[Federal Register Volume 69, Number 167 (Monday, August 30, 2004)]
[Rules and Regulations]
[Pages 52816-52830]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-19642]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9157]
RIN 1545-AW33


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: Final regulation.

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SUMMARY: This document contains final 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 regulations 
affect issuers and holders of such instruments.

DATES: Effective Date: These regulations are effective August 30, 2004.
    Applicability date: These regulations apply to debt instruments 
issued on or after October 29, 2004.

FOR FURTHER INFORMATION CONTACT: Milton Cahn, (202) 622-3860 (not a 
toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1831. Responses to these collections of information 
are mandatory.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per [respondent/recordkeeper] varies 
from 48 minutes to 1 hour 12 minutes, depending on individual 
circumstances, with an estimated average of 1 hour.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS

[[Page 52817]]

Reports Clearance Officer, SE:W:CAR:MP:T:T:SP Washington, DC 20224, and 
to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503.
    Books or records relating to this 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

    This document contains amendments to 26 CFR part 1. On August 29, 
2003, a notice of proposed rulemaking (REG-106486-98) relating to the 
taxation of nonfunctional currency denominated contingent payment debt 
instruments was published in the Federal Register (68 FR 51944). No 
public hearing was requested or held. One written comment responding to 
the notice of proposed rulemaking was received. After consideration of 
this comment, the proposed regulations are adopted as amended by this 
Treasury decision. The revisions are discussed below.

Summary of Comments

    Treasury and the IRS received one comment letter in response to the 
notice of proposed rulemaking. The issues raised in that comment letter 
are addressed below.

1. Exceptions Described in Sec.  1.1275-4(a)(2)

    The comment letter notes that in describing instruments subject to 
Sec.  1.988-6 by reference to Sec.  1.1275-4(b)(1), it was unclear 
whether the exceptions set forth in Sec.  1.1275-4(a)(2) applied to 
instruments described in Sec.  1.988-6(a)(1).
    It was intended to be implicit from the reference to Sec.  1.1275-
4(b)(1) that debt instruments excluded from the application of Sec.  
1.1275-4 by reason of Sec.  1.1275-4(a)(2) (other than by reason of 
being subject to section 988) are similarly excluded from Sec.  1.988-
6. Nevertheless, the final regulations have been revised to make 
explicit that Sec.  1.988-6 applies only to debt instruments to which 
Sec.  1.1275-4 would otherwise apply (not taking into account the 
exclusion for debt instruments that are subject to section 988).

2. Multicurrency Debt Instruments With Related Hedges

    The comment letter expresses concern that it may be possible to 
structure arrangements to avoid the original issue discount (OID) rules 
using a multicurrency debt instrument that has a nonfunctional currency 
as the predominant currency and partial hedges of that instrument. That 
is, it may be possible to closely replicate the economic attributes of 
a dollar denominated instrument with OID through a combination of a 
multicurrency instrument without OID and a partial hedge of that 
instrument. The comment letter suggests that Sec.  1.988-5(a) would not 
apply in such a case, because the hedge would not be a complete hedge 
of all payments.
    Treasury and the IRS believe that an anti-abuse rule is appropriate 
to prevent the potential abuse described above. Accordingly, an anti-
abuse rule applicable to debt instruments subject to section 988 is 
included in Sec.  1.988-2(b)(18). This anti-abuse rule is patterned 
after the anti-abuse rule contained in Sec.  1.1275-2(g) and permits 
the Commissioner to apply or depart from the applicable regulations as 
necessary or appropriate to achieve a reasonable result. No inference 
is intended as to how the Commissioner may apply the anti-abuse rule 
contained in Sec.  1.1275-2(g) to nonfunctional currency denominated 
debt instruments.
    In addition, Treasury and the IRS believe that Sec.  1.988-2(f) may 
be applied in the situation described. Furthermore, Treasury and the 
IRS note that under Sec.  1.988-5(a)(8)(iii) the Commissioner can 
integrate a foreign currency denominated debt instrument with a partial 
hedge of that instrument.

3. Multicurrency Debt Instrument--Determination of Predominant Currency

    The comment letter proposes the use of a special anti-abuse rule in 
the case where the net present value of all payments in, or determined 
with respect to, the predominant currency of a multicurrency instrument 
does not exceed 50 percent of the present value of all payments. The 
letter requests that, in such a case, the comparable yield be 
determined on a synthetic basis by reference to the weighted average of 
the comparable yields in each component currency rather than by 
reference to the predominant currency. There are two stated rationales 
for this request. First, the holder could avoid accrual of OID if a 
multicurrency contingent payment debt instrument's predominant currency 
is a currency with a low interest rate and the other currencies in 
which payments are denominated or with respect to which payments are 
determined are highly inflationary currencies (but not 
hyperinflationary currencies). Second, if the predominant low interest 
rate currency in such an instrument is the U.S. dollar and the issuer 
is foreign, a holder's gain upon disposition of the instrument would be 
characterized as foreign source interest income rather than as U.S. 
source foreign currency gain.
    Treasury and the IRS agree that the letter has identified an issue 
to be addressed. However, Treasury and the IRS believe the proposed 
solution of creating a synthetic yield (and presumably a synthetic 
currency to measure currency gain or loss) is overly complex and would 
be difficult to administer. Instead, Treasury and the IRS have added a 
special rule that applies if there is no single currency for which the 
net present value in functional currency of all payments denominated 
in, or determined by reference to, that currency is greater than 50 
percent of the total value of all payments. In such a case, if the 
discount rate attributable to the currency that would otherwise be the 
predominant currency differs by 10 percentage points or more from the 
discount rate attributable to any other currency in which payments are 
denominated or with respect to which payments are determined, the 
Commissioner can determine the predominant currency under any 
reasonable method.

4. Integrated Debt Instruments

    The comment letter requests clarification that Sec.  1.988-6 does 
not apply to transactions that are composed of a nonfunctional currency 
contingent payment debt instrument (or a multicurrency debt instrument) 
and a qualified hedge and that are subject to the integration rules of 
Sec.  1.988-5. Treasury and the IRS believe that the proposed 
regulations are clear on this point, because Sec.  1.988-5(a)(5)(i) 
provides that a taxpayer may treat a debt instrument and a hedge as an 
integrated economic transaction only if, among other things, all the 
contingent features of an instrument are fully hedged such that the 
synthetic debt instrument resulting from integration is not a 
contingent payment instrument. Accordingly, no change has been made in 
the final regulations regarding this issue.

5. Alternative Payment Schedule and Fixed Yield Rules

    Section 1.1275-4(a)(2)(iii) provides that the contingent payment 
debt instrument rules in Sec.  1.1275-4 do not apply to a debt 
instrument subject to Sec.  1.1272-1(c) (a debt instrument that 
provides for certain alternative payment schedules) or Sec.  1.1272-
1(d) (a debt instrument that provides for a fixed

[[Page 52818]]

yield). The comment letter requests that the final regulations clarify 
that, for purposes of applying Sec. Sec.  1.1272-1(c) and 1.1272-1(d) 
to a nonfunctional currency denominated debt instrument, the yield of 
the instrument be determined in the instrument's denomination currency, 
rather than in the taxpayer's functional currency. Treasury and the IRS 
believe that it is clear under Sec.  1.988-2(b)(2)(ii)(A) 
(determinations regarding OID in a nonfunctional currency denominated 
debt instrument are made in the currency of the debt instrument) that 
these provisions are applied by using the debt instrument's 
denomination currency. Accordingly, no change has been made in the 
final regulations regarding this issue.

6. Predominant Currency of a Multicurrency Debt Instrument Is the Same 
as the Taxpayer's Functional Currency

    The comment letter requests that the final regulations clarify that 
if the predominant currency of a multicurrency debt instrument is the 
taxpayer's functional currency, then section 988 does not apply to that 
instrument. Treasury and the IRS believe that Sec.  1.988-6(d)(4) of 
the proposed regulations is clear on this point. Accordingly, no 
further clarification is made in the final regulations.

7. Other Regulatory Provisions

    The comment letter requests that the final regulations clarify that 
debt instruments subject to Sec.  1.988-6 be treated for purposes of 
other regulations as if they were subject to Sec.  1.1275-4. Section 
1.988-6 provides that the rules of Sec.  1.1275-4 apply to debt 
instruments subject to Sec.  1.988-6, except as otherwise provided in 
Sec.  1.988-6. Accordingly, a reference to a debt instrument subject to 
Sec.  1.1275-4 will also refer to a debt instrument subject to Sec.  
1.988-6, unless otherwise provided in Sec.  1.988-6. Treasury and the 
IRS therefore believe that no further clarification is necessary.

8. Netting Currency Gain or Loss With Other Gain or Loss Upon a 
Disposition of the Instrument

    In response to a request in the preamble to the proposed 
regulations for comments regarding netting, the comment letter proposes 
that foreign currency gain or loss be netted with other gain or loss on 
the disposition of a debt instrument. Treasury and the IRS are 
concerned about this type of netting in the context of foreign currency 
contingent payment debt instruments. Depending on the particular terms 
of such an instrument, a change in value due to a contingency may be 
recognized for tax purposes in a year prior to the recognition of 
foreign currency gain or loss upon disposition of the instrument or may 
be recognized concurrently with the recognition of foreign currency 
gain or loss upon disposition. Treasury and the IRS therefore have 
concluded that netting is not appropriate in the context of foreign 
currency contingent payment debt instruments.

9. Tax Exempt Foreign Currency Contingent Payment Debt Instruments

    In response to a request in the preamble to the proposed 
regulations for comments regarding tax exempt foreign currency 
contingent payment debt instruments, the comment letter requests 
certain modifications to Sec.  1.1275-4(d)(3) to take into account the 
policy considerations underlying Sec.  1.988-3(c). Treasury and the IRS 
appreciate these comments but believe the matter deserves more careful 
study before any regulations specifically addressing tax exempt foreign 
currency contingent payment debt instruments can be issued.

10. Multicurrency Debt Instruments With No Non-Currency Contingencies

    In response to the request for comments contained in the preamble 
to the proposed regulations, the comment letter requests that all gain 
or loss on a sale of a multicurrency debt instrument that has no non-
currency contingencies be characterized wholly as foreign currency gain 
or loss. Treasury and the IRS are concerned that such treatment would 
differ inappropriately from the treatment of gain or loss in respect of 
a contingent payment debt instrument that has currency contingencies 
and non-currency contingencies. Accordingly, no change has been made in 
the final regulations regarding this issue.

Effect on Other Documents

    The following publications are obsolete with regard to debt 
instruments issued on or after October 29, 2004: Announcement 99-76, 
1999-2 C.B. 223.

Special Analyses

    It has been determined that this final regulation 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 26 U.S.C. 7805(f), the notice of proposed rulemaking 
preceding these final regulations was submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

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

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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


0
Par. 2. Section 1.988-0 is amended as follows:
0
1. The introductory text is revised.
0
2. Entries are added for Sec. Sec.  1.988-2(b)(18), 1.988-2(h) and 
1.988-6.

    The revision and additions read as follows:


Sec.  1.988-0  Taxation of gain or loss from a section 988 transaction; 
Table of Contents.

    This section lists captioned paragraphs contained in Sec. Sec.  
1.988-1 through 1.988-6.
* * * * *

Sec.  1.988-2 Recognition and Computation of Exchange Gain or Loss

* * * * *
    (b) * * *
    (18) Interaction of section 988 and Sec.  1.1275-2(g).
* * * * *

[[Page 52819]]

    (h) Timing of income and deductions from notional principal 
contracts.
* * * * *

Sec.  1.988-6 Nonfunctional Currency Contingent Payment Debt 
Instruments

    (a) In general.
    (1) Scope.
    (2) Exception for hyperinflationary currencies.
    (b) Instruments described in paragraph (a)(1)(i) of this 
section.
    (1) In general.
    (2) Application of noncontingent bond method.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method.
    (4) Determination of gain or loss not attributable to foreign 
currency.
    (5) Determination of foreign currency gain or loss.
    (6) Source of gain or loss.
    (7) Basis different from adjusted issue price.
    (8) Fixed but deferred contingent payments.
    (c) Examples.
    (d) Multicurrency debt instruments.
    (1) In general.
    (2) Determination of denomination currency.
    (3) Issuer/holder consistency.
    (4) Treatment of payments in currencies other than the 
denomination currency.
    (e) Instruments issued for nonpublicly traded property.
    (1) Applicability.
    (2) Separation into components.
    (3) Treatment of components consisting of one or more 
noncontingent payments in the same currency.
    (4) Treatment of components consisting of contingent payments.
    (5) Basis different from adjusted issue price.
    (6) Treatment of holder on sale, exchange, or retirement.
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec.  1.1275-4(d).
    (g) Effective date.


0
Par. 3. Section 1.988-2 is amended by:
0
1. Adding the text of paragraph (b)(2)(i)(B)(1).
0
2. Revising paragraph (b)(2)(i)(B)(2).
0
3. Adding the text of paragraph (b)(18).
    The additions and revision read 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 payment debt instruments for which one or more 
payments are denominated in, or determined by reference to, a 
nonfunctional currency.
    (2) Certain instruments are not contingent payment debt 
instruments. For purposes of sections 163(e) and 1271 through 1275 and 
the regulations thereunder, a debt instrument does not provide for 
contingent payments merely because the instrument is denominated in, or 
all payments of which are determined with reference to, a single 
nonfunctional currency. See Sec.  1.988-6 for the treatment of 
nonfunctional currency contingent payment debt instruments.
* * * * *
    (18) Interaction of section 988 and Sec.  1.1275-2(g)--(i) In 
general. If a principal purpose of structuring a debt instrument 
subject to section 988 and any related hedges is to achieve a result 
that is unreasonable in light of the purposes of section 163(e), 
section 988, sections 1271 through 1275, or any related section of the 
Internal Revenue Code, the Commissioner can apply or depart from the 
regulations under the applicable sections as necessary or appropriate 
to achieve a reasonable result. For example, if this paragraph (b)(18) 
applies to a multicurrency debt instrument and a hedge or hedges, the 
Commissioner can wholly or partially integrate transactions or treat 
portions of the debt instrument as separate instruments where 
appropriate. See also Sec.  1.1275-2(g).
    (ii) Unreasonable result. Whether a result is unreasonable is 
determined based on all the facts and circumstances. In making this 
determination, a significant fact is whether the treatment of the debt 
instrument is expected to have a substantial effect on the issuer's or 
a holder's U.S. tax liability. Another significant fact is whether the 
result is obtainable without the application of Sec.  1.988-6 and any 
related provisions (e.g., if the debt instrument and the contingency 
were entered into separately). A result will not be considered 
unreasonable, however, in the absence of an expected substantial effect 
on the present value of a taxpayer's tax liability.
    (iii) Effective date. This paragraph (b)(18) shall apply to debt 
instruments issued on or after October 29, 2004.
* * * * *

0
Par. 4. 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) and to which Sec.  1.1275-4(a) would 
otherwise apply if the debt instrument were denominated in the 
taxpayer's functional currency. Except as provided 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

[[Page 52820]]

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 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:

[[Page 52821]]

    (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 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 paragraph (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 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

[[Page 52822]]

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 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,

[[Page 52823]]

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 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.......................  [pound]1.00 = $1.00
Dec. 31, 2005.......................  [pound]1.00 = $1.10
Dec. 31, 2006.......................  [pound]1.00 = $1.20
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate  (pounds to dollars)
------------------------------------------------------------------------
2005................................  [pound]1.00 = $1.05
2006................................  [pound]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 [pound]100 of interest on the debt 
instrument for 2005 (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 ($1.05 x [pound]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 [pound]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 [pound]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 [pound]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 [pound]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 [pound]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 [pound]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 [pound]1210 
([pound]1100 plus [pound]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 [pound]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, 
[pound]100 of the [pound]1210 (representing the interest accrued in 
2005) is translated at the rate at which it was accrued ([pound]1 = 
$1.05), resulting in an amount realized of $105; [pound]110 of the 
[pound]1210 (representing the interest accrued in 2006) is 
translated into dollars at the rate at which it was accrued 
([pound]1 = $1.15), resulting in an amount realized of $126.50; and 
[pound]1000 of the [pound]1210 (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 $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

[[Page 52824]]

foreign currency gain under section 988 on the instrument with 
respect to the consideration actually received at maturity (except 
for the net positive adjustment), [pound]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 
[[pound]100 x ($1.20-$1.05)]. With respect to interest accrued in 
2006, the foreign currency gain equals $5.50 [[pound]110 x ($1.20-
$1.15)]. With respect to principal, the foreign currency gain is 
$200 [[pound]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 [pound]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 [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 
($1.15 x [pound]110 = $126.50).
    (B) Effect of net negative adjustment. The payment actually made 
on December 31, 2006, is [pound]975, rather than the projected 
[pound]1210. Under paragraph (b)(2)(ii) of this section, Z has a net 
negative adjustment of [pound]235 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]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 [pound]125 net negative 
adjustment as an ordinary loss to the extent of the [pound]100 
previously accrued interest in 2005. 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 = $1.05). Accordingly, Z has an ordinary loss of $105 in 
2006. The remaining [pound]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 [pound]1210 
([pound]1100 plus [pound]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 [pound]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 
[pound]25. Therefore, Z is treated as receiving [pound]1185 
([pound]1210-[pound]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, [pound]100 of the [pound]1185 
(representing the interest accrued in 2005) is translated at the 
rate at which it was accrued ([pound]1 = $1.05), resulting in an 
amount realized of $105; [pound]110 of the [pound]1185 (representing 
the interest accrued in 2006) is translated into dollars at the rate 
at which it was accrued ([pound]1 = $1.15), resulting in an amount 
realized of $126.50; and [pound]975 of the [pound]1185 (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 $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, [pound]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 [[pound]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:

------------------------------------------------------------------------
                Date                    Spot rate  (pounds to 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
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate  (pounds to 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 = $66.30). Accordingly, Z accrues $121.30 of 
interest income in 2005.

[[Page 52825]]

    (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 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-

[[Page 52826]]

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 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:

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


------------------------------------------------------------------------
           Accrual period              Average rate  (pounds to dollars)
------------------------------------------------------------------------
July 1-Dec. 31, 2005................  [pound]1.00 = $1.50
Jan. 1-June 30, 2006................  [pound]1.00 = $1.50
July 1-Dec. 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]5.01 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

[[Page 52827]]

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, 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 poundsunder 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:

------------------------------------------------------------------------
                Date                    Spot rate  (pounds to 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
------------------------------------------------------------------------


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

[[Page 52828]]

($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 2006 (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 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) of 
this section 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--(i) In general. 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. Except as otherwise provided in paragraph (d)(2)(ii) 
of this section, the predominant currency of the instrument shall be 
the currency with the greatest value 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).
    (ii) Difference in discount rate of greater than 10 percentage 
points. This Sec.  1.988-6(d)(2)(ii) applies if no currency has a value 
determined under paragraph (d)(2)(i) of this section that is greater 
than 50% of the total value of all payments. In such a case, if the 
difference between the discount rate in the denomination currency 
otherwise determined under (d)(2)(i) of this section and the discount 
rate determined under paragraph (d)(2)(i) of this section with respect 
to any other currency in which payments are made (or determined by 
reference to) pursuant to the instrument is greater than 10 percentage 
points, then the Commissioner may determine the predominant currency 
under any reasonable method.
    (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

[[Page 52829]]

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 under 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 payment 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 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)--(1) In general. Except as provided in 
paragraph (f)(2) of this section, section 1.988-6 shall not apply to a 
debt instrument the interest on which is excluded from gross income 
under section 103(a).
    (2) Operative rules. [RESERVED].
    (g) Effective date. This section shall apply to debt instruments 
issued on or after October 29, 2004.

0
Par. 5. In Sec.  1.1275-2, paragraph (g)(1) is amended by adding a 
sentence at the end of the paragraph to read as follows:


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

* * * * *
    (g) * * * (1) * * * See also Sec.  1.988-2(b)(18) for debt 
instruments with payments denominated in (or determined by reference 
to) a currency other than the taxpayer's functional currency.
* * * * *

0
Par. 6. 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);
* * * * *

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

0
Par. 7. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


0
Par. 8. Section 602.101(b) adding an entry to the table in numerical 
order to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
    CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.988-6...................................................     1545-1831
                                * * * * *
------------------------------------------------------------------------



[[Page 52830]]

Nancy J. Jardini,
Acting Deputy Commissioner of Services and Enforcement.

    Approved: July 16, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-19642 Filed 8-27-04; 8:45 am]
BILLING CODE 4830-01-P