[Federal Register Volume 68, Number 168 (Friday, August 29, 2003)]
[Proposed Rules]
[Pages 51944-51958]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-21827]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106486-98; INTL-0015-91]
RIN 1545-AW33; RIN 1545-PP78


Guidance Regarding the Treatment of Certain Contingent Payment 
Debt Instruments With One or More Payments That Are Denominated in, or 
Determined by Reference to, a Nonfunctional Currency

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; notice of public hearing; and 
withdrawal of previous proposed regulations section.

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SUMMARY: This document contains proposed regulations regarding the 
treatment of contingent payment debt instruments for which one or more 
payments are denominated in, or determined by reference to, a currency 
other than the taxpayer's functional currency. These regulations are 
necessary because current regulations do not provide guidance 
concerning the tax treatment of such instruments. The proposed 
regulations generally provide that taxpayers should apply the existing 
rules under section 1275 of the Internal Revenue Code, with certain 
modifications, to nonfunctional currency contingent payment debt 
instruments. This document also withdraws existing proposed regulations 
and provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments and requests to speak (with 
outlines of oral comments to be discussed) at the public hearing 
scheduled for December 3, 2003, at 10 a.m. must be submitted by 
November 12, 2003.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106486-98), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 4 p.m. to: REG-106486-98, Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or sent 
electronically, via the IRS Internet site at: http://www.irs.gov/regs. 
The public hearing will be held in room 6718, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Milton Cahn at (202) 622-3870; concerning submission and delivery of 
comments and the public hearing, Treena Garrett, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP 
Washington, DC 20224. Comments on the collection of Information should 
be received by October 28, 2003. Comments are specifically requested 
concerning:
    Whether the proposed collections of information is necessary for 
the proper performance of the functions of the Internal Revenue 
Service, including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collections of information in this proposed regulation are in 
Sec.  1.988-6(a)(1) (cross reference to Sec.  1.1275-4) and Sec.  
1.988-6(d)(3). This information is required to ensure consistency in 
the treatment of the debt instrument between the issuer and the 
holders. This information will be used for audit and examination 
purposes. The disclosure of information is mandatory as regards the 
issuers of nonfunctional currency contingent payment debt instruments. 
The reporting of information is mandatory as regards holders of debt 
instruments which determine their own projected payment schedule. The 
recordkeeping requirement is mandatory for any party that determines 
the comparable yield and projected payment schedule for a debt 
instrument. The likely respondents are business or other for-profit 
institutions.
    Taxpayers provide the information on a statement attached to its 
timely filed federal income tax return for the taxable year that 
includes the acquisition date of the debt instrument.
    Estimated total annual reporting, and/or recordkeeping burden: 100 
hours.
    Estimated average annual burden hours per respondent and/or 
recordkeeper: 1 hour.
    Estimated number of respondents and/or recordkeepers: 100.
    Estimated annual frequency of responses: on occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On March 17, 1992, Treasury and the IRS issued proposed regulations 
(INTL-0015-91), Sec. Sec.  1.988-1(a)(3), (4) and (5), regarding 
contingent payment debt instruments, dual currency debt instruments and 
multi-currency debt

[[Page 51945]]

instruments. The proposed regulations followed the general approach in 
the then-proposed Sec.  1.1275-4(g) contingent payment debt regulations 
(LR-189-84; 51 FR 12022 (1986), amended at 56 FR 8308 (1991)) and 
bifurcated such debt instruments into contingent and noncontingent 
components. After an instrument was bifurcated, the proposed 
regulations applied the rules in Sec. Sec.  1.988-1 through 1.988-5, as 
appropriate, to the resulting components.
    On December 16, 1994, Treasury and the IRS withdrew the then 
proposed Sec.  1.1275-4(g) regulations and proposed a new set of Sec.  
1.1275-4 regulations (FI-59-91, 59 FR-64884). These regulations were 
finalized on June 14, 1996.
    Section 1.1275-4 of the final regulations adopted the 
``noncontingent bond method'' for certain contingent payment debt 
instruments. Under the noncontingent bond method, interest accrues on a 
contingent payment debt instrument at a rate equal to the instrument's 
comparable yield, which is the yield at which an issuer would issue a 
fixed rate debt instrument with terms and conditions similar to those 
of the contingent payment debt instrument. In addition, the 
noncontingent bond method treats all interest on a debt instrument as 
original issue discount, which must be taken into account as it 
accrues, regardless of the taxpayer's normal method of accounting.
    Under the noncontingent bond method, the comparable yield is used 
to construct a projected payment schedule for the debt instrument, 
which includes a projected amount for each contingent payment. If the 
actual amount of a contingent payment is greater than the projected 
amount, the difference is treated as additional interest. If the actual 
amount of a contingent payment is less than the projected amount, the 
difference generally offsets current interest accruals. In some cases, 
the difference may result in a loss to the holder and income to the 
issuer.
    On August 2, 1999, as a result of the withdrawal of the 1994 
proposed Sec.  1.1275-4(g) regulations and the promulgation of the 
final Sec.  1.1275-4 regulations, the IRS issued Announcement 99-76 
(1999-2 C.B. 223) which provided a description of a regulatory approach 
that Treasury and the IRS were considering as a replacement to the 
proposed regulations in Sec. Sec.  1.988-1(a)(3), (4) and (5) for 
contingent payment debt instruments with one or more payments 
denominated in, or determined by reference to, a nonfunctional 
currency. Announcement 99-76 stated that Treasury and the IRS were 
considering issuing regulations that would apply the noncontingent bond 
method in the taxpayer's nonfunctional currency and would translate 
payments received on the instrument into functional currency under the 
rules of Sec. Sec.  1.988-1 through 1.988-5. Announcement 99-76 
requested comments on this approach. No comments were received.
    Treasury and the IRS believe that proposed regulations Sec.  1.988-
1(a)(3), (4) and (5) should be withdrawn because they incorporate the 
bifurcation approach rather than the noncontingent bond method 
ultimately adopted under Sec.  1.1275-4. Treasury and the IRS believe, 
as reflected in Announcement 99-76, that nonfunctional currency 
contingent payment debt instruments should be accounted for under rules 
similar to those that govern the treatment of functional currency 
contingent payment debt instruments. Treasury and the IRS believe that 
providing a consistent set of rules in this area is in the best 
interests of sound tax administration.

Explanation of Provisions

In General

    These proposed regulations provide guidance for four different 
types of debt instruments: (1) Debt instruments issued for money or 
publicly-traded property for which all payments of principal and 
interest are denominated in, or determined by reference to, a single 
nonfunctional currency and which have one or more non-currency 
contingencies, (2) debt instruments issued for money or publicly-traded 
property for which payments of principal or interest are denominated 
in, or determined by reference to, more than one currency and which 
have no non-currency contingencies, (3) debt instruments issued for 
money or publicly-traded property for which payments of principal or 
interest are denominated in, or determined by reference to, more than 
one currency and which also have one or more non-currency 
contingencies, and (4) debt instruments which otherwise would fall into 
one of the three foregoing categories but for the fact that the 
instruments are not issued for money or publicly-traded property. These 
proposed regulations do not discuss the treatment of tax-exempt 
obligations described in Sec.  1.1275-4(d) which are denominated in one 
or more nonfunctional currencies. Comments are requested as to the 
proper treatment of such instruments.
    Consistent with the approach described in Announcement 99-76, these 
proposed regulations generally apply the rules of Sec.  1.1275-4(b) 
(i.e., the noncontingent bond method) to nonfunctional currency 
contingent payment debt instruments issued for money or publicly traded 
property. The proposed regulations generally provide that the 
noncontingent bond method is applied in the currency in which the 
instrument is denominated (the denomination currency).
    Application of the Sec.  1.1275-4(b) rules to nonfunctional 
currency contingent instruments generally requires taxpayers (i) to 
accrue interest in the denomination currency at a yield at which the 
issuer would issue a fixed rate debt instrument denominated in the 
denomination currency with terms and conditions similar to those of the 
contingent payment debt instrument, (ii) to translate the interest 
accrued from the denomination currency into the functional currency 
(and account for foreign currency gain or loss on payments of interest 
and principal) under the principles of Sec.  1.988-2(b), and (iii) to 
account for gain or loss arising from contingencies in a manner 
consistent with the rules of Sec.  1.1275-4(b).

Applying the Noncontingent Bond Method in the Denomination Currency

    As noted, the proposed regulations require taxpayers to apply the 
noncontingent bond method in the instrument's denomination currency. 
For example, in the case of an instrument whose denomination currency 
is the British pound, an issuer whose functional currency is the U.S. 
dollar would first determine the comparable yield of the instrument, 
that is, the yield at which the issuer would issue a fixed rate 
instrument in British pounds with terms and conditions similar to those 
of the instrument actually being issued. Second, the issuer would 
construct a projected payment schedule applying that yield. Third, the 
amount of interest accrued in each taxable year would be determined in 
British pounds based on the comparable yield and translated into 
dollars under the principles of section 988. Fourth, the issuer and 
holder would account for differences between the projected amount of 
payments and the actual amount of payments (so-called positive 
adjustments and negative adjustments) under rules similar to those in 
Sec.  1.1275-4(b). Consistent with the rules of Sec.  1.1275-4(b), the 
proposed regulations provide that net positive adjustments are treated 
as additional interest on the instrument. Net negative adjustments 
generally offset current interest accruals, and in some cases may 
result in a loss to the holder and income to the issuer. Finally, the 
issuer and holders would

[[Page 51946]]

determine foreign currency gain or loss with respect to interest and 
principal payments on the instrument.

Determination of the Comparable Yield and Projected Payment Schedule

    Consistent with Sec.  1.1275-4(b)(4)(iv), the holder uses the yield 
and projected payment schedule determined by the issuer to determine 
the holder's interest accruals and adjustments for a debt instrument. 
If the issuer does not determine a comparable yield and projected 
payment schedule for the debt instrument, or if the issuer's comparable 
yield or projected payment schedule is unreasonable, the holder of the 
debt instrument must determine the comparable yield and the projected 
payment schedule for the debt instrument under the rules of the 
proposed regulations. A holder that determines its own comparable yield 
and projected payment schedule must explicitly disclose, in the manner 
set forth in Sec.  1.1275-4(b)(4)(iv), both this fact and the reason 
why the holder made its own determination.

Determination of Basis

    In general, the proposed regulations provide that a holder 
maintains its adjusted basis in functional currency by computing basis 
adjustments in the denomination currency under the rules of Sec.  
1.1275-4(b)(7)(iii) and then translating such adjustments into 
functional currency. Thus, the proposed regulations provide that a 
holder's basis is increased by the holder's accrued but unpaid interest 
inclusions on the debt instrument, generally without regard to any 
positive or negative adjustments, and decreased by the amount of any 
noncontingent payment and the projected amount of any contingent 
payment previously made on the debt instrument to the holder. These 
amounts are translated into functional currency under the principles of 
Sec.  1.988-2(b).

Determination of Amount Realized

    The proposed regulations generally follow Sec.  1.1275-4(b)(7)(iv) 
in determining the amount realized, but do so in the denomination 
currency. Thus, for purposes of determining the amount realized by a 
holder on the scheduled retirement of a debt instrument, the holder 
generally is treated as receiving the projected amount of any 
contingent payment due at maturity. In the case of a sale, exchange or 
unscheduled retirement of a debt instrument, general recognition 
principles of tax law generally apply (e.g., section 1001(b)). However, 
the amount realized by a holder on either the scheduled retirement, or 
the sale, exchange, or unscheduled retirement of a debt instrument, is 
reduced by any negative adjustment carryforward existing in the taxable 
year of the sale, exchange or retirement.
    To calculate gain or loss other than foreign currency gain or loss, 
the proposed regulations require the translation of the amount realized 
into functional currency. Foreign currency gain or loss is computed 
separately, as described below. The proposed regulations generally 
translate the amount realized by reference to the rates used to 
translate the components of interest and principal that make up 
adjusted basis. The amount realized is translated using the adjusted 
basis rates in order to separate from the foreign currency gain or loss 
the amount of gain or loss on the sale, exchange or retirement of the 
debt instrument which does not result from changes in foreign exchange 
rates. Thus, where the amount realized in the denomination currency 
equals the adjusted basis of the instrument in the denomination 
currency prior to translation, the amount realized is translated in its 
entirety by reference to the rates used to translate adjusted basis. 
Where the amount realized differs from the adjusted basis prior to 
translation, additional attribution and translation rules are required.
    Where the amount realized in the denomination currency is less than 
the adjusted basis in the denomination currency, that is, where the 
holder realizes a loss (not taking into account foreign currency gain 
or loss), the following rules apply as to which parts of adjusted basis 
are not recovered. In the case of a scheduled retirement at maturity, 
the loss is attributable to principal (the amount in denomination 
currency which the holder paid to purchase the debt instrument). The 
loss is attributable to principal because the holder will not entirely 
recover the holder's original investment in the debt instrument. In the 
case of a sale or exchange, the loss is first attributable to accrued 
interest. Attributing the loss first to interest results in symmetrical 
treatment between a loss resulting from a negative adjustment and a 
loss resulting from a sale.
    When the holder's amount realized in the denomination currency 
exceeds the amount of its basis in the denomination currency prior to 
translation, that is, where the holder realizes a gain (not taking into 
account foreign currency gain or loss), the excess of amount realized 
over adjusted basis is translated at the spot rate on the date of 
receipt. This rule ensures symmetrical treatment between a positive 
adjustment and a gain on the instrument.

Determination of Foreign Currency Gain or Loss

    The proposed regulations provide that foreign currency gain or loss 
is determined on an instrument with respect to principal and interest 
based on the comparable yield and projected payment schedule under the 
principles of Sec.  1.988-2(b). In general, no foreign currency gain or 
loss is recognized until payment is made or received pursuant to the 
instrument, and no foreign currency gain or loss is computed with 
respect to positive or negative adjustments. However, foreign currency 
gain or loss is determined with respect to positive adjustments 
described in Sec.  1.1275-4(b)(9)(ii) (relating to certain fixed but 
deferred contingent payments), based upon the difference between the 
spot rate on the date the positive adjustment becomes fixed and the 
spot rate on the date the positive adjustment is paid or received.

Source Rules

    Consistent with the rules of Sec.  1.1275-4(b)(6)(ii), the proposed 
regulations provide that all gain (other than foreign currency gain) on 
an instrument is characterized as interest for all tax purposes, 
including source and character rules. Losses of a holder from a 
contingent payment debt instrument are generally sourced by reference 
to the rules of Sec.  1.1275-4(b)(9)(iv). Under Sec.  1.1275-
4(b)(9)(iv), a holder's deductions or loss related to a contingent 
payment debt instrument that are treated as ordinary losses are treated 
as deductions that are definitely related to the class of gross income 
to which income from such debt instrument belongs. Deductions or losses 
that the holder treats as capital losses are allocated, consistently 
with the general principles of Sec.  1.865-1(b)(2), to the class of 
gross income with respect to which interest income from the instrument 
would give rise.

Treatment of Subsequent Holders

    The proposed regulations provide that the rules of Sec.  1.1275-
4(b)(9) generally apply to subsequent holders of an instrument who 
purchase the instrument for an amount greater or less than the 
instrument's adjusted issue price (determined in the denomination 
currency). Accordingly, to the extent that the purchase price for an 
instrument exceeds the adjusted issue price of the instrument, the 
holder is required to allocate such excess to interest accrued on the 
instrument or to projected payments on the instrument

[[Page 51947]]

in a reasonable manner. Each such allocation is treated as a negative 
adjustment on the instrument, and the holder's basis on the instrument 
is decreased as these negative adjustments are taken into account.
    To the extent that the adjusted issue price of the instrument 
exceeds its purchase price, the holder is required to allocate such 
excess to interest accrued on the instrument or to projected payments 
on the instrument in a reasonable manner. As the difference is taken 
into account, the holder is treated as receiving a positive adjustment 
on the instrument, and the holder's basis is increased as these 
positive adjustments are taken into account.
    The proposed regulations generally translate the difference between 
the purchase price and adjusted issue price into functional currency at 
the rate used to translate the interest or projected payment subject to 
the adjustment. Thus, for example, a positive adjustment attributable 
to interest is translated at the same rate used to translate interest 
in the period in which it accrues (e.g., the average rate for the 
accrual period). The basis adjustment corresponding to such a positive 
or negative adjustment is translated at the same rate applicable to the 
positive or negative adjustment itself.

Netting

    The proposed regulations do not provide for the netting of market 
gain or loss with currency gain or loss on nonfunctional currency 
contingent payment debt instruments. On the one hand, different 
character and source rules generally apply to market gain or loss and 
currency gain or loss, and netting such items may produce results 
inconsistent with the tax treatment of other types of instruments. On 
the other hand, where market gain or loss and currency gain or loss 
counteract each other with respect to a taxpayer, requiring separate 
recognition of such gain and loss may not accurately reflect the 
economic benefits and burdens associated with the instrument. 
Accordingly, Treasury and the IRS request comments regarding the extent 
to which netting should be permitted or required. Examples 2 and 4 of 
the proposed regulations demonstrate cases in which netting potentially 
could be permitted or required because both illustrate instances in 
which market loss could be netted against currency gain.

Debt Instruments Denominated in Multiple Currencies

    In the case of an instrument for which payments are denominated in, 
or determined by reference to, more than one currency, the proposed 
regulations provide that the issuer must first determine the 
instrument's predominant currency, which will be used as the 
instrument's denomination currency for purposes of applying the rules 
of the proposed regulations. The predominant currency of the instrument 
is determined on the issue date by comparing the present value in 
functional currency of the noncontingent and projected payments 
denominated in, or determined by reference to, each currency. For this 
purpose, the applicable discount rate must be a nonfunctional currency 
discount rate, but the rate may be determined using any method, 
consistently applied, that reasonably reflects the instrument's 
economic substance. If a taxpayer does not determine a discount rate 
using such a method, the Commissioner may choose a method for 
determining the discount rate that does reflect the instrument's 
economic substance.
    After the denomination currency has been determined, all payments 
on the instrument that are denominated in, or determined by reference 
to, a currency other than the denomination currency are treated as non-
currency related contingent payments for purposes of applying the rules 
of the proposed regulations. Treasury and the IRS request comments 
regarding whether all gain or loss with respect to a debt instrument 
for which payments are denominated in, or determined by reference to, 
more than one currency and which has no non-currency contingencies 
should be treated as foreign currency gain or loss.

Debt Instruments Issued for Non-Publicly Traded Property

    In the case of a nonfunctional currency contingent debt instrument 
issued for non-publicly traded property, the instrument is not 
accounted for using the noncontingent bond method. Rather, the debt 
instrument is separated into its components based on the currency in 
which the payments are denominated and whether the payments are 
contingent or noncontingent. The noncontingent components in each 
currency are treated as a separate debt instrument denominated in the 
currency in which the payment (or payments) is denominated. A component 
consisting of a contingent payment is generally treated in the manner 
provided in Sec.  1.1275-4(c)(4). For purposes of the contingent 
payment, the test rate (the interest rate which is used to discount the 
contingent payment so as to determine the amount of the payment which 
is treated as principal, and the amount which is treated as interest) 
is determined by reference to the dollar unless the dollar does not 
reasonably reflect the economic substance of the contingent component.

Proposed Effective Dates

    Section 1.988-6 is proposed to apply to nonfunctional currency 
contingent payment debt instruments issued 60 days or more after the 
date Sec.  1.988-6 is published as a final regulation in the Federal 
Register.

Special Analysis

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required.
    It is hereby certified that these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based upon the fact that few, if any, small 
entities issue or hold foreign currency denominated contingent payment 
debt instruments. Generally, it is expected that the only domestic 
holders of these instruments will likely be financial institutions, 
investment banking firms, investment funds, and other sophisticated 
investors, due to the foreign currency risk and other contingencies 
inherent in these instruments. Therefore, a Regulatory Flexibility 
Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is 
not required.
    Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed regulations and how they can be made easier to understand. 
All comments will be available for public inspection and copying.
    A public hearing has been scheduled for December 3, 2003, at 10 
a.m. in room 6718 Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue entrance. In addition, all visitors 
must present photo identification to enter the building.

[[Page 51948]]

Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by November 12, 2003. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

    The principal author of these regulations is Milton Cahn of the 
Office of the Associate Chief Counsel (International). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

    Section 1.988-1(a)(3), (4) and (5) as proposed on March 17, 1992 at 
57 FR 9218 income tax regulations are withdrawn, and 26 CFR Part 1 is 
proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.988-2 is amended by:
    1. Adding the text of paragraph (b)(2)(i)(B)(1).
    2. Removing the last sentence of paragraph (b)(2)(i)(B)(2).
    The addition reads as follows:


Sec.  1.988-2  Recognition and computation of exchange gain or loss.

* * * * *
    (b) * * *
    (2) * * *
    (i) * * *
    (B) * * * (1) Operative rules. See Sec.  1.988-6 for rules 
applicable to contingent debt instruments for which one or more 
payments are denominated in, or determined by reference to, a 
nonfunctional currency.
* * * * *
    Par. 3. Section 1.988-6 is added to read as follows:


Sec.  1.988-6  Nonfunctional currency contingent payment debt 
instruments.

    (a) In general--(1) Scope. This section determines the accrual of 
interest and the amount, timing, source, and character of any gain or 
loss on nonfunctional currency contingent payment debt instruments 
described in this paragraph (a)(1). Except as set forth by the rules in 
this section, the rules in Sec.  1.1275-4 (relating to contingent 
payment debt instruments) apply to the following instruments--
    (i) A debt instrument described in Sec.  1.1275-4(b)(1) for which 
all payments of principal and interest are denominated in, or 
determined by reference to, a single nonfunctional currency and which 
has one or more non-currency related contingencies;
    (ii) A debt instrument described in Sec.  1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has no non-currency 
related contingencies;
    (iii) A debt instrument described in Sec.  1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has one or more non-
currency related contingencies; and
    (iv) A debt instrument otherwise described in paragraph (a)(1)(i), 
(ii) or (iii) of this section, except that the debt instrument is 
described in Sec.  1.1275-4(c)(1) rather than Sec.  1.1275-4(b)(1) 
(e.g., the instrument is issued for non-publicly traded property).
    (2) Exception for hyperinflationary currencies--(i) In general. 
Except as provided in paragraph (a)(2)(ii) of this section, this 
section shall not apply to an instrument described in paragraph (a)(1) 
of this section if any payment made under such instrument is determined 
by reference to a hyperinflationary currency, as defined in Sec.  
1.985-1(b)(2)(ii)(D). In such case, the amount, timing, source and 
character of interest, principal, foreign currency gain or loss, and 
gain or loss relating to a non-currency contingency shall be determined 
under the method that reflects the instrument's economic substance.
    (ii) Discretion as to method. If a taxpayer does not account for an 
instrument described in paragraph (a)(2)(i) of this section in a manner 
that reflects the instrument's economic substance, the Commissioner may 
apply the rules of this section to such an instrument or apply the 
principles of Sec.  1.988-2(b)(15), reasonably taking into account the 
contingent feature or features of the instrument.
    (b) Instruments described in paragraph (a)(1)(i) of this section--
(1) In general. Paragraph (b)(2) of this section provides rules for 
applying the noncontingent bond method (as set forth in Sec.  1.1275-
4(b)) in the nonfunctional currency in which a debt instrument 
described in paragraph (a)(1)(i) of this section is denominated, or by 
reference to which its payments are determined (the denomination 
currency). Paragraph (b)(3) of this section describes how amounts 
determined in paragraph (b)(2) of this section shall be translated from 
the denomination currency of the instrument into the taxpayer's 
functional currency. Paragraph (b)(4) of this section describes how 
gain or loss (other than foreign currency gain or loss) shall be 
determined and characterized with respect to the instrument. Paragraph 
(b)(5) of this section describes how foreign currency gain or loss 
shall be determined with respect to accrued interest and principal on 
the instrument. Paragraph (b)(6) of this section provides rules for 
determining the source and character of any gain or loss with respect 
to the instrument. Paragraph (b)(7) of this section provides rules for 
subsequent holders of an instrument who purchase the instrument for an 
amount other than the adjusted issue price of the instrument. Paragraph 
(c) of this section provides examples of the application of paragraph 
(b) of this section. See paragraph (d) of this section for the 
determination of the denomination currency of an instrument described 
in paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of 
this section for the treatment of an instrument described in paragraph 
(a)(1)(iv) of this section.
    (2) Application of noncontingent bond method--(i) Accrued interest. 
Interest accruals on an instrument described in paragraph (a)(1)(i) of 
this section are initially determined in the denomination currency of 
the instrument by applying the noncontingent bond method, set forth in 
Sec.  1.1275-4(b), to the instrument in its denomination currency. 
Accordingly, the comparable yield, projected payment schedule, and 
comparable fixed rate debt instrument, described in Sec.  1.1275-
4(b)(4), are determined in the denomination currency. For purposes of 
applying the noncontingent bond method to instruments described in this 
paragraph, the applicable Federal rate described in Sec.  1.1275-
4(b)(4)(i) shall be

[[Page 51949]]

the rate described in Sec.  1.1274-4(d) with respect to the 
denomination currency.
    (ii) Net positive and negative adjustments. Positive and negative 
adjustments, and net positive and net negative adjustments, with 
respect to an instrument described in paragraph (a)(1)(i) of this 
section are determined by applying the rules of Sec.  1.1275-4(b)(6) 
(and Sec.  1.1275-4(b)(9)(i) and (ii), if applicable) in the 
denomination currency. Accordingly, a net positive adjustment is 
treated as additional interest (in the denomination currency) on the 
instrument. A net negative adjustment first reduces interest that 
otherwise would be accrued by the taxpayer during the current tax year 
in the denomination currency. If a net negative adjustment exceeds the 
interest that would otherwise be accrued by the taxpayer during the 
current tax year in the denomination currency, the excess is treated as 
ordinary loss (if the taxpayer is a holder of the instrument) or 
ordinary income (if the taxpayer is the issuer of the instrument). The 
amount treated as ordinary loss by a holder with respect to a net 
negative adjustment is limited, however, to the amount by which the 
holder's total interest inclusions on the debt instrument (determined 
in the denomination currency) exceed the total amount of the holder's 
net negative adjustments treated as ordinary loss on the debt 
instrument in prior taxable years (determined in the denomination 
currency). Similarly, the amount treated as ordinary income by an 
issuer with respect to a net negative adjustment is limited to the 
amount by which the issuer's total interest deductions on the debt 
instrument (determined in the denomination currency) exceed the total 
amount of the issuer's net negative adjustments treated as ordinary 
income on the debt instrument in prior taxable years (determined in the 
denomination currency). To the extent a net negative adjustment exceeds 
the current year's interest accrual and the amount treated as ordinary 
loss to a holder (or ordinary income to the issuer), the excess is 
treated as a negative adjustment carryforward, within the meaning of 
Sec.  1.1275-4(b)(6)(iii)(C), in the denomination currency.
    (iii) Adjusted issue price. The adjusted issue price of an 
instrument described in paragraph (a)(1)(i) of this section is 
determined by applying the rules of Sec.  1.1275-4(b)(7) in the 
denomination currency. Accordingly, the adjusted issue price is equal 
to the debt instrument's issue price in the denomination currency, 
increased by the interest previously accrued on the debt instrument 
(determined without regard to any net positive or net negative 
adjustments on the instrument) and decreased by the amount of any 
noncontingent payment and the projected amount of any contingent 
payment previously made on the instrument. All adjustments to the 
adjusted issue price are calculated in the denomination currency.
    (iv) Adjusted basis. The adjusted basis of an instrument described 
in paragraph (a)(1)(i) of this section is determined by applying the 
rules of Sec.  1.1275-4(b)(7) in the taxpayer's functional currency. In 
accordance with those rules, a holder's basis in the debt instrument is 
increased by the interest previously accrued on the debt instrument 
(translated into functional currency), without regard to any net 
positive or net negative adjustments on the instrument (except as 
provided in paragraph (b)(7) or (8) of this section, if applicable), 
and decreased by the amount of any noncontingent payment and the 
projected amount of any contingent payment previously made on the 
instrument to the holder (translated into functional currency). See 
paragraph (b)(3)(iii) of this section for translation rules.
    (v) Amount realized. The amount realized by a holder and the 
repurchase price paid by the issuer on the scheduled or unscheduled 
retirement of a debt instrument described in paragraph (a)(1)(i) of 
this section are determined by applying the rules of Sec.  1.1275-
4(b)(7) in the denomination currency. For example, with regard to a 
scheduled retirement at maturity, the holder is treated as receiving 
the projected amount of any contingent payment due at maturity, reduced 
by the amount of any negative adjustment carryforward. For purposes of 
translating the amount realized by the holder into functional currency, 
the rules of paragraph (b)(3)(iv) of this section shall apply.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method--(i) Accrued interest. The amount of accrued 
interest, determined under paragraph (b)(2)(i) of this section, is 
translated into the taxpayer's functional currency at the average 
exchange rate, as described in Sec.  1.988-2(b)(2)(iii)(A), or, at the 
taxpayer's election, at the appropriate spot rate, as described in 
Sec.  1.988-2(b)(2)(iii)(B).
    (ii) Net positive and negative adjustments--(A) Net positive 
adjustments. A net positive adjustment, as referenced in paragraph 
(b)(2)(ii) of this section, is translated into the taxpayer's 
functional currency at the spot rate on the last day of the taxable 
year in which the adjustment is taken into account under Sec.  1.1275-
4(b)(6), or, if earlier, the date the instrument is disposed of or 
otherwise terminated.
    (B) Net negative adjustments. A net negative adjustment is treated 
and, where necessary, is translated from the denomination currency into 
the taxpayer's functional currency under the following rules:
    (1) The amount of a net negative adjustment determined in the 
denomination currency that reduces the current year's interest in that 
currency shall first reduce the current year's accrued but unpaid 
interest, and then shall reduce the current year's interest which was 
accrued and paid. No translation is required.
    (2) The amount of a net negative adjustment treated as ordinary 
income or loss under Sec.  1.1275-4(b)(6)(iii)(B) first is attributable 
to accrued but unpaid interest accrued in prior taxable years. For this 
purpose, the net negative adjustment shall be treated as attributable 
to any unpaid interest accrued in the immediately preceding taxable 
year, and thereafter to unpaid interest accrued in each preceding 
taxable year. The amount of the net negative adjustment applied to 
accrued but unpaid interest is translated into functional currency at 
the same rate used, in each of the respective prior taxable years, to 
translate the accrued interest.
    (3) Any amount of the net negative adjustment remaining after the 
application of paragraphs (b)(3)(ii)(B)(1) and (2) of this section is 
attributable to interest accrued and paid in prior taxable years. The 
amount of the net negative adjustment applied to such amounts is 
translated into functional currency at the spot rate on the date the 
debt instrument was issued or, if later, acquired.
    (4) Any amount of the net negative adjustment remaining after 
application of paragraphs (b)(3)(ii)(B)(1), (2) and (3) of this section 
is a negative adjustment carryforward, within the meaning of Sec.  
1.1275-4(b)(6)(iii)(C). A negative adjustment carryforward is carried 
forward in the denomination currency and is applied to reduce interest 
accruals in subsequent years. In the year in which the instrument is 
sold, exchanged or retired, any negative adjustment carryforward not 
applied to interest reduces the holder's amount realized on the 
instrument (in the denomination currency). An issuer of a debt 
instrument described in paragraph (a)(1)(i) of this section who takes 
into income a negative adjustment carryforward (that is not applied to 
interest) in the year the instrument is

[[Page 51950]]

retired, as described in Sec.  1.1275-4(b)(6)(iii)(C), translates such 
income into functional currency at the spot rate on the date the 
instrument was issued.
    (iii) Adjusted basis--(A) In general. Except as otherwise provided 
in this paragraph and paragraphs (b)(7) or (8) of this section, a 
holder determines and maintains adjusted basis by translating the 
denomination currency amounts determined under Sec.  1.1275-
4(b)(7)(iii) into functional currency as follows:
    (1) The holder's initial basis in the instrument is determined by 
translating the amount paid by the holder to acquire the instrument (in 
the denomination currency) into functional currency at the spot rate on 
the date the instrument was issued or, if later, acquired.
    (2) An increase in basis attributable to interest accrued on the 
instrument is translated at the rate applicable to such interest under 
paragraph (b)(3)(i) of this section.
    (3) Any noncontingent payment and the projected amount of any 
contingent payments determined in the denomination currency that 
decrease the holder's basis in the instrument under Sec.  1.1275-
4(b)(7)(iii) are translated as follows:
    (i) The payment first is attributable to the most recently accrued 
interest to which prior amounts have not already been attributed. The 
payment is translated into functional currency at the rate at which the 
interest was accrued.
    (ii) Any amount remaining after the application of paragraph 
(b)(3)(iii)(A)(3)(i) of this section is attributable to principal. Such 
amounts are translated into functional currency at the spot rate on the 
date the instrument was issued or, if later, acquired.
    (B) Exception for interest reduced by a negative adjustment 
carryforward. Solely for purposes of this Sec.  1.988-6, any amounts of 
accrued interest income that are reduced as a result of a negative 
adjustment carryforward shall be treated as principal and translated at 
the spot rate on the date the instrument was issued or, if later, 
acquired.
    (iv) Amount realized--(A) Instrument held to maturity--(1) In 
general. With respect to an instrument held to maturity, a holder 
translates the amount realized by separating such amount in the 
denomination currency into the component parts of interest and 
principal that make up adjusted basis prior to translation under 
paragraph (b)(3)(iii) of this section, and translating each of those 
component parts of the amount realized at the same rate used to 
translate the respective component parts of basis under paragraph 
(b)(3)(iii) of this section. The amount realized first shall be 
translated by reference to the component parts of basis consisting of 
accrued interest during the taxpayer's holding period as determined 
under paragraph (b)(3)(iii) of this section and ordering such amounts 
on a last in first out basis. Any remaining portion of the amount 
realized shall be translated by reference to the rate used to translate 
the component of basis consisting of principal as determined under 
paragraph (b)(3)(iii) of this section.
    (2) Subsequent purchases at discount and fixed but deferred 
contingent payments. For purposes of this paragraph (b)(3)(iv) of this 
section, any amount which is required to be added to adjusted basis 
under paragraph (b)(7) or (8) of this section shall be treated as 
additional interest which was accrued on the date the amount was added 
to adjusted basis. To the extent included in amount realized, such 
amounts shall be translated into functional currency at the same rates 
at which they were translated for purposes of determining adjusted 
basis. See paragraphs (b)(7)(iv) and (b)(8) of this section for rules 
governing the rates at which the amounts are translated for purposes of 
determining adjusted basis.
    (B) Sale, exchange, or unscheduled retirement--(1) Holder. In the 
case of a sale, exchange, or unscheduled retirement, application of the 
rule stated in paragraph (b)(3)(iv)(A) of this section shall be 
modified as follows. The holder's amount realized first shall be 
translated by reference to the principal component of basis as 
determined under paragraph (b)(3)(iii) of this section, and then to the 
component of basis consisting of accrued interest as determined under 
paragraph (b)(3)(iii) of this section and ordering such amounts on a 
first in first out basis. Any gain recognized by the holder (i.e., any 
excess of the sale price over the holder's basis, both expressed in the 
denomination currency) is translated into functional currency at the 
spot rate on the payment date.
    (2) Issuer. In the case of an unscheduled retirement of the debt 
instrument, any excess of the adjusted issue price of the debt 
instrument over the amount paid by the issuer (expressed in 
denomination currency) shall first be attributable to accrued unpaid 
interest, to the extent the accrued unpaid interest had not been 
previously offset by a negative adjustment, on a last-in-first-out 
basis, and then to principal. The accrued unpaid interest shall be 
translated into functional currency at the rate at which the interest 
was accrued. The principal shall be translated at the spot rate on the 
date the debt instrument was issued.
    (C) Effect of negative adjustment carryforward with respect to the 
issuer. Any amount of negative adjustment carryforward treated as 
ordinary income under Sec.  1.1275-4(b)(6)(iii)(C) shall be translated 
at the exchange rate on the day the debt instrument was issued.
    (4) Determination of gain or loss not attributable to foreign 
currency. A holder of a debt instrument described in paragraph 
(a)(1)(i) of this section shall recognize gain or loss upon sale, 
exchange, or retirement of the instrument equal to the difference 
between the amount realized with respect to the instrument, translated 
into functional currency as described in paragraph (b)(3)(iv) of this 
section, and the adjusted basis in the instrument, determined and 
maintained in functional currency as described in paragraph (b)(3)(iii) 
of this section. The amount of any gain or loss so determined is 
characterized as provided in Sec.  1.1275-4(b)(8), and sourced as 
provided in paragraph (b)(6) of this section.
    (5) Determination of foreign currency gain or loss--(i) In general. 
Other than in a taxable disposition of the debt instrument, foreign 
currency gain or loss is recognized with respect to a debt instrument 
described in paragraph (a)(1)(i) of this section only when payments are 
made or received. No foreign currency gain or loss is recognized with 
respect to a net positive or negative adjustment, as determined under 
paragraph (b)(2)(ii) of this section (except with respect to a positive 
adjustment described in paragraph (b)(8) of this section). As described 
in this paragraph (b)(5), foreign currency gain or loss is determined 
in accordance with the rules of Sec.  1.988-2(b).
    (ii) Foreign currency gain or loss attributable to accrued 
interest. The amount of foreign currency gain or loss recognized with 
respect to payments of interest previously accrued on the instrument is 
determined by translating the amount of interest paid or received into 
functional currency at the spot rate on the date of payment and 
subtracting from such amount the amount determined by translating the 
interest paid or received into functional currency at the rate at which 
such interest was accrued under the rules of paragraph (b)(3)(i) of 
this section. For purposes of this paragraph, the amount of any payment 
that is treated as accrued interest shall be reduced by the amount of 
any net negative adjustment treated as ordinary loss (to the holder) or 
ordinary income (to the issuer), as provided in paragraph (b)(2)(ii) of 
this

[[Page 51951]]

section. For purposes of determining whether the payment consists of 
interest or principal, see the payment ordering rules in paragraph 
(b)(5)(iv) of this section.
    (iii) Principal. The amount of foreign currency gain or loss 
recognized with respect to payment or receipt of principal is 
determined by translating the amount paid or received into functional 
currency at the spot rate on the date of payment or receipt and 
subtracting from such amount the amount determined by translating the 
principal into functional currency at the spot rate on the date the 
instrument was issued or, in case of the holder, if later, acquired. 
For purposes of determining whether the payment consists of interest or 
principal, see the payment ordering rules in paragraph (b)(5)(iv) of 
this section.
    (iv) Payment ordering rules--(A) In general. Except as provided in 
paragraph (b)(5)(iv)(B) of this section, payments with respect to an 
instrument described in paragraph (a)(1)(i) of this section shall be 
treated as follows:
    (1) A payment shall first be attributable to any net positive 
adjustment on the instrument that has not previously been taken into 
account.
    (2) Any amount remaining after applying paragraph (b)(5)(iv)(A)(1) 
of this section shall be attributable to accrued but unpaid interest, 
remaining after reduction by any net negative adjustment, and shall be 
attributable to the most recent accrual period to the extent prior 
amounts have not already been attributed to such period.
    (3) Any amount remaining after applying paragraphs (b)(5)(iv)(A)(1) 
and (2) of this section shall be attributable to principal. Any 
interest paid in the current year that is reduced by a net negative 
adjustment shall be considered a payment of principal for purposes of 
determining foreign currency gain or loss.
    (B) Special rule for sale or exchange or unscheduled retirement. 
Payments made or received upon a sale or exchange or unscheduled 
retirement shall first be applied against the principal of the debt 
instrument (or in the case of a subsequent purchaser, the purchase 
price of the instrument in denomination currency) and then against 
accrued unpaid interest (in the case of a holder, accrued while the 
holder held the instrument).
    (C) Subsequent purchaser that has a positive adjustment allocated 
to a daily portion of interest. A positive adjustment that is allocated 
to a daily portion of interest pursuant to paragraph (b)(7)(iv) of this 
section shall be treated as interest for purposes of applying the 
payment ordering rule of this paragraph (b)(5)(iv).
    (6) Source of gain or loss. The source of foreign currency gain or 
loss recognized with respect to an instrument described in paragraph 
(a)(1)(i) of this section shall be determined pursuant to Sec.  1.988-
4. Consistent with the rules of Sec.  1.1275-4(b)(8), all gain (other 
than foreign currency gain) on an instrument described in paragraph 
(a)(1)(i) of this section is treated as interest income for all 
purposes. The source of an ordinary loss (other than foreign currency 
loss) with respect to an instrument described in paragraph (a)(1)(i) of 
this section shall be determined pursuant to Sec.  1.1275-4(b)(9)(iv). 
The source of a capital loss with respect to an instrument described in 
paragraph (a)(1)(i) of this section shall be determined pursuant to 
Sec.  1.865-1(b)(2).
    (7) Basis different from adjusted issue price--(i) In general. The 
rules of Sec.  1.1275-4(b)(9)(i), except as set forth in this paragraph 
(b)(7), shall apply to an instrument described in paragraph (a)(1)(i) 
of this section purchased by a subsequent holder for more or less than 
the instrument's adjusted issue price.
    (ii) Determination of basis. If an instrument described in 
paragraph (a)(1)(i) of this section is purchased by a subsequent 
holder, the subsequent holder's initial basis in the instrument shall 
equal the amount paid by the holder to acquire the instrument, 
translated into functional currency at the spot rate on the date of 
acquisition.
    (iii) Purchase price greater than adjusted issue price. If the 
purchase price of the instrument (determined in the denomination 
currency) exceeds the adjusted issue price of the instrument, the 
holder shall, consistent with the rules of Sec.  1.1275-4(b)(9)(i)(B), 
reasonably allocate such excess to the daily portions of interest 
accrued on the instrument or to a projected payment on the instrument. 
To the extent attributable to interest, the excess shall be reasonably 
allocated over the remaining term of the instrument to the daily 
portions of interest accrued and shall be a negative adjustment on the 
dates the daily portions accrue. On the date of such adjustment, the 
holder's adjusted basis in the instrument is reduced by the amount 
treated as a negative adjustment under this paragraph (b)(7)(iii), 
translated into functional currency at the rate used to translate the 
interest which is offset by the negative adjustment. To the extent 
related to a projected payment, such excess shall be treated as a 
negative adjustment on the date the payment is made. On the date of 
such adjustment, the holder's adjusted basis in the instrument is 
reduced by the amount treated as a negative adjustment under this 
paragraph (b)(7)(iii), translated into functional currency at the spot 
rate on the date the instrument was acquired.
    (iv) Purchase price less than adjusted issue price. If the purchase 
price of the instrument (determined in the denomination currency) is 
less than the adjusted issue price of the instrument, the holder shall, 
consistent with the rules of Sec.  1.1275-4(b)(9)(i)(C), reasonably 
allocate the difference to the daily portions of interest accrued on 
the instrument or to a projected payment on the instrument. To the 
extent attributable to interest, the difference shall be reasonably 
allocated over the remaining term of the instrument to the daily 
portions of interest accrued and shall be a positive adjustment on the 
dates the daily portions accrue. On the date of such adjustment, the 
holder's adjusted basis in the instrument is increased by the amount 
treated as a positive adjustment under this paragraph (b)(7)(iv), 
translated into functional currency at the rate used to translate the 
interest to which it relates. For purposes of determining adjusted 
basis under paragraph (b)(3)(iii) of this section, such increase in 
adjusted basis shall be treated as an additional accrual of interest 
during the period to which the positive adjustment relates. To the 
extent related to a projected payment, such difference shall be treated 
as a positive adjustment on the date the payment is made. On the date 
of such adjustment, the holder's adjusted basis in the instrument is 
increased by the amount treated as a positive adjustment under this 
paragraph (b)(7)(iv), translated into functional currency at the spot 
rate on the date the adjustment is taken into account. For purposes of 
determining the amount realized on the instrument in functional 
currency under paragraph (b)(3)(iv) of this section, amounts 
attributable to the excess of the adjusted issue price of the 
instrument over the purchase price of the instrument shall be 
translated into functional currency at the same rate at which the 
corresponding adjustments are taken into account under this paragraph 
(b)(7)(iv) for purposes of determining the adjusted basis of the 
instrument.
    (8) Fixed but deferred contingent payments. In the case of an 
instrument with a contingent payment that becomes fixed as to amount 
before the payment is due, the rules of Sec.  1.1275-4(b)(9)(ii) shall 
be applied in the denomination currency of the instrument. For this 
purpose, foreign currency gain or loss shall be recognized on the date 
payment

[[Page 51952]]

is made or received with respect to the instrument under the principles 
of paragraph (b)(5) of this section. Any increase or decrease in basis 
required under Sec.  1.1275-4(b)(9)(ii)(D) shall be taken into account 
at the same exchange rate as the corresponding net positive or negative 
adjustment is taken into account.
    (c) Examples. The provisions of paragraph (b) of this section may 
be illustrated by the following examples. In each example, assume that 
the instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the 
instrument is a debt instrument for federal income tax purposes. The 
examples are as follows:

    Example 1. Treatment of net positive adjustment--(i) Facts. On 
December 31, 2004, Z, a calendar year U.S. resident taxpayer whose 
functional currency is the U.S. dollar, purchases from a foreign 
corporation, at original issue, a zero-coupon debt instrument with a 
non-currency contingency for [pound]1000. All payments of principal 
and interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the 
British pound). The debt instrument would be subject to Sec.  
1.1275-4(b) if it were denominated in dollars. The debt instrument's 
comparable yield, determined in British pounds under paragraph 
(b)(2)(i) of this section and Sec.  1.1275-4(b), is 10 percent, 
compounded annually, and the projected payment schedule, as 
constructed under the rules of Sec.  1.1275-4(b), provides for a 
single payment of [pound]1210 on December 31, 2006 (consisting of a 
noncontingent payment of [pound]975 and a projected payment of 
[pound]235). The debt instrument is a capital asset in the hands of 
Z. Z does not elect to use the spot-rate convention described in 
Sec.  1.988-2(b)(2)(iii)(B). The payment actually made on December 
31, 2006, is [pound]1300. The relevant pound/dollar spot rates over 
the term of the instrument are as follows:

------------------------------------------------------------------------
                  Date                    Spot rate  (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004..........................  []1.00=$1.00
Dec. 31, 2005..........................  []1.00=$1.10
Dec. 31, 2006..........................  []1.00=$1.20
------------------------------------------------------------------------


------------------------------------------------------------------------
                                             Average rate  (pounds to
             Accrual period                          dollars)
------------------------------------------------------------------------
2005...................................  []1.00=$1.05
2006...................................  []1.00=$1.15
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues 
[]100 of interest on 
the debt instrument for 2005 (issue price of 
[]1000 x 10 percent). 
Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]100 at the average exchange rate for the accrual period 
($1.05 x []100 = 
$105). Accordingly, Z has interest income in 2005 of $105.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) 
and (iv) of this section, the adjusted issue price of the debt 
instrument determined in pounds and Z's adjusted basis in dollars in 
the debt instrument are increased by the interest accrued in 2005. 
Thus, on January 1, 2006, the adjusted issue price of the debt 
instrument is [pound]1100. For purposes of determining Z's dollar 
basis in the debt instrument, the $1000 basis ($1.00 x 
[]1000 original cost 
basis) is increased by the [pound]100 of accrued interest, 
translated at the rate at which interest was accrued for 2005. See 
paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted 
basis in the debt instrument as of January 1, 2006, is $1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]110 of interest on the debt 
instrument for 2006 (adjusted issue price of 
[]1100 x 10 percent). 
Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]110 at the average exchange rate for the accrual period 
($1.15 x []110 = 
$126.50). Accordingly, Z has interest income in 2006 of $126.50.
    (B) Effect of net positive adjustment. The payment actually made 
on December 31, 2006, is [pound]1300, rather than the projected 
[pound]1210. Under paragraph (b)(2)(ii) of this section, Z has a net 
positive adjustment of 
[]90 on December 31, 
2006, attributable to the difference between the amount of the 
actual payment and the amount of the projected payment. Under 
paragraph (b)(3)(ii)(A) of this section, the 
[]90 net positive 
adjustment is treated as additional interest income and is 
translated into dollars at the spot rate on the last day of the year 
($1.20 x []90 = $108). 
Accordingly, Z has a net positive adjustment of $108 resulting in a 
total interest inclusion for 2006 of $234.50 ($126.50 + $108 = 
$234.50).
    (C) Adjusted issue price and basis. Based on the projected 
payment schedule, the adjusted issue price of the debt instrument 
immediately before the payment at maturity is 
[]1210 
([]1100 plus 
[]110 of accrued 
interest for 2006). Z's adjusted basis in dollars, based only on the 
noncontingent payment and the projected amount of the contingent 
payment to be received, is $1231.50 ($1105 plus $126.50 of accrued 
interest for 2006).
    (D) Amount realized. Even though Z receives [pound]1300 at 
maturity, for purposes of determining the amount realized, Z is 
treated under paragraph (b)(2)(v) of this section as receiving the 
projected amount of the contingent payment on December 31, 2006. 
Therefore, Z is treated as receiving 
[]1210 on December 31, 
2006. Under paragraph (b)(3)(iv) of this section, Z translates its 
amount realized into dollars and computes its gain or loss on the 
instrument (other than foreign currency gain or loss) by breaking 
the amount realized into its component parts. Accordingly, 
[]100 of the 
[pound]1210 (representing the interest accrued in 2005) is 
translated at the rate at which it was accrued 
([]1 = $1.05), 
resulting in an amount realized of $105; 
[]110 of the 
[]1210 (representing 
the interest accrued in 2006) is translated into dollars at the rate 
at which it was accrued 
([]1 = $1.15), 
resulting in an amount realized of $126.50; and 
[]1000 of the 
[]1210 (representing a 
return of principal) is translated into dollars at the spot rate on 
the date the instrument was purchased 
([]1 = $1), resulting 
in an amount realized of $1000. Z's total amount realized is 
$1231.50, the same as its basis, and Z recognizes no gain or loss 
(before consideration of foreign currency gain or loss) on 
retirement of the instrument.
    (E) Foreign currency gain or loss. Under paragraph (b)(5) of 
this section Z recognizes foreign currency gain under section 988 on 
the instrument with respect to the consideration actually received 
at maturity (except for the net positive adjustment), 
[]1210. The amount of 
recognized foreign currency gain is determined based on the 
difference between the spot rate on the date the instrument matures 
and the rates at which the principal and interest were taken into 
account. With respect to the portion of the payment attributable to 
interest accrued in 2005, the foreign currency gain is $15 
[[]100 x ($1.20-
$1.05)]. With respect to interest accrued in 2006, the foreign 
currency gain equals $5.50 
[[]110 x ($1.20-
$1.15)]. With respect to principal, the foreign currency gain is 
$200 [[]1000 x ($1.20-
$1.00)]. Thus, Z recognizes a total foreign currency gain on 
December 31, 2006, of $220.50.
    (F) Source. Z has interest income of $105 in 2005, interest 
income of $234.50 in 2006 (attributable to [pound]110 of accrued 
interest and the [pound]90 net positive adjustment), and a foreign 
currency gain of $220.50 in 2006. Under paragraph (b)(6) of this 
section and section 862(a)(1), the interest income is sourced by 
reference to the residence of the payor and is therefore from 
sources without the United States. Under paragraph (b)(6) of this 
section and Sec.  1.988-4, Z's foreign currency gain of $220.50 is 
sourced by reference to Z's residence and is therefore from sources 
within the United States.
    Example 2. Treatment of net negative adjustment--(i) Facts. 
Assume the same facts as in Example 1, except that Z receives 
[pound]975 at maturity instead of [pound]1300.
    (ii) Treatment in 2005. The treatment of the debt instrument in 
2005 is the same as in Example 1. Thus, Z has interest income in 
2005 of $105. On January 1, 2006, the adjusted issue price of the 
debt instrument is 
[]1100, and Z's 
adjusted basis in the instrument is $1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section and based on the 
comparable yield, Z's accrued interest for 2006 is 
[]110 (adjusted issue 
price of []1100 x 10 
percent). Under paragraph (b)(3)(i) of this section, the 
[]110 of accrued 
interest is translated at the average exchange rate for the accrual 
period ($1.15 x []110 
= $126.50).
    (B) Effect of net negative adjustment. The payment actually made 
on December 31, 2006, is 
[]975, rather than the 
projected []1210. 
Under paragraph (b)(2)(ii) of this section, Z has a net negative 
adjustment of []235 on 
December 31, 2006, attributable to the difference between the amount 
of the actual payment and the amount of the

[[Page 51953]]

projected payment. Z's accrued interest income of 
[]110 in 2006 is 
reduced to zero by the net negative adjustment. Under paragraph 
(b)(3)(ii)(B)(1) of this section the net negative adjustment which 
reduces the current year's interest is not translated into 
functional currency. Under paragraph (b)(2)(ii) of this section, Z 
treats the remaining 
[]125 net negative 
adjustment as an ordinary loss to the extent of the 
[]100 previously 
accrued interest in 2005. This 
[]100 ordinary loss is 
attributable to interest accrued but not paid in the preceding year. 
Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z 
translates the loss into dollars at the average rate for such year 
([]1 = $1.05). 
Accordingly, Z has an ordinary loss of $105 in 2006. The remaining 
[]25 of net negative 
adjustment is a negative adjustment carryforward under paragraph 
(b)(2)(ii) of this section.
    (C) Adjusted issue price and basis. Based on the projected 
payment schedule, the adjusted issue price of the debt instrument 
immediately before the payment at maturity is 
[]1210 
([]1100 plus 
[]110 of accrued 
interest for 2006). Z's adjusted basis in dollars, based only on the 
noncontingent payments and the projected amount of the contingent 
payments to be received, is $1231.50 ($1105 plus $126.50 of accrued 
interest for 2006).
    (D) Amount realized. Even though Z receives 
[]975 at maturity, for 
purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected 
amount of the contingent payment on December 31, 2006, reduced by 
the amount of Z's negative adjustment carryforward of 
[]25. Therefore, Z is 
treated as receiving 
[]1185 
([]1210-
[]25) on December 31, 
2006. Under paragraph (b)(3)(iv) of this section, Z translates its 
amount realized into dollars and computes its gain or loss on the 
instrument (other than foreign currency gain or loss) by breaking 
the amount realized into its component parts. Accordingly, 
[]100 of the 
[]1185 (representing 
the interest accrued in 2005) is translated at the rate at which it 
was accrued ([]1 = 
$1.05), resulting in an amount realized of $105; 
[]110 of the 
[]1185 (representing 
the interest accrued in 2006) is translated into dollars at the rate 
at which it was accrued 
([]1 = $1.15), 
resulting in an amount realized of $126.50; and 
[]975 of the 
[]1185 (representing a 
return of principal) is translated into dollars at the spot rate on 
the date the instrument was purchased 
([]1 = $1), resulting 
in an amount realized of $975. Z's amount realized is $1206.50 ($105 
+ $126.50 + $975 = $1206.50), and Z recognizes a capital loss 
(before consideration of foreign currency gain or loss) of $25 on 
retirement of the instrument ($1206.50-$1231.50 = -$25).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the consideration actually received at 
maturity, []975. Under 
paragraph (b)(5)(ii) of this section, no foreign currency gain or 
loss is recognized with respect to unpaid accrued interest reduced 
to zero by the net negative adjustment resulting in 2006. In 
addition, no foreign currency gain or loss is recognized with 
respect to unpaid accrued interest from 2005, also reduced to zero 
by the ordinary loss. Accordingly, Z recognizes foreign currency 
gain with respect to principal only. Thus, Z recognizes a total 
foreign currency gain on December 31, 2006, of $195 
[[]975 x ($1.20-
$1.00)].
    (F) Source. In 2006, Z has an ordinary loss of $105, a capital 
loss of $25, and a foreign currency gain of $195. Under paragraph 
(b)(6) of this section and Sec.  1.1275-4(b)(9)(iv), the $105 
ordinary loss generally reduces Z's foreign source passive income 
under section 904(d) and the regulations thereunder. Under paragraph 
(b)(6) of this section and Sec.  1.865-1(b)(2), the $25 capital loss 
is sourced by reference to how interest income on the instrument 
would have been sourced. Therefore, the $25 capital loss generally 
reduces Z's foreign source passive income under section 904(d) and 
the regulations thereunder. Under paragraph (b)(6) of this section 
and Sec.  1.988-4, Z's foreign currency gain of $195 is sourced by 
reference to Z's residence and is therefore from sources within the 
United States.
    Example 3. Negative adjustment and periodic interest payments--
(i) Facts. On December 31, 2004, Z, a calendar year U.S. resident 
taxpayer whose functional currency is the U.S. dollar, purchases 
from a foreign corporation, at original issue, a two-year debt 
instrument with a non-currency contingency for [pound]1000. All 
payments of principal and interest with respect to the instrument 
are denominated in, or determined by reference to, a single 
nonfunctional currency (the British pound). The debt instrument 
would be subject to Sec.  1.1275-4(b) if it were denominated in 
dollars. The debt instrument's comparable yield, determined in 
British pounds under Sec. Sec.  1.988-2(b)(2) and 1.1275-4(b), is 10 
percent, compounded semiannually. The debt instrument provides for 
semiannual interest payments of [pound]30 payable each June 30, and 
December 31, and a contingent payment at maturity on December 31, 
2006, which is projected to equal [pound]1086.20 (consisting of a 
noncontingent payment of [pound]980 and a projected payment of 
[pound]106.20) in addition to the interest payable at maturity. The 
debt instrument is a capital asset in the hands of Z. Z does not 
elect to use the spot-rate convention described in Sec.  1.988-
2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 
[pound]981.00. The relevant pound/dollar spot rates over the term of 
the instrument are as follows:

------------------------------------------------------------------------
                                                Spot rate  (pounds to
                   Date                               dollars)
------------------------------------------------------------------------
Dec. 31, 2004.............................  [pound]1.00=$1.00
June 30, 2005.............................  [pound]1.00=$1.20
Dec. 31, 2005.............................  [pound]1.00=$1.40
June 30, 2006.............................  [pound]1.00=$1.60
Dec. 31, 2006.............................  [pound]1.00=$1.80
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Average rate  (pounds to
              Accrual period                          dollars)
------------------------------------------------------------------------
Jan.-June 2005............................  [pound]1.00=$1.10
July-Dec. 2005............................  [pound]1.00=$1.30
Jan.-June 2006............................  [pound]1.00=$1.50
July-Dec. 2006............................  [pound]1.00=$1.70
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]50 of interest on the debt 
instrument for the January-June accrual period (issue price of 
[pound]1000 x 10 percent/2). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]50 at the average exchange rate for 
the accrual period ($1.10 x [pound]50 = $55.00). Similarly, Z 
accrues [pound]51 of interest in the July-December accrual period 
[([pound]1000 + [pound]50-[pound]30) x 10 percent/2], which is 
translated at the average exchange rate for the accrual period 
($1.30 x [pound]51 = [pound]66.30). Accordingly, Z accrues 
[pound]121.30 of interest income in 2005.
    (B) Adjusted issue price and basis--(1) January-June accrual 
period. Under paragraphs (b)(2)(iii) and (iv) of this section, the 
adjusted issue price of the debt instrument determined in pounds and 
Z's adjusted basis in dollars in the debt instrument are increased 
by the interest accrued, and decreased by the interest payment made, 
in the January-June accrual period. Thus, on July 1, 2005, the 
adjusted issue price of the debt instrument is [pound]1020 
([pound]1000 + [pound]50-[pound]30 = [pound]1020). For purposes of 
determining Z's dollar basis in the debt instrument, the $1000 basis 
is increased by the [pound]50 of accrued interest, translated, under 
paragraph (b)(3)(iii) of this section, at the rate at which interest 
was accrued for the January-June accrual period ($1.10 x [pound]50 = 
$55). The resulting amount is reduced by the [pound]30 payment of 
interest made during the accrual period, translated, under paragraph 
(b)(3)(iii) of this section and Sec.  1.988-2(b)(7), at the rate 
applicable to accrued interest ($1.10 x [pound]30 = $33). 
Accordingly, Z's adjusted basis as of July 1, 2005, is $1022 ($1000 
+ $55-$33).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) 
and (iv) of this section, the adjusted issue price of the debt 
instrument determined in pounds and Z's adjusted basis in dollars in 
the debt instrument are increased by the interest accrued, and 
decreased by the interest payment made, in the July-December accrual 
period. Thus, on January 1, 2006, the adjusted issue price of the 
instrument is [pound]1041 ([pound]1020 + [pound]51-[pound]30 = 
[pound]1041). For purposes of determining Z's dollar basis in the 
debt instrument, the $1022 basis is increased by the [pound]51 of 
accrued interest, translated, under paragraph (b)(3)(iii) of this 
section, at the rate at which interest was accrued for the July-
December accrual period ($1.30 x [pound]51 = $66.30). The resulting 
amount is reduced by the [pound]30 payment of interest made during 
the accrual period, translated, under paragraph (b)(3)(iii) of this 
section and Sec.  1.988-2(b)(7), at the rate applicable to accrued 
interest ($1.30 x [pound]30 = $39). Accordingly, Z's adjusted basis 
as of January 1, 2006, is $1049.30 ($1022 + $66.30-$39).
    (C) Foreign currency gain or loss. Z will recognize foreign 
currency gain on the receipt of each [pound]30 payment of interest 
actually received during 2005. The amount of foreign currency gain 
in each case is determined, under paragraph (b)(5)(ii) of this 
section, by reference to the difference between the spot rate on the 
date the [pound]30 payment was made and the average exchange

[[Page 51954]]

rate for the accrual period during which the interest accrued. 
Accordingly, Z recognizes $3 of foreign currency gain on the 
January-June interest payment [[pound]30 x ($1.20-$1.10)], and $3 of 
foreign currency gain on the July-December interest payment 
[[pound]30 x ($1.40-$1.30)]. Z recognizes in 2005 a total of $6 of 
foreign currency gain.
    (D) Source. Z has interest income of $121.30 and a foreign 
currency gain of $6. Under paragraph (b)(6) of this section and 
section 862(a)(1), the interest income is sourced by reference to 
the residence of the payor and is therefore from sources without the 
United States. Under paragraph (b)(6) of this section and Sec.  
1.988-4, Z's foreign currency gain of $6 is sourced by reference to 
Z's residence and is therefore from sources within the United 
States.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z's accrued interest for the January-June accrual 
period is [pound]52.05 (adjusted issue price of [pound]1041 x 10 
percent/2). Under paragraph (b)(3)(i) of this section, Z translates 
the [pound]52.05 at the average exchange rate for the accrual period 
($1.50 x [pound]52.05 = $78.08). Similarly, Z accrues [pound]53.15 
of interest in the July-December accrual period [([pound]1041 + 
[pound]52.05-[pound]30) x 10 percent/2], which is translated at the 
average exchange rate for the accrual period ($1.70 x [pound]53.15 = 
$90.35). Accordingly, Z accrues [pound]105.20, or $168.43, of 
interest income in 2006.
    (B) Effect of net negative adjustment. The payment actually made 
on December 31, 2006, is [pound]981.00, rather than the projected 
[pound]1086.20. Under paragraph (b)(2)(ii)(B) of this section, Z has 
a net negative adjustment of [pound]105.20 on December 31, 2006, 
attributable to the difference between the amount of the actual 
payment and the amount of the projected payment. Z's accrued 
interest income of [pound]105.20 in 2006 is reduced to zero by the 
net negative adjustment. Elimination of the 2006 accrued interest 
fully utilizes the net negative adjustment.
    (C) Adjusted issue price and basis--(1) January-June accrual 
period. Under paragraphs (b)(2)(iii) and (iv) of this section, the 
adjusted issue price of the debt instrument determined in pounds and 
Z's adjusted basis in dollars in the debt instrument are increased 
by the interest accrued, and decreased by the interest payment made, 
in the January-June accrual period. Thus, on July 1, 2006, the 
adjusted issue price of the debt instrument is [pound]1063.05 
([pound]1041 + [pound]52.05-[pound]30 = [pound]1063.05). For 
purposes of determining Z's dollar basis in the debt instrument, the 
$1049.30 adjusted basis is increased by the [pound]52.05 of accrued 
interest, translated, under paragraph (b)(3)(iii) of this section, 
at the rate at which interest was accrued for the January-June 
accrual period ($1.50 x [pound]52.05 = $78.08). The resulting amount 
is reduced by the [pound]30 payment of interest made during the 
accrual period, translated, under paragraph (b)(3)(iii) of this 
section and Sec.  1.988-2(b)(7), at the rate applicable to accrued 
interest ($1.50 x [pound]30 = $45). Accordingly, Z's adjusted basis 
as of July 1, 2006, is $1082.38 ($1049.30 + $78.08-$45).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) 
and (iv) of this section, the adjusted issue price of the debt 
instrument determined in pounds and Z's adjusted basis in dollars in 
the debt instrument are increased by the interest accrued, and 
decreased by the interest payment made, in the July-December accrual 
period. Thus, immediately before maturity on December 31, 2006, the 
adjusted issue price of the instrument is [pound]1086.20 
([pound]1063.05 + [pound]53.15-[pound]30 = [pound]1086.20). For 
purposes of determining Z's dollar basis in the debt instrument, the 
$1082.38 adjusted basis is increased by the [pound]53.15 of accrued 
interest, translated, under paragraph (b)(3)(iii) of this section, 
at the rate at which interest was accrued for the July-December 
accrual period ($1.70 x [pound]53.15 = $90.36). The resulting amount 
is reduced by the [pound]30 payment of interest made during the 
accrual period, translated, under paragraph (b)(3)(iii) of this 
section and Sec.  1.988-2(b)(7), at the rate applicable to accrued 
interest ($1.70 x [pound]30 = $51). Accordingly, Z's adjusted basis 
on December 31, 2006, immediately prior to maturity is $1121.74 
($1082.38 + $90.36-$51).
    (D) Amount realized. Even though Z receives [pound]981.00 at 
maturity, for purposes of determining the amount realized, Z is 
treated under paragraph (b)(2)(v) of this section as receiving the 
projected amount of the contingent payment on December 31, 2006. 
Therefore, Z is treated as receiving [pound]1086.20 on December 31, 
2006. Under paragraph (b)(3)(iv) of this section, Z translates its 
amount realized into dollars and computes its gain or loss on the 
instrument (other than foreign currency gain or loss) by breaking 
the amount realized into its component parts. Accordingly, [pound]20 
of the [pound]1086.20 (representing the interest accrued in the 
January-June 2005 accrual period, less [pound]30 interest paid) is 
translated into dollars at the rate at which it was accrued 
([pound]1 = $1.10), resulting in an amount realized of $22; 
[pound]21 of the [pound]1086.20 (representing the interest accrued 
in the July-December 2005 accrual period, less [pound]30 interest 
paid) is translated into dollars at the rate at which it was accrued 
([pound]1 = $1.30), resulting in an amount realized of $27.30; 
[pound]22.05 of the [pound]1086.20 (representing the interest 
accrued in the January-June 2006 accrual period, less [pound]30 
interest paid) is translated into dollars at the rate at which it 
was accrued ([pound]1 = $1.50), resulting in an amount realized of 
$33.08; [pound]23.15 of the [pound]1086.20 (representing the 
interest accrued in the July 1-December 31, 2006 accrual period, 
less the [pound]30 interest payment) is translated into dollars at 
the rate at which it was accrued ([pound]1 = $1.70), resulting in an 
amount realized of $39.36; and [pound]1000 (representing principal) 
is translated into dollars at the spot rate on the date the 
instrument was purchased ([pound]1 = $1), resulting in an amount 
realized of $1000. Accordingly, Z's total amount realized is 
$1121.74 ($22 + $27.30 + $33.08 + $39.36 + $1000), the same as its 
basis, and Z recognizes no gain or loss (before consideration of 
foreign currency gain or loss) on retirement of the instrument.
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to each [pound]30 payment actually received during 
2006. These payments, however, are treated as payments of principal 
for this purpose because all 2006 accrued interest is reduced to 
zero by the net negative adjustment. See paragraph (b)(5)(iv)(A)(3) 
of this section. The amount of foreign currency gain in each case is 
determined, under paragraph (b)(5)(iii) of this section, by 
reference to the difference between the spot rate on the date the 
[pound]30 payment is made and the spot rate on the date the debt 
instrument was issued. Accordingly, Z recognizes $18 of foreign 
currency gain on the January-June 2006 interest payment [[pound]30 x 
($1.60 - $1.00)], and $24 of foreign currency gain on the July-
December 2006 interest payment [[pound]30 x ($1.80 - $1.00)]. Z 
separately recognizes foreign currency gain with respect to the 
consideration actually received at maturity, [pound]981.00. The 
amount of such gain is determined based on the difference between 
the spot rate on the date the instrument matures and the rates at 
which the principal and interest were taken into account. With 
respect to the portion of the payment attributable to interest 
accrued in January-June 2005 (other than the [pound]30 payments), 
the foreign currency gain is $14 [[pound]20 x ($1.80 - $1.10)]. With 
respect to the portion of the payment attributable to interest 
accrued in July-December 2005 (other than the [pound]30 payments), 
the foreign currency gain is $10.50 [[pound]21 x ($1.80 - $1.30)]. 
With respect to the portion of the payment attributable to interest 
accrued in 2006 (other than the [pound]30 payments), no foreign 
currency gain or loss is recognized under paragraph (b)(5)(ii) of 
this section because such interest was reduced to zero by the net 
negative adjustment. With respect to the portion of the payment 
attributable to principal, the foreign currency gain is $752 
[[pound]940 x ($1.80 - $1.00)]. Thus, Z recognizes a foreign 
currency gain of $42 on receipt of the two [pound]30 payments in 
2006, and $776.50 ($14 + $10.50 + $752) on receipt of the payment at 
maturity, for a total 2006 foreign currency gain of $818.50.
    (F) Source. Under paragraph (b)(6) of this section and Sec.  
1.988-4, Z's foreign currency gain of $818.50 is sourced by 
reference to Z's residence and is therefore from sources within the 
United States.
    Example 4. Purchase price greater than adjusted issue price--(i) 
Facts. On July 1, 2005, Z, a calendar year U.S. resident taxpayer 
whose functional currency is the U.S. dollar, purchases a debt 
instrument with a non-currency contingency for [pound]1405. All 
payments of principal and interest with respect to the instrument 
are denominated in, or determined by reference to, a single 
nonfunctional currency (the British pound). The debt instrument 
would be subject to Sec.  1.1275-4(b) if it were denominated in 
dollars. The debt instrument was originally issued by a foreign 
corporation on December 31, 2003, for an issue price of [pound]1000, 
and matures on December 31, 2006. The debt instrument's comparable 
yield, determined in British pounds under Sec. Sec.  1.988-2(b)(2) 
and 1.1275-4(b), is 10.25 percent, compounded semiannually, and the 
projected payment schedule for the debt instrument (determined as of 
the issue date under the rules of

[[Page 51955]]

Sec.  1.1275-4(b)) provides for a single payment at maturity of 
[pound]1349.70 (consisting of a noncontingent payment of [pound]1000 
and a projected payment of [pound]349.70). At the time of the 
purchase, the adjusted issue price of the debt instrument is 
[pound]1161.76, assuming semiannual accrual periods ending on June 
30 and December 31 of each year. The increase in the value of the 
debt instrument over its adjusted issue price is due to an increase 
in the expected amount of the contingent payment. The debt 
instrument is a capital asset in the hands of Z. Z does not elect to 
use the spot-rate convention described in Sec.  1.988-
2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 
[pound]1400. The relevant pound/dollar spot rates over the term of 
the instrument are as follows:

------------------------------------------------------------------------
                                                Spot rate  (pounds to
                   Date                               dollars)
------------------------------------------------------------------------
July 1, 2005..............................  [pound]1.00=$1.00
Dec. 31, 2006.............................  [pound]1.00=$2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Average rate  (pounds to
              Accrual period                          dollars)
------------------------------------------------------------------------
July 1-December 31, 2005..................  [pound]1.00=$1.50
January 1-June 30, 2006...................  [pound]1.00=$1.50
July 1-December 31, 2006..................  [pound]1.00=$1.50
------------------------------------------------------------------------

    (ii) Initial basis. Under paragraph (b)(7)(ii) of this section, 
Z's initial basis in the debt instrument is $1405, Z's purchase 
price of [pound]1405, translated into functional currency at the 
spot rate on the date the debt instrument was purchased ([pound]1 = 
$1).
    (iii) Allocation of purchase price differential. Z purchased the 
debt instrument for [pound]1405 when its adjusted issue price was 
[pound]1161.76. Under paragraph (b)(7)(iii) of this section, Z 
allocates the [pound]243.24 excess of purchase price over adjusted 
issue price to the contingent payment at maturity. This allocation 
is reasonable because the excess is due to an increase in the 
expected amount of the contingent payment and not, for example, to a 
decrease in prevailing interest rates.
    (iv) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]59.54 of interest on the debt 
instrument for the July-December 2005 accrual period (issue price of 
[pound]1161.76 x 10.25 percent/2). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]59.54 of interest at the average 
exchange rate for the accrual period ($1.50 x [pound]59.54 = 
$89.31). Accordingly, Z has interest income in 2005 of $89.31.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) 
and (iv) of this section, the adjusted issue price of the debt 
instrument determined in pounds and Z's adjusted basis in dollars in 
the debt instrument are increased by the interest accrued in July-
December 2005. Thus, on January 1, 2006, the adjusted issue price of 
the debt instrument is [pound]1221.30 ([pound]1161.76 + 
[pound]59.54). For purposes of determining Z's dollar basis in the 
debt instrument on January 1, 2006, the $1405 basis is increased by 
the [pound]59.54 of accrued interest, translated at the rate at 
which interest was accrued for the July-December 2005 accrual 
period. Paragraph (b)(3)(iii) of this section. Accordingly, Z's 
adjusted basis in the instrument, as of January 1, 2006, is $1494.31 
[$1405 + ([pound]59.54 x $1.50)].
    (v) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]62.59 of interest on the debt 
instrument for the January-June 2006 accrual period (issue price of 
[pound]1221.30 x 10.25 percent/2). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]62.59 of accrued interest at the 
average exchange rate for the accrual period ($1.50 x [pound]62.59 = 
$93.89). Similarly, Z accrues [pound]65.80 of interest in the July-
December 2006 accrual period [([pound]1221.30 + [pound]62.59) x 
10.25 percent/2], which is translated at the average exchange rate 
for the accrual period ($1.50 x [pound]65.80 = $98.70). Accordingly, 
Z accrues [pound]128.39, or $192.59, of interest income in 2006.
    (B) Effect of positive and negative adjustments--(1) Offset of 
positive adjustment. The payment actually made on December 31, 2006, 
is [pound]1400, rather than the projected [pound]1349.70. Under 
paragraph (b)(2)(ii) of this section, Z has a positive adjustment of 
[pound]50.30 on December 31, 2006, attributable to the difference 
between the amount of the actual payment and the amount of the 
projected payment. Under paragraph (b)(7)(iii) of this section, 
however, Z also has a negative adjustment of [pound]243.24, 
attributable to the excess of Z's purchase price for the debt 
instrument over its adjusted issue price. Accordingly, Z will have a 
net negative adjustment of [pound]192.94 ([pound]50.30 -
[pound]243.24 = -[pound]192.94) for 2006.
    (2) Offset of accrued interest. Z's accrued interest income of 
[pound]128.39 in 2006 is reduced to zero by the net negative 
adjustment. The net negative adjustment which reduces the current 
year's interest is not translated into functional currency. Under 
paragraph (b)(2)(ii) of this section, Z treats the remaining 
[pound]64.55 net negative adjustment as an ordinary loss to the 
extent of the [pound]59.54 previously accrued interest in 2005. This 
[pound]59.54 ordinary loss is attributable to interest accrued but 
not paid in the preceding year. Therefore, under paragraph 
(b)(3)(ii)(B)(2) of this section, Z translates the loss into dollars 
at the average rate for such year ([pound]1 = $1.50). Accordingly, Z 
has an ordinary loss of $89.31 in 2006. The remaining [pound]5 of 
net negative adjustment is a negative adjustment carryforward under 
paragraph (b)(2)(ii) of this section.
    (C) Adjusted issue price and basis--(1) January-June accrual 
period. Under paragraph (b)(2)(iii) of this section, the adjusted 
issue price of the debt instrument on July 1, 2006, is 
[pound]1283.89 ([pound]1221.30 + [pound]62.59 = [pound]1283.89). 
Under paragraphs (b)(2)(iv) and (b)(3)(iii) of this section, Z's 
adjusted basis as of July 1, 2006, is $1588.20 ($1494.31 + $93.89).
    (2) July-December accrual period. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument 
immediately before the payment at maturity is [pound]1349.70 
([pound]1283.89 + [pound]65.80 accrued interest for July-December). 
Z's adjusted basis in dollars, based only on the noncontingent 
payments and the projected amount of the contingent payments to be 
received, is $1686.90 ($1588.20 plus $98.70 of accrued interest for 
July-December).
    (3) Adjustment to basis upon contingent payment. Under paragraph 
(b)(7)(iii) of this section, Z's adjusted basis in the debt 
instrument is reduced at maturity by [pound]243.24, the excess of 
Z's purchase price for the debt instrument over its adjusted issue 
price. For this purpose, the adjustment is translated into 
functional currency at the spot rate on the date the instrument was 
acquired ([pound]1 = $1). Accordingly, Z's adjusted basis in the 
debt instrument at maturity is $1443.66 ($1686.90 -$243.24).
    (D) Amount realized. Even though Z receives [pound]1400 at 
maturity, for purposes of determining the amount realized, Z is 
treated under paragraph (b)(2)(v) of this section as receiving the 
projected amount of the contingent payment on December 31, 2006, 
reduced by the amount of Z's negative adjustment carryforward of 
[pound]5.01. Therefore, Z is treated as receiving [pound]1344.69 
([pound]1349.70 -[pound]5.01) on December 31, 2006. Under paragraph 
(b)(3)(iv) of this section, Z translates its amount realized into 
dollars and computes its gain or loss on the instrument (other than 
foreign currency gain or loss) by breaking the amount realized into 
its component parts. Accordingly, [pound]59.54 of the [pound]1344.69 
(representing the interest accrued in 2005) is translated at the 
rate at which it was accrued ([pound]1 = $1.50), resulting in an 
amount realized of $89.31; [pound]62.59 of the [pound]1344.69 
(representing the interest accrued in January-June 2006) is 
translated into dollars at the rate at which it was accrued 
([pound]1 = $1.50), resulting in an amount realized of $93.89; 
[pound]65.80 of the [pound]1344.69 (representing the interest 
accrued in July-December 2006) is translated into dollars at the 
rate at which it was accrued ([pound]1 = $1.50), resulting in an 
amount realized of $98.70; and [pound]1156.76 of the [pound]1344.69 
(representing a return of principal) is translated into dollars at 
the spot rate on the date the instrument was purchased ([pound]1 = 
$1), resulting in an amount realized of $1156.76. Z's amount 
realized is $1438.66 ($89.31 + $93.89 + $98.70 + $1156.76), and Z 
recognizes a capital loss (before consideration of foreign currency 
gain or loss) of $5 on retirement of the instrument ($1438.66 -
$1443.66 = -$5).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain under section 988 on the instrument with respect to the entire 
consideration actually received at maturity, [pound]1400. While 
foreign currency gain or loss ordinarily would not have arisen with 
respect to [pound]50.30 of the [pound]1400, which was initially 
treated as a positive adjustment in 2006, the larger negative 
adjustment in 2006 reduced this positive adjustment to zero. 
Accordingly, foreign currency gain or loss is recognized with 
respect to the entire [pound]1400. Under paragraph (b)(5)(ii) of 
this section, however, no foreign currency gain or loss is 
recognized with respect to unpaid accrued interest reduced to zero 
by the net negative adjustment resulting in 2006, and no foreign 
currency gain or loss is recognized with respect to unpaid accrued 
interest from 2005,

[[Page 51956]]

also reduced to zero by the ordinary loss. Therefore, the entire 
[pound]1400 is treated as a return of principal for the purpose of 
determining foreign currency gain or loss, and Z recognizes a total 
foreign currency gain on December 31, 2001, of $1400 [[pound]1400 x 
($2.00 -$1.00)].
    (F) Source. Z has an ordinary loss of $89.31, a capital loss of 
$5, and a foreign currency gain of $1400. Under paragraph (b)(6) of 
this section and Sec.  1.1275-4(b)(9)(iv), the $89.31 ordinary loss 
generally reduces Z's foreign source passive income under section 
904(d) and the regulations thereunder. Under paragraph (b)(6) of 
this section and Sec.  1.865-1(b)(2), the $5 capital loss is sourced 
by reference to how interest income on the instrument would have 
been sourced. Therefore, the $5 capital loss generally reduces Z's 
foreign source passive income under section 904(d) and the 
regulations thereunder. Under paragraph (b)(6) of this section and 
Sec.  1.988-4, Z's foreign currency gain of $1400 is sourced by 
reference to Z's residence and is therefore from sources within the 
United States.
    Example 5. Sale of an instrument with a negative adjustment 
carryforward--(i) Facts. On December 31, 2003, Z, a calendar year 
U.S. resident taxpayer whose functional currency is the U.S. dollar, 
purchases at original issue a debt instrument with non-currency 
contingencies for [pound]1000. All payments of principal and 
interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the 
British pound). The debt instrument would be subject to Sec.  
1.1275-4(b) if it were denominated in dollars. The debt instrument's 
comparable yield, determined in British pounds under Sec. Sec.  
1.988-2(b)(2) and 1.1275-4(b), is 10 percent, compounded annually, 
and the projected payment schedule for the debt instrument provides 
for payments of [pound]310 on December 31, 2005 (consisting of a 
noncontingent payment of [pound]50 and a projected amount of 
[pound]260) and [pound]990 on December 31, 2006 (consisting of a 
noncontingent payment of [pound]940 and a projected amount of 
[pound]50). The debt instrument is a capital asset in the hands of 
Z. Z does not elect to use the spot-rate convention described in 
Sec.  1.988-2(b)(2)(iii)(B). The payment actually made on December 
31, 2005, is [pound]50. On December 30, 2006, Z sells the debt 
instrument for [pound]940. The relevant pound/dollar spot rates over 
the term of the instrument are as follows:

------------------------------------------------------------------------
                                                Spot rate (pounds to
                   Date                               dollars)
------------------------------------------------------------------------
Dec. 31, 2003.............................  [pound]1.00=$1.00
Dec. 31, 2005.............................  [pound]1.00=$2.00
Dec. 30, 2006.............................  [pound]1.00=$2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
                                              Average rate  (pounds to
              Accrual period                          dollars)
------------------------------------------------------------------------
January 1--December 31, 2004..............  [pound]1.00=$2.00
January 1--December 31, 2005..............  [pound]1.00=$2.00
January 1--December 31, 2006..............  [pound]1.00=$2.00
------------------------------------------------------------------------

    (ii) Treatment in 2004--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]100 of interest on the debt 
instrument for 2004 (issue price of [pound]1000 x 10 percent). Under 
paragraph (b)(3)(i) of this section, Z translates the [pound]100 at 
the average exchange rate for the accrual period ($2.00 x [pound]100 
= $200). Accordingly, Z has interest income in 2004 of $200.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) 
and (iv) of this section, the adjusted issue price of the debt 
instrument determined in pounds and Z's adjusted basis in dollars in 
the debt instrument are increased by the interest accrued in 2004. 
Thus, on January 1, 2005, the adjusted issue price of the debt 
instrument is [pound]1100. For purposes of determining Z's dollar 
basis in the debt instrument, the $1000 basis ($1.00 x [pound]1000 
original cost basis) is increased by the [pound]100 of accrued 
interest, translated at the rate at which interest was accrued for 
2004. See paragraph (b)(3)(iii) of this section. Accordingly, Z's 
adjusted basis in the debt instrument as of January 1, 2005, is 
$1200 ($1000 + $200).
    (iii) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z's accrued interest for 2005 is [pound]110 
(adjusted issue price of [pound]1100 x 10 percent). Under paragraph 
(b)(3)(i) of this section, the [pound]110 of accrued interest is 
translated at the average exchange rate for the accrual period 
($2.00 x [pound]110 = $220).
    (B) Effect of net negative adjustment. The payment actually made 
on December 31, 2005, is [pound]50, rather than the projected 
[pound]310. Under paragraph (b)(2)(ii) of this section, Z has a net 
negative adjustment of [pound]260 on December 31, 2005, attributable 
to the difference between the amount of the actual payment and the 
amount of the projected payment. Z's accrued interest income of 
[pound]110 in 2005 is reduced to zero by the net negative 
adjustment. Under paragraph (b)(3)(ii)(B)(1) of this section, the 
net negative adjustment which reduces the current year's interest is 
not translated into functional currency. Under paragraph (b)(2)(ii) 
of this section, Z treats the remaining [pound]150 net negative 
adjustment as an ordinary loss to the extent of the [pound]100 
previously accrued interest in 2004. This [pound]100 ordinary loss 
is attributable to interest accrued but not paid in the preceding 
year. Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z 
translates the loss into dollars at the average rate for such year 
([pound]1 = $2.00). Accordingly, Z has an ordinary loss of $200 in 
2005. The remaining [pound]50 of net negative adjustment is a 
negative adjustment carryforward under paragraph (b)(2)(ii) of this 
section.
    (C) Adjusted issue price and basis. Based on the projected 
payment schedule, the adjusted issue price of the debt instrument on 
January 1, 2006 is [pound]900, i.e., the adjusted issue price of the 
debt instrument on January 1, 2005 ([pound]1100), increased by the 
interest accrued in 2005 ([pound]110), and decreased by the 
projected amount of the December 31, 2005, payment ([pound]310). See 
paragraph (b)(2)(iii) of this section. Z's adjusted basis in 
dollars, based only on the noncontingent payments and the projected 
amount of the contingent payments to be received, is $900 
(determined as described below). Z's adjusted basis on January 1, 
2006 is Z's adjusted basis on January 1, 2005 ($1200), increased by 
the functional currency amount of interest accrued in 2005 ($220), 
and decreased by the amount of the payments made in 2005, based 
solely on the projected payment schedule, ([pound]310). The amount 
of the projected payment is first attributable to the interest 
accrued in 2005 ([pound]110), and then to the interest accrued in 
2004 ([pound]100), and the remaining amount to principal 
([pound]100). The interest component of the projected payment is 
translated into functional currency at the rates at which it was 
accrued, and the principal component of the projected payment is 
translated into functional currency at the spot rate on the date the 
instrument was issued. See paragraph (b)(3)(iii) of this section. 
Accordingly, Z's adjusted basis in the debt instrument, following 
the increase of adjusted basis for interest accrued in 2005 ($1200 + 
$220 = $1420), is decreased by $520 ($220 + $200 + $100 = $520). Z's 
adjusted basis on January 1, 2006 is therefore, $900.
    (D) Foreign currency gain or loss. Z will recognize foreign 
currency gain on the receipt of the [pound]50 payment actually 
received on December 31, 2005. Based on paragraph (b)(5)(iv) of this 
section, the [pound]50 payment is attributable to principal since 
the accrued unpaid interest was completely eliminated by the net 
negative adjustment. The amount of foreign currency gain is 
determined, under paragraph (b)(5)(iii) of this section, by 
reference to the difference between the spot rate on the date the 
[pound]50 payment was made and the spot rate on the date the debt 
instrument was issued. Accordingly, Z recognizes $50 of foreign 
currency gain on the [pound]50 payment. [($2.00-$1.00) x [pound]50 = 
$50]. Under paragraph (b)(6) of this section and Sec.  1.988-4, Z's 
foreign currency gain of $50 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    (iv) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the 
comparable yield, Z accrues [pound]90 of interest on the debt 
instrument for 2004 (adjusted issue price of [pound]900 x 10 
percent). Under paragraph (b)(3)(i) of this section, Z translates 
the [pound]90 at the average exchange rate for the accrual period 
($2.00 x [pound]90 = $180). Accordingly, prior to taking into 
account the 2005 negative adjustment carryforward, Z has interest 
income in 2006 of $180.
    (B) Effect of net negative adjustment. The [pound]50 negative 
adjustment carryforward from 2005 is a negative adjustment for 2006. 
Since there are no other positive or negative adjustments, there is 
a [pound]50 negative adjustment in 2006 which reduces Z's accrued 
interest income by [pound]50. Accordingly, after giving effect to 
the [pound]50 negative

[[Page 51957]]

adjustment carryforward, Z will accrue $80 of interest income. 
[([pound]90-[pound]50) x $2.00 = $80]
    (C) Adjusted issue price. Under paragraph (b)(2)(iii) of this 
section, the adjusted issue price of the debt instrument determined 
in pounds is increased by the interest accrued in 2006 (prior to 
taking into account the negative adjustment carryforward). Thus, on 
December 30, 2006, the adjusted issue price of the debt instrument 
is [pound]990.
    (D) Adjusted basis. For purposes of determining Z's dollar basis 
in the debt instrument, Z's $900 adjusted basis on January 1, 2006 
is increased by the accrued interest, translated at the rate at 
which interest was accrued for 2006. See paragraph (b)(3)(iii)(A) of 
this section. Note, however, that under paragraph (b)(3)(iii)(B) the 
amount of accrued interest which is reduced as a result of the 
negative adjustment carryforward, i.e., [pound]50, is treated for 
purposes of this section as principal, and is translated at the spot 
rate on the date the instrument was issued, i.e., [pound]1.00 
=$1.00. Accordingly, Z's adjusted basis in the debt instrument as of 
December 30, 2006, is $1030 ($900 + $50 + $80).
    (E) Amount realized. Z's amount realized in denomination 
currency is [pound]940, i.e., the amount of pounds Z received on the 
sale of the debt instrument. Under paragraph (b)(3)(iv)(B)(1) of 
this section, Z's amount realized is first translated by reference 
to the principal component of basis (including the amount which is 
treated as principal under paragraph (b)(3)(iii)(B) of this section) 
and then the remaining amount realized, if any, is translated by 
reference to the accrued unpaid interest component of adjusted 
basis. Thus, [pound]900 of Z's amount realized is translated by 
reference to the principal component of adjusted basis. The 
remaining [pound]40 of Z's amount realized is treated as principal 
under paragraph (b)(3)(iii)(B) of this section, and is also 
translated by reference to the principal component of adjusted 
basis. Accordingly, Z's amount realized in functional currency is 
$940. (No part of Z's amount realized is attributable to the 
interest accrued on the debt instrument.) Z realizes a loss of $90 
on the sale of the debt instrument ($1030 basis--$940 amount 
realized). Under paragraph (b)(4) of this section and Sec.  1.1275-
4(b)(8), $80 of the loss is characterized as ordinary loss, and the 
remaining $10 of loss is characterized as capital loss. Under 
Sec. Sec.  1.988-6(b)(6) and 1.1275-4(b)(9)(iv) the $80 ordinary 
loss is treated as a deduction that is definitely related to the 
interest income accrued on the debt instrument. Similarly, under 
Sec. Sec.  1.988-6(b)(6) and 1.865-1(b)(2) the $10 capital loss is 
also allocated to the interest income from the debt instrument.
    (F) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the [pound]940 he received on the sale of the 
debt instrument. Under paragraph (b)(5)(iv) of this section, the 
[pound]940 Z received is attributable to principal (and the amount 
which is treated as principal under paragraph (b)(3)(iii)(B) of this 
section). Thus, Z recognizes foreign currency gain on December 31, 
2006, of $940. [($2.00-$1.00) x [pound]940]. Under paragraph (b)(6) 
of this section and Sec.  1.988-4, Z's foreign currency gain of $940 
is sourced by reference to Z's residence and is therefore from 
sources within the United States.
    (d) Multicurrency debt instruments--(1) In general. Except as 
provided in this paragraph (d), a multicurrency debt instrument 
described in paragraph (a)(1)(ii) or (iii) of this section shall be 
treated as an instrument described in paragraph (a)(1)(i) of this 
section and shall be accounted for under the rules of paragraph (b) of 
this section. Because payments on an instrument described in paragraph 
(a)(1)(ii) or (iii) of this section are denominated in, or determined 
by reference to, more than one currency, the issuer and holder or 
holders of the instrument are required to determine the denomination 
currency of the instrument under paragraph (d)(2) of this section 
before applying the rules of paragraph (b) of this section.
    (2) Determination of denomination currency. The denomination 
currency of an instrument described in paragraph (a)(1)(ii) or (iii) of 
this section shall be the predominant currency of the instrument. The 
predominant currency of the instrument shall be determined by comparing 
the functional currency value of the noncontingent and projected 
payments denominated in, or determined by reference to, each currency 
on the issue date, discounted to present value (in each relevant 
currency), and translated (if necessary) into functional currency at 
the spot rate on the issue date. For this purpose, the applicable 
discount rate may be determined using any method, consistently applied, 
that reasonably reflects the instrument's economic substance. If a 
taxpayer does not determine a discount rate using such a method, the 
Commissioner may choose a method for determining the discount rate that 
does reflect the instrument's economic substance. The predominant 
currency is determined as of the issue date and does not change based 
on subsequent events (e.g., changes in value of one or more 
currencies).
    (3) Issuer/holder consistency. The issuer determines the 
denomination currency under the rules of paragraph (d)(2) of this 
section and provides this information to the holders of the instrument 
in a manner consistent with the issuer disclosure rules of Sec.  
1.1275-2(e). If the issuer does not determine the denomination currency 
of the instrument, or if the issuer's determination is unreasonable, 
the holder of the instrument must determine the denomination currency 
under the rules of paragraph (d)(2) of this section. A holder that 
determines the denomination currency itself must explicitly disclose 
this fact on a statement attached to the holder's timely filed federal 
income tax return for the taxable year that includes the acquisition 
date of the instrument.
    (4) Treatment of payments in currencies other than the denomination 
currency. For purposes of applying the rules of paragraph (b) of this 
section to debt instruments described in paragraph (a)(1)(ii) or (iii) 
of this section, payments not denominated in (or determined by 
reference to) the denomination currency shall be treated as non-
currency-related contingent payments. Accordingly, if the denomination 
currency of the instrument is determined to be the taxpayer's 
functional currency, the instrument shall be accounted for under Sec.  
1.1275-4(b) rather than this section.
    (e) Instruments issued for nonpublicly traded property--(1) 
Applicability. This paragraph (e) applies to debt instruments issued 
for nonpublicly traded property that would be described in paragraph 
(a)(1)(i), (ii), or (iii) of this section, but for the fact that such 
instruments are described in Sec.  1.1275-4(c)(1) rather than Sec.  
1.1275-4(b)(1). For example, this paragraph (e) generally applies to a 
contingent debt instrument denominated in a nonfunctional currency that 
is issued for non-publicly traded property. Generally the rules of 
Sec.  1.1275-4(c) apply except as set forth by the rules of this 
paragraph (e).
    (2) Separation into components. An instrument described in this 
paragraph (e) is not accounted for using the noncontingent bond method 
of Sec.  1.1275-4(b) and paragraph (b) of this section. Rather, the 
instrument is separated into its component payments. Each noncontingent 
payment or group of noncontingent payments which is denominated in a 
single currency shall be considered a single component treated as a 
separate debt instrument denominated in the currency of the payment or 
group of payments. Each contingent payment shall be treated separately 
as provided in paragraph (e)(4) of this section.
    (3) Treatment of components consisting of one or more noncontingent 
payments in the same currency. The issue price of each component 
treated as a separate debt instrument which consists of one or more 
noncontingent payments is the sum of the present values of the 
noncontingent payments contained in the separate instrument. The 
present value of any noncontingent payment shall be determined under 
Sec.  1.1274-2(c)(2), and the test rate shall be determined under Sec.  
1.1274-4 with respect to the currency in which each separate instrument 
is considered denominated. No interest payments on the separate debt 
instrument are

[[Page 51958]]

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. Interest income or 
expense is translated, and exchange gain or loss is recognized on the 
separate debt instrument as provided in Sec.  1.988-2(b)(2), if the 
instrument is denominated in a nonfunctional currency.
    (4) Treatment of components consisting of contingent payments--(i) 
General rule. A component consisting of a contingent payment shall 
generally be treated in the manner provided in Sec.  1.1275-4(c)(4). 
However, except as provided in paragraph (e)(4)(ii) of this section, 
the test rate shall be determined by reference to the U.S. dollar 
unless the dollar does not reasonably reflect the economic substance of 
the contingent component. In such case, the test rate shall be 
determined by reference to the currency which most reasonably reflects 
the economic substance of the contingent component. Any amount received 
in nonfunctional currency from a component consisting of a contingent 
payment shall be translated into functional currency at the spot rate 
on the date of receipt. Except in the case when the payment becomes 
fixed more than six months before the payment is due, no foreign 
currency gain or loss shall be recognized on a contingent payment 
component.
    (ii) Certain delayed contingent payments--(A) Separate debt 
instrument relating to the fixed component. The rules of Sec.  1.1275-
4(c)(4)(iii) shall apply to a contingent component the payment of which 
becomes fixed more than 6 months before the payment is due. For this 
purpose, the denomination currency of the separate debt instrument 
relating to the fixed payment shall be the currency in which payment is 
to be made and the test rate for such separate debt instrument shall be 
determined in the currency of that instrument. If the separate debt 
instrument relating to the fixed payment is denominated in 
nonfunctional currency, the rules of Sec.  1.988-2(b)(2) shall apply to 
that instrument for the period beginning on the date the payment is 
fixed and ending on the payment date.
    (B) Contingent component. With respect to the contingent component, 
the issue price considered to have been paid by the issuer to the 
holder under Sec.  1.1275-4(c)(4)(iii)(A) shall be translated, if 
necessary, into the functional currency of the issuer or holder at the 
spot rate on the date the payment becomes fixed.
    (5) Basis different from adjusted issue price. The rules of Sec.  
1.1275-4(c)(5) shall apply to an instrument subject to this paragraph 
(e).
    (6) Treatment of a holder on sale, exchange, or retirement. The 
rules of Sec.  1.1275-4(c)(6) shall apply to an instrument subject to 
this paragraph (e).
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec.  1.1275-4(d). [RESERVED]
    (g) Effective date. This section shall apply to debt instruments 
issued 60 days or more after the date final regulations are published 
in the Federal Register.
    Par. 4. In Sec.  1.1275-4, paragraph (a)(2)(iv) is revised to read 
as follows:


Sec.  1.1275-4  Contingent payment debt instruments.

    (a) * * *
    (2) * * *
    (iv) A debt instrument subject to section 988 (except as provided 
in Sec.  1.988-6);
* * * * *

David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 03-21827 Filed 8-28-03; 8:45 am]
BILLING CODE 4830-01-P