[Federal Register Volume 78, Number 3 (Friday, January 4, 2013)]
[Rules and Regulations]
[Pages 666-668]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-31747]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9609]
RIN 1545-BK45; 1545-BL29


Treasury Inflation-Protected Securities Issued at a Premium; Bond 
Premium Carryforward

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final regulations that provide guidance 
on the tax treatment of Treasury Inflation-Protected Securities issued 
with more than a de minimis amount of premium. This document also 
contains temporary regulations that provide guidance on the tax 
treatment of a debt instrument with a bond premium carryforward in the 
holder's final accrual period, including a Treasury bill acquired at a 
premium. The regulations in this document provide guidance to holders 
of Treasury Inflation-Protected Securities and other debt instruments. 
The text of the temporary regulations in this document also serves as 
the text of the proposed regulations (REG-140437-12) set forth in the 
Proposed Rules section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on January 4, 
2013.
    Applicability Dates: For the dates of applicability, see Sec. Sec.  
1.171-2T(a)(4)(i)(C)(2) and 1.1275-7(h)(2).

FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 622-3900 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On December 5, 2011, temporary regulations (TD 9561) relating to 
the federal income tax treatment of Treasury Inflation-Protected 
Securities issued with more than a de minimis amount of premium were 
published in the Federal Register (76 FR 75781). See Sec.  1.1275-7T. A 
notice of proposed rulemaking (REG-130777-11) cross-referencing the 
temporary regulations was published in the Federal Register for the 
same day (76 FR 75829). No comments were received on the notice of 
proposed rulemaking. No public hearing was requested or held.
    The proposed regulations are adopted without substantive change by 
this Treasury decision, and the corresponding temporary regulations are 
removed.

Explanation of Provisions

1. Final Regulations--Treasury Inflation-Protected Securities (TIPS) 
Issued With More Than a De Minimis Amount of Premium

    The following is a general explanation of the provisions in the 
final regulations, which are the same as the provisions in the 
temporary regulations. However, the provisions that were in the 
temporary regulations are now contained in newly designated paragraphs 
(g)(2) and (h)(2) of Sec.  1.1275-7 of the final regulations.
    TIPS are securities issued by the Department of the Treasury. The 
principal amount of a TIPS is adjusted for any inflation or deflation 
that occurs over the term of the security. The rules for the taxation 
of inflation-indexed debt instruments, including TIPS, are contained in 
Sec.  1.1275-7 of the Income Tax Regulations. See also Sec.  1.171-3(b) 
(rules for inflation-indexed debt instruments with bond premium).
    Under Sec.  1.1275-7(d)(2)(i), the coupon bond method described in 
Sec.  1.1275-7(d) is not available with respect to inflation-indexed 
debt instruments that are issued with more than a de minimis amount of 
premium (that is, an amount greater than .0025 times the stated 
principal amount of the security times the number of complete years to 
the security's maturity). Prior to 2011, TIPS had not been issued with 
more than a de minimis amount of premium, and the coupon bond method 
had applied to TIPS rather than the more complex discount bond method 
described in Sec.  1.1275-7(e).
    In 2011, the Treasury Department anticipated that TIPS might be 
issued with more than a de minimis amount of premium. As a result, in 
Notice 2011-21 (2011-19 IRB 761), to provide a more uniform method for 
the federal income taxation of TIPS, the Treasury Department and the 
IRS announced that regulations would be issued to provide that 
taxpayers must use the coupon bond method described in Sec.  1.1275-
7(d) for TIPS issued with more than a de minimis amount of premium. As 
a result, the discount bond method described in Sec.  1.1275-7(e) would 
not apply to TIPS issued with more than a de minimis amount of premium. 
Notice 2011-21 provided that the regulations would be effective for 
TIPS issued on or after April 8, 2011. On December 5, 2011, the 
Treasury Department and the IRS published the temporary regulations in 
the Federal Register. These temporary regulations contained the rules 
described in Notice 2011-21 and applied to TIPS issued on or after 
April 8, 2011. As noted earlier in this preamble, the final regulations 
are substantively the same as the temporary regulations.
    Under the final regulations, a taxpayer must use the coupon bond 
method described in Sec.  1.1275-7(d) for a TIPS that is issued with 
more than a de minimis amount of premium. The final regulations include 
the example from the temporary regulations illustrating how to apply 
the coupon bond method to a TIPS issued with more than a de minimis 
amount of premium and a negative yield. As stated in Notice 2011-21, 
the final regulations apply to TIPS issued on or after April 8, 2011. 
See Sec.  601.601(d)(2)(ii)(b).

2. Temporary Regulations--Treatment of Bond Premium Carryforward in a 
Holder's Final Accrual Period

    During the consideration of the final regulations relating to TIPS 
issued with more than a de minimis amount of premium, the Treasury 
Department and the IRS received questions about the holder's treatment 
of a taxable zero coupon debt instrument, including a Treasury bill, 
acquired at a premium and a negative yield. In this situation, as 
described in more detail below, under Sec. Sec.  1.171-2 and 1.1016-
5(b) of the current regulations, a holder that elected to amortize the 
bond premium generally would have a capital loss upon the sale, 
retirement, or other disposition of the debt instrument rather than an 
ordinary deduction under section 171(a)(1) for all or a portion of the 
bond premium. This situation, which has arisen as a result of recent 
market conditions, was not contemplated when the current regulations 
were adopted in 1997.
    Under section 171 and Sec.  1.171-2 of the current regulations, an 
electing holder amortizes bond premium by offsetting the qualified 
stated interest (as

[[Page 667]]

defined in Sec.  1.1273-1(c)) allocable to an accrual period with the 
bond premium allocable to the period. If the bond premium allocable to 
an accrual period exceeds the qualified stated interest allocable to 
the accrual period, the excess is treated by the holder as a bond 
premium deduction under section 171(a)(1) for the accrual period. 
However, the amount treated as a bond premium deduction is limited to 
the amount by which the holder's total interest inclusions on the bond 
in prior accrual periods exceed the total amount treated by the holder 
as a bond premium deduction on the bond in prior accrual periods. If 
the bond premium allocable to an accrual period exceeds the sum of the 
qualified stated interest allocable to the accrual period and the 
amount treated as a deduction under section 171(a)(1), the excess is 
carried forward to the next accrual period and is treated as bond 
premium allocable to that period. See Sec.  1.171-2(a)(4). Under Sec.  
1.1016-5(b) of the current regulations, a holder's basis in a bond is 
reduced by the amount of bond premium used to offset qualified stated 
interest on the bond and the amount of bond premium allowed as a 
deduction under section 171(a)(1).
    In the case of a zero coupon debt instrument, including a Treasury 
bill, there is no qualified stated interest. Therefore, under Sec.  
1.171-2, the amount of bond premium allocable to an accrual period will 
always exceed the qualified stated interest allocable to the accrual 
period (zero) and, because there will be no bond premium deductions in 
any prior accrual periods, such amount will be carried forward to the 
next accrual period. As a result, upon the sale, retirement, or other 
disposition of the debt instrument, there will be a bond premium 
carryforward determined as of the end of the holder's final accrual 
period in an amount equal to the total amount of bond premium allocable 
to the holder's final accrual period, which includes the bond premium 
allocable by the holder to each prior accrual period. In this 
situation, because there is no qualified stated interest to offset the 
bond premium carryforward and because the holder's basis in the bond 
has not been reduced, under the current regulations, the holder would 
have a capital loss in an amount at least equal to the bond premium 
carryforward. The Treasury Department and the IRS, however, believe 
that the amount of the bond premium carryforward in this situation 
should be treated as a bond premium deduction under section 171(a)(1) 
rather than as a capital loss for the holder's taxable year in which 
the sale, retirement, or other disposition occurs.
    In order to provide immediate guidance to investors, the temporary 
regulations in this document and the notice of proposed rulemaking that 
cross-references these temporary regulations (REG-140437-12) address 
this issue by adding a specific rule for the treatment of a bond 
premium carryforward determined as of the end of the holder's final 
accrual period for any taxable bond for which the holder has elected to 
amortize bond premium. Thus, for example, under Sec.  1.171-
2T(a)(4)(i)(C), an electing holder that purchases a taxable zero coupon 
debt instrument at a premium deducts all or a portion of the premium 
under section 171(a)(1) when the instrument is sold, retired, or 
otherwise disposed of rather than as a capital loss.
    In addition, because the rules in Sec.  1.171-3 for inflation-
indexed debt instruments, including TIPS, generally treat a bond 
premium carryforward as a deflation adjustment, Sec.  1.171-3 is 
amended to apply the rule in Sec.  1.171-2T(a)(4)(i)(C)(1) to any 
remaining deflation adjustment attributable to bond premium as of the 
end of the holder's accrual period in which the bond is sold, retired, 
or otherwise disposed of.
    Section 1.171-2T(a)(4)(i)(C)(1) applies to a debt instrument (bond) 
acquired on or after January 4, 2013. A taxpayer, however, may rely on 
this section for a debt instrument (bond) acquired before that date.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13563. Therefore, a regulatory 
assessment is not required. It has also been determined that section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does 
not apply to these regulations, and because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, the proposed regulations preceding these 
final regulations were submitted to the Chief Counsel for Advocacy of 
the Small Business Administration for comment on their impact on small 
business. No comments were received. In addition, pursuant to section 
7805(f) of the Code, the temporary regulations in this document have 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is William E. Blanchard, 
Office of Associate Chief Counsel (Financial Institutions and 
Products). However, other personnel from the IRS and the Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by removing 
the entry for Sec.  1.1275-7T and by adding an entry in numerical order 
to read in part as follows:

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

    Section 1.171-2T also issued under 26 U.S.C. 171(e). * * *


0
Par. 2. Section 1.171-2T is added to read as follows:


Sec.  1.171-2T  Amortization of bond premium (temporary).

    (a)(1) through (a)(4)(i)(B) [Reserved]. For further guidance, see 
Sec.  1.171-2(a)(1) through (a)(4)(i)(B).
    (C) Carryforward in holder's final accrual period--(1) If there is 
a bond premium carryforward determined under Sec.  1.171-2(a)(4)(i)(B) 
as of the end of the holder's accrual period in which the bond is sold, 
retired, or otherwise disposed of, the holder treats the amount of the 
carryforward as a bond premium deduction under section 171(a)(1) for 
the holder's taxable year in which the sale, retirement, or other 
disposition occurs. For purposes of Sec.  1.1016-5(b), the holder's 
basis in the bond is reduced by the amount of bond premium allowed as a 
deduction under this paragraph (a)(4)(i)(C)(1).
    (2) Effective/applicability date. Notwithstanding Sec.  1.171-
5(a)(1), paragraph (a)(4)(i)(C)(1) of this section applies to a bond 
acquired on or after January 4, 2013. A taxpayer, however, may rely on 
paragraph (a)(4)(i)(C)(1) of this section for a bond acquired before 
that date.
    (ii) through (c) [Reserved]. For further guidance, see Sec.  1.171-
2(a)(4)(ii) through (c).
    (d) Expiration date. The applicability of this section expires on 
or before December 31, 2015.

[[Page 668]]


0
Par. 3. Section 1.171-3 is amended by adding a new sentence before the 
last sentence in paragraph (b) to read as follows:


Sec.  1.171-3  Special rules for certain bonds.

* * * * *
    (b) * * * However, the rules in Sec.  1.171-2T(a)(4)(i)(C) apply to 
any remaining deflation adjustment attributable to bond premium as of 
the end of the holder's accrual period in which the bond is sold, 
retired, or otherwise disposed of. * * *
* * * * *

0
Par. 4. Section 1.1271-0(b) is amended by revising the entries for 
Sec.  1.1275-7(g) and (h) to read as follows:


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

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


Sec.  1.1275-7  Inflation-indexed debt instruments.

* * * * *
    (g) TIPS.
    (1) Reopenings.
    (2) TIPS issued with more than a de minimis amount of premium.
    (h) Effective/applicability dates.
    (1) In general.
    (2) TIPS issued with more than a de minimis amount of premium.

0
Par. 5. Section 1.1275-7 is amended as follows:
0
1. Revising the last sentence of paragraph (b)(1).
0
2. Adding a new sentence at the end of paragraph (d)(2)(i).
0
3. Revising paragraph (g).
0
4. Revising paragraph (h).
    The revisions and addition read as follows:


Sec.  1.1275-7  Inflation-indexed debt instruments.

* * * * *
    (b) * * *
    (1) * * * For example, this section applies to Treasury Inflation-
Protected Securities (TIPS).
* * * * *
    (d) * * *
    (2) * * *
    (i) * * * See paragraph (g)(2) of this section, however, for the 
treatment of TIPS issued with more than a de minimis amount of premium.
* * * * *
    (g) TIPS--(1) Reopenings. For rules concerning a reopening of TIPS, 
see paragraphs (d)(2), (k)(3)(iii), and (k)(3)(v) of Sec.  1.1275-2.
    (2) TIPS issued with more than a de minimis amount of premium--(i) 
Coupon bond method. Notwithstanding paragraph (d)(2)(i) of this 
section, the coupon bond method described in paragraph (d) of this 
section applies to TIPS issued with more than a de minimis amount of 
premium. For this purpose, the de minimis amount is determined using 
the principles of Sec.  1.1273-1(d).
    (ii) Example. The following example illustrates the application of 
the bond premium rules to a TIPS issued with bond premium:

    Example. (i) Facts. X, a calendar year taxpayer, purchases at 
original issuance TIPS with a stated principal amount of $100,000 
and a stated interest rate of .125 percent, compounded semiannually. 
For purposes of this example, assume that the TIPS are issued in 
Year 1 on January 1, stated interest is payable on June 30 and 
December 31 of each year, and that the TIPS mature on December 31, 
Year 5. X pays $102,000 for the TIPS, which is the issue price for 
the TIPS as determined under Sec.  1.1275-2(d)(1). Assume that the 
inflation-adjusted principal amount for the first coupon in Year 1 
is $101,225 (resulting in an interest payment of $63.27) and for the 
second coupon in Year 1 is $102,500 (resulting in an interest 
payment of $64.06). X elects to amortize bond premium under Sec.  
1.171-4. (For simplicity, contrary to actual practice, the TIPS in 
this example were issued on the date with respect to which the 
calculation of the first coupon began.)
    (ii) Bond premium. The stated interest on the TIPS is qualified 
stated interest under Sec.  1.1273-1(c). X acquired the TIPS with 
bond premium of $2,000 (basis of $102,000 minus the TIPS' stated 
principal amount of $100,000). See Sec. Sec.  1.171-1(d), 1.171-
3(b), and paragraph (f)(3) of this section. The $2,000 is more than 
the de minimis amount of premium for the TIPS of $1,250 (.0025 times 
the stated principal amount of the TIPS ($100,000) times the number 
of complete years to the TIPS' maturity (5 years)). Under paragraph 
(g)(2)(i) of this section, X must use the coupon bond method to 
determine X's income from the TIPS.
    (iii) Allocation of bond premium. Under Sec.  1.171-3(b), the 
bond premium of $2,000 is allocable to each semiannual accrual 
period by assuming that there will be no inflation or deflation over 
the term of the TIPS. Moreover, for purposes of Sec.  1.171-2, the 
yield of the securities is determined by assuming that there will be 
no inflation or deflation over their term. Based on this assumption, 
for purposes of section 171, the TIPS provide for semiannual 
interest payments of $62.50 and a $100,000 payment at maturity. As a 
result, the yield of the securities for purposes of section 171 is -
0.2720 percent, compounded semiannually. Under Sec.  1.171-2, the 
bond premium allocable to an accrual period is the excess of the 
qualified stated interest allocable to the accrual period ($62.50 
for each accrual period) over the product of the taxpayer's adjusted 
acquisition price at the beginning of the accrual period (determined 
without regard to any inflation or deflation) and the taxpayer's 
yield. Therefore, the $2,000 of bond premium is allocable to each 
semiannual accrual period in Year 1 as follows: $201.22 to the 
accrual period ending on June 30, Year 1 (the excess of the stated 
interest of $62.50 over ($102,000 x -0.002720/2)); and $200.95 to 
the accrual period ending on December 31, Year 1 (the excess of the 
stated interest of $62.50 over ($101,798.78 x -0. 002720/2)). The 
adjusted acquisition price at the beginning of the accrual period 
ending on December 31, Year 1 is $101,798.78 (the adjusted 
acquisition price of $102,000 at the beginning of the accrual period 
ending on June 30, Year 1 reduced by the $201.22 of premium 
allocable to that accrual period).
    (iv) Income determined by applying the coupon bond method and 
the bond premium rules. Under paragraph (d)(4) of this section, the 
application of the coupon bond method to the TIPS results in a 
positive inflation adjustment in Year 1 of $2,500, which is 
includible in X's income for Year 1. However, because X acquired the 
TIPS at a premium and elected to amortize the premium, the premium 
allocable to Year 1 will offset the income on the TIPS as follows: 
The premium allocable to the first accrual period of $201.22 first 
offsets the interest payable for that period of $63.27. The 
remaining $137.95 of premium is treated as a deflation adjustment 
that offsets the positive inflation adjustment. See Sec.  1.171-
3(b). The premium allocable to the second accrual period of $200.95 
first offsets the interest payable for that period of $64.06. The 
remaining $136.89 of premium is treated as a deflation adjustment 
that further offsets the positive inflation adjustment. As a result, 
X does not include in income any of the stated interest received in 
Year 1 and includes in Year 1 income only $2,225.16 of the positive 
inflation adjustment for Year 1 ($2,500 - $137.94 - $136.89).
    (h) Effective/applicability dates--(1) In general. This section 
applies to an inflation-indexed debt instrument issued on or after 
January 6, 1997.
    (2) TIPS issued with more than a de minimis amount of premium. 
Notwithstanding paragraph (h)(1) of this section, paragraph (g)(2) of 
this section applies to TIPS issued with more than a de minimis amount 
of premium on or after April 8, 2011.


Sec.  1.1275-7T  [Removed]

0
Par. 6. Section 1.1275-7T is removed.

0
Par. 7. Section 1.1286-2 is amended by removing the language 
``Inflation-Indexed'' and adding the language ``Inflation-Protected'' 
in its place.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: December 20, 2012.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-31747 Filed 1-3-13; 8:45 am]
BILLING CODE 4830-01-P