[Federal Register Volume 62, Number 3 (Monday, January 6, 1997)]
[Rules and Regulations]
[Pages 615-621]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-33398]
=======================================================================
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8709]
RIN 1545-AU44
Inflation-Indexed Debt Instruments
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary and final regulations.
-----------------------------------------------------------------------
SUMMARY: This document contains temporary regulations relating to the
federal income tax treatment of inflation-indexed debt instruments,
including Treasury Inflation-Indexed Securities. The text of the
temporary regulations also serves as the text of the proposed
regulations set forth in the notice of proposed rulemaking on this
subject in the Proposed Rules section of this issue of the Federal
Register. This document also contains amendments to final regulations
to reflect the addition of the temporary regulations. The regulations
in this document provide needed guidance to holders and issuers of
inflation-indexed debt instruments.
EFFECTIVE DATE: The regulations are effective January 6, 1997.
FOR FURTHER INFORMATION CONTACT: Jeffrey W. Maddrey, (202) 622-3940, or
William E. Blanchard, (202) 622-3950 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
The Department of the Treasury published final rules describing the
terms and conditions of new debt instruments that it plans to issue.
The payments on these debt instruments (Treasury Inflation-Indexed
Securities) will be indexed for inflation and deflation.
On June 14, 1996, the IRS published final regulations in the
Federal Register relating to certain debt instruments that provide for
contingent payments (61 FR 30133). The preamble to the final
regulations indicates that the noncontingent bond method described in
Sec. 1.1275-4(b) might be inappropriate for the Treasury Inflation-
Indexed Securities. On October 15, 1996, the IRS published Notice 96-51
(1996-42 I.R.B. 6), which announced the IRS's intention to issue
temporary and proposed regulations that would provide guidance on the
federal income tax treatment of the Treasury Inflation-Indexed
Securities and other debt instruments with similar terms. This document
contains the temporary regulations described in Notice 96-51.
Explanation of Provisions
A. In General
The temporary regulations provide rules for the treatment of
certain debt instruments that are indexed for inflation and deflation,
including Treasury Inflation-Indexed Securities. The temporary
regulations generally require holders and issuers of inflation-indexed
debt instruments to account for interest and original issue discount
(OID) using constant yield principles. In addition, the temporary
regulations generally require holders and issuers of inflation-indexed
debt instruments to account for inflation and deflation by making
current adjustments to their OID accruals.
B. Applicability
The temporary regulations apply to inflation-indexed debt
instruments. In general, an inflation-indexed debt instrument is a debt
instrument that (1) Is issued for cash, (2) is indexed for inflation
and deflation (as described
[[Page 616]]
below), and (3) is not otherwise a contingent payment debt instrument.
The temporary regulations do not apply, however, to certain debt
instruments, such as debt instruments issued by qualified state tuition
programs.
C. Indexing Methodology
A debt instrument is considered indexed for inflation and deflation
if the payments on the instrument are indexed by reference to the
change in value of a general price or wage index over the term of the
instrument. Specifically, the amount of each payment on an inflation-
indexed debt instrument must equal the product of (1) The amount of the
payment that would be payable on the instrument (determined as if there
were no inflation or deflation over the term of the instrument) and (2)
the ratio of the value of the reference index for the payment date to
the value of the reference index for the issue date.
The reference index for a debt instrument is the mechanism for
measuring inflation and deflation over the term of the instrument. This
mechanism associates the value of a single qualified inflation index
for a particular month with a specified day of a succeeding month. For
example, under the terms of the Treasury Inflation-Indexed Securities,
the reference index for the first day of a month is the value of a
qualified inflation index for the third preceding month. The reference
index must be reset once a month to the current value of a qualified
inflation index. Between reset dates, the value of the reference index
is determined through straight-line interpolation.
A qualified inflation index is a general price or wage index that
is updated and published at least monthly by an agency of the United
States Government. A general price or wage index is an index that
measures price or wage changes in the economy as a whole. An index is
not general if it only measures price or wage changes in a particular
segment of the economy. For example, the non-seasonally adjusted U.S.
City Average All Items Consumer Price Index for All Urban Consumers
(CPI-U), which is published by the Bureau of Labor Statistics of the
Department of Labor, is a qualified inflation index because it measures
general price changes in the economy. By contrast, the gasoline price
component of the CPI-U is not a qualified inflation index because it
only measures price changes in a particular segment of the economy.
D. Coupon Bond Method
The temporary regulations provide a simplified method of accounting
for qualified stated interest and inflation adjustments on certain
inflation-indexed debt instruments (the coupon bond method). To qualify
for the coupon bond method, an inflation-indexed debt instrument must
satisfy two conditions. First, there must be no more than a de minimis
difference between the debt instrument's issue price and its principal
amount for the issue date. Second, all stated interest on the debt
instrument must be qualified stated interest. Because Treasury
Inflation-Indexed Securities that are not stripped into principal and
interest components satisfy both of these conditions, the coupon bond
method applies to these securities.
If an inflation-indexed debt instrument qualifies for the coupon
bond method, the stated interest payable on the debt instrument is
taken into account under the taxpayer's regular method of accounting.
Any increase in the inflation-adjusted principal amount is treated as
OID for the period in which the increase occurs. Any decrease in the
inflation-adjusted principal amount is taken into account under the
rules for deflation adjustments described below.
For example, if a taxpayer holds a Treasury Inflation-Indexed
Security for an entire calendar year and the taxpayer uses the cash
receipts and disbursements method of accounting (cash method), the
taxpayer generally includes in income the interest payments received on
the security during the year. In addition, the taxpayer includes in
income an amount of OID measured by subtracting the inflation-adjusted
principal amount of the security at the beginning of the year from the
inflation-adjusted principal amount of the security at the end of the
year. If the taxpayer uses an accrual method of accounting rather than
the cash method, the taxpayer includes in income the qualified stated
interest that accrued on the debt instrument during the year and an
amount of OID measured by subtracting the inflation-adjusted principal
amount of the security at the beginning of the year from the inflation-
adjusted principal amount of the security at the end of the year.
E. Discount Bond Method
If an inflation-indexed debt instrument does not qualify for the
coupon bond method (for example, because it is issued at a discount),
the instrument is subject to the discount bond method. In general, the
discount bond method requires holders and issuers to make current
adjustments to their OID accruals to account for inflation and
deflation.
Under the discount bond method, a taxpayer determines the amount of
OID allocable to an accrual period by using steps similar to those
provided in Sec. 1.1272-1(b)(1). First, the taxpayer determines the
yield to maturity of the debt instrument as if there were no inflation
or deflation over the term of the instrument. Second, the taxpayer
determines the length of the accrual periods to be used to allocate OID
over the term of the debt instrument, provided no accrual period is
longer than one month. Third, the taxpayer determines the percentage
change in the value of the reference index during the accrual period by
comparing the value at the beginning of the period to the value at the
end of the period. Fourth, the taxpayer determines the OID allocable to
the accrual period by using a formula that takes into account both the
yield of the debt instrument and the percentage change in the value of
the reference index during the period. Fifth, the taxpayer allocates to
each day in the accrual period a ratable portion of the OID for the
accrual period (the daily portions). If the daily portions for an
accrual period are positive amounts, these amounts are taken into
account under section 163(e) by an issuer and under section 1272 by a
holder. If the daily portions for an accrual period are negative
amounts, these amounts are taken into account under the rules for
deflation adjustments described below.
Under Notice 96-51, the discount bond method would have allowed
qualified stated interest. The temporary regulations, however, provide
that no interest payments on an inflation-indexed debt instrument
subject to the discount bond method are qualified stated interest. The
Treasury and the IRS believe that this change simplifies the taxation
of an inflation-indexed debt instrument subject to the discount bond
method.
F. Deflation Adjustments
The temporary regulations treat deflation adjustments in a manner
consistent with the treatment of net negative adjustments on contingent
payment debt instruments under Sec. 1.1275-4(b)(6)(iii). If a holder
has a deflation adjustment for a taxable year, the deflation adjustment
first reduces the amount of interest otherwise includible in income
with respect to the debt instrument for the taxable year. If the amount
of the deflation adjustment exceeds the interest otherwise includible
in income for the taxable
[[Page 617]]
year, the holder treats the excess as an ordinary loss in the taxable
year. However, the amount treated as an ordinary loss is limited to the
amount by which the holder's total interest inclusions on the debt
instrument in prior taxable years exceed the total amount treated by
the holder as an ordinary loss on the debt instrument in prior taxable
years. If the deflation adjustment exceeds the interest otherwise
includible in income by the holder with respect to the debt instrument
for the taxable year and the amount treated as an ordinary loss for the
taxable year, the excess is carried forward to offset interest income
on the debt instrument in subsequent taxable years. Similar rules apply
to determine an issuer's interest deductions and income for the debt
instrument.
G. Minimum Guarantee
Certain inflation-indexed debt instruments may provide for an
additional payment at maturity (a minimum guarantee payment) if the
total amount of inflation-adjusted principal paid on the debt
instrument is less than the instrument's stated principal amount. Under
both the coupon bond method and the discount bond method, a minimum
guarantee payment is ignored until the payment is made. If a minimum
guarantee payment is made, the payment is treated as interest on the
date it is paid.
In general, the temporary regulations only allow a debt instrument
that is indexed by reference to the CPI-U to provide for a minimum
guarantee payment. The Treasury and the IRS believe that there is only
a small possibility that the total amount of principal paid on a debt
instrument indexed to the CPI-U will be less than the instrument's
stated principal amount. In this case, it is appropriate to ignore the
minimum guarantee payment until it is paid.
H. Principal Amount for the Issue Date
For purposes of the temporary regulations, if an inflation-indexed
debt instrument is issued with pre-issuance accrued interest, the
principal amount of the instrument for the issue date includes an
adjustment for inflation or deflation. This adjustment is measured by
the change in the value of the reference index between the date on
which interest starts to accrue (the dated date in the case of a
Treasury Inflation-Indexed Security) and the issue date. The stated
principal amount of a debt instrument under the regulations, however,
is not adjusted for inflation or deflation between the date on which
interest starts to accrue and the issue date. Therefore, the stated
principal amount of the debt instrument is the same regardless of
whether interest accrues on the instrument from the issue date or from
an earlier date. The stated principal amount of a Treasury Inflation-
Indexed Security is the par amount of the security, as defined in the
final rules published by the Treasury Department describing the terms
and conditions of Treasury Inflation-Indexed Securities.
When there is a difference between the stated principal amount of
an inflation-indexed debt instrument and its principal amount for the
issue date, the instrument's principal amount for the issue date
generally is used for purposes of applying the rules in the temporary
regulations to the instrument. For example, the debt instrument's
principal amount for the issue date is used to determine whether the
instrument qualifies for the coupon bond method. The temporary
regulations require the use of a debt instrument's stated principal
amount rather than its principal amount for the issue date to measure
the amount of a minimum guarantee payment.
I. Strips
Treasury Inflation-Indexed Securities are eligible for the
Department of the Treasury's Separate Trading of Registered Interest
and Principal of Securities (STRIPS) program. Under this program, the
interest and principal components of a Treasury Inflation-Indexed
Security may be transferred as separate instruments (stripped bonds and
coupons). In general, section 1286 treats the holder of a stripped bond
(or coupon) as if the holder purchased a newly issued debt instrument
that has OID. The temporary regulations provide that the holder of a
component of a Treasury Inflation-Indexed Security that is stripped
under the Treasury STRIPS program must use the discount bond method to
account for the OID on the component.
J. Information Reporting
The temporary regulations do not provide any new information
reporting rules for inflation-indexed debt instruments. The OID and any
qualified stated interest on an inflation-indexed debt instrument
should be reported on Form 1099-OID. The IRS plans to issue guidance
for the reporting of OID on Treasury Inflation-Indexed Securities that
are stripped under the STRIPS program.
K. Effective Date
The temporary regulations apply to an inflation-indexed debt
instrument issued on or after January 6, 1997.
Special Analyses
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)
does not apply to these regulations and, because the regulations do not
impose a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Internal Revenue Code, these temporary
regulations will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on their impact on small
business.
Drafting Information
The principal author of the regulations is Jeffrey W. Maddrey,
Office of Assistant Chief Counsel (Financial Institutions and
Products). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
two entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1275-7T also issued under 26 U.S.C. 1275(d). * * *
Section 1.1286-2T also issued under 26 U.S.C. 1286(f). * * *
Par. 2. Section 1.1271-0 is amended by--
1. Revising the second sentence of paragraph (a);
2. Revising the introductory text of paragraph (b); and
3. Adding entries for Sec. 1.1275-7T in paragraph (b).
The revisions and additions read as follows:
Sec. 1.1271-0 Original issue discount; effective date; table of
contents.
(a) * * * Taxpayers, however, may rely on these sections (as
contained in
[[Page 618]]
26 CFR part 1 revised April 1, 1996) for debt instruments issued after
December 21, 1992, and before April 4, 1994.
(b) Table of contents. This section lists captioned paragraphs
contained in Secs. 1.1271-1 through 1.1275-7T.
* * * * *
Sec. 1.1275-7T Inflation-indexed debt instruments (temporary).
(a) Overview.
(b) Applicability.
(1) In general.
(2) Exceptions.
(c) Definitions.
(1) Inflation-indexed debt instrument.
(2) Reference index.
(3) Qualified inflation index.
(4) Inflation-adjusted principal amount.
(5) Minimum guarantee payment.
(d) Coupon bond method.
(1) In general.
(2) Applicability.
(3) Qualified stated interest.
(4) Inflation adjustments.
(5) Example.
(e) Discount bond method.
(1) In general.
(2) No qualified stated interest.
(3) OID.
(4) Example.
(f) Special rules.
(1) Deflation adjustments.
(2) Adjusted basis.
(3) Subsequent holders.
(4) Minimum guarantee.
(5) Temporary unavailability of a qualified inflation index.
(g) Reopenings.
(h) Effective date.
* * * * *
Sec. 1.1275.4 [Amended]
Par. 3. Section 1.1275-4 is amended by--
1. Removing the word ``or'' from the end of paragraph (a)(2)(vi);
2. Redesignating paragraph (a)(2)(vii) as paragraph (a)(2)(viii);
and
3. Adding a new paragraph (a)(2)(vii).
The addition reads as follows:
Sec. 1.1275-4 Contingent payment debt instruments.
(a) * * *
(2) * * *
(vii) An inflation-indexed debt instrument (as defined in
Sec. 1.1275-7T); or
* * * * *
Par. 4. Section 1.1275-7T is added to read as follows:
Sec. 1.1275-7T Inflation-indexed debt instruments (temporary).
(a) Overview. This section provides rules for the federal income
tax treatment of an inflation-indexed debt instrument. If a debt
instrument is an inflation-indexed debt instrument, one of two methods
will apply to the instrument: the coupon bond method (as described in
paragraph (d) of this section) or the discount bond method (as
described in paragraph (e) of this section). Both methods determine the
amount of OID that is taken into account each year by a holder or an
issuer of an inflation-indexed debt instrument.
(b) Applicability--(1) In general. Except as provided in paragraph
(b)(2) of this section, this section applies to an inflation-indexed
debt instrument as defined in paragraph (c)(1) of this section. For
example, this section applies to Treasury Inflation-Indexed Securities.
(2) Exceptions. This section does not apply to an inflation-indexed
debt instrument that is also--
(i) A debt instrument (other than a tax-exempt obligation)
described in section 1272(a)(2) (for example, U.S. savings bonds,
certain loans between natural persons, and short-term taxable
obligations); or
(ii) A debt instrument subject to section 529 (certain debt
instruments issued by qualified state tuition programs).
(c) Definitions. The following definitions apply for purposes of
this section:
(1) Inflation-indexed debt instrument. An inflation-indexed debt
instrument is a debt instrument that satisfies the following
conditions:
(i) Issued for cash. The debt instrument is issued for U.S. dollars
and all payments on the instrument are denominated in U.S. dollars.
(ii) Indexed for inflation and deflation. Except for a minimum
guarantee payment (as defined in paragraph (c)(5) of this section),
each payment on the debt instrument is indexed for inflation and
deflation. A payment is indexed for inflation and deflation if the
amount of the payment is equal to--
(A) The amount that would be payable if there were no inflation or
deflation over the term of the debt instrument, multiplied by
(B) A ratio, the numerator of which is the value of the reference
index for the date of the payment and the denominator of which is the
value of the reference index for the issue date.
(iii) No other contingencies. No payment on the debt instrument is
subject to a contingency other than the inflation contingency or the
contingencies described in this paragraph (c)(1)(iii). A debt
instrument may provide for--
(A) A minimum guarantee payment as defined in paragraph (c)(5) of
this section; or
(B) Payments under one or more alternate payment schedules if the
payments under each payment schedule are indexed for inflation and
deflation and a payment schedule for the debt instrument can be
determined under Sec. 1.1272-1(c). (For purposes of this section, the
rules of Sec. 1.1272-1(c) are applied to the debt instrument by
assuming that no inflation or deflation will occur over the term of the
instrument.)
(2) Reference index. The reference index is an index used to
measure inflation and deflation over the term of a debt instrument. To
qualify as a reference index, an index must satisfy the following
conditions:
(i) The value of the index is reset once a month to a current value
of a single qualified inflation index (as defined in paragraph (c)(3)
of this section). For this purpose, a value of a qualified inflation
index is current if the value has been updated and published within the
preceding six month period.
(ii) The reset occurs on the same day of each month (the reset
date).
(iii) The value of the index for any date between reset dates is
determined through straight-line interpolation.
(3) Qualified inflation index. A qualified inflation index is a
general price or wage index that is updated and published at least
monthly by an agency of the United States Government (for example, the
non-seasonally adjusted U.S. City Average All Items Consumer Price
Index for All Urban Consumers (CPI-U), which is published by the Bureau
of Labor Statistics of the Department of Labor).
(4) Inflation-adjusted principal amount. For any date, the
inflation-adjusted principal amount of an inflation-indexed debt
instrument is an amount equal to--
(i) The outstanding principal amount of the debt instrument
(determined as if there were no inflation or deflation over the term of
the instrument), multiplied by
(ii) A ratio, the numerator of which is the value of the reference
index for the date and the denominator of which is the value of the
reference index for the issue date.
(5) Minimum guarantee payment. In general, a minimum guarantee
payment is an additional payment made at maturity on a debt instrument
if the total amount of inflation-adjusted principal paid on the
instrument is less than the instrument's stated principal amount. The
amount of the additional payment must be no more than the excess, if
any, of the debt instrument's stated principal amount over the total
amount of inflation-adjusted principal paid on the instrument. An
additional payment is not a minimum guarantee
[[Page 619]]
payment unless the qualified inflation index used to determine the
reference index is either the CPI-U or an index designated for this
purpose by the Commissioner in the Federal Register or the Internal
Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter). See
paragraph (f)(4) of this section for the treatment of a minimum
guarantee payment.
(d) Coupon bond method--(1) In general. This paragraph (d)
describes the method (coupon bond method) to be used to account for
qualified stated interest and inflation adjustments (OID) on an
inflation-indexed debt instrument described in paragraph (d)(2) of this
section.
(2) Applicability. The coupon bond method applies to an inflation-
indexed debt instrument that satisfies the following conditions:
(i) Issued at par. The debt instrument is issued at par. A debt
instrument is issued at par if the difference between its issue price
and principal amount for the issue date is less than the de minimis
amount. For this purpose, the de minimis amount is determined using the
principles of Sec. 1.1273-1(d).
(ii) All stated interest is qualified stated interest. All stated
interest on the debt instrument is qualified stated interest. For
purposes of this paragraph (d), stated interest is qualified stated
interest if the interest is unconditionally payable in cash, or is
constructively received under section 451, at least annually at a
single fixed rate. Stated interest is payable at a single fixed rate if
the amount of each interest payment is determined by multiplying the
inflation adjusted principal amount for the payment date by the single
fixed rate.
(3) Qualified stated interest. Under the coupon bond method,
qualified stated interest is taken into account under the taxpayer's
regular method of accounting. The amount of accrued but unpaid
qualified stated interest as of any date is determined by using the
principles of Sec. 1.446-3(e)(2)(ii) (relating to notional principal
contracts). For example, if the interval between interest payment dates
spans two taxable years, a taxpayer using an accrual method of
accounting determines the amount of accrued qualified stated interest
for the first taxable year by reference to the inflation-adjusted
principal amount at the end of the first taxable year.
(4) Inflation adjustments--(i) Current accrual. Under the coupon
bond method, an inflation adjustment is taken into account for each
taxable year in which the debt instrument is outstanding.
(ii) Amount of inflation adjustment. For any relevant period (such
as the taxable year or the portion of the taxable year during which a
taxpayer holds an inflation-indexed debt instrument), the amount of the
inflation adjustment is equal to--
(A) The sum of the inflation-adjusted principal amount at the end
of the period and the principal payments made during the period, minus
(B) The inflation-adjusted principal amount at the beginning of the
period.
(iii) Positive inflation adjustments. A positive inflation
adjustment is OID.
(iv) Negative inflation adjustments. A negative inflation
adjustment is a deflation adjustment that is taken into account under
the rules of paragraph (f)(1) of this section.
(5) Example. The following example illustrates the coupon bond
method:
Example. (i) Facts. On October 15, 1997, X purchases at original
issue, for $100,000, a debt instrument that is indexed for inflation
and deflation. The debt instrument matures on October 15, 1999, has
a stated principal amount of $100,000, and has a stated interest
rate of 5 percent, compounded semiannually. The debt instrument
provides that the principal amount is indexed to the CPI-U. Interest
is payable on April 15 and October 15 of each year. The amount of
each interest payment is determined by multiplying the inflation-
adjusted principal amount for each interest payment date by the
stated interest rate, adjusted for the length of the accrual period.
The debt instrument provides for a single payment of the inflation-
adjusted principal amount at maturity. In addition, the debt
instrument provides for an additional payment at maturity equal to
the excess, if any, of $100,000 over the inflation-adjusted
principal amount at maturity. X uses the cash receipts and
disbursements method of accounting and the calendar year as its
taxable year.
(ii) Indexing methodology. The debt instrument provides that the
inflation-adjusted principal amount for any day is determined by
multiplying the principal amount of the instrument for the issue
date by a ratio, the numerator of which is the value of the
reference index for the day the inflation-adjusted principal amount
is to be determined and the denominator of which is the value of the
reference index for the issue date. The value of the reference index
for the first day of a month is the value of the CPI-U for the third
preceding month. The value of the reference index for any day other
than the first day of a month is determined based on a straight-line
interpolation between the value of the reference index for the first
day of the month and the value of the reference index for the first
day of the next month.
(iii) Inflation-indexed debt instrument subject to the coupon
bond method. Under paragraph (c)(1) of this section, the debt
instrument is an inflation-indexed debt instrument. Because there is
no difference between the debt instrument's issue price ($100,000)
and its principal amount for the issue date ($100,000) and because
all stated interest is qualified stated interest, the coupon bond
method applies to the instrument.
(iv) Reference index values. Assume the following table lists
the relevant reference index values for 1997 through 1999:
------------------------------------------------------------------------
Reference
Date index
value
------------------------------------------------------------------------
Oct. 15, 1997................................................ 100
Jan. 1, 1998................................................. 101
Apr. 15, 1998................................................ 103
Oct. 15, 1998................................................ 105
Jan. 1, 1999................................................. 99
------------------------------------------------------------------------
(v) Treatment of X in 1997. X does not receive any payments of
interest on the debt instrument in 1997. Therefore, X has no
qualified stated interest income for 1997. X, however, must take
into account the inflation adjustment for 1997. The inflation-
adjusted principal amount for January 1, 1998, is $101,000 ($100,000
x 101/100). Therefore, the inflation adjustment for 1997 is
$1,000, the inflation-adjusted principal amount for January 1, 1998
($101,000) minus the principal amount for the issue date ($100,000).
X includes the $1,000 inflation adjustment in income as OID in 1997.
(vi) Treatment of X in 1998. In 1998, X receives two payments of
interest: On April 15, 1998, X receives a payment of $2,575
($100,000 x 103/100 x .05/2), and on October 15, 1998, X
receives a payment of $2,625 ($100,000 x 105/100 x .05/2).
Therefore, X's qualified stated interest income for 1998 is $5,200
($2,575 + $2,625). X also must take into account the inflation
adjustment for 1998. The inflation-adjusted principal amount for
January 1, 1999, is $99,000 ($100,000 x 99/100). Therefore, the
inflation adjustment for 1998 is negative $2,000, the inflation-
adjusted principal amount for January 1, 1999 ($99,000) minus the
inflation-adjusted principal amount for January 1, 1998 ($101,000).
Because the amount of the inflation adjustment is negative, it is a
deflation adjustment. Under paragraph (f)(1)(i) of this section, X
uses this $2,000 deflation adjustment to reduce the interest
otherwise includible in income by X with respect to the debt
instrument in 1998. Therefore, X includes $3,200 in income for 1998,
the qualified stated interest income for 1998 ($5,200) minus the
deflation adjustment ($2,000).
(e) Discount bond method--(1) In general. This paragraph (e)
describes the method (discount bond method) to be used to account for
OID on an inflation-indexed debt instrument that does not qualify for
the coupon bond method.
(2) No qualified stated interest. Under the discount bond method,
no interest on an inflation-indexed debt instrument is qualified stated
interest.
(3) OID. Under the discount bond method, the amount of OID that
accrues on an inflation-indexed debt instrument is determined as
follows:
[[Page 620]]
(i) Step one: Determine the debt instrument's yield to maturity.
The yield of the debt instrument is determined under the rules of
Sec. 1.1272-1(b)(1)(i). In calculating the yield under those rules for
purposes of this paragraph (e)(3)(i), the payment schedule of the debt
instrument is determined as if there were no inflation or deflation
over the term of the instrument.
(ii) Step two: Determine the accrual periods. The accrual periods
are determined under the rules of Sec. 1.1272-1(b)(1)(ii). However, no
accrual period can be longer than 1 month.
(iii) Step three: Determine the percentage change in the reference
index during the accrual period. The percentage change in the reference
index during the accrual period is equal to--
(A) The ratio of the value of the reference index at the end of the
period to the value of the reference index at the beginning of the
period,
(B) Minus one.
(iv) Step four: Determine the OID allocable to each accrual period.
The OID allocable to an accrual period (n) is determined by using the
following formula:
OID(n) = AIP(n) x [r + inf(n) + (r x inf(n))]
in which,
r = yield of the debt instrument as determined under paragraph
(e)(3)(i) of this section (adjusted for the length of the accrual
period);
inf(n) = percentage change in the value of the reference index for
period (n) as determined under paragraph (e)(3)(iii) of this section;
and
AIP(n) = adjusted issue price at the beginning of period (n).
(v) Step five: Determine the daily portions of OID. The daily
portions of OID are determined and taken into account under the rules
of Sec. 1.1272-1(b)(1)(iv). If the daily portions determined under this
paragraph (e)(3)(v) are negative amounts, however, these amounts
(deflation adjustments) are taken into account under the rules for
deflation adjustments described in paragraph (f)(1) of this section.
(4) Example. The following example illustrates the discount bond
method:
Example. (i) Facts. On November 15, 1997, X purchases at
original issue, for $91,403, a zero-coupon debt instrument that is
indexed for inflation and deflation. The principal amount of the
debt instrument for the issue date is $100,000. The debt instrument
provides for a single payment on November 15, 2000. The amount of
the payment will be determined by multiplying $100,000 by a
fraction, the numerator of which is the CPI-U for September 2000,
and the denominator of which is the CPI-U for September 1997. The
debt instrument also provides that in no event will the payment on
November 15, 2000, be less than $100,000. X uses the cash receipts
and disbursements method of accounting and the calendar year as its
taxable year.
(ii) Inflation-indexed debt instrument. Under paragraph (c)(1)
of this section, the instrument is an inflation-indexed debt
instrument. The debt instrument's principal amount for the issue
date ($100,000) exceeds its issue price ($91,403) by $8,597, which
is more than the de minimis amount for the debt instrument ($750).
Therefore, the coupon bond method does not apply to the debt
instrument. As a result, the discount bond method applies to the
debt instrument.
(iii) Yield and accrual period. Assume X chooses monthly accrual
periods ending on the 15th day of each month. The yield of the debt
instrument is determined as if there were no inflation or deflation
over the term of the instrument. Therefore, based on the issue price
of $91,403 and an assumed payment at maturity of $100,000, the yield
of the debt instrument is 3 percent, compounded monthly.
(iv) Percentage change in reference index. Assume that the CPI-U
for September 1997 is 160; for October 1997 is 161.2; and for
November 1997 is 161.7. The value of the reference index for
November 15, 1997, is 160, the value of the CPI-U for September
1997. Similarly, the value of the reference index for December 15,
1997, is 161.2, and for January 15, 1998, is 161.7. The percentage
change in the reference index from November 15, 1997, to December
15, 1997, (inf1) is 0.0075 (161.2/160-1); the percentage change
in the reference index from December 15, 1997, to January 15, 1998,
(inf2) is 0.0031 (161.7/161.2-1).
(v) Treatment of X in 1997. For the accrual period ending on
December 15, 1997, r is .0025 (.03/12), inf1 is .0075, and the
product of r and inf1 is .00001875. Under paragraph (e)(3) of
this section, the amount of OID allocable to the accrual period
ending on December 15, 1997, is $916. This amount is determined by
multiplying the issue price of the debt instrument ($91,403) by
.01001875 (the sum of r, inf1, and the product of r and
inf1). The adjusted issue price of the debt instrument on
December 15, 1997, is $92,319 ($91,403+$916). For the accrual period
ending on January 15, 1998, r is .0025 (.03/12), inf2 is .0031,
and the product of r and inf2 is .00000775. Under paragraph
(e)(3) of this section, the amount of OID allocable to the accrual
period ending on January 15, 1998, is $518. This amount is
determined by multiplying the adjusted issue price of the debt
instrument ($92,319) by .00560775 (the sum of r, inf2, and the
product of r and inf2). Because the accrual period ending on
January 15, 1998, spans two taxable years, only $259 of this amount
($518/30 days x 15 days) is allocable to 1997. Therefore, X includes
$1,175 of OID in income for 1997 ($916+$259).
(f) Special rules. The following rules apply to an inflation-
indexed debt instrument:
(1) Deflation adjustments--(i) Holder. A deflation adjustment
reduces the amount of interest otherwise includible in income by a
holder with respect to the debt instrument for the taxable year. For
purposes of this paragraph (f)(1)(i), interest includes OID, qualified
stated interest, and market discount. If the amount of the deflation
adjustment exceeds the interest otherwise includible in income by the
holder with respect to the debt instrument for the taxable year, the
excess is treated as an ordinary loss by the holder for the taxable
year. However, the amount treated as an ordinary loss is limited to the
amount by which the holder's total interest inclusions on the debt
instrument in prior taxable years exceed the total amount treated by
the holder as an ordinary loss on the debt instrument in prior taxable
years. If the deflation adjustment exceeds the interest otherwise
includible in income by the holder with respect to the debt instrument
for the taxable year and the amount treated as an ordinary loss for the
taxable year, this excess is carried forward to reduce the amount of
interest otherwise includible in income by the holder with respect to
the debt instrument for subsequent taxable years.
(ii) Issuer. A deflation adjustment reduces the interest otherwise
deductible by the issuer with respect to the debt instrument for the
taxable year. For purposes of this paragraph (f)(1)(ii), interest
includes OID and qualified stated interest. If the amount of the
deflation adjustment exceeds the interest otherwise deductible by the
issuer with respect to the debt instrument for the taxable year, the
excess is treated as ordinary income by the issuer for the taxable
year. However, the amount treated as ordinary income is limited to the
amount by which the issuer's total interest deductions on the debt
instrument in prior taxable years exceed the total amount treated by
the issuer as ordinary income on the debt instrument in prior taxable
years. If the deflation adjustment exceeds the interest otherwise
deductible by the issuer with respect to the debt instrument for the
taxable year and the amount treated as ordinary income for the taxable
year, this excess is carried forward to reduce the interest otherwise
deductible by the issuer with respect to the debt instrument for
subsequent taxable years. If there is any excess remaining upon the
retirement of the debt instrument, the issuer takes the excess amount
into account as ordinary income.
(2) Adjusted basis. A holder's adjusted basis in an inflation-
indexed debt instrument is determined under Sec. 1.1272-1(g). However,
a holder's adjusted basis in the debt instrument is decreased by the
amount of any
[[Page 621]]
deflation adjustment the holder takes into account to reduce the amount
of interest otherwise includible in income or treats as an ordinary
loss with respect to the instrument during the taxable year. The
decrease occurs when the deflation adjustment is taken into account
under paragraph (f)(1) of this section.
(3) Subsequent holders. A holder determines the amount of
acquisition premium or market discount on an inflation-indexed debt
instrument by reference to the adjusted issue price of the instrument
on the date the holder acquires the instrument. A holder determines the
amount of bond premium on an inflation-indexed debt instrument by
assuming that the amount payable at maturity on the instrument is equal
to the instrument's inflation-adjusted principal amount for the day the
holder acquires the instrument. Any premium or market discount is taken
into account over the remaining term of the debt instrument as if there
were no further inflation or deflation. See section 171 for additional
rules relating to the amortization of bond premium and sections 1276
through 1278 for additional rules relating to market discount.
(4) Minimum guarantee. Under both the coupon bond method and the
discount bond method, a minimum guarantee payment is ignored until the
payment is made. If there is a minimum guarantee payment, the payment
is treated as interest on the date it is paid.
(5) Temporary unavailability of a qualified inflation index.
Notwithstanding any other rule of this section, an inflation-indexed
debt instrument may provide for a substitute value of the qualified
inflation index if and when the publication of the value of the
qualified inflation index is temporarily delayed. The substitute value
may be determined by the issuer under any reasonable method. For
example, if the CPI-U is not reported for a particular month, the debt
instrument may provide that a substitute value may be determined by
increasing the last reported value by the average monthly percentage
increase in the qualified inflation index over the preceding twelve
months. The use of a substitute value does not result in a reissuance
of the debt instrument.
(g) Reopenings. For purposes of Sec. 1.1275-2(d)(2), a reopening of
Treasury Inflation-Indexed Securities is a qualified reopening if--
(1) The terms of the securities issued in the reopening are the
same as the terms of the original securities; and
(2) The reopening occurs not more than one year after the original
securities were first issued to the public.
(h) Effective date. This section applies to an inflation-indexed
debt instrument issued on or after January 6, 1997.
Par. 5. Section 1.1286-2T is added to read as follows:
Sec. 1.1286-2T Stripped inflation-indexed debt instruments
(temporary).
Stripped inflation-indexed debt instruments. If a Treasury
Inflation-Indexed Security is stripped under the Department of the
Treasury's Separate Trading of Registered Interest and Principal of
Securities (STRIPS) program, the holders of the principal and coupon
components must use the discount bond method (as described in
Sec. 1.1275-7T(e)) to account for the original issue discount on the
components.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: December 6, 1996.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 96-33398 Filed 12-31-96; 12:57 pm]
BILLING CODE 4830-01-U
