Td 8674

Section 1275.—Other Definitions and
Special Rules
26 CFR 1.1275–4: Contingent payment debt
instruments.

T.D. 8674
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Debt Instruments with Original Issue
Discount; Contingent Payments; AntiAbuse Rule
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations relating to the tax
treatment of debt instruments that
provide for one or more contingent
payments. This document also contains
final regulations that treat a debt
instrument and a related hedge as an
integrated transaction. In addition, this
document contains amendments to the
original issue discount regulations, and
finalizes the anti-abuse rule relating to
those regulations. The final regulations
in this document provide needed guidance to holders and issuers of contingent payment debt instruments.
DATES: Except as noted below, the
regulations are effective August 13,
1996. The amendments to §1.1275–5
are effective June 14, 1996, except for
paragraphs (a)(6), (b)(2), and (c)(1),
which are effective August 13, 1996.
The removal of §1.483–2T is effective
June 14, 1996. The removal of
§1.1275–2T is effective August 13,
1996.
For dates of applicability of these
regulations, see Effective Dates under
Supplementary Information.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations
(other than §1.1275–6), William E.
Blanchard, (202) 622-3950, or Jeffrey
W. Maddrey, (202) 622-3940; or concerning §1.1275–6, Michael S. Novey,
(202) 622-3900 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations have

been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under
control number 1545–1450. Responses
to these collections of information are
required to determine a taxpayer’s
interest income or deductions on a
contingent payment debt instrument.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information
displays a valid control number.
The estimated annual burden per
respondent/recordkeeper varies from .3
hours to .5 hours, depending on individual circumstances, with an estimated
average of .47 hours.
Comments concerning the accuracy
of this burden estimate and suggestions
for reducing this burden should be sent
to the Internal Revenue Service, Attn:
IRS Reports Clearance Officer, T:FP,
Washington, DC 20224, and to the
Office of Management and Budget,
Attn: Desk Officer for the Department
of the Treasury, Office of Information
and Regulatory Affairs, Washington,
DC 20503.
Books or records relating to the
collections of information must be
retained as long as their contents may
become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.

also contained proposed amendments to
the regulations under sections 483
(relating to unstated interest), 1001
(relating to the amount realized on a
sale, exchange, or other disposition of
property), 1272 (relating to the accrual
of OID), 1274 (relating to debt instruments issued for nonpublicly traded
property), and 1275(c) (relating to OID
information reporting requirements),
and to §1.1275–5 (relating to variable
rate debt instruments). In addition, the
notice contained proposed regulations
relating to the integration of a contingent payment or variable rate debt
instrument with a related hedge. The
notice withdrew the proposed regulations relating to contingent payment
debt instruments that were previously
published in the Federal Register on
April 8, 1986 (51 FR 12087), and
February 28, 1991 (56 FR 8308).
On March 16, 1995, the IRS held a
public hearing on the proposed regulations. In addition, the IRS received a
number of written comments on the
proposed regulations. The proposed
regulations, with certain changes to
respond to comments, are adopted as
final regulations. In addition, certain
clarifying and conforming amendments
are made to the OID regulations that
were published in the Federal Register
on February 2, 1994. The comments
and significant changes are discussed
below.

Background

Section 1.1275–4 Contingent payment
debt instruments

Section 1275(d) of the Internal Revenue Code (Code) grants the Secretary
the authority to prescribe regulations
under the original issue discount (OID)
provisions of the Code (sections 163(e)
and 1271 through 1275), including
regulations relating to debt instruments
that provide for contingent payments.
On February 2, 1994, the IRS published final OID regulations in the
Federal Register (59 FR 4799 [TD
8517, 1994–1 C.B. 38]). However, the
final OID regulations did not contain
rules for contingent payment debt
instruments.
On December 16, 1994, the IRS
published a notice of proposed
rulemaking in the Federal Register (59
FR 62884 [FI–59–91, 1995–1 C.B.
894]) relating to the tax treatment of
debt instruments that provide for one or
more contingent payments. The notice

7

Explanation of Provisions

A. Noncontingent bond method
Under the noncontingent bond
method in the proposed regulations, a
taxpayer computes interest accruals on
a contingent payment debt instrument
by setting a payment schedule as of the
issue date and applying the OID rules
to the payment schedule. The payment
schedule consists of all fixed payments
on the debt instrument and a projected
amount for each contingent payment.
For market-based contingencies (i.e.,
contingencies for which price quotes
are readily available), the projected
amount is the forward price of the
contingency. For other contingencies,
the issuer first determines a reasonable
yield for the debt instrument and then
sets projected amounts equal to the
relative expected payments on the

contingencies so that the payment
schedule produces the reasonable yield.
These rules were designed to produce a
yield similar to the yield the issuer
would obtain on a fixed rate debt
instrument.
Commentators suggested that the
regulations could be simplified if they
used the same basic methodology for
both market-based and non-marketbased contingencies. In addition, commentators suggested that forward price
quotes would be variable or manipulable and that taxpayers will set more
appropriate payment schedules if they
first determine yield and then set the
payment schedule to fit the yield.
The final regulations adopt these
suggestions and generally conform the
treatment of debt instruments that
provide for either market-based or nonmarket-based contingent payments.
Thus, for any contingent payment debt
instrument subject to the noncontingent
bond method, a taxpayer first determines the yield on the instrument and
then sets the payment schedule to fit
the yield. The yield is determined by
the yield at which the issuer would
issue a fixed rate debt instrument with
terms and conditions similar to the
contingent payment debt instrument
(the comparable yield). Relevant terms
and conditions include the level of
subordination, term, timing of payments, and general market conditions.
For example, if a hedge is available
such that the issuer or holder could
integrate the debt instrument and the
hedge into a synthetic fixed-rate debt
instrument under the rules of §1.1275–
6, the comparable yield is the yield that
the synthetic fixed-rate debt instrument
would have. If a §1.1275–6 hedge (or
the substantial equivalent) is not available, but similar fixed rate debt instruments of the issuer trade at a price that
reflects a spread above a benchmark
rate, the comparable yield is the sum of
the value of the benchmark rate on the
issue date and the spread. In all cases,
the yield must be a reasonable yield for
the issuer and may not be less than the
applicable Federal rate (AFR).
Once the comparable yield is determined, the payment schedule is set to
produce the comparable yield. The final
regulations retain the general approach
of the proposed regulations in determining the payment schedule. Thus, for
market-based payments, the projected
payment is the forward price of the
payment. For non-market-based payments, the projected payment is the

expected amount of the payment as of
the issue date.
Commentators were concerned that a
taxpayer could overstate the yield on a
contingent payment debt instrument
and, therefore, claim excess interest
deductions during the term of the instrument. They were particularly concerned about a long-term debt instrument that has non-market-based
payments because the taxpayer’s determination would be hard to verify and
any excess interest deductions would
not be recaptured for a long time.
The final regulations address this
concern by providing that the comparable yield for a debt instrument is
presumed to be the AFR if the
instrument provides for a non-marketbased payment and is part of an issue
that is marketed or sold in substantial
part to tax-exempt investors or other
investors for whom the treatment of the
debt instrument is not expected to have
a substantial effect on their U.S. tax
liability. A taxpayer may overcome this
presumption only with clear and convincing evidence that the comparable
yield for the debt instrument should be
a specific yield that is higher than the
AFR. Appraisals and other valuations
of nonpublicly traded property cannot
be used to overcome the presumption,
nor can references to general market
rates. An issuer may, for example,
overcome the presumption by showing
that recently issued similar debt instruments of the issuer trade at a price that
reflects a specific yield.
One commentator suggested that the
use of the term projected payment
schedule caused securities law problems because the issuer could be seen
as making representations to the holder
about the expected payments. The
comparable yield and projected payment schedule determined under these
regulations are for tax purposes only
and are not assurances by the issuer
with respect to the payments. The final
regulations retain the term projected
payment schedule, but an issuer may
use a different term to describe the
payment schedule (e.g., payment schedule determined under §1.1275–4) if the
language used by the issuer is clear.
Under the proposed regulations, projected payments rather than actual
payments are used to determine the
adjusted issue price of a debt instrument, the holder’s basis in a debt
instrument, and the amount of any
contingent payment treated as made on

8

the scheduled retirement of a debt
instrument. One commentator questioned the use of projected payments to
make these determinations. The approach in the proposed regulations is
appropriate, however, because a positive or negative adjustment is used to
take into account the difference between the actual amount and the
projected amount of a contingent payment. This difference would be counted
twice if the adjusted issue price, the
holder’s basis, and the amount deemed
paid on retirement were based on the
actual amount rather than the projected
amount of a contingent payment. Thus,
the approach used in the proposed
regulations is retained in the final
regulations.
B. Tax-exempt obligations
In response to comments, the rules
contained in §1.1275–4(d) relating to
tax-exempt contingent payment obligations have been revised. Under the
proposed regulations, tax-exempt obligations are generally subject to the
noncontingent bond method, with the
following modifications: (1) The yield
on which interest accruals are based
may not exceed the greater of the yield
on the obligation, determined without
regard to the non-market-based contingent payments, and the tax-exempt
AFR that applies to the obligation; (2)
Positive adjustments are treated as gain
from the sale or exchange of the
obligation rather than as interest; and
(3) Negative adjustments reduce the
amount of tax-exempt interest, and,
therefore, are generally not taken into
account as deductible losses. These
modifications to the noncontingent
bond method for tax-exempt obligations were added because the IRS and
Treasury believe that when a property
right is embedded in a tax-exempt
obligation it is generally inappropriate
to treat payments on the right as
interest on an obligation of a state or
political subdivision.
Several commentators suggested that
the proposed regulations relating to taxexempt obligations are overly restrictive. These commentators questioned
the reason for limiting the rate of
accrual to the tax-exempt AFR and
characterizing positive adjustments as
taxable gain rather than interest. They
also questioned the fairness of treating
negative adjustments as nondeductible
adjustments to tax-exempt interest
when positive adjustments are treated

as taxable gain. Some of the commentators suggested that, at a minimum,
the interest limitations should not apply
to contingent obligations that pay interest based on interest rate formulas that
reflect the cost of funds rather than
changes in the value of embedded
property rights. Finally, commentators
noted that programs involving municipal refinancings of real estate projects
(for example, low-income multi-family
housing projects) would be jeopardized
by the proposed regulations because
payments on tax-exempt obligations
issued to finance these projects are in
certain cases contingent in part on the
revenues or appreciation in value of the
project.
The IRS and Treasury continue to
believe that gain from a property right
should not be recharacterized as taxexempt interest merely because the
property right is embedded in a taxexempt obligation. The IRS and Treasury nevertheless recognize that certain
types of traditional tax-exempt financings should not be subject to the
interest limitations of the proposed
regulations (e.g., financings on which
interest is computed in a manner that
relates to the cost of funds). Accordingly, §1.1275–4(d) has been revised to
include a category of tax-exempt obligations that will be subject to the
noncontingent bond method without the
tax-exempt interest limitations contained in the proposed regulations. This
category of tax-exempt obligations includes (1) obligations that would
qualify as variable rate debt instruments (VRDIs) except for the failure to
meet certain of the technical requirements of the VRDI definition (such as
the cap and floor limitations, or the
requirement that interest be paid or
compounded at least annually), and (2)
certain obligations issued to refinance
an obligation, the proceeds of which
were used to finance a project.
For other tax-exempt obligations, the
interest restrictions of the proposed
regulations are adopted in final form.
Section 1.1275–4(d) has been revised,
however, to provide that a negative
adjustment is treated as a taxable loss
from the sale or exchange of the
obligation, rather than as a nondeductible adjustment to tax-exempt interest.
C. Prepaid tuition plans
A number of commentators asked
whether contracts issued under state-

sponsored prepaid tuition plans are
subject to §1.1275–4. Although the
terms of the contracts vary, the contracts generally are issued pursuant to a
plan created by a state to enable the
participants in the plan to save for
post-secondary education for themselves or other designated beneficiaries.
In addition, the plans generally provide
protection against increases in the costs
of higher education or otherwise subsidize these costs, often by providing for
contingent payments that are linked to
the future costs of post-secondary
education.
The commentators argue that
§1.1275–4 does not apply to the
contracts because the contracts are not
debt instruments for federal income tax
purposes. In addition, the commentators
argue that, even if the contracts are
debt instruments, the noncontingent
bond method would be unduly burdensome and inappropriate for contracts of
this type.
The final regulations under §1.1275–
4 do not affect the treatment of
contracts issued pursuant to statesponsored prepaid tuition plans,
whether or not the contracts are debt
instruments. The final regulations, like
the proposed regulations, only apply to
debt instruments. Thus, the final regulations do not apply to contracts
issued pursuant to a plan created by a
state to enable participants to save for
post-secondary education if the contracts are not debt instruments. In
addition, the final regulations provide
an exception for any debt instrument
issued pursuant to a state-sponsored
prepaid tuition plan.
This exception applies to a contract
issued pursuant to a plan or arrangement if: The plan or arrangement is
created by a state statute; the plan or
arrangement has a primary objective of
enabling the participants to pay for the
costs of post-secondary education for
themselves or their designated beneficiaries; and the contingencies under the
contract are related to such purpose.
These characteristics are intended to
describe all existing state-sponsored
prepaid tuition plans. Therefore, the
final regulations do not change the tax
treatment of a contract issued pursuant
to these plans. As a result, if the
contract is a debt instrument, the
contingent payments on the contract are
not taken into account by an individual
until the payments are made.
The exception in the final regulations
is intended to apply only to the existing

9

state-sponsored prepaid tuition plans
and to any future plans that are substantially similar to the existing plans.
In addition, no inference is intended as
to whether contracts issued by any
state-sponsored prepaid tuition plan are
debt instruments.
D. Debt instruments subject to
section 1274
The proposed regulations provide a
method for contingent payment debt
instruments not subject to the noncontingent bond method (i.e., a nonpublicly traded debt instrument issued
in a sale or exchange of nonpublicly
traded property). Under the method, a
debt instrument’s noncontingent payments are treated as a separate debt
instrument, which is generally taxed
under the rules for noncontingent debt
instruments. The debt instrument’s contingent payments are taken into account
when made. A portion of each contingent payment is treated as principal,
based on the amount determined by
discounting the payment at the AFR
from the payment date to the issue
date, and the remainder is treated as
interest. Special rules are provided if a
contingent payment becomes fixed
more than 6 months before it is due.
The final regulations generally adopt
the method in the proposed regulations.
In addition, the final regulations contain rules for a holder whose basis in a
debt instrument is different from the
instrument’s adjusted issue price (e.g.,
a subsequent holder).
E. Inflation-indexed bonds
The Treasury recently announced
that it was considering issuing bonds
indexed to inflation (61 FR 25164).
Depending on their ultimate structure,
the noncontingent bond method might
be inappropriate for these bonds. If the
Treasury issues these bonds, the Treasury and IRS may issue regulations to
provide a simplified tax treatment for
the bonds. The treatment would require
current accrual of the inflation
component.
Other amendments to the OID
regulations
A. Alternative payment schedules
under §1.1272–1(c)
Section 1.1272–1(c) provides rules to
determine the yield and maturity of

certain debt instruments that provide
for one or more alternative payment
schedules applicable upon the occurrence of a contingency (or contingencies), provided that the timing and
amounts of the payments that comprise
each payment schedule are known as of
the issue date. Under these rules, the
yield and maturity of a debt instrument
are generally determined by assuming
that the payments will be made under
the payment schedule most likely to
occur (based on all the facts and
circumstances as of the issue date).
Special rules are provided for unconditional options and mandatory sinking
funds.
The general rules in §1.1272–1(c)
produce a reasonable result when a
debt instrument has one stated payment
schedule that is very likely to occur
and one or more alternative payment
schedules that are unlikely to occur. In
this case, adherence to the stated
payment schedule will result in accruals on the debt instrument that
reasonably reflect the expected return
on the instrument. The rules can lead to
unreasonable results, however, if a debt
instrument provides for a stated payment schedule and one or more alternative payment schedules that differ
significantly and that have a comparable likelihood of occurring. In this
case, the accruals based on the payment
schedule identified as most likely to
occur could differ significantly from
the expected return on the debt instrument, which would reflect all the
payment schedules and their relative
probabilities of occurrence.
Because the general rules of
§1.1272–1(c) could produce unreasonable results, these rules have been
modified. Under the final regulations, if
a single payment schedule is significantly more likely than not to occur,
the yield and maturity of the debt
instrument are calculated based on that
payment schedule. As a result, any
other debt instrument that provides for
an alternative payment schedule (other
than because of an unconditional option
or mandatory sinking fund) will generally be subject to the rules in §1.1275–
4 for contingent payment debt instruments. The final regulations generally
retain the rules for mandatory sinking
funds and unconditional options.
B. Remote and incidental
contingencies
The proposed regulations provide
that a payment subject to a remote or

incidental contingency is not considered a contingent payment for purposes
of §1.1275–4. In response to a comment, the rule relating to remote and
incidental contingencies has been
broadened, through the addition of new
§1.1275–2(h), to provide that remote
and incidental contingencies are generally ignored for purposes of sections
163(e) (other than section 163(e)(5))
and 1271 through 1275 and the regulations thereunder. Thus, for example, if
an otherwise fixed payment debt instrument provides for an additional payment that will be made upon the
occurrence of a contingency and there
is a remote likelihood that the contingency will occur, the contingent
payment is ignored for purposes of
computing OID accruals on the instrument. If the contingency occurs, however, then, solely for purposes of
sections 1272 and 1273, the debt
instrument is treated as reissued. Therefore, OID on the debt instrument is
redetermined.
C. Definition of qualified stated
interest
The addition of the rules for remote
or incidental contingencies and the
changes to the rules for alternative
payment schedules allow simplification
of the definition of qualified stated
interest. Under §1.1273–1(c), as published in the Federal Register on
February 2, 1994, qualified stated
interest must be unconditionally payable in cash or property at least
annually at a single fixed rate. Interest
is unconditionally payable only if late
payment (other than a late payment that
occurs within a reasonable grace
period) or nonpayment is expected to
be penalized or reasonable remedies
exist to compel payment.
This definition of unconditionally
payable can be read to conflict with the
alternative payment schedule rules. For
example, if a debt instrument has two
alternative payment schedules, one
schedule can be stated as the required
payment schedule and the other schedule can be stated as a penalty if the
required payments are not made. The
required payments might then be
treated as unconditionally payable and,
therefore, as being qualified stated
interest even if they would not be
qualified stated interest if treated under
the alternative payment schedule rules.
Under this treatment, if a payment is
not made, the reissuance rules of the

10

alternative payment schedule regime do
not apply. Holders can thus argue that
no OID would accrue with respect to
the debt instrument even though OID
would accrue if the instrument were
treated as having an alternative payment schedule and holders fully expect
any unmade payment to be made in the
future.
The remote or incidental rules in
§1.1275–2(h) provide a better mechanism for determining whether a payment is qualified stated interest and
determining the treatment if no payment is made. Thus, the final regulations modify the definition of unconditionally payable so that interest is
unconditionally payable only if reasonable legal remedies exist to compel
payment or the debt instrument otherwise provides terms and conditions that
make the likelihood of late payment
(other than a late payment that occurs
within a reasonable grace period) or
nonpayment remote. If the payment is
not made (other than because of insolvency, default, or similar circumstances), the final regulations require a
deemed reissuance for OID purposes,
which ensures that OID will accrue.
This approach should simplify the
treatment of many debt instruments and
yet ensure that OID accrues in appropriate circumstances.
D. OID anti-abuse rule
On February 2, 1994, the IRS
published in the Federal Register
temporary and proposed regulations
that contained an anti-abuse rule for
purposes of the OID regulations
(§1.1275–2T (59 FR 4831); §1.1275–
2(g) (59 FR 4878)). Under the antiabuse rule, the Commissioner can apply
or depart from the regulations under
section 163(e) or sections 1271 through
1275 as necessary to achieve a reasonable result if a principal purpose in
structuring a debt instrument or engaging in a transaction is to achieve a
result under the regulations that is
unreasonable in light of the applicable
statutes. This rule is adopted as a final
regulation with some clarifying changes
and the addition of an example to
illustrate its application to certain contingent payment debt instruments.
E. Determination of issue price under
section 1274
Under the proposed regulations, the
issue price of a contingent payment

debt instrument that is subject to
section 1274 (i.e., a debt instrument
issued in exchange for nonpublicly
traded property) is determined without
taking into account the instrument’s
contingent payments. Thus, the issue
price of the debt instrument (and the
buyer’s initial basis in the property) is
limited to an amount determined by
taking into account only the noncontingent payments. The buyer’s basis in
the property, however, is increased by
the amount of a contingent payment
treated as principal. This approach was
adopted primarily because it is inappropriate to allow a buyer a basis in
property that reflects anticipated contingent payments that are uncertain in
amount. In addition, this approach
limits the ability of the buyer to
overstate interest deductions over the
term of the debt instrument. The
approach of the proposed regulations
has been adopted in the final regulations for taxable debt instruments subject to section 1274. See §1.1274–2(g).
It is not appropriate, however, to
apply this approach to tax-exempt
contingent payment obligations subject
to section 1274. Because the present
value of projected contingent payments
generally is not included in the issue
price of a taxable debt instrument
subject to section 1274, the instrument
is accounted for under §1.1275–4(c).
This regime is not appropriate for taxexempt obligations because it does not
distinguish between tax-exempt interest
and gain attributable to an embedded
property right. Thus, in order to permit
tax-exempt obligations to be subject to
the noncontingent bond method under
§1.1275–4(b), the final regulations
provide special rules to determine the
issue price of a tax-exempt contingent
payment obligation subject to section
1274.
Under these rules, the issue price of
a tax-exempt contingent payment obligation subject to section 1274 is equal
to the fair market value of the obligation on the issue date (or, in the case of
an obligation that provides for interestbased or revenue-based payments, the
greater of the obligation’s fair market
value or stated principal amount). In
addition, the obligation is subject to the
rules of §1.1275–4(d) (the noncontingent bond method for tax-exempt
contingent payment obligations) rather
than §1.1275–4(c). However, to ensure
that the buyer’s basis is the same as if
the buyer had issued a taxable debt
instrument, the final regulations limit

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

11

between a §1.1275–6 hedge and a qualifying debt instrument, a taxpayer may
still integrate the hedge and the instrument. The mismatch is dealt with
according to the rules for incidental
contingencies.
The final regulations also clarify the
timing of income, deductions, gains, and
losses from a hedge of a contingent
payment debt instrument not subject to
integration. Under §1.446–4, the income, deductions, gains, and losses must
match the income, deductions, gains,
and losses from the debt instrument.
The final regulations clarify that gain or
loss realized on a transaction that
hedges a contingent payment on a debt
instrument subject to §1.1275–4(c) is
taken into account when the contingent
payment is taken into account under
§1.1275–4(c). This treatment does not
allow the taxpayer to change the timing
of the income, deductions, gains, and
losses from the debt instrument.
Effective Dates
In general, the final regulations apply
to debt instruments issued on or after
August 13, 1996. Section 1.1275–6
applies to a qualifying debt instrument
issued on or after August 13, 1996.
Section 1.1275–6 also applies to a
qualifying debt instrument acquired by
the taxpayer on or after August 13,
1996, if the qualifying debt instrument
is a fixed rate debt instrument or a
VRDI or if the qualifying debt instrument and the §1.1275–6 hedge are
acquired by the taxpayer substantially
contemporaneously. Except as otherwise
provided in the regulations, the changes
to §1.1275–5 apply to debt instruments
issued on or after April 4, 1994.
Debt instruments issued before the
effective date of the final regulations
For a contingent payment debt instrument issued before August 13,
1996, a taxpayer may use any reasonable method to account for the debt
instrument, including a method that
would have been required under the
proposed regulations when the debt
instrument was issued. However, unless
§1.1275–6 applies to the debt instrument, integration is not a reasonable
method to account for the instrument.
Consent to change accounting method
The Commissioner grants consent for
a taxpayer to change its method of

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

Section 1.1275–6 also issued under 26
U.S.C. 1275(d). * * *
Par. 2. Section 1.163–7 is amended
by adding a sentence at the end of
paragraph (a) to read as follows:
§1.163–7 Deduction for OID on
certain debt instruments.
(a) * * * To determine the amount
of interest (OID) that is deductible each
year on a debt instrument that provides
for contingent payments, see §1.1275–
4.
*

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

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

*

*

*

*

*

Adoption of Amendments to the
Regulations

*

*

*

*

Par. 3. Section 1.446–4 is amended
by:
1. Redesignating paragraphs (a)(2)(ii) and (a)(2)(iii) as paragraphs (a)(2)(iii) and (a)(2)(iv), respectively.
2. Adding a new paragraph (a)(2)(ii).
3. Adding a sentence at the end of
paragraph (e)(4).
The additions read as follows:
§1.446–4 Hedging transactions.
(a) * * *
(2) * * *
(ii) An integrated transaction subject
to §1.1275–6;
*

Drafting Information

*

*

*

*

*

*

(e) * * *
(4) * * * Similarly, gain or loss
realized on a transaction that hedges a
contingent payment on a debt instrument subject to §1.1275–4(c) (a contingent payment debt instrument issued
for nonpublicly traded property) is
taken into account when the contingent
payment is taken into account under
§1.1275–4(c).
*

*

*

*

*

*

§1.483–2T [Removed]
Accordingly, 26 CFR parts 1 and
602 are amended as follows:
Part 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by removing the
entry for §1.1275–2T and adding two
entries in numerical order to read as
follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.483–4 also issued under 26
U.S.C. 483(f). * * *

Par. 4. Section 1.483–2T is removed
effective June 14, 1996.
Par. 5. Section 1.483–4 is added to
read as follows:
§1.483–4 Contingent payments.
(a) In general. This section applies
to a contract for the sale or exchange
of property (the overall contract) if the
contract provides for one or more
contingent payments and the contract is

12

subject to section 483. This section
applies even if the contract provides for
adequate stated interest under §1.483–
2. If this section applies to a contract,
interest under the contract is generally
computed and accounted for using rules
similar to those that would apply if the
contract were a debt instrument subject
to §1.1275–4(c). Consequently, all noncontingent payments under the overall
contract are treated as if made under a
separate contract, and interest accruals
on this separate contract are computed
under rules similar to those contained
in §1.1275–4(c)(3). Each contingent
payment under the overall contract is
characterized as principal and interest
under rules similar to those contained
in §1.1275–4(c)(4). However, any interest, or amount treated as interest, on a
contract subject to this section is taken
into account by a taxpayer under the
taxpayer’s regular method of accounting (e.g., an accrual method or the cash
receipts and disbursements method).
(b) Examples. The following examples illustrate the provisions of paragraph (a) of this section.
Example 1. Deferred payment sale with
contingent interest—(i) Facts. On December 31,
1996, A sells depreciable personal property to B.
As consideration for the sale, B issues to A a
debt instrument with a maturity date of December 31, 2001. The debt instrument provides for a
principal payment of $200,000 on the maturity
date, and a payment of interest on December 31
of each year, beginning in 1997, equal to a
percentage of the total gross income derived
from the property in that year. However, the total
interest payable on the debt instrument over its
entire term is limited to a maximum of $50,000.
Assume that on December 31, 1996, the shortterm applicable Federal rate is 4 percent,
compounded annually, and the mid-term applicable Federal rate is 5 percent, compounded
annually.
(ii) Treatment of noncontingent payment as
separate contract. Each payment of interest is a
contingent payment. Accordingly, under paragraph (a) of this section, for purposes of
applying section 483 to the debt instrument, the
right to the noncontingent payment of $200,000
is treated as a separate contract. The amount of
unstated interest on this separate contract is
equal to $43,295, which is the amount by which
the payment ($200,000) exceeds the present
value of the payment ($156,705), calculated
using the test rate of 5 percent, compounded
annually. The $200,000 payment is thus treated
as consisting of a payment of interest of $43,295
and a payment of principal of $156,705. The
interest is includible in A’s gross income, and
deductible by B, under their respective methods
of accounting.
(iii) Treatment of contingent payments. Assume that the amount of the contingent payment
that is paid on December 31, 1997, is $20,000.
Under paragraph (a) of this section, the $20,000
payment is treated as a payment of principal of
$19,231 (the present value, as of the date of sale,

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

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

*

*

*

*

*

(g) Debt instruments issued in exchange for property—(1) In general. If
a debt instrument is issued in exchange
for property, the amount realized attributable to the debt instrument is the

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

13

§1.1012–1 Basis of property.
*

*

*

*

*

*

(g) Debt instruments issued in exchange for property—(1) In general.
For purposes of paragraph (a) of this
section, if a debt instrument is issued
in exchange for property, the cost of
the property that is attributable to the
debt instrument is the issue price of the
debt instrument as determined under
§1.1273–2 or §1.1274–2, whichever is
applicable. If, however, the issue price
of the debt instrument is determined
under section 1273(b)(4), the cost of
the property attributable to the debt
instrument is its stated principal
amount reduced by any unstated interest (as determined under section 483).
(2) Certain tax-exempt obligations.
This paragraph (g)(2) applies to a taxexempt obligation (as defined in section 1275(a)(3)) that is issued in
exchange for property and that has an
issue price determined under §1.1274–
2(j) (concerning tax-exempt contingent
payment obligations and certain taxexempt variable rate debt instruments
subject to section 1274). Notwithstanding paragraph (g)(1) of this section, if
this paragraph (g)(2) applies to a taxexempt obligation, for purposes of
paragraph (a) of this section, the cost
of the property that is attributable to
the obligation is the sum of the present
values of the noncontingent payments
(as determined under §1.1274–2(c)).
(3) Effective date. This paragraph (g)
applies to sales or exchanges that occur
on or after August 13, 1996.
Par. 8. Section 1.1271–0(b) is
amended by:
1. Revising the entries for paragraphs (c)(2), (c)(3), (c)(4), and (d) of
§1.1272–1.
2. Adding an entry for paragraph
(c)(7) of §1.1272–1.
3. Revising the entry for paragraph
(g) and adding entries for paragraphs
(i) and (j) of §1.1274–2.
4. Removing the language ‘‘[Reserved]’’ from the entry for paragraph
(g) and adding entries for paragraphs
(g), (h), (i), and (j) of §1.1275–2.
5. Removing the entries for
§1.1275–2T.
6. Adding entries for §1.1275–4.
7. Adding entries for paragraphs
(a)(5) and (a)(6) of §1.1275–5.
8. Revising the entries for paragraphs (c)(1) and (c)(5) of §1.1275–5.
9. Adding entries for §1.1275–6.

The revisions and additions read as
follows:
§1.1271–0 Original issue discount;
effective date; table of contents.
*

*

*

*

*

*

*

*

*

*

*

(b) * * *
*

§1.1272–1 Current inclusion of OID
in income.
*

*

*

*

*

*

(c) * * *
(2) Payment schedule that is significantly more likely than
not to occur.
(3) Mandatory sinking fund provision.
(4) Consistency rule. [Reserved]
*

*

*

*

*

*

(7) Effective date.
(d) Certain debt instruments that
provide for a fixed yield.
*

*

*

*

*

*

§1.1274–2 Issue price of debt
instruments to which section 1274
applies.
*

*

*

*

*

*

(g) Treatment of contingent payment
debt instruments.
*
(i)
(j)

*

*

*

*

*

[Reserved]
Special rules for tax-exempt
obligations.
(1) Certain variable rate debt instruments.
(2) Contingent payment debt instruments.
(3) Effective date.
*

*

*

*

*

*

§1.1275–2 Special rules relating to
debt instruments.
*

*

*

*

*

*

(g) Anti-abuse rule.
(1) In general.
(2) Unreasonable result.
(3) Examples.
(4) Effective date.
(h) Remote and incidental contingencies.
(1) In general.
(2) Remote contingencies.
(3) Incidental contingencies.
(4) Aggregation rule.
(5) Consistency rule.

(6) Subsequent adjustments.
(7) Effective date.
(i) [Reserved]
(j) Treatment of certain modifications.
* * * * * *
§1.1275–4 Contingent payment debt
instruments.
(a) Applicability.
(1) In general.
(2) Exceptions.
(3) Insolvency and default.
(4) Convertible debt instruments.
(5) Remote and incidental contingencies.
(b) Noncontingent bond method.
(1) Applicability.
(2) In general.
(3) Description of method.
(4) Comparable yield and projected payment schedule.
(5) Qualified stated interest.
(6) Adjustments.
(7) Adjusted issue price, adjusted
basis, and retirement.
(8) Character on sale, exchange,
or retirement.
(9) Operating rules.
(c) Method for debt instruments not
subject to the noncontingent
bond method.
(1) Applicability.
(2) Separation into components.
(3) Treatment of noncontingent
payments.
(4) Treatment of contingent payments.
(5) Basis different from adjusted
issue price.
(6) Treatment of a holder on
sale, exchange, or retirement.
(7) Examples.
(d) Rules for tax-exempt obligations.
(1) In general.
(2) Certain tax-exempt obligations with interest-based or
revenue-based payments
(3) All other tax-exempt obligations.
(4) Basis different from adjusted
issue price.
(e) Amounts treated as interest under
this section.
(f) Effective date.
§1.1275–5 Variable rate debt
instruments.
(a) * * *
(5) No contingent principal payments.
(6) Special rule for debt instruments issued for nonpublicly
traded property.

14

* * * * * *
(c) * * *
(1) Definition.
* * * * * *
(5) Tax-exempt obligations.
* * * * * *
§1.1275–6 Integration of qualifying
debt instruments.
(a) In general.
(b) Definitions.
(1) Qualifying debt instrument.
(2) Section 1.1275–6 hedge.
(3) Financial instrument.
(4) Synthetic debt instrument.
(c) Integrated transaction.
(1) Integration by taxpayer.
(2) Integration by Commissioner.
(d) Special rules for legging into
and legging out of an integrated
transaction.
(1) Legging into.
(2) Legging out.
(e) Identification requirements.
(f) Taxation of integrated transactions.
(1) General rule.
(2) Issue date.
(3) Term.
(4) Issue price.
(5) Adjusted issue price.
(6) Qualified stated interest.
(7) Stated redemption price at
maturity.
(8) Source of interest income and
allocation of expense.
(9) Effectively connected income.
(10) Not a short-term obligation.
(11) Special rules in the event of
integration by the Commissioner.
(12) Retention of separate transaction rules for certain purposes.
(13) Coordination with consolidated return rules.
(g) Predecessors and successors.
(h) Examples.
(i) [Reserved]
(j) Effective date.
Par. 9. Section 1.1272–1 is amended
by:
1. Revising paragraphs (b)(2)(ii), (c),
and (d).
2. Adding a sentence at the end of
paragraph (f)(2).
3. Removing the language ‘‘determining yield and maturity’’ from the
first sentence of paragraph (j) Example
5 (iii) and adding the language ‘‘sections 1272 and 1273’’ in its place.

4. Removing the language ‘‘determining yield and maturity’’ from the
second sentence of paragraph (j) Example 7 (v) and adding the language
‘‘sections 1272 and 1273’’ in its place.
The revisions and addition read as
follows:
§1.1272–1 Current inclusion of OID
in income.
*

*

*

*

*

*

(b) * * *
(2) * * *
(ii) A debt instrument that provides
for contingent payments, other than a
debt instrument described in paragraph
(c) or (d) of this section or except as
provided in §1.1275–4; or
*

*

*

*

*

*

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

of this section, if a debt instrument is
subject to a mandatory sinking fund
provision, the provision is ignored for
purposes of computing the yield and
maturity of the debt instrument if the
use and terms of the provision meet
reasonable commercial standards. For
purposes of the preceding sentence, a
mandatory sinking fund provision is a
provision that meets the following
requirements:
(i) The provision requires the issuer
to redeem a certain amount of debt
instruments in an issue prior to
maturity.
(ii) The debt instruments actually
redeemed are chosen by lot or purchased by the issuer either in the open
market or pursuant to an offer made to
all holders (with any proration determined by lot).
(iii) On the issue date, the specific
debt instruments that will be redeemed
on any date prior to maturity cannot be
identified.
(4) Consistency rule. [Reserved]
(5) Treatment of certain options.
Notwithstanding paragraphs (c)(2) and
(3) of this section, the rules of this
paragraph (c)(5) determine the yield
and maturity of a debt instrument that
provides the holder or issuer with an
unconditional option or options, exercisable on one or more dates during
the term of the debt instrument, that, if
exercised, require payments to be made
on the debt instrument under an alternative payment schedule or schedules
(e.g., an option to extend or an option
to call a debt instrument at a fixed
premium). Under this paragraph (c)(5),
an issuer is deemed to exercise or not
exercise an option or combination of
options in a manner that minimizes the
yield on the debt instrument, and a
holder is deemed to exercise or not
exercise an option or combination of
options in a manner that maximizes the
yield on the debt instrument. If both
the issuer and the holder have options,
the rules of this paragraph (c)(5) are
applied to the options in the order that
they may be exercised. See paragraph
(j) Example 5 through Example 8 of
this section.
(6) Subsequent adjustments. If a
contingency described in this paragraph
(c) (including the exercise of an option
described in paragraph (c)(5) of this
section) actually occurs or does not
occur, contrary to the assumption made
pursuant to this paragraph (c) (a change
in circumstances), then, solely for

15

purposes of sections 1272 and 1273,
the debt instrument is treated as retired
and then reissued on the date of the
change in circumstances for an amount
equal to its adjusted issue price on that
date. See paragraph (j) Example 5 and
Example 7 of this section. If, however,
the change in circumstances results in a
substantially contemporaneous pro-rata
prepayment as defined in §1.1275–
2(f)(2), the pro-rata prepayment is
treated as a payment in retirement of a
portion of the debt instrument, which
may result in gain or loss to the holder.
See paragraph (j) Example 6 and
Example 8 of this section.
(7) Effective date. This paragraph (c)
applies to debt instruments issued on or
after August 13, 1996.
(d) Certain debt instruments that
provide for a fixed yield. If a debt
instrument provides for one or more
contingent payments but all possible
payment schedules under the terms of
the instrument result in the same fixed
yield, the yield of the debt instrument
is the fixed yield. For example, the
yield of a debt instrument with principal payments that are fixed in total
amount but that are uncertain as to
time (such as a demand loan) is the
stated interest rate if the issue price of
the instrument is equal to the stated
principal amount and interest is paid or
compounded at a fixed rate over the
entire term of the instrument. This
paragraph (d) applies to debt instruments issued on or after August 13,
1996.
*

*

*

*

*

*

(f) * * *
(2) * * * For purposes of the
preceding sentence, the last possible
date that the debt instrument could be
outstanding is determined without regard to §1.1275–2(h) (relating to payments subject to remote or incidental
contingencies).
*

*

*

*

*

*

Par. 10. Section 1.1273–1 is
amended by:
1. Removing the language ‘‘principal payments uncertain as to time’’ in
the fourth sentence of paragraph (a)
and adding the language ‘‘a fixed
yield’’ in its place.
2. Revising paragraph (c)(1)(ii).
3. Revising paragraph (f) Example 4.
The revisions read as follows:

§1.1273–1 Definition of OID.
* * * * * *
(c) * * * (1) * * *
(ii) Unconditionally payable. Interest
is unconditionally payable only if reasonable legal remedies exist to compel
timely payment or the debt instrument
otherwise provides terms and conditions that make the likelihood of late
payment (other than a late payment that
occurs within a reasonable grace
period) or nonpayment a remote contingency (within the meaning of
§1.1275–2(h)). For purposes of the
preceding sentence, remedies or other
terms and conditions are not taken into
account if the lending transaction does
not reflect arm’s length dealing and the
holder does not intend to enforce the
remedies or other terms and conditions.
For purposes of determining whether
interest is unconditionally payable, the
possibility of nonpayment due to default, insolvency, or similar circumstances, or due to the exercise of a
conversion option described in
§1.1272–1(e) is ignored. This paragraph (c)(1)(ii) applies to debt instruments issued on or after August 13,
1996.
* *
(f) * * *

*

*

*

*

Example 4. Qualified stated interest on a debt
instrument that is subject to an option—(i)
Facts. On January 1, 1997, A issues, for
$100,000, a 10-year debt instrument that
provides for a $100,000 principal payment at
maturity and for annual interest payments of
$10,000. Under the terms of the debt instrument,
A has the option, exercisable on January 1, 2002,
to lower the annual interest payments to $8,000.
In addition, the debt instrument gives the holder
an unconditional right to put the debt instrument
back to A, exercisable on January 1, 2002, in
return for $100,000.
(ii) Amount of qualified stated interest. Under
paragraph (c)(2) of this section, the debt
instrument provides for qualified stated interest
to the extent of the lowest fixed rate at which
qualified stated interest would be payable under
any payment schedule. If the payment schedule
determined by assuming that the issuer’s option
will be exercised and the put option will not be
exercised were treated as the debt instrument’s
sole payment schedule, only $8,000 of each
annual interest payment would be qualified stated
interest. Under any other payment schedule, the
debt instrument would provide for annual
qualified stated interest payments of $10,000.
Accordingly, only $8,000 of each annual interest
payment is qualified stated interest. Any excess
of each annual interest payment over $8,000 is
included in the debt instrument’s stated redemption price at maturity.

* * * * * *
Par. 11. Section 1.1274–2
amended by:

is

1. Removing the language
‘‘§1.1272–1(c)(3)(ii)’’ from paragraph
(e) and adding the language ‘‘§1.1272–
1(c)(3)’’ in its place.
2. Revising paragraph (g).
3. Adding and reserving paragraph
(i) and adding paragraph (j).
The revisions and additions read as
follows:
§1.1274–2 Issue price of debt
instruments to which section 1274
applies.
*

*

*

*

*

*

(g) Treatment of contingent payment
debt instruments. Notwithstanding paragraph (b) of this section, if a debt
instrument subject to section 1274
provides for one or more contingent
payments, the issue price of the debt
instrument is the lesser of the instrument’s noncontingent principal payments and the sum of the present
values of the noncontingent payments
(as determined under paragraph (c) of
this section). However, if the debt
instrument is issued in a potentially
abusive situation, the issue price of the
debt instrument is the fair market value
of the noncontingent payments. For
additional rules relating to a debt
instrument that provides for one or
more contingent payments, see
§1.1275–4. This paragraph (g) applies
to debt instruments issued on or after
August 13, 1996.
*

*

*

*

*

*

(i) [Reserved]
(j) Special rules for tax-exempt
obligations—(1) Certain variable rate
debt instruments. Notwithstanding paragraph (b) of this section, if a taxexempt obligation (as defined in section 1275(a)(3)) is a variable rate debt
instrument (within the meaning of
§1.1275–5) that pays interest at an
objective rate and is subject to section
1274, the issue price of the obligation
is the greater of the obligation’s fair
market value and its stated principal
amount.
(2) Contingent payment debt instruments. Notwithstanding paragraphs (b)
and (g) of this section, if a tax-exempt
obligation (as defined in section
1275(a)(3)) is subject to section 1274
and §1.1275–4, the issue price of the
obligation is the fair market value of
the obligation. However, in the case of
a tax-exempt obligation that is subject

16

to §1.1275–4(d)(2) (an obligation that
provides for interest-based or revenuebased payments), the issue price of the
obligation is the greater of the obligation’s fair market value and its stated
principal amount.
(3) Effective date. This paragraph (j)
applies to debt instruments issued on or
after August 13, 1996.
Par. 12. Section 1.1275–2 is
amended by adding the text of paragraph (g), adding paragraph (h), adding
and reserving paragraph (i), and adding
paragraph (j) to read as follows:
§1.1275–2 Special rules relating to
debt instruments.
*

*

*

*

*

*

(g) Anti-abuse rule—(1) In general.
If a principal purpose in structuring a
debt instrument or engaging in a transaction is to achieve a result that is
unreasonable in light of the purposes of
section 163(e), sections 1271 through
1275, or any related section of the
Code, the Commissioner can apply or
depart from the regulations under the
applicable sections as necessary or
appropriate to achieve a reasonable
result. For example, if this paragraph
(g) applies to a debt instrument that
provides for a contingent payment, the
Commissioner can treat the contingency as if it were a separate
position.
(2) Unreasonable result. Whether a
result is unreasonable is determined
based on all the facts and circumstances. In making this determination, a
significant fact is whether the treatment
of the debt instrument is expected to
have a substantial effect on the issuer’s
or a holder’s U.S. tax liability. In the
case of a contingent payment debt
instrument, another significant fact is
whether the result is obtainable without
the application of §1.1275–4 and any
related provisions (e.g., if the debt
instrument and the contingency were
entered into separately). A result will
not be considered unreasonable, however, in the absence of an expected
substantial effect on the present value
of a taxpayer’s tax liability.
(3) Examples. The following examples illustrate the provisions of this
paragraph (g).
Example 1. A issues a current-pay, increasingrate note that provides for an early call option.
Although the option is deemed exercised on the
call date under §1.1272–1(c)(5), the option is not
expected to be exercised by A. In addition, a

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

(4) Effective date. This paragraph (g)
applies to debt instruments issued on or
after August 13, 1996.
(h) Remote and incidental contingencies—(1) In general. This paragraph (h) applies to a debt instrument
if one or more payments on the
instrument are subject to either a
remote or incidental contingency.
Whether a contingency is remote or
incidental is determined as of the issue
date of the debt instrument, including
any date there is a deemed reissuance
of the debt instrument under paragraph
(h)(6)(ii) or (j) of this section or
§1.1272–1(c)(6). Except as otherwise
provided, the treatment of the contingency under this paragraph (h) applies for all purposes of sections 163(e)
(other than section 163(e)(5)) and 1271
through 1275 and the regulations thereunder. For purposes of this paragraph

(h), the possibility of impairment of a
payment by insolvency, default, or
similar circumstances is not a
contingency.
(2) Remote contingencies. A contingency is remote if there is a remote
likelihood either that the contingency
will occur or that the contingency will
not occur. If there is a remote likelihood that the contingency will occur, it
is assumed that the contingency will
not occur. If there is a remote likelihood that the contingency will not
occur, it is assumed that the contingency will occur.
(3) Incidental contingencies—(i)
Contingency relating to amount. A
contingency relating to the amount of a
payment is incidental if, under all
reasonably expected market conditions,
the potential amount of the payment is
insignificant relative to the total expected amount of the remaining payments on the debt instrument. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(i), the payment
is ignored until the payment is made.
However, see paragraph (h)(6)(i)(B) of
this section for the treatment of the
debt instrument if a change in circumstances occurs prior to the date the
payment is made.
(ii) Contingency relating to time. A
contingency relating to the timing of a
payment is incidental if, under all
reasonably expected market conditions,
the potential difference in the timing of
the payment (from the earliest date to
the latest date) is insignificant. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(ii), the payment
is treated as made on the earliest date
that the payment could be made pursuant to the contingency. If the payment is not made on this date, a
taxpayer makes appropriate adjustments
to take into account the delay in
payment. However, see paragraph
(h)(6)(i)(C) of this section for the
treatment of the debt instrument if the
delay is not insignificant.
(4) Aggregation rule. For purposes
of paragraph (h)(2) of this section, if a
debt instrument provides for multiple
contingencies each of which has a
remote likelihood of occurring but,
when all of the contingencies are considered together, there is a greater than
remote likelihood that at least one of
the contingencies will occur, none of
the contingencies is treated as a remote

17

contingency. For purposes of paragraph
(h)(3)(i) of this section, if a debt
instrument provides for multiple contingencies each of which is incidental
but the potential total amount of all of
the payments subject to the contingencies is not, under reasonably expected
market conditions, insignificant relative
to the total expected amount of the
remaining payments on the debt instrument, none of the contingencies is
treated as incidental.
(5) Consistency rule. For purposes
of paragraphs (h)(2) and (3) of this section, the issuer’s determination that a
contingency is either remote or incidental is binding on all holders. However, the issuer’s determination is not
binding on a holder that explicitly
discloses that its determination is different from the issuer’s determination.
Unless otherwise prescribed by the
Commissioner, the disclosure must be
made on a statement attached to the
holder’s timely filed federal income tax
return for the taxable year that includes
the acquisition date of the debt instrument. See §1.1275–2(e) for rules relating to the issuer’s obligation to disclose
certain information to holders.
(6) Subsequent adjustments—(i) Applicability. This paragraph (h)(6) applies to a debt instrument when there is
a change in circumstances. For purposes of the preceding sentence, there
is a change in circumstances if—
(A) A remote contingency actually
occurs or does not occur, contrary to
the assumption made in paragraph
(h)(2) of this section;
(B) A payment subject to an incidental contingency described in paragraph (h)(3)(i) of this section becomes
fixed in an amount that is not insignificant relative to the total expected
amount of the remaining payments on
the debt instrument; or
(C) A payment subject to an incidental contingency described in paragraph (h)(3)(ii) of this section becomes
fixed such that the difference between
the assumed payment date and the due
date of the payment is not insignificant.
(ii) In general. If a change in
circumstances occurs, solely for purposes of sections 1272 and 1273, the
debt instrument is treated as retired and
then reissued on the date of the change
in circumstances for an amount equal
to the instrument’s adjusted issue price
on that date.
(iii) Contingent payment debt instruments. Notwithstanding paragraph

(h)(6)(ii) of this section, in the case of
a contingent payment debt instrument
subject to §1.1275–4, if a change in
circumstances occurs, no retirement or
reissuance is treated as occurring, but
any payment that is fixed as a result of
the change in circumstances is governed by the rules in §1.1275–4 that
apply when the amount of a contingent
payment becomes fixed.
(7) Effective date. This paragraph (h)
applies to debt instruments issued on or
after August 13, 1996.
(i) [Reserved]
(j) Treatment of certain modifications. If the terms of a debt instrument
are modified to defer one or more
payments, and the modification does
not cause an exchange under section
1001, then, solely for purposes of
sections 1272 and 1273, the debt instrument is treated as retired and then
reissued on the date of the modification
for an amount equal to the instrument’s
adjusted issue price on that date. This
paragraph (j) applies to debt instruments issued on or after August 13,
1996.
§1.1275–2T [Removed]
Par. 13. Section 1.1275–2T is removed effective August 13, 1996.
Par. 14. In §1.1275–3, paragraph
(b)(1)(i) is revised to read as follows:
§1.1275–3 OID information reporting
requirements.
*

*

*

*

*

*

(b) * * * (1) * * *
(i) Set forth on the face of the debt
instrument the issue price, the amount
of OID, the issue date, the yield to
maturity, and, in the case of a debt
instrument subject to the rules of
§1.1275–4(b), the comparable yield and
projected payment schedule; or
*

*

*

*

*

*

Par. 15. Section 1.1275–4 is added to
read as follows:
§1.1275–4 Contingent payment debt
instruments.
(a) Applicability—(1) In general.
Except as provided in paragraph (a)(2)
of this section, this section applies to
any debt instrument that provides for
one or more contingent payments. In
general, paragraph (b) of this section

applies to a contingent payment debt
instrument that is issued for money or
publicly traded property and paragraph
(c) of this section applies to a contingent payment debt instrument that is
issued for nonpublicly traded property.
Paragraph (d) of this section provides
special rules for tax-exempt obligations. See §1.1275–6 for a taxpayer’s
treatment of a contingent payment debt
instrument and a hedge.
(2) Exceptions. This section does not
apply to—
(i) A debt instrument that has an
issue price determined under section
1273(b)(4) (e.g., a debt instrument
subject to section 483);
(ii) A variable rate debt instrument
(as defined in §1.1275–5);
(iii) A debt instrument subject to
§1.1272–1(c) (a debt instrument that
provides for certain contingencies) or
§1.1272–1(d) (a debt instrument that
provides for a fixed yield);
(iv) A debt instrument subject to
section 988 (except as provided in
section 988 and the regulations
thereunder);
(v) A debt instrument to which
section 1272(a)(6) applies (certain interests in or mortgages held by a
REMIC, and certain other debt instruments with payments subject to
acceleration);
(vi) A debt instrument (other than a
tax-exempt obligation) described in
section 1272(a)(2) (e.g., U.S. savings
bonds, certain loans between natural
persons, and short-term taxable obligations); or
(vii) A debt instrument issued pursuant to a plan or arrangement if—
(A) The plan or arrangement is
created by a state statute;
(B) A primary objective of the plan
or arrangement is to enable the participants to pay for the costs of postsecondary education for themselves or
their designated beneficiaries; and
(C) Contingent payments on the debt
instrument are related to such
objective.
(3) Insolvency and default. A payment is not contingent merely because
of the possibility of impairment by
insolvency, default, or similar circumstances.
(4) Convertible debt instruments. A
debt instrument does not provide for
contingent payments merely because it
provides for an option to convert the
debt instrument into the stock of the

18

issuer, into the stock or debt of a
related party (within the meaning of
section 267(b) or 707(b)(1)), or into
cash or other property in an amount
equal to the approximate value of such
stock or debt.
(5) Remote and incidental contingencies. A payment is not a contingent
payment merely because of a contingency that, as of the issue date, is
either remote or incidental. See
§1.1275–2(h) for the treatment of remote and incidental contingencies.
(b) Noncontingent bond method—(1)
Applicability. The noncontingent bond
method described in this paragraph (b)
applies to a contingent payment debt
instrument that has an issue price
determined under §1.1273–2 (e.g., a
contingent payment debt instrument
that is issued for money or publicly
traded property).
(2) In general. Under the noncontingent bond method, interest on a debt
instrument must be taken into account
whether or not the amount of any payment is fixed or determinable in the
taxable year. The amount of interest
that is taken into account for each
accrual period is determined by constructing a projected payment schedule
for the debt instrument and applying
rules similar to those for accruing OID
on a noncontingent debt instrument. If
the actual amount of a contingent payment is not equal to the projected
amount, appropriate adjustments are
made to reflect the difference.
(3) Description of method. The following steps describe how to compute
the amount of income, deductions,
gain, and loss under the noncontingent
bond method:
(i) Step one: Determine the comparable yield. Determine the comparable
yield for the debt instrument under the
rules of paragraph (b)(4) of this section. The comparable yield is determined as of the debt instrument’s issue
date.
(ii) Step two: Determine the projected payment schedule. Determine the
projected payment schedule for the
debt instrument under the rules of
paragraph (b)(4) of this section. The
projected payment schedule is determined as of the issue date and remains
fixed throughout the term of the debt
instrument (except under paragraph
(b)(9)(ii) of this section, which applies
to a payment that is fixed more than 6
months before it is due).
(iii) Step three: Determine the daily
portions of interest. Determine the

daily portions of interest on the debt
instrument for a taxable year as follows. The amount of interest that
accrues in each accrual period is the
product of the comparable yield of the
debt instrument (properly adjusted for
the length of the accrual period) and
the debt instrument’s adjusted issue
price at the beginning of the accrual
period. See paragraph (b)(7)(ii) of this
section to determine the adjusted issue
price of the debt instrument. The daily
portions of interest are determined by
allocating to each day in the accrual
period the ratable portion of the interest
that accrues in the accrual period.
Except as modified by paragraph
(b)(3)(iv) of this section, the daily
portions of interest are includible in
income by a holder for each day in the
holder’s taxable year on which the
holder held the debt instrument and are
deductible by the issuer for each day
during the issuer’s taxable year on
which the issuer was primarily liable
on the debt instrument.
(iv) Step four: Adjust the amount of
income or deductions for differences
between projected and actual contingent payments. Make appropriate
adjustments to the amount of income or
deductions attributable to the debt
instrument in a taxable year for any
differences between projected and actual contingent payments. See paragraph (b)(6) of this section to determine the amount of an adjustment and
the treatment of the adjustment.
(4) Comparable yield and projected
payment schedule. This paragraph (b)(4) provides rules for determining the
comparable yield and projected payment schedule for a debt instrument.
The comparable yield and projected
payment schedule must be supported by
contemporaneous documentation showing that both are reasonable, are based
on reliable, complete, and accurate
data, and are made in good faith.
(i) Comparable yield—(A) In general. Except as provided in paragraph
(b)(4)(i)(B) of this section, the comparable yield for a debt instrument is the
yield at which the issuer would issue a
fixed rate debt instrument with terms
and conditions similar to those of the
contingent payment debt instrument
(the comparable fixed rate debt instrument), including the level of subordination, term, timing of payments, and
general market conditions. For example, if a §1.1275–6 hedge (or the
substantial equivalent) is available, the
comparable yield is the yield on the

synthetic fixed rate debt instrument that
would result if the issuer entered into
the §1.1275–6 hedge. If a §1.1275–6
hedge (or the substantial equivalent) is
not available, but similar fixed rate
debt instruments of the issuer trade at a
price that reflects a spread above a
benchmark rate, the comparable yield is
the sum of the value of the benchmark
rate on the issue date and the spread. In
determining the comparable yield, no
adjustments are made for the riskiness
of the contingencies or the liquidity of
the debt instrument. The comparable
yield must be a reasonable yield for the
issuer and must not be less than the
applicable Federal rate (based on the
overall maturity of the debt instrument).
(B) Presumption for certain debt
instruments. This paragraph (b)(4)(i)(B)
applies to a debt instrument if the
instrument provides for one or more
contingent payments not based on
market information and the instrument
is part of an issue that is marketed or
sold in substantial part to persons for
whom the inclusion of interest under
this paragraph (b) is not expected to
have a substantial effect on their U.S.
tax liability. If this paragraph
(b)(4)(i)(B) applies to a debt instrument, the instrument’s comparable
yield is presumed to be the applicable
Federal rate (based on the overall
maturity of the debt instrument). A
taxpayer may overcome this presumption only with clear and convincing
evidence that the comparable yield for
the debt instrument should be a specific
yield (determined using the principles
in paragraph (b)(4)(i)(A) of this section) that is higher than the applicable
Federal rate. The presumption may not
be overcome with appraisals or other
valuations of nonpublicly traded property. Evidence used to overcome the
presumption must be specific to the
issuer and must not be based on
comparable issuers or general market
conditions.
(ii) Projected payment schedule. The
projected payment schedule for a debt
instrument includes each noncontingent
payment and an amount for each
contingent payment determined as
follows:
(A) Market-based payments. If a
contingent payment is based on market
information (a market-based payment),
the amount of the projected payment is
the forward price of the contingent
payment. The forward price of a
contingent payment is the amount one

19

party would agree, as of the issue date,
to pay an unrelated party for the right
to the contingent payment on the
settlement date (e.g., the date the
contingent payment is made). For example, if the right to a contingent
payment is substantially similar to an
exchange-traded option, the forward
price is the spot price of the option (the
option premium) compounded at the
applicable Federal rate from the issue
date to the date the contingent payment
is due.
(B) Other payments. If a contingent
payment is not based on market information (a non-market-based payment),
the amount of the projected payment is
the expected value of the contingent
payment as of the issue date.
(C) Adjustments to the projected
payment schedule. The projected payment schedule must produce the comparable yield. If the projected payment
schedule does not produce the comparable yield, the schedule must be adjusted consistent with the principles of
this paragraph (b)(4) to produce the
comparable yield. For example, the
adjusted amounts of non-market-based
payments must reasonably reflect the
relative expected values of the payments and must not be set to accelerate
or defer income or deductions. If the
debt instrument contains both marketbased and non-market-based payments,
adjustments are generally made first to
the non-market-based payments because more objective information is
available for the market-based
payments.
(iii) Market information. For purposes of this paragraph (b), market
information is any information on
which an objective rate can be based
under §1.1275–5(c)(1) or (2).
(iv) Issuer/holder consistency. The
issuer’s projected payment schedule is
used to determine the holder’s interest
accruals and adjustments. The issuer
must provide the projected payment
schedule to the holder in a manner
consistent with the issuer disclosure
rules of §1.1275–2(e). If the issuer
does not create a projected payment
schedule for a debt instrument or the
issuer’s projected payment schedule is
unreasonable, the holder of the debt
instrument must determine the comparable yield and projected payment
schedule for the debt instrument under
the rules of this paragraph (b)(4). A
holder that determines its own projected payment schedule must explicitly

disclose this fact and the reason why
the holder set its own schedule (e.g.,
why the issuer’s projected payment
schedule is unreasonable). Unless otherwise prescribed by the Commissioner,
the disclosure must be made on a
statement attached to the holder’s
timely filed federal income tax return
for the taxable year that includes the
acquisition date of the debt instrument.
(v) Issuer’s determination respected—(A) In general. If the issuer
maintains the contemporaneous documentation required by this paragraph
(b)(4), the issuer’s determination of the
comparable yield and projected payment schedule will be respected unless
either is unreasonable.
(B) Unreasonable determination. For
purposes of paragraph (b)(4)(v)(A) of
this section, a comparable yield or
projected payment schedule generally
will be considered unreasonable if it is
set with a purpose to overstate, understate, accelerate, or defer interest accruals on the debt instrument. In a
determination of whether a comparable
yield or projected payment schedule is
unreasonable, consideration will be
given to whether the treatment of the
debt instrument under this section is
expected to have a substantial effect on
the issuer’s or holder’s U.S. tax liability. For example, if a taxable issuer
markets a debt instrument to a holder
not subject to U.S. taxation, the comparable yield will be given close
scrutiny and will not be respected
unless contemporaneous documentation
shows that the yield is not too high.
(C) Exception. Paragraph (b)(4)(v)(A) of this section does not apply to a
debt instrument subject to paragraph
(b)(4)(i)(B) of this section (concerning
a yield presumption for certain debt
instruments that provide for nonmarket-based payments).
(vi) Examples. The following examples illustrate the provisions of this
paragraph (b)(4). In each example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Market-based payment—(i) Facts.
On December 31, 1996, X corporation issues for
$1,000,000 a debt instrument that matures on
December 31, 2006. The debt instrument provides for annual payments of interest, beginning
in 1997, at the rate of 6 percent and for a
payment at maturity equal to $1,000,000 plus the
excess, if any, of the price of 10,000 shares of

publicly traded stock in an unrelated corporation
on the maturity date over $350,000, or less the
excess, if any, of $350,000 over the price of
10,000 shares of the stock on the maturity date.
On the issue date, the forward price to purchase
10,000 shares of the stock on December 31,
2006, is $350,000.
(ii) Comparable yield. Under paragraph
(b)(4)(i) of this section, the debt instrument’s
comparable yield is the yield on the synthetic
debt instrument that would result if X corporation entered into a §1.1275–6 hedge. A §1.1275–
6 hedge in this case is a forward contract to
purchase 10,000 shares of the stock on December
31, 2006. If X corporation entered into this
hedge, the resulting synthetic debt instrument
would yield 6 percent, compounded annually.
Thus, the comparable yield on the debt instrument is 6 percent, compounded annually.
(iii) Projected payment schedule. Under paragraph (b)(4)(ii) of this section, the projected
payment schedule for the debt instrument consists of 10 annual payments of $60,000 and a
projected amount for the contingent payment at
maturity. Because the right to the contingent
payment is based on market information, the
projected amount of the contingent payment is
the forward price of the payment. The right to
the contingent payment is substantially similar to
a right to a payment of $1,000,000 combined
with a cash-settled forward contract for the
purchase of 10,000 shares of the stock for
$350,000 on December 31, 2006. Because the
forward price to purchase 10,000 shares of the
stock on December 31, 2006, is $350,000, the
amount to be received or paid under the forward
contract is projected to be zero. As a result, the
projected amount of the contingent payment at
maturity is $1,000,000, consisting of the
$1,000,000 base amount and no additional
amount to be received or paid under the forward
contract.
(A) Assume, alternatively, that on the issue
date the forward price to purchase 10,000 shares
of the stock on December 31, 2006, is $370,000.
If X corporation entered into a §1.1275–6 hedge
(a forward contract to purchase the shares for
$370,000), the resulting synthetic debt instrument
would yield 6.15 percent, compounded annually.
Thus, the comparable yield on the debt instrument is 6.15 percent, compounded annually. The
projected payment schedule for the debt instrument consists of 10 annual payments of $60,000
and a projected amount for the contingent
payment at maturity. The projected amount of
the contingent payment is $1,020,000, consisting
of the $1,000,000 base amount plus the excess
$20,000 of the forward price of the stock over
the purchase price of the stock under the forward
contract.
(B) Assume, alternatively, that on the issue
date the forward price to purchase 10,000 shares
of the stock on December 31, 2006, is $330,000.
If X corporation entered into a §1.1275–6 hedge,
the resulting synthetic debt instrument would
yield 5.85 percent, compounded annually. Thus,
the comparable yield on the debt instrument is
5.85 percent, compounded annually. The projected payment schedule for the debt instrument
consists of 10 annual payments of $60,000 and a
projected amount for the contingent payment at
maturity. The projected amount of the contingent
payment is $980,000, consisting of the
$1,000,000 base amount minus the excess
$20,000 of the purchase price of the stock under
the forward contract over the forward price of
the stock.

20

Example 2. Non-market-based payments—(i)
Facts. On December 31, 1996, Y issues to Z for
$1,000,000 a debt instrument that matures on
December 31, 2000. The debt instrument has a
stated principal amount of $1,000,000, payable at
maturity, and provides for payments on December 31 of each year, beginning in 1997, of
$20,000 plus 1 percent of Y’s gross receipts, if
any, for the year. On the issue date, Y has
outstanding fixed rate debt instruments with
maturities of 2 to 10 years that trade at a price
that reflects an average of 100 basis points over
Treasury bonds. These debt instruments have
terms and conditions similar to those of the debt
instrument. Assume that on December 31, 1996,
4-year Treasury bonds have a yield of 6.5
percent, compounded annually, and that no
§1.1275–6 hedge is available for the debt
instrument. In addition, assume that the interest
inclusions attributable to the debt instrument are
expected to have a substantial effect on Z’s U.S.
tax liability.
(ii) Comparable yield. The comparable yield
for the debt instrument is equal to the value of
the benchmark rate (i.e., the yield on 4-year
Treasury bonds) on the issue date plus the
spread. Thus, the debt instrument’s comparable
yield is 7.5 percent, compounded annually.
(iii) Projected payment schedule. Y anticipates
that it will have no gross receipts in 1997, but
that it will have gross receipts in later years, and
those gross receipts will grow each year for the
next three years. Based on its business projections, Y believes that it is not unreasonable to
expect that its gross receipts in 1999 and each
year thereafter will grow by between 6 percent
and 13 percent over the prior year. Thus, Y must
take these expectations into account in establishing a projected payment schedule for the debt
instrument that results in a yield of 7.5 percent,
compounded annually. Accordingly, Y could
reasonably set the following projected payment
schedule for the debt instrument:
Date
12/31/1997
12/31/1998
12/31/1999
12/31/2000

Noncontingent
payment
$ 20,000
20,000
20,000
1,020,000

Contingent
payment
$ 0
70,000
75,600
83,850

(5) Qualified stated interest. No
amounts payable on a debt instrument
to which this paragraph (b) applies are
qualified stated interest within the
meaning of §1.1273–1(c).
(6) Adjustments. This paragraph
(b)(6) provides rules for the treatment
of positive and negative adjustments
under the noncontingent bond method.
A taxpayer takes into account only
those adjustments that occur during a
taxable year while the debt instrument
is held by the taxpayer or while the
taxpayer is primarily liable on the debt
instrument.
(i) Determination of positive and
negative adjustments. If the amount of
a contingent payment is more than the
projected amount of the contingent
payment, the difference is a positive
adjustment on the date of the payment.

If the amount of a contingent payment
is less than the projected amount of the
contingent payment, the difference is a
negative adjustment on the date of the
payment (or on the scheduled date of
the payment if the amount of the
payment is zero).
(ii) Treatment of net positive adjustments. The amount, if any, by which
total positive adjustments on a debt
instrument in a taxable year exceed the
total negative adjustments on the debt
instrument in the taxable year is a net
positive adjustment. A net positive
adjustment is treated as additional
interest for the taxable year.
(iii) Treatment of net negative adjustments. The amount, if any, by
which total negative adjustments on a
debt instrument in a taxable year
exceed the total positive adjustments on
the debt instrument in the taxable year
is a net negative adjustment. A taxpayer’s net negative adjustment on a
debt instrument for a taxable year is
treated as follows:
(A) Reduction of interest accruals.
A net negative adjustment first reduces
interest for the taxable year that the
taxpayer would otherwise account for
on the debt instrument under paragraph
(b)(3)(iii) of this section.
(B) Ordinary income or loss. If the
net negative adjustment exceeds the
interest for the taxable year that the
taxpayer would otherwise account for
on the debt instrument under paragraph
(b)(3)(iii) of this section, the excess is
treated as ordinary loss by a holder and
ordinary income by an issuer. However, the amount treated as ordinary
loss by a holder is limited to the
amount by which the holder’s total
interest inclusions on the debt instrument exceed the total amount of the
holder’s net negative adjustments
treated as ordinary loss on the debt
instrument in prior taxable years. The
amount treated as ordinary income by
an issuer is limited to the amount by
which the issuer’s total interest deductions on the debt instrument exceed the
total amount of the issuer’s net negative adjustments treated as ordinary
income on the debt instrument in prior
taxable years.
(C) Carryforward. If the net negative adjustment exceeds the sum of the
amounts treated by the taxpayer as a
reduction of interest and as ordinary
income or loss (as the case may be) on
the debt instrument for the taxable
year, the excess is a negative adjust-

ment carryforward for the taxable year.
In general, a taxpayer treats a negative
adjustment carryforward for a taxable
year as a negative adjustment on the
debt instrument on the first day of the
succeeding taxable year. However, if a
holder of a debt instrument has a
negative adjustment carryforward on
the debt instrument in a taxable year in
which the debt instrument is sold,
exchanged, or retired, the negative
adjustment carryforward reduces the
holder’s amount realized on the sale,
exchange, or retirement. If an issuer of
a debt instrument has a negative
adjustment carryforward on the debt
instrument for a taxable year in which
the debt instrument is retired, the issuer
takes the negative adjustment carryforward into account as ordinary income.
(D) Treatment under section 67. A
net negative adjustment is not subject
to section 67 (the 2-percent floor on
miscellaneous itemized deductions).
(iv) Cross-references. If a holder has
a basis in a debt instrument that is
different from the debt instrument’s
adjusted issue price, the holder may
have additional positive or negative
adjustments under paragraph (b)(9)(i)
of this section. If the amount of a
contingent payment is fixed more than
6 months before the date it is due, the
amount and timing of the adjustment
are determined under paragraph
(b)(9)(ii) of this section.
(7) Adjusted issue price, adjusted
basis, and retirement—(i) In general. If
a debt instrument is subject to the
noncontingent bond method, this paragraph (b)(7) provides rules to determine the adjusted issue price of the
debt instrument, the holder’s basis in
the debt instrument, and the treatment
of any scheduled or unscheduled retirements. In general, because any difference between the actual amount of a
contingent payment and the projected
amount of the payment is taken into
account as an adjustment to income or
deduction, the projected payments are
treated as the actual payments for
purposes of making adjustments to
issue price and basis and determining
the amount of any contingent payment
made on a scheduled retirement.
(ii) Definition of adjusted issue
price. The adjusted issue price of a
debt instrument is equal to the debt
instrument’s issue price, increased by
the interest previously accrued on the
debt instrument under paragraph
(b)(3)(iii) of this section (determined

21

without regard to any adjustments
taken into account under paragraph
(b)(3)(iv) of this section), and decreased by the amount of any noncontingent payment and the projected
amount of any contingent payment
previously made on the debt instrument. See paragraph (b)(9)(ii) of this
section for special rules that apply
when a contingent payment is fixed
more than 6 months before it is due.
(iii) Adjustments to basis. A holder’s
basis in a debt instrument is increased
by the interest previously accrued by
the holder on the debt instrument under
paragraph (b)(3)(iii) of this section
(determined without regard to any
adjustments taken into account under
paragraph (b)(3)(iv) of this section),
and decreased by the amount of any
noncontingent payment and the projected amount of any contingent payment previously made on the debt
instrument to the holder. See paragraph
(b)(9)(i) of this section for special rules
that apply when basis is different from
adjusted issue price and paragraph
(b)(9)(ii) of this section for special
rules that apply when a contingent
payment is fixed more than 6 months
before it is due.
(iv) Scheduled retirements. For purposes of determining the amount realized by a holder and the repurchase
price paid by the issuer on the scheduled retirement of a debt instrument, a
holder is treated as receiving, and the
issuer is treated as paying, the projected amount of any contingent payment due at maturity. If the amount
paid or received is different from the
projected amount, see paragraph (b)(6)
of this section for the treatment of the
difference by the taxpayer. Under paragraph (b)(6)(iii)(C) of this section, the
amount realized by a holder on the
retirement of a debt instrument is
reduced by any negative adjustment
carryforward determined in the taxable
year of the retirement.
(v) Unscheduled retirements. An unscheduled retirement of a debt instrument (or the receipt of a pro-rata
prepayment that is treated as a retirement of a portion of a debt instrument
under §1.1275-2(f)) is treated as a
repurchase of the debt instrument (or a
pro-rata portion of the debt instrument)
by the issuer from the holder for the
amount paid by the issuer to the holder.
(vi) Examples. The following examples illustrate the provisions of paragraphs (b)(6) and (7) of this section. In

each example, assume that the instrument described is a debt instrument for
federal income tax purposes. No inference is intended, however, as to
whether the instrument is a debt
instrument for federal income tax
purposes.
Example 1. Treatment of positive and negative
adjustments—(i) Facts. On December 31, 1996,
Z, a calendar year taxpayer, purchases a debt
instrument subject to this paragraph (b) at
original issue for $1,000. The debt instrument’s
comparable yield is 10 percent, compounded
annually, and the projected payment schedule
provides for payments of $500 on December 31,
1997 (consisting of a noncontingent payment of
$375 and a projected amount of $125) and $660
on December 31, 1998 (consisting of a noncontingent payment of $600 and a projected amount
of $60). The debt instrument is a capital asset in
the hands of Z.
(ii) Adjustment in 1997. Based on the projected payment schedule, Z’s total daily portions
of interest on the debt instrument are $100 for
1997 (issue price of $1,000 x 10 percent).
Assume that the payment actually made on
December 31, 1997, is $375, rather than the
projected $500. Under paragraph (b)(6)(i) of this
section, Z has a negative adjustment of $125 on
December 31, 1997, attributable to the difference
between the amount of the actual payment and
the amount of the projected payment. Because Z
has no positive adjustments for 1997, Z has a net
negative adjustment of $125 on the debt
instrument for 1997. This net negative adjustment reduces to zero the $100 total daily
portions of interest Z would otherwise include in
income in 1997. Accordingly, Z has no interest
income on the debt instrument for 1997. Because
Z had no interest inclusions on the debt
instrument for prior taxable years, the remaining
$25 of the net negative adjustment is a negative
adjustment carryforward for 1997 that results in
a negative adjustment of $25 on January 1, 1998.
(iii) Adjustment to issue price and basis. Z’s
total daily portions of interest on the debt
instrument are $100 for 1997. The adjusted issue
price of the debt instrument and Z’s adjusted
basis in the debt instrument are increased by this
amount, despite the fact that Z does not include
this amount in income because of the net
negative adjustment for 1997. In addition, the
adjusted issue price of the debt instrument and
Z’s adjusted basis in the debt instrument are
decreased on December 31, 1997, by the
projected amount of the payment on that date
($500). Thus, on January 1, 1998, Z’s adjusted
basis in the debt instrument and the adjusted
issue price of the debt instrument are $600.
(iv) Adjustments in 1998. Based on the projected payment schedule, Z’s total daily portions
of interest are $60 for 1998 (adjusted issue price
of $600 ⫻ 10 percent). Assume that the payment
actually made on December 31, 1998, is $700,
rather than the projected $660. Under paragraph
(b)(6)(i) of this section, Z has a positive
adjustment of $40 on December 31, 1998,
attributable to the difference between the amount
of the actual payment and the amount of the
projected payment. Because Z also has a
negative adjustment of $25 on January 1, 1998,
Z has a net positive adjustment of $15 on the
debt instrument for 1998 (the excess of the $40
positive adjustment over the $25 negative adjustment). As a result, Z has $75 of interest income

on the debt instrument for 1998 (the $15 net
positive adjustment plus the $60 total daily
portions of interest that are taken into account by
Z in that year).
(v) Retirement. Based on the projected payment schedule, Z’s adjusted basis in the debt
instrument immediately before the payment at
maturity is $660 ($600 plus $60 total daily
portions of interest for 1998). Even though Z
receives $700 at maturity, for purposes of
determining the amount realized by Z on
retirement of the debt instrument, Z is treated as
receiving the projected amount of the contingent
payment on December 31, 1998. Therefore, Z is
treated as receiving $660 on December 31, 1998.
Because Z’s adjusted basis in the debt instrument
immediately before its retirement is $660, Z
recognizes no gain or loss on the retirement.
Example 2. Negative adjustment carryforward
for year of sale—(i) Facts. Assume the same
facts as in Example 1 of this paragraph
(b)(7)(vi), except that Z sells the debt instrument
on January 1, 1998, for $630.
(ii) Gain on sale. On the date the debt
instrument is sold, Z’s adjusted basis in the debt
instrument is $600. Because Z has a negative
adjustment of $25 on the debt instrument on
January 1, 1998, and has no positive adjustments
on the debt instrument in 1998, Z has a net
negative adjustment for 1998 of $25. Because Z
has not included in income any interest on the
debt instrument, the entire $25 net negative
adjustment is a negative adjustment carryforward
for the taxable year of the sale. Under paragraph
(b)(6)(iii)(C) of this section, the $25 negative
adjustment carryforward reduces the amount
realized by Z on the sale of the debt instrument
from $630 to $605. Thus, Z has a gain on the
sale of $5 ($605 – $600). Under paragraph
(b)(8)(i) of this section, the gain is treated as
interest income.
Example 3. Negative adjustment carryforward
for year of retirement—(i) Facts. Assume the
same facts as in Example 1 of this paragraph
(b)(7)(vi), except that the payment actually made
on December 31, 1998, is $615, rather than the
projected $660.
(ii) Adjustments in 1998. Under paragraph
(b)(6)(i) of this section, Z has a negative
adjustment of $45 on December 31, 1998,
attributable to the difference between the amount
of the actual payment and the amount of the
projected payment. In addition, Z has a negative
adjustment of $25 on January 1, 1998. See
Example 1 (ii) of this paragraph (b)(7)(vi).
Because Z has no positive adjustments in 1998,
Z has a net negative adjustment of $70 for 1998.
This net negative adjustment reduces to zero the
$60 total daily portions of interest Z would
otherwise include in income for 1998. Therefore,
Z has no interest income on the debt instrument
for 1998. Because Z had no interest inclusions
on the debt instrument for 1997, the remaining
$10 of the net negative adjustment is a negative
adjustment carryforward for 1998 that reduces
the amount realized by Z on retirement of the
debt instrument.
(iii) Loss on retirement. Immediately before
the payment at maturity, Z’s adjusted basis in the
debt instrument is $660. Under paragraph
(b)(7)(iv) of this section, Z is treated as receiving
the projected amount of the contingent payment,
or $660, as the payment at maturity. Under
paragraph (b)(6)(iii)(C) of this section, however,
this amount is reduced by any negative adjustment carryforward determined for the taxable
year of retirement to calculate the amount Z

22

realizes on retirement of the debt instrument.
Thus, Z has a loss of $10 on the retirement of
the debt instrument, equal to the amount by
which Z’s adjusted basis in the debt instrument
($660) exceeds the amount Z realizes on the
retirement of the debt instrument ($660 minus
the $10 negative adjustment carryforward). Under paragraph (b)(8)(ii) of this section, the loss is
a capital loss.

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

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

took into account as an ordinary loss. Because E
has not had any net negative adjustments on the
debt instrument, $95 of the $105 loss is an
ordinary loss. The remaining $10 of the $105
loss is a capital loss.

(9) Operating rules. The rules of
this paragraph (b)(9) apply to a debt
instrument subject to the noncontingent
bond method notwithstanding any other
rule of this paragraph (b).
(i) Basis different from adjusted issue price. This paragraph (b)(9)(i)
provides rules for a holder whose basis
in a debt instrument is different from
the adjusted issue price of the debt
instrument (e.g., a subsequent holder
that purchases the debt instrument for
more or less than the instrument’s
adjusted issue price).
(A) General rule. The holder accrues interest under paragraph (b)(3)(iii) of this section and makes
adjustments under paragraph (b)(3)(iv)
of this section based on the projected
payment schedule determined as of the
issue date of the debt instrument.
However, upon acquiring the debt
instrument, the holder must reasonably
allocate any difference between the
adjusted issue price and the basis to
daily portions of interest or projected
payments over the remaining term of
the debt instrument. Allocations are
taken into account under paragraphs
(b)(9)(i)(B) and (C) of this section.
(B) Basis greater than adjusted issue
price. If the holder’s basis in the debt
instrument exceeds the debt instrument’s adjusted issue price, the amount
of the difference allocated to a daily
portion of interest or to a projected
payment is treated as a negative
adjustment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s
adjusted basis in the debt instrument is
reduced by the amount the holder treats
as a negative adjustment under this
paragraph (b)(9)(i)(B). See paragraph
(b)(9)(ii)(E) of this section for a special
rule that applies when a contingent
payment is fixed more than 6 months
before it is due.
(C) Basis less than adjusted issue
price. If the holder’s basis in the debt
instrument is less than the debt instrument’s adjusted issue price, the amount
of the difference allocated to a daily
portion of interest or to a projected
payment is treated as a positive adjustment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s

23

adjusted basis in the debt instrument is
increased by the amount the holder
treats as a positive adjustment under
this paragraph (b)(9)(i)(C). See paragraph (b)(9)(ii)(E) of this section for a
special rule that applies when a contingent payment is fixed more than 6
months before it is due.
(D) Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1272(a)(7), 1276, and 1281 do not
apply. Other rules of those sections,
such as section 171(b)(4), continue to
apply to the extent relevant.
(E) Safe harbor for exchange listed
debt instruments. If the debt instrument
is exchange listed property (within the
meaning of §1.1273–2(f)(2)), it is
reasonable for the holder to allocate
any difference between the holder’s
basis and the adjusted issue price of the
debt instrument pro-rata to daily portions of interest (as determined under
paragraph (b)(3)(iii) of this section)
over the remaining term of the debt
instrument. A pro-rata allocation is not
reasonable, however, to the extent the
holder’s yield on the debt instrument,
determined after taking into account the
amounts allocated under this paragraph
(b)(9)(i)(E), is less than the applicable
Federal rate for the instrument. For
purposes of the preceding sentence, the
applicable Federal rate for the debt
instrument is determined as if the
purchase date were the issue date and
the remaining term of the instrument
were the term of the instrument.
(F) Examples. The following examples illustrate the provisions of this
paragraph (b)(9)(i). In each example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes. In addition, assume that
each instrument is not exchange listed
property.
Example 1. Basis greater than adjusted issue
price—(i) Facts. On July 1, 1998, Z purchases
for $1,405 a debt instrument that matures on
December 31, 1999, and promises to pay on the
maturity date $1,000 plus the increase, if any, in
the price of a specified amount of a commodity
from the issue date to the maturity date. The debt
instrument was originally issued on December
31, 1996, for an issue price of $1,000. The
comparable yield for the debt instrument is 10.25
percent, compounded semiannually, and the
projected payment schedule for the debt instrument (determined as of the issue date) provides
for a single payment at maturity of $1,350. At
the time of the purchase, the debt instrument has

an adjusted issue price of $1,162, assuming
semiannual accrual periods ending on December
31 and June 30 of each year. The increase in the
value of the debt instrument over its adjusted
issue price is due to an increase in the expected
amount of the contingent payment and not to a
decrease in market interest rates. The debt
instrument is a capital asset in the hands of Z. Z
is a calendar year taxpayer.
(ii) Allocation of the difference between basis
and adjusted issue price. Z’s basis in the debt
instrument on July 1, 1998, is $1,405. Under
paragraph (b)(9)(i)(A) of this section, Z allocates
the $243 difference between basis ($1,405) and
adjusted issue price ($1,162) to the contingent
payment at maturity. Z’s allocation of the
difference between basis and adjusted issue price
is reasonable because the increase in the value of
the debt instrument over its adjusted issue price
is due to an increase in the expected amount of
the contingent payment.
(iii) Treatment of debt instrument for 1998.
Based on the projected payment schedule, $60 of
interest accrues on the debt instrument from July
1, 1998 to December 31, 1998 (the product of
the debt instrument’s adjusted issue price on July
1, 1998 ($1,162) and the comparable yield
properly adjusted for the length of the accrual
period (10.25 percent/2)). Z has no net negative
or positive adjustments for 1998. Thus, Z
includes in income $60 of total daily portions of
interest for 1998. On December 31, 1998, Z’s
adjusted basis in the debt instrument is $1,465
($1,405 original basis, plus total daily portions of
$60 for 1998).
(iv) Effect of allocation to contingent payment
at maturity. Assume that the payment actually
made on December 31, 1999, is $1,400, rather
than the projected $1,350. Thus, under paragraph
(b)(6)(i) of this section, Z has a positive
adjustment of $50 on December 31, 1999. In
addition, under paragraph (b)(9)(i)(B) of this
section, Z has a negative adjustment of $243 on
December 31, 1999, which is attributable to the
difference between Z’s basis in the debt instrument on July 1, 1998, and the instrument’s
adjusted issue price on that date. As a result, Z
has a net negative adjustment of $193 for 1999.
This net negative adjustment reduces to zero the
$128 total daily portions of interest Z would
otherwise include in income in 1999. Accordingly, Z has no interest income on the debt
instrument for 1999. Because Z had $60 of
interest inclusions for 1998, $60 of the remaining
$65 net negative adjustment is treated by Z as an
ordinary loss for 1999. The remaining $5 of the
net negative adjustment is a negative adjustment
carryforward for 1999 that reduces the amount
realized by Z on the retirement of the debt
instrument from $1,350 to $1,345.
(v) Loss at maturity. On December 31, 1999,
Z’s basis in the debt instrument is $1,350
($1,405 original basis, plus total daily portions of
$60 for 1998 and $128 for 1999, minus the
negative adjustment of $243). As a result, Z
realizes a loss of $5 on the retirement of the debt
instrument (the difference between the amount
realized on the retirement ($1,345) and Z’s
adjusted basis in the debt instrument ($1,350)).
Under paragraph (b)(8)(ii) of this section, the $5
loss is treated as loss from the retirement of the
debt instrument. Consequently, Z realizes a total
loss of $65 on the debt instrument for 1999 (a
$60 ordinary loss and a $5 capital loss).
Example 2. Basis less than adjusted issue
price—(i) Facts. On January 1, 1999, Y purchases for $910 a debt instrument that pays 7

percent interest semiannually on June 30 and
December 31 of each year, and that promises to
pay on December 31, 2001, $1,000 plus or minus
$10 times the positive or negative difference, if
any, between a specified amount and the value of
an index on December 31, 2001. However, the
payment on December 31, 2001, may not be less
than $650. The debt instrument was originally
issued on December 31, 1996, for an issue price
of $1,000. The comparable yield for the debt
instrument is 9.80 percent, compounded semiannually, and the projected payment schedule for
the debt instrument (determined as of the issue
date) provides for semiannual payments of $35
and a contingent payment at maturity of $1,175.
On January 1, 1999, the debt instrument has an
adjusted issue price of $1,060, assuming semiannual accrual periods ending on December 31 and
June 30 of each year. Y is a calendar year
taxpayer.
(ii) Allocation of the difference between basis
and adjusted issue price. Y’s basis in the debt
instrument on January 1, 1999, is $910. Under
paragraph (b)(9)(i)(A) of this section, Y must
allocate the $150 difference between basis ($910)
and adjusted issue price ($1,060) to daily
portions of interest or to projected payments.
These amounts will be positive adjustments taken
into account at the time the daily portions accrue
or the payments are made.
(A) Assume that, because of a decrease in the
relevant index, the expected value of the
payment at maturity has declined by about 9
percent. Based on forward prices on January 1,
1999, Y determines that approximately $105 of
the difference between basis and adjusted issue
price is allocable to the contingent payment. Y
allocates the remaining $45 to daily portions of
interest on a pro-rata basis (i.e., the amount
allocated to an accrual period equals the product
of $45 and a fraction, the numerator of which is
the total daily portions for the accrual period and
the denominator of which is the total daily
portions remaining on the debt instrument on
January 1, 1999). This allocation is reasonable.
(B) Assume alternatively that, based on yields
of comparable debt instruments and its purchase
price for the debt instrument, Y determines that
an appropriate yield for the debt instrument is 13
percent, compounded semiannually. Based on
this determination, Y allocates $55.75 of the
difference between basis and adjusted issue price
to daily portions of interest as follows: $15.19 to
the daily portions of interest for the taxable year
ending December 31, 1999; $18.40 to the daily
portions of interest for the taxable year ending
December 31, 2000; and $22.16 to the daily
portions of interest for the taxable year ending
December 31, 2001. Y allocates the remaining
$94.25 to the contingent payment at maturity.
This allocation is reasonable.

(ii) Fixed but deferred contingent
payments. This paragraph (b)(9)(ii)
provides rules that apply when the
amount of a contingent payment becomes fixed before the payment is due.
For purposes of paragraph (b) of this
section, if a contingent payment becomes fixed within the 6-month period
ending on the due date of the payment,
the payment is treated as a contingent
payment even after the payment is
fixed. If a contingent payment becomes
fixed more than 6 months before the

24

payment is due, the following rules
apply to the debt instrument.
(A) Determining adjustments. The
amount of the adjustment attributable
to the contingent payment is equal to
the difference between the present
value of the amount that is fixed and
the present value of the projected
amount of the contingent payment. The
present value of each amount is determined by discounting the amount from
the date the payment is due to the date
the payment becomes fixed, using a
discount rate equal to the comparable
yield on the debt instrument. The
adjustment is treated as a positive or
negative adjustment, as appropriate, on
the date the contingent payment becomes fixed. See paragraph (b)(9)(ii)(G) of this section to determine the
timing of the adjustment if all remaining contingent payments on the debt
instrument become fixed substantially
contemporaneously.
(B) Payment schedule. The contingent payment is no longer treated as
a contingent payment after the date the
amount of the payment becomes fixed.
On the date the contingent payment
becomes fixed, the projected payment
schedule for the debt instrument is
modified prospectively to reflect the
fixed amount of the payment. Therefore, no adjustment is made under
paragraph (b)(3)(iv) of this section
when the contingent payment is actually made.
(C) Accrual period. Notwithstanding
the determination under §1.1272–1(b)(1)(ii) of accrual periods for the debt
instrument, an accrual period ends on
the day the contingent payment becomes fixed, and a new accrual period
begins on the day after the day the
contingent payment becomes fixed.
(D) Adjustments to basis and adjusted issue price. The amount of any
positive adjustment on a debt instrument determined under paragraph (b)(9)(ii)(A) of this section increases the
adjusted issue price of the instrument
and the holder’s adjusted basis in the
instrument. Similarly, the amount of
any negative adjustment on a debt
instrument determined under paragraph
(b)(9)(ii)(A) of this section decreases
the adjusted issue price of the instrument and the holder’s adjusted basis in
the instrument.
(E) Basis different from adjusted
issue price. If a holder’s basis in a debt
instrument exceeds the debt instrument’s adjusted issue price, the amount

allocated to a projected payment under
paragraph (b)(9)(i) of this section is
treated as a negative adjustment on the
date the payment becomes fixed. If a
holder’s basis in a debt instrument is
less than the debt instrument’s adjusted
issue price, the amount allocated to a
projected payment under paragraph
(b)(9)(i) of this section is treated as a
positive adjustment on the date the
payment becomes fixed.
(F) Special rule for certain contingent interest payments. Notwithstanding paragraph (b)(9)(ii)(A) of this
section, this paragraph (b)(9)(ii)(F) applies to contingent stated interest payments that are adjusted to compensate
for contingencies regarding the reasonableness of the debt instrument’s stated
rate of interest. For example, this
paragraph (b)(9)(ii)(F) applies to a debt
instrument that provides for an increase
in the stated rate of interest if the credit
quality of the issuer or liquidity of the
debt instrument deteriorates. Contingent
stated interest payments of this type are
recognized over the period to which
they relate in a reasonable manner.
(G) Special rule when all contingent
payments become fixed. Notwithstanding paragraph (b)(9)(ii)(A) of this
section, if all the remaining contingent
payments on a debt instrument become
fixed substantially contemporaneously,
any positive or negative adjustments on
the instrument are taken into account in
a reasonable manner over the period to
which they relate. For purposes of the
preceding sentence, a payment is
treated as a fixed payment if all
remaining contingencies with respect to
the payment are remote or incidental
(within the meaning of §1.1275–2(h)).
(H) Example. The following example illustrates the provisions of this
paragraph (b)(9)(ii). In this example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example. Fixed but deferred payments—(i)
Facts. On December 31, 1996, B, a calendar year
taxpayer, purchases a debt instrument at original
issue for $1,000. The debt instrument matures on
December 31, 2002, and provides for a payment
of $1,000 at maturity. In addition, on December
31, 1999, and December 31, 2002, the debt
instrument provides for payments equal to the
excess of the average daily value of an index for
the 6-month period ending on September 30 of
the preceding year over a specified amount. The
debt instrument’s comparable yield is 10 percent,
compounded annually, and the instrument’s

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

(iii) Timing contingencies. This paragraph (b)(9)(iii) provides rules for debt
instruments that have payments that are
contingent as to time.
(A) Treatment of certain options. If
a taxpayer has an unconditional option
to put or call the debt instrument, to

25

exchange the debt instrument for other
property, or to extend the maturity date
of the debt instrument, the projected
payment schedule is determined by
using the principles of §1.1272–1(c)(5).
(B) Other timing contingencies.
[Reserved]
(iv) Cross-border transactions—(A)
Allocation of deductions. For purposes
of §1.861–8, the holder of a debt
instrument shall treat any deduction or
loss treated as an ordinary loss under
paragraph (b)(6)(iii)(B) or (b)(8)(ii) of
this section as a deduction that is
definitely related to the class of gross
income to which income from such
debt instrument belongs. Accordingly,
if a U.S. person holds a debt instrument issued by a related controlled
foreign corporation and, pursuant to
section 904(d)(3) and the regulations
thereunder, any interest accrued by
such U.S. person with respect to such
debt instrument would be treated as
foreign source general limitation income, any deductions relating to a net
negative adjustment will reduce the
U.S. person’s foreign source general
limitation income. The holder shall
apply the general rules relating to
allocation and apportionment of deductions to any other deduction or loss
realized by the holder with respect to
the debt instrument.
(B) Investments in United States real
property. Notwithstanding paragraph
(b)(8)(i) of this section, gain on the
sale, exchange, or retirement of a debt
instrument that is a United States real
property interest is treated as gain for
purposes of sections 897, 1445, and
6039C.
(v) Coordination with subchapter M
and related provisions. For purposes of
sections 852(c)(2) and 4982 and
§1.852–11, any positive adjustment,
negative adjustment, income, or loss on
a debt instrument that occurs after
October 31 of a taxable year is treated
in the same manner as foreign currency
gain or loss that is attributable to a
section 988 transaction.
(vi) Coordination with section 1092.
A holder treats a negative adjustment
and an issuer treats a positive adjustment as a loss with respect to a
position in a straddle if the debt
instrument is a position in a straddle
and the contingency (or any portion of
the contingency) to which the adjustment relates would be part of the
straddle if entered into as a separate
position.

(c) Method for debt instruments not
subject to the noncontingent bond
method—(1) Applicability. This paragraph (c) applies to a contingent
payment debt instrument (other than a
tax-exempt obligation) that has an issue
price determined under §1.1274–2. For
example, this paragraph (c) generally
applies to a contingent payment debt
instrument that is issued for nonpublicly traded property.
(2) Separation into components. If
paragraph (c) of this section applies to
a debt instrument (the overall debt
instrument), the noncontingent payments are subject to the rules in
paragraph (c)(3) of this section, and the
contingent payments are accounted for
separately under the rules in paragraph
(c)(4) of this section.
(3) Treatment of noncontingent payments. The noncontingent payments are
treated as a separate debt instrument.
The issue price of the separate debt
instrument is the issue price of the
overall debt instrument, determined
under §1.1274–2(g). No interest payments on the separate debt instrument
are qualified stated interest payments
(within the meaning of §1.1273–1(c))
and the de minimis rules of section
1273(a)(3) and §1.1273–1(d) do not
apply to the separate debt instrument.
(4) Treatment of contingent payments—(i) In general. Except as
provided in paragraph (c)(4)(iii) of this
section, the portion of a contingent
payment treated as interest under paragraph (c)(4)(ii) of this section is
includible in gross income by the
holder and deductible from gross income by the issuer in their respective
taxable years in which the payment is
made.
(ii) Characterization of contingent
payments as principal and interest—
(A) General rule. A contingent payment is treated as a payment of
principal in an amount equal to the
present value of the payment, determined by discounting the payment at
the test rate from the date the payment
is made to the issue date. The amount
of the payment in excess of the amount
treated as principal under the preceding
sentence is treated as a payment of
interest.
(B) Test rate. The test rate used for
purposes of paragraph (c)(4)(ii)(A) of
this section is the rate that would be
the test rate for the overall debt
instrument under §1.1274–4 if the term
of the overall debt instrument began on

the issue date of the overall debt
instrument and ended on the date the
contingent payment is made. However,
in the case of a contingent payment
that consists of a payment of stated
principal accompanied by a payment of
stated interest at a rate that exceeds the
test rate determined under the preceding sentence, the test rate is the stated
interest rate.
(iii) Certain delayed contingent
payments—(A) General rule. Notwithstanding paragraph (c)(4)(ii) of this
section, if a contingent payment becomes fixed more than 6 months before
the payment is due, the issuer and
holder are treated as if the issuer had
issued a separate debt instrument on
the date the payment becomes fixed,
maturing on the date the payment is
due. This separate debt instrument is
treated as a debt instrument to which
section 1274 applies. The stated principal amount of this separate debt
instrument is the amount of the payment that becomes fixed. An amount
equal to the issue price of this debt
instrument is characterized as interest
or principal under the rules of paragraph (c)(4)(ii) of this section and
accounted for as if this amount had
been paid by the issuer to the holder on
the date that the amount of the payment
becomes fixed. To determine the issue
price of the separate debt instrument,
the payment is discounted at the test
rate from the maturity date of the
separate debt instrument to the date
that the amount of the payment becomes fixed.
(B) Test rate. The test rate used for
purposes of paragraph (c)(4)(iii)(A) of
this section is determined in the same
manner as the test rate under paragraph
(c)(4)(ii)(B) of this section is determined except that the date the contingent payment is due is used rather
than the date the contingent payment is
made.
(5) Basis different from adjusted
issue price. This paragraph (c)(5)
provides rules for a holder whose basis
in a debt instrument is different from
the instrument’s adjusted issue price
(e.g., a subsequent holder). This paragraph (c)(5), however, does not apply
if the holder is reporting income under
the installment method of section 453.
(i) Allocation of basis. The holder
must allocate basis to the noncontingent component (i.e., the right to the
noncontingent payments) and to any
separate debt instruments described in

26

paragraph (c)(4)(iii) of this section in
an amount up to the total of the
adjusted issue price of the noncontingent component and the adjusted
issue prices of the separate debt instruments. The holder must allocate the
remaining basis, if any, to the contingent component (i.e., the right to the
contingent payments).
(ii) Noncontingent component. Any
difference between the holder’s basis in
the noncontingent component and the
adjusted issue price of the noncontingent component, and any difference
between the holder’s basis in a separate
debt instrument and the adjusted issue
price of the separate debt instrument, is
taken into account under the rules for
market discount, premium, and acquisition premium that apply to a noncontingent debt instrument.
(iii) Contingent component. Amounts
received by the holder that are treated
as principal payments under paragraph
(c)(4)(ii) of this section reduce the
holder’s basis in the contingent component. If the holder’s basis in the
contingent component is reduced to
zero, any additional principal payments
on the contingent component are
treated as gain from the sale or
exchange of the debt instrument. Any
basis remaining on the contingent
component on the date the final contingent payment is made increases the
holder’s adjusted basis in the noncontingent component (or, if there are no
remaining noncontingent payments, is
treated as loss from the sale or
exchange of the debt instrument).
(6) Treatment of a holder on sale,
exchange, or retirement. This paragraph (c)(6) provides rules for the
treatment of a holder on the sale,
exchange, or retirement of a debt
instrument subject to paragraph (c) of
this section. Under this paragraph
(c)(6), the holder must allocate the
amount received from the sale, exchange, or retirement of a debt instrument first to the noncontingent
component and to any separate debt
instruments described in paragraph
(c)(4)(iii) of this section in an amount
up to the total of the adjusted issue
price of the noncontingent component
and the adjusted issue prices of the
separate debt instruments. The holder
must allocate the remaining amount
received, if any, to the contingent
component.
(i) Amount allocated to the noncontingent component. The amount allo-

cated to the noncontingent component
and any separate debt instruments is
treated as an amount realized from the
sale, exchange, or retirement of the
noncontingent component or separate
debt instrument.
(ii) Amount allocated to the contingent component. The amount allocated to the contingent component is
treated as a contingent payment that is
made on the date of the sale, exchange,
or retirement and is characterized as
interest and principal under the rules of
paragraph (c)(4)(ii) of this section.
(7) Examples. The following examples illustrate the provisions of this
paragraph (c). In each example, assume
that the instrument described is a debt
instrument for federal income tax purposes. No inference is intended, however, as to whether the instrument is a
debt instrument for federal income tax
purposes.
Example 1. Contingent interest payments—(i)
Facts. A owns Blackacre, unencumbered depreciable real estate. On January 1, 1997, A sells
Blackacre to B. As consideration for the sale, B
makes a downpayment of $1,000,000 and issues
to A a debt instrument that matures on December
31, 2001. The debt instrument provides for a
payment of principal at maturity of $5,000,000
and a contingent payment of interest on December 31 of each year equal to a fixed percentage
of the gross rents B receives from Blackacre in
that year. Assume that the debt instrument is not
issued in a potentially abusive situation. Assume
also that on January 1, 1997, the short-term
applicable Federal rate is 5 percent, compounded
annually, and the mid-term applicable Federal
rate is 6 percent, compounded annually.
(ii) Determination of issue price. Under
§1.1274–2(g), the issue price of the debt
instrument is $3,736,291, which is the present
value, as of the issue date, of the $5,000,000
noncontingent payment due at maturity, calculated using a discount rate equal to the mid-term
applicable Federal rate. Under §1.1012–1(g)(1),
B’s basis in Blackacre on January 1, 1997, is
$4,736,291 ($1,000,000 down payment plus the
$3,736,291 issue price of the debt instrument).
(iii) Noncontingent payment treated as separate debt instrument. Under paragraph (c)(3) of
this section, the right to the noncontingent
payment of principal at maturity is treated as a
separate debt instrument. The issue price of this
separate debt instrument is $3,736,291 (the issue
price of the overall debt instrument). The
separate debt instrument has a stated redemption
price at maturity of $5,000,000 and, therefore,
OID of $1,263,709.
(iv) Treatment of contingent payments. Assume that the amount of contingent interest that
is fixed and paid on December 31, 1997, is
$200,000. Under paragraph (c)(4)(ii) of this
section, this payment is treated as consisting of a
payment of principal of $190,476, which is the
present value of the payment, determined by
discounting the payment at the test rate of 5
percent, compounded annually, from the date the
payment is made to the issue date. The
remainder of the $200,000 payment ($9,524) is

treated as interest. The additional amount treated
as principal gives B additional basis in Blackacre
on December 31, 1997. The portion of the payment treated as interest is includible in gross
income by A and deductible by B in their
respective taxable years in which December 31,
1997 occurs. The remaining contingent payments
on the debt instrument are accounted for
similarly, using a test rate of 5 percent,
compounded annually, for the contingent payments due on December 31, 1998, and December
31, 1999, and a test rate of 6 percent,
compounded annually, for the contingent payments due on December 31, 2000, and December
31, 2001.
Example 2. Fixed but deferred payment—(i)
Facts. The facts are the same as in paragraph
(c)(7) Example 1 of this section, except that the
contingent payment of interest that is fixed on
December 31, 1997, is not payable until December 31, 2001, the maturity date.
(ii) Treatment of deferred contingent payment.
Assume that the amount of the payment that
becomes fixed on December 31, 1997, is
$200,000. Because this amount is not payable
until December 31, 2001, under paragraph
(c)(4)(iii) of this section, a separate debt
instrument to which section 1274 applies is
treated as issued by B on December 31, 1997
(the date the payment is fixed). The maturity
date of this separate debt instrument is December
31, 2001 (the date on which the payment is due).
The stated principal amount of this separate debt
instrument is $200,000, the amount of the
payment that becomes fixed. The imputed
principal amount of the separate debt instrument
is $158,419, which is the present value, as of
December 31, 1997, of the $200,000 payment,
computed using a discount rate equal to the test
rate of the overall debt instrument (6 percent,
compounded annually). An amount equal to the
issue price of the separate debt instrument is
treated as an amount paid on December 31,
1997, and characterized as interest and principal
under the rules of paragraph (c)(4)(ii) of this
section. The amount of the deemed payment
characterized as principal is equal to $150,875,
which is the present value, as of January 1, 1997
(the issue date of the overall debt instrument), of
the deemed payment, computed using a discount
rate of 5 percent, compounded annually. The
amount of the deemed payment characterized as
interest is $7,544 ($158,419 – $150,875), which
is includible in gross income by A and
deductible by B in their respective taxable years
in which December 31, 1997 occurs.

(d) Rules for tax-exempt
obligations—(1) In general. Except as
modified by this paragraph (d), the
noncontingent bond method described
in paragraph (b) of this section applies
to a tax-exempt obligation (as defined
in section 1275(a)(3)) to which this
section applies. Paragraph (d)(2) of this
section applies to certain tax-exempt
obligations that provide for interestbased payments or revenue-based payments and paragraph (d)(3) of this
section applies to all other obligations.
Paragraph (d)(4) of this section provides rules for a holder whose basis in
a tax-exempt obligation is different
from the adjusted issue price of the
obligation.

27

(2) Certain tax-exempt obligations
with interest-based or revenue-based
payments—(i) Applicability. This paragraph (d)(2) applies to a tax-exempt
obligation that provides for interestbased payments or revenue-based
payments.
(ii) Interest-based payments. A taxexempt obligation provides for interestbased payments if the obligation would
otherwise qualify as a variable rate
debt instrument under §1.1275–5 except that—
(A) The obligation provides for
more than one fixed rate;
(B) The obligation provides for one
or more caps, floors, or governors (or
similar restrictions) that are fixed as of
the issue date;
(C) The interest on the obligation is
not compounded or paid at least
annually; or
(D) The obligation provides for interest at one or more rates equal to the
product of a qualified floating rate and
a fixed multiple greater than zero and
less than .65, or at one or more rates
equal to the product of a qualified
floating rate and a fixed multiple
greater than zero and less than .65,
increased or decreased by a fixed rate.
(iii) Revenue-based payments. A taxexempt obligation provides for
revenue-based payments if the
obligation—
(A) Is issued to refinance (including
a series of refinancings) an obligation
(in a series of refinancings, the original
obligation), the proceeds of which were
used to finance a project or enterprise;
and
(B) Would otherwise qualify as a
variable rate debt instrument under
§1.1275–5 except that it provides for
stated interest payments at least annually based on a single fixed percentage of the revenue, value, change in
value, or other similar measure of the
performance of the refinanced project
or enterprise.
(iv) Modifications to the noncontingent bond method. If a tax-exempt
obligation is subject to this paragraph
(d)(2), the following modifications to
the noncontingent bond method described in paragraph (b) of this section
apply to the obligation.
(A) Daily portions and net positive
adjustments. The daily portions of
interest determined under paragraph
(b)(3)(iii) of this section and any net
positive adjustment on the obligation
are interest for purposes of section 103.

(B) Net negative adjustments. A net
negative adjustment for a taxable year
reduces the amount of tax-exempt
interest the holder would otherwise
account for on the obligation for the
taxable year under paragraph (b)(3)(iii)
of this section. If the net negative
adjustment exceeds this amount, the
excess is a nondeductible, noncapitalizable loss. If a regulated investment
company (RIC) within the meaning of
section 851 has a net negative adjustment in a taxable year that would be a
nondeductible, noncapitalizable loss under the prior sentence, the RIC must
use this loss to reduce its tax-exempt
interest income on other tax-exempt
obligations held during the taxable
year.
(C) Gains. Any gain recognized on
the sale, exchange, or retirement of the
obligation is gain from the sale or
exchange of the obligation.
(D) Losses. Any loss recognized on
the sale, exchange, or retirement of the
obligation is treated the same as a net
negative adjustment under paragraph
(d)(2)(iv)(B) of this section.
(E) Special rule for losses and net
negative adjustments. Notwithstanding
paragraphs (d)(2)(iv)(B) and (D) of this
section, on the sale, exchange, or
retirement of the obligation, the holder
may claim a loss from the sale or
exchange of the obligation to the extent
the holder has not received in cash or
property the sum of its original investment in the obligation and any amounts
included in income under paragraph
(d)(4)(ii) of this section.
(3) All other tax-exempt
obligations—(i) Applicability. This
paragraph (d)(3) applies to a taxexempt obligation that is not subject to
paragraph (d)(2) of this section.
(ii) Modifications to the noncontingent bond method. If a tax-exempt
obligation is subject to this paragraph
(d)(3), the following modifications to
the noncontingent bond method described in paragraph (b) of this section
apply to the obligation.
(A) Modification to projected payment schedule. The comparable yield
for the obligation is the greater of the
obligation’s yield, determined without
regard to the contingent payments, and
the tax-exempt applicable Federal rate
that applies to the obligation. The
Internal Revenue Service publishes the
tax-exempt applicable Federal rate for
each month in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii) of this
chapter).

(B) Daily portions. The daily portions of interest determined under
paragraph (b)(3)(iii) of this section are
interest for purposes of section 103.
(C) Adjustments. A net positive adjustment on the obligation is treated as
gain to the holder from the sale or
exchange of the obligation in the
taxable year of the adjustment. A net
negative adjustment on the obligation is
treated as a loss to the holder from the
sale or exchange of the obligation in
the taxable year of the adjustment.
(D) Gains and losses. Any gain or
loss recognized on the sale, exchange,
or retirement of the obligation is gain
or loss from the sale or exchange of the
obligation.
(4) Basis different from adjusted
issue price. This paragraph (d)(4)
provides rules for a holder whose basis
in a tax-exempt obligation is different
from the adjusted issue price of the
obligation. The rules of paragraph
(b)(9)(i) of this section do not apply to
tax-exempt obligations.
(i) Basis greater than adjusted issue
price. If the holder’s basis in the
obligation exceeds the obligation’s adjusted issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis
over the remaining term of the obligation. The amount allocated to a daily
portion of interest is not deductible by
the holder. However, the holder’s basis
in the obligation is reduced by the
amount allocated to a daily portion of
interest on the date the daily portion
accrues.
(ii) Basis less than adjusted issue
price. If the holder’s basis in the
obligation is less than the obligation’s
adjusted issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis
over the remaining term of the obligation. The amount allocated to a daily
portion of interest is includible in
income by the holder as ordinary
income on the date the daily portion
accrues. The holder’s adjusted basis in
the obligation is increased by the
amount includible in income by the
holder under this paragraph (d)(4)(ii)
on the date the daily portion accrues.
(iii) Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1276, and 1288 do not apply. Other
rules of those sections continue to
apply to the extent relevant.

28

(e) Amounts treated as interest under this section. Amounts treated as
interest under this section are treated as
OID for all purposes of the Internal
Revenue Code.
(f) Effective date. This section applies to debt instruments issued on or
after August 13, 1996.
Par. 16. Section 1.1275–5 is
amended by:
1. Revising paragraph (a)(1).
2. Removing the language ‘‘The
debt instrument must provide for stated
interest’’ from the introductory language of paragraph (a)(3)(i) and adding
the language ‘‘The debt instrument
must not provide for any stated interest
other than stated interest’’ in its place.
3. Removing the language ‘‘less
than 1 year’’ from the first sentence of
paragraph (a)(3)(ii) and adding the
language ‘‘1 year or less’’ in its place.
4. Adding paragraphs (a)(5) and
(a)(6).
5. Revising paragraph (b)(2).
6. Revising paragraphs (c)(1) and
(c)(5).
7. Removing the language ‘‘cost of
newly borrowed funds’’ from paragraph (c)(3)(ii) and adding the language ‘‘qualified floating rate’’ in its
place.
8. Revising paragraph (d) introductory text; revising Examples 4 through
9; and adding Example 10.
9. Revising paragraph (e)(2).
10. Revising paragraph (e)(3)(v) introductory text; revising Example 3 (ii);
and removing Example 3 (iii).
The revisions and additions read as
follows:
§1.1275–5 Variable rate debt
instruments.
(a) Applicability—(1) In general.
This section provides rules for variable
rate debt instruments. Except as
provided in paragraph (a)(6) of this
section, a variable rate debt instrument
is a debt instrument that meets the
conditions described in paragraphs
(a)(2), (3), (4), and (5) of this section.
If a debt instrument that provides for a
variable rate of interest does not
qualify as a variable rate debt instrument, the debt instrument is a contingent payment debt instrument. See
§1.1275–4 for the treatment of a
contingent payment debt instrument.
See §1.1275–6 for a taxpayer’s treat-

ment of a variable rate debt instrument
and a hedge.
*

*

*

*

*

*

(5) No contingent principal payments. Except as provided in paragraph
(a)(2) of this section, the debt instrument must not provide for any principal payments that are contingent
(within the meaning of §1.1275–4(a)).
(6) Special rule for debt instruments
issued for nonpublicly traded property.
A debt instrument (other than a taxexempt obligation) that would otherwise qualify as a variable rate debt
instrument under this section is not a
variable rate debt instrument if section
1274 applies to the instrument and any
stated interest payments on the instrument are treated as contingent payments under §1.1274–2. This paragraph
(a)(6) applies to debt instruments
issued on or after August 13, 1996.
(b) * * *
(2) Certain rates based on a
qualified floating rate. For a debt
instrument issued on or after August
13, 1996, a variable rate is a qualified
floating rate if it is equal to either—
(i) The product of a qualified floating rate described in paragraph (b)(1)
of this section and a fixed multiple that
is greater than .65 but not more than
1.35; or
(ii) The product of a qualified floating rate described in paragraph (b)(1)
of this section and a fixed multiple that
is greater than .65 but not more than
1.35, increased or decreased by a fixed
rate.
*

*

*

*

*

*

(c) Objective rate—(1) Definition—
(i) In general. For debt instruments
issued on or after August 13, 1996, an
objective rate is a rate (other than a
qualified floating rate) that is determined using a single fixed formula and
that is based on objective financial or
economic information. For example, an
objective rate generally includes a rate
that is based on one or more qualified
floating rates or on the yield of actively
traded personal property (within the
meaning of section 1092(d)(1)).
(ii) Exception. For purposes of paragraph (c)(1)(i) of this section, an
objective rate does not include a rate
based on information that is within the
control of the issuer (or a related party
within the meaning of section 267(b) or
707(b)(1)) or that is unique to the

circumstances of the issuer (or a related
party within the meaning of section
267(b) or 707(b)(1)), such as dividends,
profits, or the value of the issuer’s
stock. However, a rate does not fail to
be an objective rate merely because it
is based on the credit quality of the
issuer.
* * * * * *
(5) Tax-exempt obligations. Notwithstanding paragraph (c)(1) of this section, in the case of a tax-exempt
obligation (within the meaning of section 1275(a)(3)), a variable rate is an
objective rate only if it is a qualified
inverse floating rate or a qualified
inflation rate. A rate is a qualified
inflation rate if the rate measures
contemporaneous changes in inflation
based on a general inflation index.
(d) Examples. The following examples illustrate the rules of paragraphs
(b) and (c) of this section. For purposes
of these examples, assume that the debt
instrument is not a tax-exempt obligation. In addition, unless otherwise
provided, assume that the rate is not
reasonably expected to result in a
significant front-loading or backloading of interest and that the rate is
not based on objective financial or
economic information that is within the
control of the issuer (or a related party)
or that is unique to the circumstances
of the issuer (or a related party).
* * * * * *
Example 4. Rate based on changes in the
value of a commodity index. On January 1, 1997,
X issues a debt instrument that provides for
annual interest payments at the end of each year
at a rate equal to the percentage increase, if any,
in the value of an index for the year immediately
preceding the payment. The index is based on
the prices of several actively traded commodities.
Variations in the value of this interest rate cannot
reasonably be expected to measure contemporaneous variations in the cost of newly borrowed
funds. Accordingly, the rate is not a qualified
floating rate. However, because the rate is based
on objective financial information using a single
fixed formula, the rate is an objective rate.
Example 5. Rate based on a percentage of
S&P 500 Index. On January 1, 1997, X issues a
debt instrument that provides for annual interest
payments at the end of each year based on a
fixed percentage of the value of the S&P 500
Index. Variations in the value of this interest rate
cannot reasonably be expected to measure
contemporaneous variations in the cost of newly
borrowed funds and, therefore, the rate is not a
qualified floating rate. Although the rate is
described in paragraph (c)(1)(i) of this section,
the rate is not an objective rate because, based
on historical data, it is reasonably expected that
the average value of the rate during the first half
of the instrument’s term will be significantly less
than the average value of the rate during the
final half of the instrument’s term.

29

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

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

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

*

*

*

*

*

Example 3. * * *
(ii) Accrual of OID and qualified stated
interest. Under paragraph (e)(2) of this section,
the variable rate debt instrument is treated as a
2-year debt instrument that has an issue price of
$90,000, a stated principal amount of $100,000,
and interest payments of $5,000 at the end of
each year. The debt instrument has $10,000 of
OID and the annual interest payments of $5,000
are qualified stated interest payments. Under
§1.1272–1, the debt instrument has a yield of
10.82 percent, compounded annually. The
amount of OID allocable to the first annual
accrual period (assuming Z uses annual accrual
periods) is $4,743.25 (($90,000 ⫻ .1082) –
$5,000), and the amount of OID allocable to the
second annual accrual period is $5,256.75
($100,000 – $94,743.25). Under paragraph
(e)(2)(iii) of this section, the $2,000 difference
between the $7,000 interest payment actually
made at maturity and the $5,000 interest payment
assumed to be made at maturity under the
equivalent fixed rate debt instrument is treated as
additional qualified stated interest for the period.

*

*

*

*

*

*

Par. 17. Section 1.1275–6 is added to
read as follows:
§1.1275–6 Integration of qualifying
debt instruments.
(a) In general. This section generally
provides for the integration of a
qualifying debt instrument with a hedge
or combination of hedges if the combined cash flows of the components are
substantially equivalent to the cash
flows on a fixed or variable rate debt
instrument. The integrated transaction
is generally subject to the rules of this
section rather than the rules to which
each component of the transaction
would be subject on a separate basis.
The purpose of this section is to permit
a more appropriate determination of the
character and timing of income, deductions, gains, or losses than would be
permitted by separate treatment of the
components. The rules of this section
affect only the taxpayer who holds (or
issues) the qualifying debt instrument
and enters into the hedge.
(b) Definitions—(1) Qualifying debt
instrument. A qualifying debt instrument is any debt instrument (including
an integrated transaction as defined in
paragraph (c) of this section) other
than—
(i) A tax-exempt obligation as defined in section 1275(a)(3);
(ii) A debt instrument to which
section 1272(a)(6) applies (certain interests in or mortgages held by a
REMIC, and certain other debt instruments with payments subject to acceleration); or
(iii) A debt instrument that is subject
to §1.483–4 or §1.1275–4(c) (certain
contingent payment debt instruments
issued for nonpublicly traded property).
(2) Section 1.1275–6 hedge—(i) In
general. A §1.1275–6 hedge is any
financial instrument (as defined in
paragraph (b)(3) of this section) if the
combined cash flows of the financial
instrument and the qualifying debt
instrument permit the calculation of a
yield to maturity (under the principles
of section 1272), or the right to the
combined cash flows would qualify
under §1.1275–5 as a variable rate debt
instrument that pays interest at a
qualified floating rate or rates (except
for the requirement that the interest
payments be stated as interest). A
financial instrument is not a §1.1275–6

30

hedge, however, if the resulting synthetic debt instrument does not have
the same term as the remaining term of
the qualifying debt instrument. A financial instrument that hedges currency
risk is not a §1.1275–6 hedge.
(ii) Limitations—(A) A debt instrument issued by a taxpayer and a debt
instrument held by the taxpayer cannot
be part of the same integrated
transaction.
(B) A debt instrument can be a
§1.1275–6 hedge only if it is issued
substantially contemporaneously with,
and has the same maturity (including
rights to accelerate or delay payments)
as, the qualifying debt instrument.
(3) Financial instrument. For purposes of this section, a financial
instrument is a spot, forward, or futures
contract, an option, a notional principal
contract, a debt instrument, or a similar
instrument, or combination or series of
financial instruments. Stock is not a
financial instrument for purposes of
this section.
(4) Synthetic debt instrument. The
synthetic debt instrument is the hypothetical debt instrument with the same
cash flows as the combined cash flows
of the qualifying debt instrument and
the §1.1275–6 hedge.
(c) Integrated transaction—(1) Integration by taxpayer. Except as otherwise provided in this section, a qualifying debt instrument and a §1.1275–6
hedge are an integrated transaction if
all of the following requirements are
satisfied:
(i) The taxpayer satisfies the identification requirements of paragraph (e)
of this section on or before the date the
taxpayer enters into the §1.1275–6
hedge.
(ii) None of the parties to the
§1.1275–6 hedge are related within the
meaning of section 267(b) or 707(b)(1),
or, if the parties are related, the party
providing the hedge uses, for federal
income tax purposes, a mark-to-market
method of accounting for the hedge and
all similar or related transactions.
(iii) Both the qualifying debt instrument and the §1.1275–6 hedge are
entered into by the same individual,
partnership, trust, estate, or corporation
(regardless of whether the corporation
is a member of an affiliated group of
corporations that files a consolidated
return).
(iv) If the taxpayer is a foreign
person engaged in a U.S. trade or

business and the taxpayer issues or
acquires a qualifying debt instrument,
or enters into a §1.1275–6 hedge,
through the trade or business, all items
of income and expense associated with
the qualifying debt instrument and the
§1.1275–6 hedge (other than interest
expense that is subject to §1.882–5)
would have been effectively connected
with the U.S. trade or business
throughout the term of the qualifying
debt instrument had this section not
applied.
(v) Neither the qualifying debt instrument, nor any other debt instrument
that is part of the same issue as the
qualifying debt instrument, nor the
§1.1275–6 hedge was, with respect to
the taxpayer, part of an integrated
transaction that was terminated or
otherwise legged out of within the 30
days immediately preceding the date
that would be the issue date of the
synthetic debt instrument.
(vi) The qualifying debt instrument
is issued or acquired by the taxpayer
on or before the date of the first
payment on the §1.1275–6 hedge,
whether made or received by the
taxpayer (including a payment made to
purchase the hedge). If the qualifying
debt instrument is issued or acquired
by the taxpayer after, but substantially
contemporaneously with, the date of
the first payment on the §1.1275–6
hedge, the qualifying debt instrument is
treated, solely for purposes of this
paragraph (c)(1)(vi), as meeting the
requirements of the preceding sentence.
(vii) Neither the §1.1275–6 hedge
nor the qualifying debt instrument was,
with respect to the taxpayer, part of a
straddle (as defined in section 1092(c))
prior to the issue date of the synthetic
debt instrument.
(2) Integration by Commissioner.
The Commissioner may treat a qualifying debt instrument and a financial
instrument (whether entered into by the
taxpayer or by a related party) as an
integrated transaction if the combined
cash flows on the qualifying debt
instrument and financial instrument are
substantially the same as the combined
cash flows required for the financial
instrument to be a §1.1275–6 hedge.
The Commissioner, however, may not
integrate a transaction unless the
qualifying debt instrument either is
subject to §1.1275–4 or is subject to
§1.1275–5 and pays interest at an
objective rate. The circumstances under
which the Commissioner may require

integration include, but are not limited
to, the following:
(i) A taxpayer fails to identify a
qualifying debt instrument and the
§1.1275–6 hedge under paragraph (e)
of this section.
(ii) A taxpayer issues or acquires a
qualifying debt instrument and a related
party (within the meaning of section
267(b) or 707(b)(1)) enters into the
§1.1275–6 hedge.
(iii) A taxpayer issues or acquires a
qualifying debt instrument and enters
into the §1.1275–6 hedge with a related
party (within the meaning of section
267(b) or 707(b)(1)).
(iv) The taxpayer legs out of an
integrated transaction and within 30
days enters into a new §1.1275–6
hedge with respect to the same qualifying debt instrument or another debt
instrument that is part of the same
issue.
(d) Special rules for legging into
and legging out of an integrated
transaction—(1) Legging into—(i) Definition. Legging into an integrated
transaction under this section means
that a §1.1275–6 hedge is entered into
after the date the qualifying debt
instrument is issued or acquired by the
taxpayer, and the requirements of paragraph (c)(1) of this section are satisfied
on the date the §1.1275–6 hedge is
entered into (the leg-in date).
(ii) Treatment. If a taxpayer legs
into an integrated transaction, the taxpayer treats the qualifying debt instrument under the applicable rules for
taking interest and OID into account up
to the leg-in date, except that the day
before the leg-in date is treated as the
end of an accrual period. As of the legin date, the qualifying debt instrument
is subject to the rules of paragraph (f)
of this section.
(iii) Anti-abuse rule. If a taxpayer
legs into an integrated transaction with
a principal purpose of deferring or
accelerating income or deductions on
the qualifying debt instrument, the
Commissioner may—
(A) Treat the qualifying debt instrument as sold for its fair market value
on the leg-in date; or
(B) Refuse to allow the taxpayer to
integrate the qualifying debt instrument
and the §1.1275–6 hedge.
(2) Legging out—(i) Definition—(A)
Legging out if the taxpayer has integrated. If a taxpayer has integrated a
qualifying debt instrument and a

31

§1.1275–6 hedge under paragraph
(c)(1) of this section, legging out
means that, prior to the maturity of the
synthetic debt instrument, the §1.1275–
6 hedge ceases to meet the requirements for a §1.1275–6 hedge, the
taxpayer fails to meet any requirement
of paragraph (c)(1) of this section, or
the taxpayer disposes of or otherwise
terminates all or a part of the qualifying debt instrument or §1.1275–6
hedge. If the taxpayer fails to meet the
requirements of paragraph (c)(1) of this
section but meets the requirements of
paragraph (c)(2) of this section, the
Commissioner may treat the taxpayer
as not legging out.
(B) Legging out if the Commissioner
has integrated. If the Commissioner
has integrated a qualifying debt instrument and a financial instrument under
paragraph (c)(2) of this section, legging
out means that, prior to the maturity of
the synthetic debt instrument, the requirements for Commissioner integration under paragraph (c)(2) of this
section are not met or the taxpayer fails
to meet the requirements for taxpayer
integration under paragraph (c)(1) of
this section and the Commissioner
agrees to allow the taxpayer to be
treated as legging out.
(C) Exception for certain nonrecognition transactions. If, in a single
nonrecognition transaction, a taxpayer
disposes of, or ceases to be primarily
liable on, the qualifying debt instrument and the §1.1275–6 hedge, the
taxpayer is not treated as legging out.
Instead, the integrated transaction is
treated under the rules governing the
nonrecognition transaction. For example, if a holder of an integrated
transaction is acquired in a reorganization under section 368(a)(1)(A), the
holder is treated as disposing of the
synthetic debt instrument in the reorganization rather than legging out. If the
successor holder is not eligible for
integrated treatment, the successor is
treated as legging out.
(ii) Operating rules. If a taxpayer
legs out (or is treated as legging out) of
an integrated transaction, the following
rules apply:
(A) The transaction is treated as an
integrated transaction during the time
the requirements of paragraph (c)(1) or
(2) of this section, as appropriate, are
satisfied.
(B) Immediately before the taxpayer
legs out, the taxpayer is treated as
selling or otherwise terminating the

synthetic debt instrument for its fair
market value and, except as provided in
paragraph (d)(2)(ii)(D) of this section,
any income, deduction, gain, or loss is
realized and recognized at that time.
(C) If, immediately after the taxpayer legs out, the taxpayer holds or
remains primarily liable on the qualifying debt instrument, adjustments are
made to reflect any difference between
the fair market value of the qualifying
debt instrument and the adjusted issue
price of the qualifying debt instrument.
If, immediately after the taxpayer legs
out, the taxpayer is a party to a
§1.1275–6 hedge, the §1.1275–6 hedge
is treated as entered into at its fair
market value.
(D) If a taxpayer legs out of an
integrated transaction by disposing of
or otherwise terminating a §1.1275–6
hedge within 30 days of legging into
the integrated transaction, then any loss
or deduction determined under paragraph (d)(2)(ii)(B) of this section is not
allowed. Appropriate adjustments are
made to the qualifying debt instrument
for any disallowed loss. The adjustments are taken into account on a yield
to maturity basis over the remaining
term of the qualifying debt instrument.
(E) If a holder of a debt instrument
subject to §1.1275–4 legs into an
integrated transaction with respect to
the instrument and subsequently legs
out of the integrated transaction, any
gain recognized under paragraph (d)(2)(ii)(B) or (C) of this section is treated
as interest income to the extent determined under the principles of §1.1275–
4(b)(8)(iii)(B) (rules for determining
the character of gain on the sale of a
debt instrument all of the payments on
which have been fixed). If the synthetic
debt instrument would qualify as a
variable rate debt instrument, the
equivalent fixed rate debt instrument
determined under §1.1275–5(e) is used
for this purpose.
(e) Identification requirements. For
each integrated transaction, a taxpayer
must enter and retain as part of its
books and records the following
information—
(1) The date the qualifying debt
instrument was issued or acquired (or
is expected to be issued or acquired) by
the taxpayer and the date the §1.1275–
6 hedge was entered into by the
taxpayer;
(2) A description of the qualifying
debt instrument and the §1.1275–6
hedge; and

(3) A summary of the cash flows
and accruals resulting from treating the
qualifying debt instrument and the
§1.1275–6 hedge as an integrated transaction (i.e., the cash flows and accruals
on the synthetic debt instrument).
(f) Taxation of integrated transactions—(1) General rule. An integrated transaction is generally treated
as a single transaction by the taxpayer
during the period that the transaction
qualifies as an integrated transaction.
Except as provided in paragraph (f)(12)
of this section, while a qualifying debt
instrument and a §1.1275–6 hedge are
part of an integrated transaction, neither the qualifying debt instrument nor
the §1.1275–6 hedge is subject to the
rules that would apply on a separate
basis to the debt instrument and the
§1.1275–6 hedge, including section
1092 or §1.446–4. The rules that would
govern the treatment of the synthetic
debt instrument generally govern the
treatment of the integrated transaction.
For example, the integrated transaction
may be subject to section 263(g) or, if
the synthetic debt instrument would be
part of a straddle, section 1092. Generally, the synthetic debt instrument is
subject to sections 163(e) and 1271
through 1275, with terms as set forth in
paragraphs (f)(2) through (13) of this
section.
(2) Issue date. The issue date of the
synthetic debt instrument is the first
date on which the taxpayer entered into
all of the components of the synthetic
debt instrument.
(3) Term. The term of the synthetic
debt instrument is the period beginning
on the issue date of the synthetic debt
instrument and ending on the maturity
date of the qualifying debt instrument.
(4) Issue price. The issue price of
the synthetic debt instrument is the
adjusted issue price of the qualifying
debt instrument on the issue date of the
synthetic debt instrument. If, as a result
of entering into the §1.1275–6 hedge,
the taxpayer pays or receives one or
more payments that are substantially
contemporaneous with the issue date of
the synthetic debt instrument, the payments reduce or increase the issue price
as appropriate.
(5) Adjusted issue price. In general,
the adjusted issue price of the synthetic
debt instrument is determined under the
principles of §1.1275–1(b).
(6) Qualified stated interest. No
amounts payable on the synthetic debt
instrument are qualified stated interest
within the meaning of §1.1273–1(c).

32

(7) Stated redemption price at
maturity—(i) Synthetic debt instruments
that are borrowings. In general, if the
synthetic debt instrument is a borrowing, the instrument’s stated redemption
price at maturity is the sum of all
amounts paid or to be paid on the
qualifying debt instrument and the
§1.1275–6 hedge, reduced by any
amounts received or to be received on
the §1.1275–6 hedge.
(ii) Synthetic debt instruments that
are held by the taxpayer. In general, if
the synthetic debt instrument is held by
the taxpayer, the instrument’s stated
redemption price at maturity is the sum
of all amounts received or to be
received by the taxpayer on the
qualifying debt instrument and the
§1.1275–6 hedge, reduced by any
amounts paid or to be paid by the
taxpayer on the §1.1275–6 hedge.
(iii) Certain amounts ignored. For
purposes of this paragraph (f)(7), if an
amount paid or received on the
§1.1275–6 hedge is taken into account
under paragraph (f)(4) of this section to
determine the issue price of the synthetic debt instrument, the amount is
not taken into account to determine the
synthetic debt instrument’s stated redemption price at maturity.
(8) Source of interest income and
allocation of expense. The source of
interest income from the synthetic debt
instrument is determined by reference
to the source of income of the qualifying debt instrument under sections
861(a)(1) and 862(a)(1). For purposes
of section 904, the character of interest
from the synthetic debt instrument is
determined by reference to the character of the interest income from the
qualifying debt instrument. Interest expense is allocated and apportioned
under regulations under section 861 or
under §1.882–5.
(9) Effectively connected income. If
the requirements of paragraph (c)(1)(iv)
of this section are satisfied, any interest
income resulting from the synthetic
debt instrument entered into by the
foreign person is treated as effectively
connected with a U.S. trade or business, and any interest expense resulting
from the synthetic debt instrument
entered into by the foreign person is
allocated and apportioned under
§1.882–5.
(10) Not a short-term obligation. For
purposes of section 1272(a)(2)(C), a
synthetic debt instrument is not treated
as a short-term obligation.

(11) Special rules in the event of
integration by the Commissioner. If the
Commissioner requires integration, appropriate adjustments are made to the
treatment of the synthetic debt instrument, and, if necessary, the qualifying
debt instrument and financial instrument. For example, the Commissioner
may treat a financial instrument that is
not a §1.1275–6 hedge as a §1.1275–6
hedge when applying the rules of this
section. The issue date of the synthetic
debt instrument is the date determined
appropriate by the Commissioner to
require integration.
(12) Retention of separate transaction rules for certain purposes. This
paragraph (f)(12) provides for the
retention of separate transaction rules
for certain purposes. In addition, by
publication in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii) of this
chapter), the Commissioner may require use of separate transaction rules
for any aspect of an integrated
transaction.
(i) Foreign persons that enter into
integrated transactions giving rise to
U.S. source income not effectively
connected with a U.S. trade or business. If a foreign person enters into an
integrated transaction that gives rise to
U.S. source interest income (determined under the source rules for the
synthetic debt instrument) not effectively connected with a U.S. trade or
business of the foreign person, paragraph (f) of this section does not apply
for purposes of sections 871(a), 881,
1441, 1442, and 6049. These sections
of the Internal Revenue Code are
applied to the qualifying debt instrument and the §1.1275–6 hedge on a
separate basis.
(ii) Relationship between taxpayer
and other persons. Because the rules of
this section affect only the taxpayer
that enters into an integrated transaction (i.e., either the issuer or a particular holder of a qualifying debt instrument), any provisions of the Internal
Revenue Code or regulations that
govern the relationship between the
taxpayer and any other person are
applied on a separate basis. For example, taxpayers must comply with any
reporting or disclosure requirements on
any qualifying debt instrument as if it
were not part of an integrated transaction. Thus, if required under §1.1275–
4(b)(4), an issuer of a contingent
payment debt instrument subject to
integrated treatment must provide the
projected payment schedule to holders.

Similarly, if a U.S. corporation enters
into an integrated transaction that includes a notional principal contract, the
source of any payment received by the
counterparty on the notional principal
contract is determined under §1.863–7
as if the contract were not part of an
integrated transaction, and, if received
by a foreign person who is not engaged
in a U.S. trade or business, the
payment is non-U.S. source income
that is not subject to U.S. withholding
tax.
(13) Coordination with consolidated
return rules. If a taxpayer enters into a
§1.1275–6 hedge with a member of the
same consolidated group (the counterparty) and the §1.1275–6 hedge is part
of an integrated transaction for the
taxpayer, the §1.1275–6 hedge is not
treated as an intercompany transaction
for purposes of §1.1502–13. If the
taxpayer legs out of integrated treatment, the taxpayer and the counterparty
are each treated as disposing of its
position in the §1.1275–6 hedge under
the principles of paragraph (d)(2) of
this section. If the §1.1275–6 hedge
remains in existence after the leg-out
date, the §1.1275–6 hedge is treated
under the rules that would otherwise
apply to the transaction (including
§1.1502–13 if the transaction is between members).
(g) Predecessors and successors. For
purposes of this section, any reference
to a taxpayer, holder, issuer, or person
includes, where appropriate, a reference
to a predecessor or successor. For
purposes of the preceding sentence, a
predecessor is a transferor of an asset
or liability (including an integrated
transaction) to a transferee (the successor) in a nonrecognition transaction.
Appropriate adjustments, if necessary,
are made in the application of this
section to predecessors and successors.
(h) Examples. The following examples illustrate the provisions of this
section. In each example, assume that
the qualifying debt instrument is a debt
instrument for federal income tax purposes. No inference is intended, however, as to whether the debt instrument
is a debt instrument for federal income
tax purposes.
Example 1. Issuer hedge—(i) Facts. On
January 1, 1997, V, a domestic corporation,
issues a 5-year debt instrument for $1,000. The
debt instrument provides for annual payments of
interest at a rate equal to the value of 1-year
LIBOR and a principal payment of $1,000 at
maturity. On the same day, V enters into a
5-year interest rate swap agreement with an

33

unrelated party. Under the swap, V pays 6
percent and receives 1-year LIBOR on a notional
principal amount of $1,000. The payments on the
swap are fixed and made on the same days as the
payments on the debt instrument. On January 1,
1997, V identifies the debt instrument and the
swap as an integrated transaction in accordance
with the requirements of paragraph (e) of this
section.
(ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The swap is
a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the swap and the debt
instrument can be calculated. V has met the
identification requirements, and the other requirements of paragraph (c)(1) of this section are
satisfied. Therefore, the transaction is an integrated transaction under this section.
(iii) Treatment of the synthetic debt instrument. The synthetic debt instrument is a 5-year
debt instrument that has an issue price of $1,000
and provides for annual interest payments of $60
and a principal payment of $1,000 at maturity.
Under paragraph (f)(6) of this section, no
amounts payable on the synthetic debt instrument
are qualified stated interest. Thus, under paragraph (f)(7)(i) of this section, the synthetic debt
instrument has a stated redemption price at
maturity of $1,300 (the sum of all amounts to be
paid on the qualifying debt instrument and the
swap, reduced by amounts to be received on the
swap). The synthetic debt instrument, therefore,
has $300 of OID.
Example 2. Issuer hedge with an option—(i)
Facts. On December 31, 1996, W, a domestic
corporation, issues for $1,000 a debt instrument
that matures on December 31, 1999. The debt
instrument has a stated principal amount of
$1,000 payable at maturity. The debt instrument
also provides for a payment at maturity equal to
$10 times the increase, if any, in the value of a
nationally known composite index of stocks from
December 31, 1996, to the maturity date. On
December 31, 1996, W purchases from an
unrelated party an option that pays $10 times the
increase, if any, in the stock index from
December 31, 1996, to December 31, 1999. W
pays $250 for the option. On December 31,
1996, W identifies the debt instrument and
option as an integrated transaction in accordance
with the requirements of paragraph (e) of this
section.
(ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The option
is a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the option and the debt
instrument can be calculated. W has met the
identification requirements, and the other requirements of paragraph (c)(1) of this section are
satisfied. Therefore, the transaction is an integrated transaction under this section.
(iii) Treatment of the synthetic debt instrument. Under paragraph (f)(4) of this section, the
issue price of the synthetic debt instrument is
equal to the issue price of the debt instrument
($1,000) reduced by the payment for the option
($250). As a result, the synthetic debt instrument
is a 3-year debt instrument with an issue price of
$750. Under paragraph (f)(7) of this section, the
synthetic debt instrument has a stated redemption
price at maturity of $1,000 (the $250 payment
for the option is not taken into account). The
synthetic debt instrument, therefore, has $250 of
OID.
Example 3. Hedge with prepaid swap—(i)
Facts. On January 1, 1997, H purchases for

£1,000 a 5-year debt instrument that provides for
semiannual payments based on 6-month pound
LIBOR and a payment of the £1,000 principal at
maturity. On the same day, H enters into a swap
with an unrelated third party under which H
receives semiannual payments, in pounds, of 10
percent, compounded semiannually, and makes
semiannual payments, in pounds, of 6-month
pound LIBOR on a notional principal amount of
£1,000. Payments on the swap are fixed and
made on the same dates as the payments on the
debt instrument. H also makes a £162 prepayment on the swap. On January 1, 1997, H
identifies the swap and the debt instrument as an
integrated transaction in accordance with the
requirements of paragraph (e) of this section.
(ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The swap is
a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the swap and the debt
instrument can be calculated. Although the debt
instrument is denominated in pounds, the swap
hedges only interest rate risk, not currency risk.
Therefore, the transaction is an integrated transaction under this section. See §1.988–5(a) for the
treatment of a debt instrument and a swap if the
swap hedges currency risk.
(iii) Treatment of the synthetic debt instrument. Under paragraph (f)(4) of this section, the
issue price of the synthetic debt instrument is
equal to the issue price of the debt instrument
(£1,000) increased by the prepayment on the
swap (£162). As a result, the synthetic debt
instrument is a 5-year debt instrument that has an
issue price of £1,162 and provides for semiannual interest payments of £50 and a principal
payment of £1,000 at maturity. Under paragraph
(f)(6) of this section, no amounts payable on the
synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(ii) of this
section, the synthetic debt instrument’s stated
redemption price at maturity is £1,500 (the sum
of all amounts to be received on the qualifying
debt instrument and the §1.1275–6 hedge,
reduced by all amounts to be paid on the
§1.1275–6 hedge other than the £162 prepayment
for the swap). The synthetic debt instrument,
therefore, has £338 of OID.
Example 4. Legging into an integrated transaction by a holder—(i) Facts. On December 31,
1996, X corporation purchases for $1,000,000 a
debt instrument that matures on December 31,
2006. The debt instrument provides for annual
payments of interest at the rate of 6 percent and
for a payment at maturity equal to $1,000,000,
increased by the excess, if any, of the price of
1,000 units of a commodity on December 31,
2006, over $350,000, and decreased by the
excess, if any, of $350,000 over the price of
1,000 units of the commodity on that date. The
projected amount of the payment at maturity
determined under §1.1275–4(b)(4) is $1,020,000.
On December 31, 1999, X enters into a cashsettled forward contract with an unrelated party
to sell 1,000 units of the commodity on
December 31, 2006, for $450,000. On December
31, 1999, X also identifies the debt instrument
and the forward contract as an integrated
transaction in accordance with the requirements
of paragraph (e) of this section.
(ii) Eligibility for integration. X meets the
requirements for integration as of December 31,
1999. Therefore, X legged into an integrated
transaction on that date. Prior to that date, X
treats the debt instrument under the applicable
rules of §1.1275–4.

(iii) Treatment of the synthetic debt instrument. As of December 31, 1999, the debt
instrument and the forward contract are treated
as an integrated transaction. The issue price of
the synthetic debt instrument is equal to the
adjusted issue price of the qualifying debt
instrument on the leg-in date, $1,004,804 (assuming one year accrual periods). The term of
the synthetic debt instrument is from December
31, 1999, to December 31, 2006. The synthetic
debt instrument provides for annual interest
payments of $60,000 and a principal payment at
maturity of $1,100,000 ($1,000,000 + $450,000 –
$350,000). Under paragraph (f)(6) of this section,
no amounts payable on the synthetic debt
instrument are qualified stated interest. Thus,
under paragraph (f)(7)(ii) of this section, the
synthetic debt instrument’s stated redemption
price at maturity is $1,520,000 (the sum of all
amounts to be received by X on the qualifying
debt instrument and the §1.1275–6 hedge,
reduced by all amounts to be paid by X on the
§1.1275–6 hedge). The synthetic debt instrument,
therefore, has $515,196 of OID.
Example 5. Abusive leg-in—(i) Facts. On
January 1, 1997, Y corporation purchases for
$1,000,000 a debt instrument that matures on
December 31, 2001. The debt instrument
provides for annual payments of interest at the
rate of 6 percent, a payment on December 31,
1999, of the increase, if any, in the price of a
commodity from January 1, 1997, to December
31, 1999, and a payment at maturity of
$1,000,000 and the increase, if any, in the price
of the commodity from December 31, 1999 to
maturity. Because the debt instrument is a
contingent payment debt instrument subject to
§1.1275–4, Y accrues interest based on the
projected payment schedule.
(ii) Leg-in. By late 1999, the price of the
commodity has substantially increased, and Y
expects a positive adjustment on December 31,
1999. In late 1999, Y enters into an agreement to
exchange the two commodity based payments on
the debt instrument for two payments on the
same dates of $100,000 each. Y identifies the
transaction as an integrated transaction in accordance with the requirements of paragraph (e) of
this section. Y disposes of the hedge in early
2000.
(iii) Treatment. The legging into an integrated
transaction has the effect of deferring the
positive adjustment from 1999 to 2000. Because
Y legged into the integrated transaction with a
principal purpose to defer the positive adjustment, the Commissioner may treat the debt
instrument as sold for its fair market value on
the leg-in date or refuse to allow integration.
Example 6. Integration of offsetting debt
instruments—(i) Facts. On January 1, 1997, Z
issues two 10-year debt instruments. The first,
Issue 1, has an issue price of $1,000, pays
interest annually at 6 percent, and, at maturity,
pays $1,000, increased by $1 times the increase,
if any, in the value of the S&P 100 Index over
the term of the instrument and reduced by $1
times the decrease, if any, in the value of the
S&P 100 Index over the term of the instrument.
However, the amount paid at maturity may not
be less than $500 or more than $1,500. The
second, Issue 2, has an issue price of $1,000,
pays interest annually at 8 percent, and, at
maturity, pays $1,000, reduced by $1 times the
increase, if any, in the value of the S&P 100
Index over the term of the instrument and
increased by $1 times the decrease, if any, in the
value of the S&P 100 Index over the term of the

34

instrument. The amount paid at maturity may not
be less than $500 or more than $1,500. On
January 1, 1997, Z identifies Issue 1 as the
qualifying debt instrument, Issue 2 as a §1.1275–
6 hedge, and otherwise meets the identification
requirements of paragraph (e) of this section.
(ii) Eligibility for integration. Both Issue 1
and Issue 2 are qualifying debt instruments. Z
has met the identification requirements by
identifying Issue 1 as the qualifying debt
instrument and Issue 2 as the §1.1275–6 hedge.
The other requirements of paragraph (c)(1) of
this section are satisfied. Therefore, the transaction is an integrated transaction under this
section.
(iii) Treatment of the synthetic debt instrument. The synthetic debt instrument has an issue
price of $2,000, provides for a payment at
maturity of $2,000, and, in addition, provides for
annual payments of $140. Under paragraph (f)(6)
of this section, no amounts payable on the
synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(i) of this
section, the synthetic debt instrument’s stated
redemption price at maturity is $3,400 (the sum
of all amounts to be paid on the qualifying debt
instrument and the §1.1275–6 hedge, reduced by
amounts to be received on the §1.1275–6 hedge
other than the $1,000 payment received on the
issue date). The synthetic debt instrument,
therefore, has $1,400 of OID.
Example 7. Integrated transaction entered into
by a foreign person—(i) Facts. X, a foreign
person, enters into an integrated transaction by
purchasing a qualifying debt instrument that pays
U.S. source interest and entering into a notional
principal contract with a U.S. corporation.
Neither the income from the qualifying debt
instrument nor the income from the notional
principal contract is effectively connected with a
U.S. trade or business. The notional principal
contract is a §1.1275–6 hedge.
(ii) Treatment of integrated transaction. Under
paragraph (f)(8) of this section, X will receive
U.S. source income from the integrated transaction. However, under paragraph (f)(12)(i) of this
section, the qualifying debt instrument and the
notional principal contract are treated as if they
are not part of an integrated transaction for
purposes of determining whether tax is due and
must be withheld on income. Accordingly,
because the §1.1275–6 hedge would produce
foreign source income under §1.863–7 to X if it
were not part of an integrated transaction, any
income on the §1.1275–6 hedge generally will
not be subject to tax under sections 871(a) and
881, and the U.S. corporation that is the
counterparty will not be required to withhold tax
on payments under the §1.1275–6 hedge under
sections 1441 and 1442.

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

by the taxpayer
temporaneously.

substantially

con-

PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 18. The authority citation for
part 602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 19. Section 602.101, paragraph
(c) is amended by:
1. Removing the following entries
from the table:
§602.101 OMB Control numbers.
*

*

*

*

*

*

(c) * * *
CFR part or section
where identified
and described
*

*

*

Current OMB
control number

*

*

*

1.1272–1(c)(4) . . . . . . . . . . . 1545–1353
*

*

*

*

*

*

1.1275–3(b) . . . . . . . . . . . . . 1545–1353
1.1275–3(c) . . . . . . . . . . . . . 1545–0887
*

*

*

*

*

*

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

*

*

*

*

*

(c) * * *
CFR part or section
where identified
and described

Current OMB
control number

issue of the Federal Register for June 14,
1996, 61 F.R. 30133)

Section 1288.—Treatment of Original
Issue Discount on Tax-Exempt
Obligations.
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.

Section 7520.—Valuation Tables
*

*

*

*

*

*

1.1275–2(h) . . . . . . . . . . . . . 1545–1450
1.1275–3 . . . . . . . . . . . . . . . 1545–0887
1545–1353
1545–1450
1.1275–4(b) . . . . . . . . . . . . . 1545–1450
1.1275–6(e) . . . . . . . . . . . . . 1545–1450
*

*

*

*

*

*

Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved March 22, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
June 11, 1996, 8:45 a.m., and published in the

35

The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.

Section 7872.—Treatment of Loans
with Below-Market Interest Rates
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.