Final Regulation

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68173
less tax than if the election had been timely
made. Assume that paragraphs (c)(2) (i), (iii),
and (iv) of this section do not apply. Under
paragraph (c)(2)(ii) of this section, the
interests of the Government are not deemed
to be prejudiced because the election does
not require an adjustment under section
481(a).
Example 5. Election requiring adjustment
under section 481(a). The facts are the same
as in Example 4 of this paragraph (f) except
that the applicable regulation provides that
the election requires an adjustment under
section 481(a). Under paragraph (c)(2)(ii) of
this section, the interests of the Government
are deemed to be prejudiced except in
unusual or compelling circumstances.
Example 6. Under examination by the IRS.
A regulation permits an automatic change in
method of accounting for an item on a cutoff basis. Taxpayer E reports income on E’s
1997 income tax return using an
impermissible method of accounting for the
item. In 2000, during the examination of the
1997 return by the IRS, the examining agent
notifies E in writing that its method of
accounting for the item is an issue under
consideration. Any change from the
impermissible method made as part of an
examination is made with an adjustment
under section 481(a). E requests relief under
this section to make the change pursuant to
the regulation for 1997. The change on a cutoff basis under the regulation would be more
favorable than if the change were made with
an adjustment under section 481(a) as part of
an examination. Under paragraph (c)(2)(iii) of
this section, the interests of the Government
are deemed to be prejudiced except in
unusual and compelling circumstances
because E seeks to change from an
impermissible method of accounting that is
an issue under consideration in the
examination on a basis that is more favorable
than if the change were made as part of an
examination.
§§ 301.9100–1T, 301.9100–2T, and 301.9100–
3T [Removed]

Par. 8. Sections 301.9100–1T,
301.9100–2T, and 301.9100–3T are
removed.
PART 601—STATEMENT OF
PROCEDURAL RULES
Par. 9. The authority citation for part
601 continues to read as follows:
Authority: 26 U.S.C. 301 and 552, unless
otherwise noted.
§ 601.204

[Amended]

Par. 10. Section 601.204 is amended
as follows:
1. In paragraph (b), the fourth
sentence is amended by removing the
language ‘‘within 180 days after the
beginning of’’ and adding ‘‘during’’ in
its place.
2. In paragraph (b), the last sentence
is removed.
§ 601.204T

[Removed]

Par. 11. Section 601.204T is removed.

PART 602—OMB CONTROL NUMBERS
UNDER THE PAPERWORK
REDUCTION ACT
Par. 12. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.

Par. 13. Section 602.101(c) is
amended by removing the entries for
§§ 301.9001–2T and 301.9001–3T, and
adding the following entry in numerical
order to the table to read as follows:
§ 602.101

*

OMB control numbers.

*
*
(c) * * *

*

*
Current
OMB control No.

CFR part or section where
identified and described

*
*
*
*
*
301.9100–1 ...............................
1545–1488
*

*

*

*

*

Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
Approved: December 10, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97–33357 Filed 12–30–97; 8:45 am]
BILLING CODE 4830–01–U

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8746]
RIN 1545–AU09

Amortizable Bond Premium
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

This document contains final
regulations relating to the federal
income tax treatment of bond premium
and bond issuance premium. The
regulations reflect changes to the law
made by the Tax Reform Act of 1986
and the Technical and Miscellaneous
Revenue Act of 1988. The regulations
will provide needed guidance to holders
and issuers of debt instruments.
DATES: Effective date: March 2, 1998.
Applicability dates: For dates of
applicability of the final regulations, see
Effective Dates under SUPPLEMENTARY
INFORMATION.
FOR FURTHER INFORMATION CONTACT:
William E. Blanchard, (202) 622–3950
(not a toll-free number).
SUMMARY:

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 requirements of the
Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)) under control number
1545–1491. Responses to these
collections of information are required
by the IRS to determine whether a
holder of a bond has elected to amortize
bond premium and whether an issuer or
a holder has changed its method of
accounting for premium.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information
displays a valid control number.
The estimated annual burden per
respondent varies from 0.25 hours to
0.75 hours, depending on individual
circumstances, with an estimated
average of 0.5 hours.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, T:FP,
Washington, DC 20224, and to the
Office of Management and Budget, Attn:
Desk Officer for the Department of
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to the
collections of information must be
retained as long as their contents may
become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.
Background
Sections 1.171–1 through 1.171–4 of
the Income Tax Regulations were
promulgated in 1957 and last amended
in 1968. In the Tax Reform Act of 1986,
section 171(b) was amended to require
that bond premium be amortized by
reference to a constant yield. In the
Technical and Miscellaneous Revenue
Act of 1988, section 171(e) was
amended to require that amortizable
bond premium be treated as an offset to
interest income.
On June 27, 1996, the IRS published
a notice of proposed rulemaking in the
Federal Register (61 FR 33396) relating
to the federal income tax treatment of
bond premium and bond issuance
premium. A public hearing was not held
because no one requested to speak at the
hearing that had been scheduled for
October 23, 1996. The IRS did receive

68174 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations
a few comments on the proposed
regulations. The proposed regulations,
with certain changes to respond to the
comments, are adopted as final
regulations.
Explanation of Provisions
In general, bond premium arises when
a holder acquires a bond for more than
the principal amount of the bond.
Similarly, bond issuance premium
arises when an issuer issues a bond for
more than the principal amount of the
bond. A holder will purchase, and an
issuer will issue, a bond for more than
its principal amount when the stated
interest rate on the bond is higher than
the current market yield for the bond.
The holder’s treatment of bond
premium is addressed in §§ 1.171–1
through 1.171–5. The issuer’s treatment
of bond issuance premium is addressed
in § 1.163–13. In each case, the
amortization of premium is based on
constant yield principles. For this
reason, the final regulations use
concepts and definitions from the
original issue discount (OID) regulations
(in general, see §§ 1.1271–1 through
1.1275–7T).
Determination of Bond Premium
Under the proposed regulations, bond
premium is defined as the excess of a
holder’s basis in a bond over the sum of
the remaining amounts payable on the
bond other than payments of qualified
stated interest. The holder generally
determines the amount of bond
premium as of the date the holder
acquires the bond.
The proposed regulations provide
special rules that limit a holder’s basis
solely for purposes of determining bond
premium. For example, if a bond is
convertible into stock of the issuer at the
holder’s option, for purposes of
determining bond premium, the holder
must reduce its basis in the bond by the
value of the conversion option. This
reduction prevents the holder from
inappropriately amortizing the cost of
the embedded conversion option.
The final regulations adopt the rules
of the proposed regulations for
determining the amount of bond
premium, if any, on a bond. However,
in response to comments, the final
regulations clarify the determination of
basis in the case of a convertible bond
acquired in a transferred basis
transaction.
Amortization of Bond Premium
(a) In General
Under section 171, the holder of a
taxable bond acquired at a premium
may elect to amortize bond premium.

The holder of a tax-exempt bond
acquired at a premium must amortize
the premium. As premium is amortized,
the holder’s basis in the bond is reduced
by a corresponding amount under
section 1016(a)(5).
Under the proposed regulations, a
holder amortizes bond premium by
offsetting qualified stated interest
income with bond premium. An offset
is calculated for each accrual period
using constant yield principles.
However, the offset for an accrual
period is only taken into account when
the holder takes qualified stated interest
into account under the holder’s regular
method of accounting. Thus, a holder
using the cash receipts and
disbursements method of accounting
does not take bond premium into
account until a qualified stated interest
payment is received.
The final regulations adopt the rules
in the proposed regulations for
amortizing bond premium.
(b) Excess Premium
For certain bonds (for example, bonds
that pay a variable rate of interest or that
provide for an interest holiday), the
amount of bond premium allocable to
an accrual period could exceed the
amount of qualified stated interest
allocable to that period. The proposed
regulations address this situation by
providing that the excess bond premium
is not allowed as a deduction but is
carried forward to future accrual
periods.
Several commentators stated that this
excess premium should be allowable as
a current deduction for the accrual
period in which the excess occurs. In
response to these comments, the final
regulations adopt rules for excess
premium that are similar to the rules for
negative adjustments on contingent
payment debt instruments and deflation
adjustments on inflation-indexed debt
instruments. Under the final
regulations, any excess bond premium
allocable to an accrual period is
deductible by the holder under section
171(a)(1) for the accrual period. The
amount deductible, however, is limited
by the amount of the holder’s prior
income inclusions on the bond. If any
of the excess bond premium is not
deductible under section 171(a)(1), this
amount is carried forward to the next
accrual period and is treated as bond
premium allocable to that period.
Bonds Subject to Certain Contingencies
If a bond provides for one or more
alternative payment schedules, the yield
of the bond cannot be determined
without making assumptions about the
actual payment schedule. The OID

regulations provide rules for making
these assumptions. For example, the
rules assume that an issuer will exercise
a call option if doing so would
minimize the yield of the debt
instrument and that a holder will
exercise a put option if doing so would
maximize the yield of the debt
instrument.
The proposed regulations under
section 171 generally use similar
assumptions to determine the holder’s
yield on a bond that provides for
alternative payment schedules.
However, in the case of an issuer’s
option on a taxable bond, the proposed
regulations reverse the assumption in
the OID regulations by assuming that
the issuer will exercise the option only
if doing so would increase the yield on
the bond. See section 171(b)(1)(B)(ii).
Thus, under the proposed regulations, a
holder generally must amortize bond
premium on a taxable bond by reference
to the stated maturity date, even if it
appears likely the bond will be called.
In this case, if the bond is actually
called, the proposed regulations provide
that the holder may deduct the
unamortized premium. If the bond is
partially called and the partial call is
not a pro-rata prepayment, the proposed
regulations do not allow the holder to
deduct a portion of the unamortized
premium. Instead, the holder must
recompute the yield of the bond on the
date of the partial call and amortize the
remaining premium by reference to the
recomputed yield.
In general, the final regulations adopt
the rules of the proposed regulations. In
response to a comment, the final
regulations limit the issuer rule for
taxable bonds to call options.
Bond Issuance Premium
Under existing § 1.61–12(c), a
corporate issuer treats premium
received upon issuance of a bond as a
separate item of income. Over the term
of the bond, the premium is taken into
income, and the full amount of the
stated interest is deducted. The
proposed regulations revise the
treatment of bond issuance premium.
Under the proposed regulations, bond
issuance premium is amortized as an
offset to the issuer’s otherwise allowable
interest deduction, not as a separate
item of income. The amount of bond
issuance premium amortized in any
period is based on a constant yield. In
addition, the proposed regulations
apply to all issuers, not just corporate
issuers.
In general, the final regulations adopt
the rules in the proposed regulations for
bond issuance premium. However, the
final regulations contain several

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68175
important changes from the proposed
regulations. First, in response to
comments, the final regulations clarify
the treatment of a debt instrument
subject to an alternative payment
schedule by explicitly cross-referencing
§ 1.1272–1(c). Second, the final
regulations provide that, in the case of
a debt instrument subject to a
mandatory sinking fund provision, the
issuer must determine the payment
schedule by assuming that a pro rata
portion of the debt instrument will be
called under the sinking fund provision.
This rule produces more economic
interest accruals than the accruals
determined by ignoring the sinking fund
provision as under the proposed
regulations. Third, the final regulations
adopt rules for excess bond issuance
premium allocable to an accrual period.
These rules are similar to the rules for
excess bond premium described above.
Aggregation Rules
Although the proposed regulations do
not provide for an aggregate method of
accounting for premium, comments
were requested on the need for an
aggregate method. Because no
comments were received, the final
regulations do not provide rules for an
aggregate method of accounting for
premium.
Bonds Not Subject to the Final
Regulations
The final regulations generally apply
to bonds acquired or issued at a
premium. Certain bonds, however, are
excluded from the application of the
final regulations. For example, the final
regulations exclude debt instruments
described in section 1272(a)(6)(C)
(regular interests in a REMIC, qualified
mortgages held by a REMIC, and certain
other debt instruments, or pools of debt
instruments, with payments subject to
acceleration). No inference is intended
regarding the treatment of debt
instruments described in section
1272(a)(6)(C).
Effective Dates
The final regulations relating to bond
premium are effective for bonds
acquired on or after March 2, 1998.
However, if a holder makes the election
to amortize bond premium for the
taxable year containing March 2, 1998,
or any subsequent taxable year, the
regulations apply to bonds held on or
after the first day of the taxable year in
which the election is made.
The final regulations relating to bond
issuance premium apply to debt
instruments issued on or after March 2,
1998.

The final regulations also provide
automatic consent for a taxpayer to
change its method of accounting for
premium in certain circumstances.
Because the change is made on a cut-off
basis, no items of income or deduction
are omitted or duplicated. Therefore, no
adjustment under section 481 is
allowed.

Authority: 26 U.S.C. 7805 * * *
Section 1.171–2 also issued under 26
U.S.C. 171(e).
Section 1.171–3 also issued under 26
U.S.C. 171(e).
Section 1.171–4 also issued under 26
U.S.C. 171(c). * * *

Special Analyses

§ 1.61–12 Income from discharge of
indebtedness.

It is hereby certified that these
regulations do not have significant
economic impact on a substantial
number of small entities. This
certification is based upon the fact that
the regulations merely require a
taxpayer to attach to the taxpayer’s
return a statement that indicates
whether the taxpayer is making an
election under section 171 or is
changing its accounting method for
bond premium or bond issuance
premium. Therefore, a Regulatory
Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C.
chapter 6) is not required.
It has been determined that this
Treasury Decision is not a significant
regulatory action as defined in EO
12866. Therefore, a regulatory
assessment is not required. It 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. Pursuant to section 7805(f)
of the Internal Revenue Code, the notice
of proposed rulemaking was submitted
to the Chief Counsel for Advocacy of the
Small Business Administration for
comment on its impact on small
business.
Drafting Information
Several persons from the Office of
Assistant Chief Counsel (Financial
Institutions and Products) and the
Treasury Department participated in the
development of these regulations.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and
recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping
requirements.
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by adding entries
in numerical order to read as follows:

Par. 2. Section 1.61–12 is amended by
revising paragraph (c) to read as follows:

*

*
*
*
*
(c) Issuance and repurchase of debt
instruments—(1) Issuance. An issuer
does not realize gain or loss upon the
issuance of a debt instrument. For rules
relating to an issuer’s interest deduction
for a debt instrument issued with bond
issuance premium, see § 1.163–13.
(2) Repurchase—(i) In general. An
issuer does not realize gain or loss upon
the repurchase of a debt instrument.
However, if a debt instrument provides
for payments denominated in, or
determined by reference to, a
nonfunctional currency, an issuer may
realize a currency gain or loss upon the
repurchase of the instrument. See
section 988 and the regulations
thereunder. For purposes of this
paragraph (c)(2), the term repurchase
includes the retirement of a debt
instrument, the conversion of a debt
instrument into stock of the issuer, and
the exchange (including an exchange
under section 1001) of a newly issued
debt instrument for an existing debt
instrument.
(ii) Repurchase at a discount. An
issuer realizes income from the
discharge of indebtedness upon the
repurchase of a debt instrument for an
amount less than its adjusted issue price
(within the meaning of § 1.1275–1(b)).
The amount of discharge of
indebtedness income is equal to the
excess of the adjusted issue price over
the repurchase price. See section 108
and the regulations thereunder for
additional rules relating to income from
discharge of indebtedness. For example,
to determine the repurchase price of a
debt instrument that is repurchased
through the issuance of a new debt
instrument, see section 108(e)(10).
(iii) Repurchase at a premium. An
issuer may be entitled to a repurchase
premium deduction upon the
repurchase of a debt instrument for an
amount greater than its adjusted issue
price (within the meaning of § 1.1275–
1(b)). See § 1.163–7(c) for the treatment
of repurchase premium.
(iv) Effective date. This paragraph
(c)(2) applies to debt instruments
repurchased on or after March 2, 1998.
*
*
*
*
*

68176 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations
Par. 3. Section 1.163–13 is added to
read as follows:
§ 1.163–13 Treatment of bond issuance
premium.

(a) General rule. If a debt instrument
is issued with bond issuance premium,
this section limits the amount of the
issuer’s interest deduction otherwise
allowable under section 163(a). In
general, the issuer determines its
interest deduction by offsetting the
interest allocable to an accrual period
with the bond issuance premium
allocable to that period. Bond issuance
premium is allocable to an accrual
period based on a constant yield. The
use of a constant yield to amortize bond
issuance premium is intended to
generally conform the treatment of debt
instruments having bond issuance
premium with those having original
issue discount. Unless otherwise
provided, the terms used in this section
have the same meaning as those terms
in section 163(e), sections 1271 through
1275, and the corresponding
regulations. Moreover, unless otherwise
provided, the provisions of this section
apply in a manner consistent with those
of section 163(e), sections 1271 through
1275, and the corresponding
regulations. In addition, the anti-abuse
rule in § 1.1275–2(g) applies for
purposes of this section. For rules
dealing with the treatment of bond
premium by a holder, see §§ 1.171–1
through 1.171–5.
(b) Exceptions. This section does not
apply to—
(1) A debt instrument described in
section 1272(a)(6)(C) (regular interests
in a REMIC, qualified mortgages held by
a REMIC, and certain other debt
instruments, or pools of debt
instruments, with payments subject to
acceleration); or
(2) A debt instrument to which
§ 1.1275–4 applies (relating to certain
debt instruments that provide for
contingent payments).
(c) Bond issuance premium. Bond
issuance premium is the excess, if any,
of the issue price of a debt instrument
over its stated redemption price at
maturity. For purposes of this section,
the issue price of a convertible bond (as
defined in § 1.171–1(e)(1)(iii)(C)) does
not include an amount equal to the
value of the conversion option (as
determined under
§ 1.171–1(e)(1)(iii)(A)).
(d) Offsetting qualified stated interest
with bond issuance premium—(1) In
general. An issuer amortizes bond
issuance premium by offsetting the
qualified stated interest allocable to an
accrual period with the bond issuance
premium allocable to the accrual period.

This offset occurs when the issuer takes
the qualified stated interest into account
under its regular method of accounting.
(2) Qualified stated interest allocable
to an accrual period. See § 1.446–2(b) to
determine the accrual period to which
qualified stated interest is allocable and
to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond issuance premium allocable
to an accrual period. The bond issuance
premium allocable to an accrual period
is determined under this paragraph
(d)(3). Within an accrual period, the
bond issuance premium allocable to the
period accrues ratably.
(i) Step one: Determine the debt
instrument’s yield to maturity. The yield
to maturity of a debt instrument is
determined under the rules of § 1.1272–
1(b)(1)(i).
(ii) Step two: Determine the accrual
periods. The accrual periods are
determined under the rules of § 1.1272–
1(b)(1)(ii).
(iii) Step three: Determine the bond
issuance premium allocable to the
accrual period. The bond issuance
premium allocable to an accrual period
is the excess of the qualified stated
interest allocable to the accrual period
over the product of the adjusted issue
price at the beginning of the accrual
period and the yield. In performing this
calculation, the yield must be stated
appropriately taking into account the
length of the particular accrual period.
Principles similar to those in § 1.1272–
1(b)(4) apply in determining the bond
issuance premium allocable to an
accrual period.
(4) Bond issuance premium in excess
of qualified stated interest—(i) Ordinary
income. If the bond issuance premium
allocable to an accrual period exceeds
the qualified stated interest allocable to
the accrual period, the excess is treated
as ordinary income by the issuer for the
accrual period. However, the amount
treated as ordinary income is limited to
the amount by which the issuer’s total
interest deductions on the debt
instrument in prior accrual periods
exceed the total amount treated by the
issuer as ordinary income on the debt
instrument in prior accrual periods.
(ii) Carryforward. If the bond issuance
premium allocable to an accrual period
exceeds the sum of the qualified stated
interest allocable to the accrual period
and the amount treated as ordinary
income for the accrual period under
paragraph (d)(4)(i) of this section, the
excess is carried forward to the next
accrual period and is treated as bond
issuance premium allocable to that
period. If a carryforward exists on the
date the debt instrument is retired, the

carryforward is treated as ordinary
income on that date.
(e) Special rules—(1) Variable rate
debt instruments. An issuer determines
bond issuance premium on a variable
rate debt instrument by reference to the
stated redemption price at maturity of
the equivalent fixed rate debt
instrument constructed for the variable
rate debt instrument. The issuer also
allocates any bond issuance premium
among the accrual periods by reference
to the equivalent fixed rate debt
instrument. The issuer constructs the
equivalent fixed rate debt instrument, as
of the issue date, by using the principles
of § 1.1275–5(e).
(2) Inflation-indexed debt
instruments. An issuer determines bond
issuance premium on an inflationindexed debt instrument by assuming
that there will be no inflation or
deflation over the term of the
instrument. The issuer also allocates
any bond issuance premium among the
accrual periods by assuming that there
will be no inflation or deflation over the
term of the instrument. The bond
issuance premium allocable to an
accrual period offsets qualified stated
interest allocable to the period.
Notwithstanding paragraph (d)(4) of this
section, if the bond issuance premium
allocable to an accrual period exceeds
the qualified stated interest allocable to
the period, the excess is treated as a
deflation adjustment under § 1.1275–
7T(f)(1)(ii). See § 1.1275–7T for other
rules relating to inflation-indexed debt
instruments.
(3) Certain debt instruments subject to
contingencies—(i) In general. Except as
provided in paragraph (e)(3)(ii) of this
section, the rules of § 1.1272–1(c) apply
to determine a debt instrument’s
payment schedule for purposes of this
section. For example, an issuer uses the
payment schedule determined under
§ 1.1272–1(c) to determine the amount,
if any, of bond issuance premium on the
debt instrument, the yield and maturity
of the debt instrument, and the
allocation of bond issuance premium to
an accrual period.
(ii) Mandatory sinking fund provision.
Notwithstanding paragraph (e)(3)(i) of
this section, if a debt instrument is
subject to a mandatory sinking fund
provision described in § 1.1272–1(c)(3),
the issuer must determine the payment
schedule by assuming that a pro rata
portion of the debt instrument will be
called under the sinking fund provision.
(4) Remote and incidental
contingencies. For purposes of
determining the amount of bond
issuance premium and allocating bond
issuance premium among accrual
periods, if a bond provides for a

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68177
contingency that is remote or incidental
(within the meaning of § 1.1275–2(h)),
the issuer takes the contingency into
account under the rules for remote and
incidental contingencies in § 1.1275–
2(h).
(f) Example. The following example
illustrates the rules of this section:
Example—(i) Facts. On February 1, 1999,
X issues for $110,000 a debt instrument
maturing on February 1, 2006, with a stated
principal amount of $100,000, payable at
maturity. The debt instrument provides for
unconditional payments of interest of
$10,000, payable on February 1 of each year.
X uses the calendar year as its taxable year,
X uses the cash receipts and disbursements
method of accounting, and X decides to use
annual accrual periods ending on February 1
of each year. X’s calculations assume a 30day month and 360-day year.
(ii) Amount of bond issuance premium.
The issue price of the debt instrument is
$110,000. Because the interest payments on
the debt instrument are qualified stated
interest, the stated redemption price at
maturity of the debt instrument is $100,000.
Therefore, the amount of bond issuance
premium is $10,000 ($110,000¥$100,000).
(iii) Bond issuance premium allocable to
the first accrual period. Based on the
payment schedule and the issue price of the
debt instrument, the yield of the debt
instrument is 8.07 percent, compounded
annually. (Although, for purposes of
simplicity, the yield as stated is rounded to
two decimal places, the computations do not
reflect this rounding convention.) The bond
issuance premium allocable to the accrual
period ending on February 1, 2000, is the
excess of the qualified stated interest
allocable to the period ($10,000) over the
product of the adjusted issue price at the
beginning of the period ($110,000) and the
yield (8.07 percent, compounded annually).
Therefore, the bond issuance premium
allocable to the accrual period is $1,118.17
($10,000¥$8,881.83).
(iv) Premium used to offset interest.
Although X makes an interest payment of
$10,000 on February 1, 2000, X only deducts
interest of $8,881.83, the qualified stated
interest allocable to the period ($10,000)
offset with the bond issuance premium
allocable to the period ($1,118.17).
(g) Effective date. This section applies to
debt instruments issued on or after March 2,
1998.

(h) Accounting method changes—(1)
Consent to change. An issuer required
to change its method of accounting for
bond issuance premium to comply with
this section must secure the consent of
the Commissioner in accordance with
the requirements of § 1.446–1(e).
Paragraph (h)(2) of this section provides
the Commissioner’s automatic consent
for certain changes.
(2) Automatic consent. The
Commissioner grants consent for an
issuer to change its method of
accounting for bond issuance premium
on debt instruments issued on or after

March 2, 1998. Because this change is
made on a cut-off basis, no items of
income or deduction are omitted or
duplicated and, therefore, no
adjustment under section 481 is
allowed. The consent granted by this
paragraph (h)(2) applies provided—
(i) The change is made to comply with
this section;
(ii) The change is made for the first
taxable year for which the issuer must
account for a debt instrument under this
section; and
(iii) The issuer attaches to its federal
income tax return for the taxable year
containing the change a statement that
it has changed its method of accounting
under this section.
PAR. 4. Sections 1.171–1 through
1.171–4 are revised to read as follows:
§ 1.171–1

Bond premium.

(a) Overview—(1) In general. This
section and §§ 1.171–2 through 1.171–5
provide rules for the determination and
amortization of bond premium by a
holder. In general, a holder amortizes
bond premium by offsetting the interest
allocable to an accrual period with the
premium allocable to that period. Bond
premium is allocable to an accrual
period based on a constant yield. The
use of a constant yield to amortize bond
premium is intended to generally
conform the treatment of bond premium
to the treatment of original issue
discount under sections 1271 through
1275. Unless otherwise provided, the
terms used in this section and §§ 1.171–
2 through 1.171–5 have the same
meaning as those terms in sections 1271
through 1275 and the corresponding
regulations. Moreover, unless otherwise
provided, the provisions of this section
and §§ 1.171–2 through 1.171–5 apply
in a manner consistent with those of
sections 1271 through 1275 and the
corresponding regulations. In addition,
the anti-abuse rule in § 1.1275–2(g)
applies for purposes of this section and
§§ 1.171–2 through 1.171–5.
(2) Cross-references. For rules dealing
with the adjustments to a holder’s basis
to reflect the amortization of bond
premium, see § 1.1016–5(b). For rules
dealing with the treatment of bond
issuance premium by an issuer, see
§ 1.163–13.
(b) Scope—(1) In general. Except as
provided in paragraph (b)(2) of this
section and § 1.171–5, this section and
§§ 1.171–2 through 1.171–4 apply to any
bond that, upon its acquisition by the
holder, is held with bond premium. For
purposes of this section and §§ 1.171–2
through 1.171–5, the term bond has the
same meaning as the term debt
instrument in § 1.1275–1(d).

(2) Exceptions. This section and
§§ 1.171–2 through 1.171–5 do not
apply to—
(i) A bond described in section
1272(a)(6)(C) (regular interests in a
REMIC, qualified mortgages held by a
REMIC, and certain other debt
instruments, or pools of debt
instruments, with payments subject to
acceleration);
(ii) A bond to which § 1.1275–4
applies (relating to certain debt
instruments that provide for contingent
payments);
(iii) A bond held by a holder that has
made a § 1.1272–3 election with respect
to the bond;
(iv) A bond that is stock in trade of
the holder, a bond of a kind that would
properly be included in the inventory of
the holder if on hand at the close of the
taxable year, or a bond held primarily
for sale to customers in the ordinary
course of the holder’s trade or business;
or
(v) A bond issued before September
28, 1985, unless the bond bears interest
and was issued by a corporation or by
a government or political subdivision
thereof.
(c) General rule—(1) Tax-exempt
obligations. A holder must amortize
bond premium on a bond that is a taxexempt obligation. See § 1.171–2(c)
Example 4.
(2) Taxable bonds. A holder may elect
to amortize bond premium on a taxable
bond. Except as provided in paragraph
(c)(3) of this section, a taxable bond is
any bond other than a tax-exempt
obligation. See § 1.171–4 for rules
relating to the election to amortize bond
premium on a taxable bond.
(3) Bonds the interest on which is
partially excludable. For purposes of
this section and §§ 1.171–2 through
1.171–5, a bond the interest on which is
partially excludable from gross income
is treated as two instruments, a taxexempt obligation and a taxable bond.
The holder’s basis in the bond and each
payment on the bond are allocated
between the two instruments based on
a reasonable method.
(d) Determination of bond premium—
(1) In general. A holder acquires a bond
at a premium if the holder’s basis in the
bond immediately after its acquisition
by the holder exceeds the sum of all
amounts payable on the bond after the
acquisition date (other than payments of
qualified stated interest). This excess is
bond premium, which is amortizable
under § 1.171–2.
(2) Additional rules for amounts
payable on certain bonds. Additional
rules apply to determine the amounts
payable on a variable rate debt
instrument, an inflation-indexed debt

68178 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations
instrument, a bond that provides for
certain alternative payment schedules,
and a bond that provides for remote or
incidental contingencies. See § 1.171–3.
(e) Basis. A holder determines its
basis in a bond under this paragraph (e).
This determination of basis applies only
for purposes of this section and
§§ 1.171–2 through 1.171–5. Because of
the application of this paragraph (e), the
holder’s basis in the bond for purposes
of these sections may differ from the
holder’s basis for determining gain or
loss on the sale or exchange of the bond.
(1) Determination of basis—(i) In
general. In general, the holder’s basis in
the bond is the holder’s basis for
determining loss on the sale or exchange
of the bond.
(ii) Bonds acquired in certain
exchanges. If the holder acquired the
bond in exchange for other property
(other than in a reorganization defined
in section 368) and the holder’s basis in
the bond is determined in whole or in
part by reference to the holder’s basis in
the other property, the holder’s basis in
the bond may not exceed its fair market
value immediately after the exchange.
See paragraph (f) Example 1 of this
section. If the bond is acquired in a
reorganization, see section 171(b)(4)(B).
(iii) Convertible bonds—(A) General
rule. If the bond is a convertible bond,
the holder’s basis in the bond is reduced
by an amount equal to the value of the
conversion option. The value of the
conversion option may be determined
under any reasonable method. For
example, the holder may determine the
value of the conversion option by
comparing the market price of the
convertible bond to the market prices of
similar bonds that do not have
conversion options. See paragraph (f)
Example 2 of this section.
(B) Convertible bonds acquired in
certain exchanges. If the bond is a
convertible bond acquired in a
transaction described in paragraph
(e)(1)(ii) of this section, the holder’s
basis in the bond may not exceed its fair
market value immediately after the
exchange reduced by the value of the
conversion option.
(C) Definition of convertible bond. A
convertible bond is a bond that provides
the holder with an option to convert the
bond into stock of the issuer, stock or
debt of a related party (within the
meaning of section 267(b) or 707(b)(1)),
or into cash or other property in an
amount equal to the approximate value
of such stock or debt.
(2) Basis in bonds held by certain
transferees. Notwithstanding paragraph
(e)(1) of this section, if the bond is
transferred basis property (as defined in
section 7701(a)(43)) and the transferor

had acquired the bond at a premium,
the holder’s basis in the bond is—
(i) The holder’s basis for determining
loss on the sale or exchange of the bond;
reduced by
(ii) Any amounts that the transferor
could not have amortized under this
paragraph (e) or under § 1.171–4(c),
except to the extent that the holder’s
basis already reflects a reduction
attributable to such nonamortizable
amounts.
(f) Examples. The following examples
illustrate the rules of this section:
Example 1. Bond received in liquidation of
a partnership interest—(i) Facts. PR is a
partner in partnership PRS. PRS does not
have any unrealized receivables or inventory
items as defined in section 751. On January
1, 1998, PRS distributes to PR a taxable bond,
issued by an unrelated corporation, in
liquidation of PR’s partnership interest. At
that time, the fair market value of PR’s
partnership interest is $40,000 and the basis
is $100,000. The fair market value of the
bond is $40,000.
(ii) Determination of basis. Under section
732(b), PR’s basis in the bond is equal to PR’s
basis in the partnership interest. Therefore,
PR’s basis for determining loss on the sale or
exchange of the bond is $100,000. However,
because the distribution is treated as an
exchange for purposes of section 171(b)(4),
PR’s basis in the bond is $40,000 for
purposes of this section and §§ 1.171–2
through 1.171–5. See paragraph (e)(1)(ii) of
this section.
Example 2. Convertible bond—(i) Facts. On
January 11, 1998, A purchases for $1,100 B
corporation’s bond maturing on January 1,
2001, with a stated principal amount of
$1,000, payable at maturity. The bond
provides for unconditional payments of
interest of $30 on January 1 and July 1 of
each year. In addition, the bond is
convertible into 15 shares of B corporation
stock at the option of the holder. On January
1, 1998, B corporation’s nonconvertible,
publicly-traded, three-year debt with a
similar credit rating trades at a price that
reflects a yield of 6.75 percent, compounded
semiannually.
(ii) Determination of basis. A’s basis for
determining loss on the sale or exchange of
the bond is $1,100. As of January 1, 1998,
discounting the remaining payments on the
bond at the yield at which B’s similar
nonconvertible bonds trade (6.75 percent,
compounded semiannually) results in a
present value of $980. Thus, the value of the
conversion option is $120. Under paragraph
(e)(1)(iii)(A) of this section, A’s basis is $980
($1,100¥$120) for purposes of this section
and §§ 1.171–2 through 1.171–5. The sum of
all amounts payable on the bond other than
qualified stated interest is $1,000. Because
A’s basis (as determined under paragraph
(e)(1)(iii)(A) of this section) does not exceed
$1,000, A does not acquire the bond at a
premium.
§ 1.171–2

Amortization of bond premium.

(a) Offsetting qualified stated interest
with premium—(1) In general. A holder

amortizes bond premium by offsetting
the qualified stated interest allocable to
an accrual period with the bond
premium allocable to the accrual period.
This offset occurs when the holder takes
the qualified stated interest into account
under the holder’s regular method of
accounting.
(2) Qualified stated interest allocable
to an accrual period. See § 1.446–2(b) to
determine the accrual period to which
qualified stated interest is allocable and
to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond premium allocable to an
accrual period. The bond premium
allocable to an accrual period is
determined under this paragraph (a)(3).
Within an accrual period, the bond
premium allocable to the period accrues
ratably.
(i) Step one: Determine the holder’s
yield. The holder’s yield is the discount
rate that, when used in computing the
present value of all remaining payments
to be made on the bond (including
payments of qualified stated interest),
produces an amount equal to the
holder’s basis in the bond as determined
under § 1.171–1(e). For this purpose, the
remaining payments include only
payments to be made after the date the
holder acquires the bond. The yield is
calculated as of the date the holder
acquires the bond, must be constant
over the term of the bond, and must be
calculated to at least two decimal places
when expressed as a percentage.
(ii) Step two: Determine the accrual
periods. A holder determines the
accrual periods for the bond under the
rules of § 1.1272–1(b)(1)(ii).
(iii) Step three: Determine the bond
premium allocable to the accrual
period. The bond premium allocable to
an accrual period is the excess of the
qualified stated interest allocable to the
accrual period over the product of the
holder’s adjusted acquisition price (as
defined in paragraph (b) of this section)
at the beginning of the accrual period
and the holder’s yield. In performing
this calculation, the yield must be stated
appropriately taking into account the
length of the particular accrual period.
Principles similar to those in § 1.1272–
1(b)(4) apply in determining the bond
premium allocable to an accrual period.
(4) Bond premium in excess of
qualified stated interest—(i) Taxable
bonds—(A) Bond premium deduction.
In the case of a taxable bond, 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

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68179
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. A deduction determined under
this paragraph (a)(4)(i)(A) is not subject
to section 67 (the 2-percent floor on
miscellaneous itemized deductions).
See Example 1 of § 1.171–3(e).
(B) Carryforward. 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
for the accrual period under paragraph
(a)(4)(i)(A) of this section, the excess is
carried forward to the next accrual
period and is treated as bond premium
allocable to that period.
(ii) Tax-exempt obligations. In the
case of a tax-exempt obligation, if the
bond premium allocable to an accrual
period exceeds the qualified stated
interest allocable to the accrual period,
the excess is a nondeductible loss. If a
regulated investment company (RIC)
within the meaning of section 851 has
excess bond premium for an accrual
period that would be a nondeductible
loss under the prior sentence, the RIC
must use this excess bond premium to
reduce its tax-exempt interest income
on other tax-exempt obligations held
during the accrual period.
(5) Additional rules for certain bonds.
Additional rules apply to determine the
amortization of bond premium on a
variable rate debt instrument, an
inflation-indexed debt instrument, a
bond that provides for certain
alternative payment schedules, and a
bond that provides for remote or
incidental contingencies. See § 1.171–3.
(b) Adjusted acquisition price. The
adjusted acquisition price of a bond at
the beginning of the first accrual period
is the holder’s basis as determined
under § 1.171–1(e). Thereafter, the
adjusted acquisition price is the holder’s
basis in the bond decreased by—
(1) The amount of bond premium
previously allocable under paragraph
(a)(3) of this section; and
(2) The amount of any payment
previously made on the bond other than
a payment of qualified stated interest.
(c) Examples. The following examples
illustrate the rules of this section. Each
example assumes the holder uses the
calendar year as its taxable year and has
elected to amortize bond premium,
effective for all relevant taxable years. In
addition, each example assumes a 30day month and 360-day year. Although,
for purposes of simplicity, the yield as
stated is rounded to two decimal places,
the computations do not reflect this

rounding convention. The examples are
as follows:
Example 1. Taxable bond—(i) Facts. On
February 1, 1999, A purchases for $110,000
a taxable bond maturing on February 1, 2006,
with a stated principal amount of $100,000,
payable at maturity. The bond provides for
unconditional payments of interest of
$10,000, payable on February 1 of each year.
A uses the cash receipts and disbursements
method of accounting, and A decides to use
annual accrual periods ending on February 1
of each year.
(ii) Amount of bond premium. The interest
payments on the bond are qualified stated
interest. Therefore, the sum of all amounts
payable on the bond (other than the interest
payments) is $100,000. Under § 1.171–1, the
amount of bond premium is $10,000
($110,000¥$100,000).
(iii) Bond premium allocable to the first
accrual period. Based on the remaining
payment schedule of the bond and A’s basis
in the bond, A’s yield is 8.07 percent,
compounded annually. The bond premium
allocable to the accrual period ending on
February 1, 2000, is the excess of the
qualified stated interest allocable to the
period ($10,000) over the product of the
adjusted acquisition price at the beginning of
the period ($110,000) and A’s yield (8.07
percent, compounded annually). Therefore,
the bond premium allocable to the accrual
period is $1,118.17 ($10,000¥$8,881.83).
(iv) Premium used to offset interest.
Although A receives an interest payment of
$10,000 on February 1, 2000, A only includes
in income $8,881.83, the qualified stated
interest allocable to the period ($10,000)
offset with bond premium allocable to the
period ($1,118.17). Under § 1.1016–5(b), A’s
basis in the bond is reduced by $1,118.17 on
February 1, 2000.
Example 2. Alternative accrual periods—(i)
Facts. The facts are the same as in Example
1 of this paragraph (c) except that A decides
to use semiannual accrual periods ending on
February 1 and August 1 of each year.
(ii) Bond premium allocable to the first
accrual period. Based on the remaining
payment schedule of the bond and A’s basis
in the bond, A’s yield is 7.92 percent,
compounded semiannually. The bond
premium allocable to the accrual period
ending on August 1, 1999, is the excess of the
qualified stated interest allocable to the
period ($5,000) over the product of the
adjusted acquisition price at the beginning of
the period ($110,000) and A’s yield, stated
appropriately taking into account the length
of the accrual period (7.92 percent/2).
Therefore, the bond premium allocable to the
accrual period is $645.29
($5,000¥$4,354.71). Although the accrual
period ends on August 1, 1999, the qualified
stated interest of $5,000 is not taken into
income until February 1, 2000, the date it is
received. Likewise, the bond premium of
$645.29 is not taken into account until
February 1, 2000. The adjusted acquisition
price of the bond on August 1, 1999, is
$109,354.71 (the adjusted acquisition price at
the beginning of the period ($110,000) less
the bond premium allocable to the period
($645.29)).

(iii) Bond premium allocable to the second
accrual period. Because the interval between
payments of qualified stated interest contains
more than one accrual period, the adjusted
acquisition price at the beginning of the
second accrual period must be adjusted for
the accrued but unpaid qualified stated
interest. See paragraph (a)(3)(iii) of this
section and § 1.1272–1(b)(4)(i)(B). Therefore,
the adjusted acquisition price on August 1,
1999, is $114,354.71 ($109,354.71 + $5,000).
The bond premium allocable to the accrual
period ending on February 1, 2000, is the
excess of the qualified stated interest
allocable to the period ($5,000) over the
product of the adjusted acquisition price at
the beginning of the period ($114,354.71) and
A’s yield, stated appropriately taking into
account the length of the accrual period (7.92
percent/2). Therefore, the bond premium
allocable to the accrual period is $472.88
($5,000¥$4,527.12).
(iv) Premium used to offset interest.
Although A receives an interest payment of
$10,000 on February 1, 2000, A only includes
in income $8,881.83, the qualified stated
interest of $10,000 ($5,000 allocable to the
accrual period ending on August 1, 1999, and
$5,000 allocable to the accrual period ending
on February 1, 2000) offset with bond
premium of $1,118.17 ($645.29 allocable to
the accrual period ending on August 1, 1999,
and $472.88 allocable to the accrual period
ending on February 1, 2000). As indicated in
Example 1 of this paragraph (c), this same
amount would be taken into income at the
same time had A used annual accrual
periods.
Example 3. Holder uses accrual method of
accounting—(i) Facts. The facts are the same
as in Example 1 of this paragraph (c) except
that A uses an accrual method of accounting.
Thus, for the accrual period ending on
February 1, 2000, the qualified stated interest
allocable to the period is $10,000, and the
bond premium allocable to the period is
$1,118.17. Because the accrual period
extends beyond the end of A’s taxable year,
A must allocate these amounts between the
two taxable years.
(ii) Amounts allocable to the first taxable
year. The qualified stated interest allocable to
the first taxable year is $9,166.67 ($10,000 ×
11⁄12). The bond premium allocable to the
first taxable year is $1,024.99 ($1,118.17 x
11⁄12).
(iii) Premium used to offset interest. For
1999, A includes in income $8,141.68, the
qualified stated interest allocable to the
period ($9,166.67) offset with bond premium
allocable to the period ($1,024.99). Under
§ 1.1016–5(b), A’s basis in the bond is
reduced by $1,024.99 in 1999.
(iv) Amounts allocable to the next taxable
year. The remaining amounts of qualified
stated interest and bond premium allocable
to the accrual period ending on February 1,
2000, are taken into account for the taxable
year ending on December 31, 2000.
Example 4. Tax-exempt obligation—(i)
Facts. On January 15, 1999, C purchases for
$120,000 a tax-exempt obligation maturing
on January 15, 2006, with a stated principal
amount of $100,000, payable at maturity. The
obligation provides for unconditional
payments of interest of $9,000, payable on

68180 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations
January 15 of each year. C uses the cash
receipts and disbursements method of
accounting, and C decides to use annual
accrual periods ending on January 15 of each
year.
(ii) Amount of bond premium. The interest
payments on the obligation are qualified
stated interest. Therefore, the sum of all
amounts payable on the obligation (other
than the interest payments) is $100,000.
Under § 1.171–1, the amount of bond
premium is $20,000 ($120,000—$100,000).
(iii) Bond premium allocable to the first
accrual period. Based on the remaining
payment schedule of the obligation and C’s
basis in the obligation, C’s yield is 5.48
percent, compounded annually. The bond
premium allocable to the accrual period
ending on January 15, 2000, is the excess of
the qualified stated interest allocable to the
period ($9,000) over the product of the
adjusted acquisition price at the beginning of
the period ($120,000) and C’s yield (5.48
percent, compounded annually). Therefore,
the bond premium allocable to the accrual
period is $2,420.55 ($9,000¥$6,579.45).
(iv) Premium used to offset interest.
Although C receives an interest payment of
$9,000 on January 15, 2000, C only receives
tax-exempt interest income of $6,579.45, the
qualified stated interest allocable to the
period ($9,000) offset with bond premium
allocable to the period ($2,420.55). Under
§ 1.1016–5(b), C’s basis in the obligation is
reduced by $2,420.55 on January 15, 2000.
§ 1.171–3

Special rules for certain bonds.

(a) Variable rate debt instruments. A
holder determines bond premium on a
variable rate debt instrument by
reference to the stated redemption price
at maturity of the equivalent fixed rate
debt instrument constructed for the
variable rate debt instrument. The
holder also allocates any bond premium
among the accrual periods by reference
to the equivalent fixed rate debt
instrument. The holder constructs the
equivalent fixed rate debt instrument, as
of the date the holder acquires the
variable rate debt instrument, by using
the principles of § 1.1275–5(e). See
paragraph (e) Example 1 of this section.
(b) Inflation-indexed debt
instruments. A holder determines bond
premium on an inflation-indexed debt
instrument by assuming that there will
be no inflation or deflation over the
remaining term of the instrument. The
holder also allocates any bond premium
among the accrual periods by assuming
that there will be no inflation or
deflation over the remaining term of the
instrument. The bond premium
allocable to an accrual period offsets
qualified stated interest allocable to the
period. Notwithstanding § 1.171–2(a)(4),
if the bond premium allocable to an
accrual period exceeds the qualified
stated interest allocable to the period,
the excess is treated as a deflation
adjustment under § 1.1275–7T(f)(1)(i).

See § 1.1275–7T for other rules relating
to inflation-indexed debt instruments.
(c) Yield and remaining payment
schedule of certain bonds subject to
contingencies—(1) Applicability. This
paragraph (c) provides rules that apply
in determining the yield and remaining
payment schedule of certain bonds that
provide for an alternative payment
schedule (or schedules) applicable upon
the occurrence of a contingency (or
contingencies). This paragraph (c)
applies, however, only if the timing and
amounts of the payments that comprise
each payment schedule are known as of
the date the holder acquires the bond
(the acquisition date) and the bond is
subject to paragraph (c)(2), (3), or (4) of
this section. A bond does not provide
for an alternative payment schedule
merely because there is a possibility of
impairment of a payment (or payments)
by insolvency, default, or similar
circumstances. See § 1.1275–4 for the
treatment of a bond that provides for a
contingency that is not described in this
paragraph (c).
(2) Remaining payment schedule that
is significantly more likely than not to
occur. If, based on all the facts and
circumstances as of the acquisition date,
a single remaining payment schedule for
a bond is significantly more likely than
not to occur, this remaining payment
schedule is used to determine and
amortize bond premium under
§§ 1.171–1 and 1.171–2.
(3) Mandatory sinking fund provision.
Notwithstanding paragraph (c)(2) of this
section, if a bond is subject to a
mandatory sinking fund provision
described in § 1.1272–1(c)(3), the
provision is ignored for purposes of
determining and amortizing bond
premium under §§ 1.171–1 and 1.171–2.
(4) Treatment of certain options—(i)
Applicability. Notwithstanding
paragraphs (c)(2) and (3) of this section,
the rules of this paragraph (c)(4)
determine the remaining payment
schedule of a bond that provides the
holder or issuer with an unconditional
option or options, exercisable on one or
more dates during the remaining term of
the bond, to alter the bond’s remaining
payment schedule.
(ii) Operating rules. A holder
determines the remaining payment
schedule of a bond by assuming that
each option will (or will not) be
exercised under the following rules:
(A) Issuer options. In general, the
issuer is deemed to exercise or not
exercise an option or combination of
options in the manner that minimizes
the holder’s yield on the obligation.
However, the issuer of a taxable bond is
deemed to exercise or not exercise a call
option or combination of call options in

the manner that maximizes the holder’s
yield on the bond.
(B) Holder options. A holder is
deemed to exercise or not exercise an
option or combination of options in the
manner that maximizes the holder’s
yield on the bond.
(C) Multiple options. If both the issuer
and the holder have options, the rules
of paragraphs (c)(4)(ii)(A) and (B) of this
section are applied to the options in the
order that they may be exercised. Thus,
the deemed exercise of one option may
eliminate other options that are later in
time.
(5) Subsequent adjustments—(i) In
general. Except as provided in
paragraph (c)(5)(ii) of this section, if a
contingency described in this paragraph
(c) (including the exercise of an option
described in paragraph (c)(4) of this
section) actually occurs or does not
occur, contrary to the assumption made
pursuant to paragraph (c) of this section
(a change in circumstances), then solely
for purposes of section 171, the bond is
treated as retired and reacquired by the
holder on the date of the change in
circumstances for an amount equal to
the adjusted acquisition price of the
bond as of that date. If, however, the
change in circumstances results in a
substantially contemporaneous pro-rata
prepayment as defined in § 1.1275–
2(f)(2), the pro-rata prepayment is
treated as a payment in retirement of a
portion of the bond. See paragraph (e)
Example 2 of this section.
(ii) Bond premium deduction on the
issuer’s call of a taxable bond. If a
change in circumstances results from an
issuer’s call of a taxable bond or a
partial call that is a pro-rata
prepayment, the holder may deduct as
bond premium an amount equal to the
excess, if any, of the holder’s adjusted
acquisition price of the bond over the
greater of—
(A) The amount received on
redemption; and
(B) The amounts that would have
been payable under the bond (other than
payments of qualified stated interest) if
no change in circumstances had
occurred.
(d) Remote and incidental
contingencies. For purposes of
determining and amortizing bond
premium, if a bond provides for a
contingency that is remote or incidental
(within the meaning of § 1.1275–2(h)),
the holder takes the contingency into
account under the rules for remote and
incidental contingencies in § 1.1275–
2(h).
(e) Examples. The following examples
illustrate the rules of this section. Each
example assumes the holder uses the
calendar year as its taxable year and has

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68181
elected to amortize bond premium,
effective for all relevant taxable years. In
addition, each example assumes a 30day month and 360-day year. Although,
for purposes of simplicity, the yield as
stated is rounded to two decimal places,
the computations do not reflect this
rounding convention. The examples are
as follows:
Example 1. Variable rate debt instrument—
(i) Facts. On March 1, 1999, E purchases for
$110,000 a taxable bond maturing on March
1, 2007, with a stated principal amount of
$100,000, payable at maturity. The bond
provides for unconditional payments of
interest on March 1 of each year based on the
percentage appreciation of a nationallyknown commodity index. On March 1, 1999,
it is reasonably expected that the bond will
yield 12 percent, compounded annually. E
uses the cash receipts and disbursements
method of accounting, and E decides to use
annual accrual periods ending on March 1 of
each year. Assume that the bond is a variable
rate debt instrument under § 1.1275–5.
(ii) Amount of bond premium. Because the
bond is a variable rate debt instrument, E
determines and amortizes its bond premium
by reference to the equivalent fixed rate debt
instrument constructed for the bond as of
March 1, 1999. Because the bond provides for
interest at a single objective rate that is
reasonably expected to yield 12 percent,
compounded annually, the equivalent fixed
rate debt instrument for the bond is an eightyear bond with a principal amount of
$100,000, payable at maturity. It provides for
annual payments of interest of $12,000. E’s
basis in the equivalent fixed rate debt
instrument is $110,000. The sum of all
amounts payable on the equivalent fixed rate
debt instrument (other than payments of
qualified stated interest) is $100,000. Under
§ 1.171–1, the amount of bond premium is
$10,000 ($110,000 ¥$100,000).
(iii) Bond premium allocable to each
accrual period. E allocates bond premium to
the remaining accrual periods by reference to

the payment schedule on the equivalent fixed
rate debt instrument. Based on the payment
schedule of the equivalent fixed rate debt
instrument and E’s basis in the bond, E’s
yield is 10.12 percent, compounded
annually. The bond premium allocable to the
accrual period ending on March 1, 2000, is
the excess of the qualified stated interest
allocable to the period for the equivalent
fixed rate debt instrument ($12,000) over the
product of the adjusted acquisition price at
the beginning of the period ($110,000) and
E’s yield (10.12 percent, compounded
annually). Therefore, the bond premium
allocable to the accrual period is $870.71
($12,000¥$11,129.29). The bond premium
allocable to all the accrual periods is listed
in the following schedule:
Accrual period
ending
3/1/00
3/1/01
3/1/02
3/1/03
3/1/04
3/1/05
3/1/06
3/1/07

............
............
............
............
............
............
............
............

Adjusted acquisition price
at beginning of
accrual period

Premium allocable to
accrual
period

$110,000.00
109,129.29
108,170.48
107,114.66
105,952.02
104,671.75
103,261.95
101,709.51

$870.71
958.81
1,055.82
1,162.64
1,280.27
1,409.80
1,552.44
1,709.51
10,000.00

(iv) Qualified stated interest for each
accrual period. Assume the bond actually
pays the following amounts of qualified
stated interest:

3/1/00
3/1/01
3/1/02
3/1/03
3/1/04
3/1/05

........................................
........................................
........................................
........................................
........................................
........................................

........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................

Example 2. Partial call that results in a
pro-rata prepayment—(i) Facts. On April 1,
1999, M purchases for $110,000 N’s taxable
bond maturing on April 1, 2006, with a stated
principal amount of $100,000, payable at
maturity. The bond provides for
unconditional payments of interest of
$10,000, payable on April 1 of each year. N

$2,000.00
0.00
0.00
10,000.00
8,000.00
12,000.00

Qualified
stated
interest

Accrual period ending

3/1/00
3/1/01
3/1/02
3/1/03
3/1/04
3/1/05
3/1/06
3/1/07

Qualified
stated
interest

Accrual period ending

Accrual period ending
3/1/06 ........................................
3/1/07 ........................................

Qualified
stated
interest
15,000.00
8,500.00

(v) Premium used to offset interest. E’s
interest income for each accrual period is
determined by offsetting the qualified stated
interest allocable to the period with the bond
premium allocable to the period. For the
accrual period ending on March 1, 2000, E
includes in income $1,129.29, the qualified
stated interest allocable to the period ($2,000)
offset with the bond premium allocable to the
period ($870.71). For the accrual period
ending on March 1, 2001, the bond premium
allocable to the accrual period ($958.81)
exceeds the qualified stated interest allocable
to the period ($0) and, therefore, E does not
have interest income for this accrual period.
However, under § 1.171–2(a)(4)(i)(A), E may
deduct as bond premium $958.81, the excess
of the bond premium allocable to the accrual
period ($958.81) over the qualified stated
interest allocable to the accrual period ($0).
For the accrual period ending on March 1,
2002, the bond premium allocable to the
accrual period ($1,055.82) exceeds the
qualified stated interest allocable to the
accrual period ($0) and, therefore, E does not
have interest income for the accrual period.
Under § 1.171–2(a)(4)(i)(A), E’s deduction for
bond premium for the accrual period is
limited to $170.48, the excess of E’s total
interest inclusions on the bond in prior
accrual periods ($1,129.29) over the total
amount treated by E as a bond premium
deduction in prior accrual periods ($958.81).
Under § 1.171–2(a)(4)(i)(B), E must carry
forward the remaining $885.34 of bond
premium allocable to the period ending
March 1, 2002, and treat it as bond premium
allocable to the period ending March 1, 2003.
The amount E includes in income for each
accrual period is shown in the following
schedule:

Premium allocable
to accrual
period

Interest
income

Premium
deduction

Premium
carryforward

$2,000.00
0.00
0.00
10,000.00
8,000.00
12,000.00
15,000.00
8,500.00

$870.71
958.81
1,055.82
1,162.64
1,280.27
1,409.80
1,552.44
1,709.51

$1,129.29
0.00
0.00
7,951.93
6,719.73
10,590.20
13,447.56
6,790.49

....................
$958.81
170.48
....................
....................
....................
....................

....................
....................
$885.34
....................
....................
....................
....................

....................

10,000.00

....................

....................

....................

has the option to call all or part of the bond
on April 1, 2001, at a 5 percent premium over
the principal amount. M uses the cash
receipts and disbursements method of
accounting.
(ii) Determination of yield and the
remaining payment schedule. M’s yield
determined without regard to the call option

is 8.07 percent, compounded annually. M’s
yield determined by assuming N exercises its
call option is 6.89 percent, compounded
annually. Under paragraph (c)(4)(ii)(A) of this
section, it is assumed N will not exercise the
call option because exercising the option
would minimize M’s yield. Thus, for
purposes of determining and amortizing

68182 Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations
bond premium, the bond is assumed to be a
seven-year bond with a single principal
payment at maturity of $100,000.
(iii) Amount of bond premium. The interest
payments on the bond are qualified stated
interest. Therefore, the sum of all amounts
payable on the bond (other than the interest
payments) is $100,000. Under § 1.171–1, the
amount of bond premium is $10,000
($110,000¥$100,000).
(iv) Bond premium allocable to the first
two accrual periods. For the accrual period
ending on April 1, 2000, M includes in
income $8,881.83, the qualified stated
interest allocable to the period ($10,000)
offset with bond premium allocable to the
period ($1,118.17). The adjusted acquisition
price on April 1, 2000, is $108,881.83
($110,000¥$1,118.17). For the accrual period
ending on April 1, 2001, M includes in
income $8,791.54, the qualified stated
interest allocable to the period ($10,000)
offset with bond premium allocable to the
period ($1,208.46). The adjusted acquisition
price on April 1, 2001, is $107,673.37
($108,881.83¥$1,208.46).
(v) Partial call. Assume N calls one-half of
M’s bond for $52,500 on April 1, 2001.
Because it was assumed the call would not
be exercised, the call is a change in
circumstances. However, the partial call is
also a pro-rata prepayment within the
meaning of § 1.1275–2(f)(2). As a result, the
call is treated as a retirement of one-half of
the bond. Under paragraph (c)(5)(ii) of this
section, M may deduct $1,336.68, the excess
of its adjusted acquisition price in the retired
portion of the bond ($107,673.37/2, or
$53,836.68) over the amount received on
redemption ($52,500). M’s adjusted basis in
the portion of the bond that remains
outstanding is $53,836.68
($107,673.37¥$53,836.68).
§ 1.171–4 Election to amortize bond
premium on taxable bonds.

(a) Time and manner of making the
election—(1) In general. A holder makes
the election to amortize bond premium
by offsetting interest income with bond
premium in the holder’s timely filed
federal income tax return for the first
taxable year to which the holder desires
the election to apply. The holder should
attach to the return a statement that the
holder is making the election under this
section.
(2) Coordination with OID election. If
a holder makes an election under
§ 1.1272–3 for a bond with bond
premium, the holder is deemed to have
made the election under this section.
(b) Scope of election. The election
under this section applies to all taxable
bonds held during or after the taxable
year for which the election is made.
(c) Election to amortize made in a
subsequent taxable year—(1) In general.
If a holder elects to amortize bond
premium and holds a taxable bond
acquired before the taxable year for
which the election is made, the holder
may not amortize amounts that would

have been amortized in prior taxable
years had an election been in effect for
those prior years.
(2) Example. The following example
illustrates the rule of this paragraph (c):
Example—(i) Facts. On May 1, 1999, C
purchases for $130,000 a taxable bond
maturing on May 1, 2006, with a stated
principal amount of $100,000, payable at
maturity. The bond provides for
unconditional payments of interest of
$15,000, payable on May 1 of each year. C
uses the cash receipts and disbursements
method of accounting and the calendar year
as its taxable year. C has not previously
elected to amortize bond premium, but does
so for 2002.
(ii) Amount to amortize. C’s basis for
determining loss on the sale or exchange of
the bond is $130,000. Thus, under § 1.171–
1, the amount of bond premium is $30,000.
Under § 1.171–2, if a bond premium election
were in effect for the prior taxable years, C
would have amortized $3,257.44 of bond
premium on May 1, 2000, and $3,551.68 of
bond premium on May 1, 2001, based on
annual accrual periods ending on May 1.
Thus, for 2002 and future years to which the
election applies, C may amortize only
$23,190.88 ($30,000¥$3,257.44¥$3,551.68).

(d) Revocation of election. The
election under this section may not be
revoked unless approved by the
Commissioner. Because a revocation of
the election is a change in accounting
method, a taxpayer must follow the
rules under § 1.446–1(e)(3)(i) to request
the Commissioner’s consent to revoke
the election. A revocation of the election
applies to all taxable bonds held during
or after the taxable year for which the
revocation is effective. The holder may
not amortize any remaining bond
premium on bonds held at the
beginning of the taxable year for which
the revocation is effective. Therefore, no
adjustment under section 481 is allowed
upon the revocation of the election
because no items of income or
deduction are omitted or duplicated.
Par. 5. Section 1.171–5 is added to
read as follows:
§ 1.171–5
rules.

Effective date and transition

(a) Effective date—(1) In general.
Sections 1.171–1 through 1.171–4 apply
to bonds acquired on or after March 2,
1998. However, if a holder makes the
election under § 1.171–4 for the taxable
year containing March 2, 1998, or any
subsequent taxable year, §§ 1.171–1
through 1.171–4 apply to bonds held on
or after the first day of the taxable year
in which the election is made.
(2) Transition rule for use of constant
yield. Notwithstanding paragraph (a)(1)
of this section, § 1.171–2(a)(3)
(providing that the bond premium
allocable to an accrual period is
determined with reference to a constant

yield) does not apply to a bond issued
before September 28, 1985.
(b) Coordination with existing
election. A holder is deemed to have
made the election under § 1.171–4 for
the taxable year containing March 2,
1998, if the holder elected to amortize
bond premium under section 171 and
that election is effective on March 2,
1998. If the holder is deemed to have
made the election under § 1.171–4 for
the taxable year containing March 2,
1998, §§ 1.171–1 through 1.171–4 apply
to bonds acquired on or after the first
day of that taxable year. See § 1.171–
4(d) for rules relating to a revocation of
an election under section 171.
(c) Accounting method changes—(1)
Consent to change. A holder required to
change its method of accounting for
bond premium to comply with
§§ 1.171–1 through 1.171–3 must secure
the consent of the Commissioner in
accordance with the requirements of
§ 1.446–1(e). Paragraph (c)(2) of this
section provides the Commissioner’s
automatic consent for certain changes. A
holder making the election under
§ 1.171–4 does not need the
Commissioner’s consent to make the
election.
(2) Automatic consent. The
Commissioner grants consent for a
holder to change its method of
accounting for bond premium with
respect to taxable bonds to which
§§ 1.171–1 through 1.171–3 apply.
Because this change is made on a cutoff basis, no items of income or
deduction are omitted or duplicated
and, therefore, no adjustment under
section 481 is allowed. The consent
granted by this paragraph (c)(2) applies
provided—
(i) The holder elected to amortize
bond premium under section 171 for a
taxable year prior to the taxable year
containing March 2, 1998, and that
election has not been revoked;
(ii) The change is made for the first
taxable year for which the holder must
account for a bond under §§ 1.171–1
through 1.171–3; and
(iii) The holder attaches to its return
for the taxable year containing the
change a statement that it has changed
its method of accounting under this
section.
Par. 6. Section 1.249–1 is amended by
revising paragraph (c) and the first
sentence of paragraph (d)(2) to read as
follows:
§ 1.249–1 Limitation on deduction of bond
premium on repurchase.

*

*
*
*
*
(c) Repurchase premium. For
purposes of this section, the term
repurchase premium means the excess

Federal Register / Vol. 62, No. 250 / Wednesday, December 31, 1997 / Rules and Regulations 68183
of the repurchase price paid or incurred
to repurchase the obligation over its
adjusted issue price (within the
meaning of § 1.1275–1(b)) as of the
repurchase date. For the general rules
applicable to the deductibility of
repurchase premium, see § 1.163–7(c).
This paragraph (c) applies to convertible
obligations repurchased on or after
March 2, 1998.
(d) * * *
(2) * * * For a convertible obligation
repurchased on or after March 2, 1998,
a call premium specified in dollars
under the terms of the obligation is
considered to be a normal call premium
on a nonconvertible obligation if the call
premium applicable when the
obligation is repurchased does not
exceed an amount equal to the interest
(including original issue discount) that
otherwise would be deductible for the
taxable year of repurchase (determined
as if the obligation were not
repurchased). * * *
*
*
*
*
*
Par. 7. Section 1.1016–5 is amended
by revising paragraph (b) to read as
follows:

(b) * * *
(2) Bond issuance premium. If a debt
instrument is issued with bond issuance
premium (as defined in § 1.163–13(c)),
for purposes of determining the issuer’s
adjusted issue price, the adjusted issue
price determined under paragraph (b)(1)
of this section is also decreased by the
amount of bond issuance premium
previously allocable under § 1.163–
13(d)(3).
*
*
*
*
*

DEPARTMENT OF THE TREASURY

PART 602—OMB CONTROL NUMBERS
UNDER THE PAPERWORK
REDUCTION ACT

This document contains final
regulations relating to the treatment of
disclaimers for estate and gift tax
purposes. The regulations clarify certain
provisions governing the disclaimer of
property interests and powers and, in
addition, conform the regulations to
court decisions holding the current
regulation invalid with respect to the
disclaimer of joint property interests.
The final regulations will affect persons
who disclaim property interests,
powers, or interests in jointly owned
property.
DATES: Effective date:
The final regulations are effective
December 31, 1997.
Applicability dates: The amendments
to §§ 25.2518–1(a) and 25.2518–2(c)(3)
(substituting the statutory language in
section 2518(b)(2)(A) ‘‘transfer creating
the interest,’’ for ‘‘taxable transfer’’) and
conforming changes to §§ 20.2041–
3(d)(6)(i), 20.2046–1, 20.2056(d)–2(a)
and (b), 25.2511–1(c)(1), 25.2514–
3(c)(5), are applicable for transfers
creating the interest or power to be
disclaimed made on or after December
31, 1997. The amendments to
§ 25.2518–2(c)(4) (relating to the
disclaimer of joint property and bank
accounts) are applicable for disclaimers
made on or after December 31, 1997.
FOR FURTHER INFORMATION CONTACT:
James F. Hogan (202) 622–3090 (not a
toll-free number).

Par. 10. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.

Par. 11. Section 602.101, paragraph
(c) is amended by:
1. Removing the following entry from
the table:
§ 602.101

*

§ 1.1016–5 Miscellaneous adjustments to
basis.

*
*
*
*
(b) Amortizable bond premium—(1)
In general. A holder’s basis in a bond is
reduced by the amount of bond
premium used to offset qualified stated
interest income under § 1.171–2. This
reduction occurs when the holder takes
the qualified stated interest into account
under the holder’s regular method of
accounting.
(2) Special rules for taxable bonds. A
holder’s basis in a taxable bond is
reduced by the amount of bond
premium allowed as a deduction under
§ 1.171–3(c)(5)(ii) (relating to the
issuer’s call of a taxable bond) or under
§ 1.171–2(a)(4)(i)(A) (relating to excess
bond premium).
(3) Special rule for tax-exempt
obligations. A holder’s basis in a taxexempt obligation is reduced by the
amount of excess bond premium that is
treated as a nondeductible loss under
§ 1.171–2(a)(4)(ii).
*
*
*
*
*

*

Current
OMB control No.

*
*
*
*
*
1.171–3 .....................................
1545–0172
*

*

*

*

*

2. Adding entries in numerical order
to the table to read as follows:
§ 602.101

*

OMB Control numbers.

*
*
(c) * * *

*

*

Current
OMB control No.

CFR part or section where
identified and described

§ 1.1275–1

Definitions.

*

*

*

*

26 CFR Parts 20 and 25
[TD 8744]
RIN 1545–AR52

Disclaimer of Interests and Powers
Internal Revenue Service (IRS),
Treasury.
ACTION: Final regulations.
AGENCY:

SUMMARY:

SUPPLEMENTARY INFORMATION:

*
*
*
*
*
1.163–13 ...................................
1545–1491
*
*
*
*
*
1.171–4 .....................................
1545–1491
1.171–5 .....................................
1545–1491

[Removed]

Par. 8. Section 1.1016–9 is removed.
Par. 9. Section 1.1275–1 is amended
by:
1. Redesignating paragraph (b)(2) as
paragraph (b)(3).
2. Adding a new paragraph (b)(2).
The addition reads as follows:
*

*

CFR part or section where
identified and described

*

§ 1.1016–9

OMB Control numbers.

*
*
(c) * * *

Internal Revenue Service

*

*

*

*

*

Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Approved: December 15, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97–33647 Filed 12–30–97; 8:45 am]
BILLING CODE 4830–01–P

Background
On August 21, 1996, the IRS
published in the Federal Register (61
FR 43197) a notice of proposed
rulemaking (REG–208216–91) amending
the regulations under section 2518. The
IRS received comments on the proposed
regulations; however, no request for a
public hearing was received so no
public hearing was held. This document
adopts final regulations with respect to
this notice of proposed rulemaking.
The proposed regulations substituted
the statutory language of section
2518(b)(2)(A), ‘‘transfer creating the
interest,’’ for ‘‘taxable transfer’’ as the