal contract is a Sec. 1.1275-6 hedge.
    (ii) Treatment of integrated transaction. Under paragraph (f)(8) 
of this section, X will receive U.S. source income from the 
integrated transaction. However, under paragraph (f)(12)(i) of this 
section, the qualifying debt instrument and the notional principal 
contract are treated as if they are not part of an integrated 
transaction for purposes of determining whether tax is due and must 
be withheld on income. Accordingly, because the Sec. 1.1275-6 hedge 
would produce foreign source income under Sec. 1.863-7 to X if it 
were not part of an integrated transaction, any income on the 
Sec. 1.1275-6 hedge generally will not be subject to tax under 
sections 871(a) and 881, and the U.S. corporation that is the 
counterparty will not be required to withhold tax on payments under 
the Sec. 1.1275-6 hedge under sections 1441 and 1442.

    (i) [Reserved]
    (j) Effective date. This section applies to a qualifying debt 
instrument issued on or after August 13, 1996. This section also 
applies to a qualifying debt instrument acquired by the taxpayer on or 
after August 13, 1996, if--
    (1) The qualifying debt instrument is a fixed rate debt instrument 
or a variable rate debt instrument; or
    (2) The qualifying debt instrument and the Sec. 1.1275-6 hedge are 
acquired by the taxpayer substantially contemporaneously.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 18. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

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


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                *         *         *         *         *               
1.1272-1(c)(4).............................................    1545-1353
                                                                        
                *         *         *         *         *               
1.1275-3(b)................................................    1545-1353
1.1275-3(c)................................................    1545-0887
                                                                        
                *         *         *         *         *               
------------------------------------------------------------------------

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


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

[[Page 30160]]



------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                *         *         *         *         *               
1.1275-2...................................................    1545-1450
1.1275-3...................................................    1545-0887
                                                               1545-1353
                                                               1545-1450
1.1275-4...................................................    1545-1450
1.1275-6...................................................    1545-1450
                                                                        
                *         *         *         *         *               
------------------------------------------------------------------------

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