[Federal Register Volume 62, Number 250 (Wednesday, December 31, 1997)]
[Rules and Regulations]
[Pages 68173-68183]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33647]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8746]
RIN 1545-AU09
Amortizable Bond Premium
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
federal income tax treatment of bond premium and bond issuance premium.
The regulations reflect changes to the law made by the Tax Reform Act
of 1986 and the Technical and Miscellaneous Revenue Act of 1988. The
regulations will provide needed guidance to holders and issuers of debt
instruments.
DATES: Effective date: March 2, 1998.
Applicability dates: For dates of applicability of the final
regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 622-3950
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations
have been reviewed and approved by the Office of Management and Budget
in accordance with the requirements of the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)) under control number 1545-1491. Responses to
these collections of information are required by the IRS to determine
whether a holder of a bond has elected to amortize bond premium and
whether an issuer or a holder has changed its method of accounting for
premium.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The estimated annual burden per respondent varies from 0.25 hours
to 0.75 hours, depending on individual circumstances, with an estimated
average of 0.5 hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,
DC 20224, and to the Office of Management and Budget, Attn: Desk
Officer for the Department of Treasury, Office of Information and
Regulatory Affairs, Washington, DC 20503.
Books or records relating to the collections of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
Sections 1.171-1 through 1.171-4 of the Income Tax Regulations were
promulgated in 1957 and last amended in 1968. In the Tax Reform Act of
1986, section 171(b) was amended to require that bond premium be
amortized by reference to a constant yield. In the Technical and
Miscellaneous Revenue Act of 1988, section 171(e) was amended to
require that amortizable bond premium be treated as an offset to
interest income.
On June 27, 1996, the IRS published a notice of proposed rulemaking
in the Federal Register (61 FR 33396) relating to the federal income
tax treatment of bond premium and bond issuance premium. A public
hearing was not held because no one requested to speak at the hearing
that had been scheduled for October 23, 1996. The IRS did receive
[[Page 68174]]
a few comments on the proposed regulations. The proposed regulations,
with certain changes to respond to the comments, are adopted as final
regulations.
Explanation of Provisions
In general, bond premium arises when a holder acquires a bond for
more than the principal amount of the bond. Similarly, bond issuance
premium arises when an issuer issues a bond for more than the principal
amount of the bond. A holder will purchase, and an issuer will issue, a
bond for more than its principal amount when the stated interest rate
on the bond is higher than the current market yield for the bond.
The holder's treatment of bond premium is addressed in Secs. 1.171-
1 through 1.171-5. The issuer's treatment of bond issuance premium is
addressed in Sec. 1.163-13. In each case, the amortization of premium
is based on constant yield principles. For this reason, the final
regulations use concepts and definitions from the original issue
discount (OID) regulations (in general, see Secs. 1.1271-1 through
1.1275-7T).
Determination of Bond Premium
Under the proposed regulations, bond premium is defined as the
excess of a holder's basis in a bond over the sum of the remaining
amounts payable on the bond other than payments of qualified stated
interest. The holder generally determines the amount of bond premium as
of the date the holder acquires the bond.
The proposed regulations provide special rules that limit a
holder's basis solely for purposes of determining bond premium. For
example, if a bond is convertible into stock of the issuer at the
holder's option, for purposes of determining bond premium, the holder
must reduce its basis in the bond by the value of the conversion
option. This reduction prevents the holder from inappropriately
amortizing the cost of the embedded conversion option.
The final regulations adopt the rules of the proposed regulations
for determining the amount of bond premium, if any, on a bond. However,
in response to comments, the final regulations clarify the
determination of basis in the case of a convertible bond acquired in a
transferred basis transaction.
Amortization of Bond Premium
(a) In General
Under section 171, the holder of a taxable bond acquired at a
premium may elect to amortize bond premium. The holder of a tax-exempt
bond acquired at a premium must amortize the premium. As premium is
amortized, the holder's basis in the bond is reduced by a corresponding
amount under section 1016(a)(5).
Under the proposed regulations, a holder amortizes bond premium by
offsetting qualified stated interest income with bond premium. An
offset is calculated for each accrual period using constant yield
principles. However, the offset for an accrual period is only taken
into account when the holder takes qualified stated interest into
account under the holder's regular method of accounting. Thus, a holder
using the cash receipts and disbursements method of accounting does not
take bond premium into account until a qualified stated interest
payment is received.
The final regulations adopt the rules in the proposed regulations
for amortizing bond premium.
(b) Excess Premium
For certain bonds (for example, bonds that pay a variable rate of
interest or that provide for an interest holiday), the amount of bond
premium allocable to an accrual period could exceed the amount of
qualified stated interest allocable to that period. The proposed
regulations address this situation by providing that the excess bond
premium is not allowed as a deduction but is carried forward to future
accrual periods.
Several commentators stated that this excess premium should be
allowable as a current deduction for the accrual period in which the
excess occurs. In response to these comments, the final regulations
adopt rules for excess premium that are similar to the rules for
negative adjustments on contingent payment debt instruments and
deflation adjustments on inflation-indexed debt instruments. Under the
final regulations, any excess bond premium allocable to an accrual
period is deductible by the holder under section 171(a)(1) for the
accrual period. The amount deductible, however, is limited by the
amount of the holder's prior income inclusions on the bond. If any of
the excess bond premium is not deductible under section 171(a)(1), this
amount is carried forward to the next accrual period and is treated as
bond premium allocable to that period.
Bonds Subject to Certain Contingencies
If a bond provides for one or more alternative payment schedules,
the yield of the bond cannot be determined without making assumptions
about the actual payment schedule. The OID regulations provide rules
for making these assumptions. For example, the rules assume that an
issuer will exercise a call option if doing so would minimize the yield
of the debt instrument and that a holder will exercise a put option if
doing so would maximize the yield of the debt instrument.
The proposed regulations under section 171 generally use similar
assumptions to determine the holder's yield on a bond that provides for
alternative payment schedules. However, in the case of an issuer's
option on a taxable bond, the proposed regulations reverse the
assumption in the OID regulations by assuming that the issuer will
exercise the option only if doing so would increase the yield on the
bond. See section 171(b)(1)(B)(ii). Thus, under the proposed
regulations, a holder generally must amortize bond premium on a taxable
bond by reference to the stated maturity date, even if it appears
likely the bond will be called. In this case, if the bond is actually
called, the proposed regulations provide that the holder may deduct the
unamortized premium. If the bond is partially called and the partial
call is not a pro-rata prepayment, the proposed regulations do not
allow the holder to deduct a portion of the unamortized premium.
Instead, the holder must recompute the yield of the bond on the date of
the partial call and amortize the remaining premium by reference to the
recomputed yield.
In general, the final regulations adopt the rules of the proposed
regulations. In response to a comment, the final regulations limit the
issuer rule for taxable bonds to call options.
Bond Issuance Premium
Under existing Sec. 1.61-12(c), a corporate issuer treats premium
received upon issuance of a bond as a separate item of income. Over the
term of the bond, the premium is taken into income, and the full amount
of the stated interest is deducted. The proposed regulations revise the
treatment of bond issuance premium. Under the proposed regulations,
bond issuance premium is amortized as an offset to the issuer's
otherwise allowable interest deduction, not as a separate item of
income. The amount of bond issuance premium amortized in any period is
based on a constant yield. In addition, the proposed regulations apply
to all issuers, not just corporate issuers.
In general, the final regulations adopt the rules in the proposed
regulations for bond issuance premium. However, the final regulations
contain several
[[Page 68175]]
important changes from the proposed regulations. First, in response to
comments, the final regulations clarify the treatment of a debt
instrument subject to an alternative payment schedule by explicitly
cross-referencing Sec. 1.1272-1(c). Second, the final regulations
provide that, in the case of a debt instrument subject to a mandatory
sinking fund provision, the issuer must determine the payment schedule
by assuming that a pro rata portion of the debt instrument will be
called under the sinking fund provision. This rule produces more
economic interest accruals than the accruals determined by ignoring the
sinking fund provision as under the proposed regulations. Third, the
final regulations adopt rules for excess bond issuance premium
allocable to an accrual period. These rules are similar to the rules
for excess bond premium described above.
Aggregation Rules
Although the proposed regulations do not provide for an aggregate
method of accounting for premium, comments were requested on the need
for an aggregate method. Because no comments were received, the final
regulations do not provide rules for an aggregate method of accounting
for premium.
Bonds Not Subject to the Final Regulations
The final regulations generally apply to bonds acquired or issued
at a premium. Certain bonds, however, are excluded from the application
of the final regulations. For example, the final regulations exclude
debt instruments described in section 1272(a)(6)(C) (regular interests
in a REMIC, qualified mortgages held by a REMIC, and certain other debt
instruments, or pools of debt instruments, with payments subject to
acceleration). No inference is intended regarding the treatment of debt
instruments described in section 1272(a)(6)(C).
Effective Dates
The final regulations relating to bond premium are effective for
bonds acquired on or after March 2, 1998. However, if a holder makes
the election to amortize bond premium for the taxable year containing
March 2, 1998, or any subsequent taxable year, the regulations apply to
bonds held on or after the first day of the taxable year in which the
election is made.
The final regulations relating to bond issuance premium apply to
debt instruments issued on or after March 2, 1998.
The final regulations also provide automatic consent for a taxpayer
to change its method of accounting for premium in certain
circumstances. Because the change is made on a cut-off basis, no items
of income or deduction are omitted or duplicated. Therefore, no
adjustment under section 481 is allowed.
Special Analyses
It is hereby certified that these regulations do not have
significant economic impact on a substantial number of small entities.
This certification is based upon the fact that the regulations merely
require a taxpayer to attach to the taxpayer's return a statement that
indicates whether the taxpayer is making an election under section 171
or is changing its accounting method for bond premium or bond issuance
premium. Therefore, a Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
It has been determined that this Treasury Decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations. Pursuant to section 7805(f) of the
Internal Revenue Code, the notice of proposed rulemaking was submitted
to the Chief Counsel for Advocacy of the Small Business Administration
for comment on its impact on small business.
Drafting Information
Several persons from the Office of Assistant Chief Counsel
(Financial Institutions and Products) and the Treasury Department
participated in the development of these regulations.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.171-2 also issued under 26 U.S.C. 171(e).
Section 1.171-3 also issued under 26 U.S.C. 171(e).
Section 1.171-4 also issued under 26 U.S.C. 171(c). * * *
Par. 2. Section 1.61-12 is amended by revising paragraph (c) to
read as follows:
Sec. 1.61-12 Income from discharge of indebtedness.
* * * * *
(c) Issuance and repurchase of debt instruments--(1) Issuance. An
issuer does not realize gain or loss upon the issuance of a debt
instrument. For rules relating to an issuer's interest deduction for a
debt instrument issued with bond issuance premium, see Sec. 1.163-13.
(2) Repurchase--(i) In general. An issuer does not realize gain or
loss upon the repurchase of a debt instrument. However, if a debt
instrument provides for payments denominated in, or determined by
reference to, a nonfunctional currency, an issuer may realize a
currency gain or loss upon the repurchase of the instrument. See
section 988 and the regulations thereunder. For purposes of this
paragraph (c)(2), the term repurchase includes the retirement of a debt
instrument, the conversion of a debt instrument into stock of the
issuer, and the exchange (including an exchange under section 1001) of
a newly issued debt instrument for an existing debt instrument.
(ii) Repurchase at a discount. An issuer realizes income from the
discharge of indebtedness upon the repurchase of a debt instrument for
an amount less than its adjusted issue price (within the meaning of
Sec. 1.1275-1(b)). The amount of discharge of indebtedness income is
equal to the excess of the adjusted issue price over the repurchase
price. See section 108 and the regulations thereunder for additional
rules relating to income from discharge of indebtedness. For example,
to determine the repurchase price of a debt instrument that is
repurchased through the issuance of a new debt instrument, see section
108(e)(10).
(iii) Repurchase at a premium. An issuer may be entitled to a
repurchase premium deduction upon the repurchase of a debt instrument
for an amount greater than its adjusted issue price (within the meaning
of Sec. 1.1275-1(b)). See Sec. 1.163-7(c) for the treatment of
repurchase premium.
(iv) Effective date. This paragraph (c)(2) applies to debt
instruments repurchased on or after March 2, 1998.
* * * * *
[[Page 68176]]
Par. 3. Section 1.163-13 is added to read as follows:
Sec. 1.163-13 Treatment of bond issuance premium.
(a) General rule. If a debt instrument is issued with bond issuance
premium, this section limits the amount of the issuer's interest
deduction otherwise allowable under section 163(a). In general, the
issuer determines its interest deduction by offsetting the interest
allocable to an accrual period with the bond issuance premium allocable
to that period. Bond issuance premium is allocable to an accrual period
based on a constant yield. The use of a constant yield to amortize bond
issuance premium is intended to generally conform the treatment of debt
instruments having bond issuance premium with those having original
issue discount. Unless otherwise provided, the terms used in this
section have the same meaning as those terms in section 163(e),
sections 1271 through 1275, and the corresponding regulations.
Moreover, unless otherwise provided, the provisions of this section
apply in a manner consistent with those of section 163(e), sections
1271 through 1275, and the corresponding regulations. In addition, the
anti-abuse rule in Sec. 1.1275-2(g) applies for purposes of this
section. For rules dealing with the treatment of bond premium by a
holder, see Secs. 1.171-1 through 1.171-5.
(b) Exceptions. This section does not apply to--
(1) A debt instrument described in section 1272(a)(6)(C) (regular
interests in a REMIC, qualified mortgages held by a REMIC, and certain
other debt instruments, or pools of debt instruments, with payments
subject to acceleration); or
(2) A debt instrument to which Sec. 1.1275-4 applies (relating to
certain debt instruments that provide for contingent payments).
(c) Bond issuance premium. Bond issuance premium is the excess, if
any, of the issue price of a debt instrument over its stated redemption
price at maturity. For purposes of this section, the issue price of a
convertible bond (as defined in Sec. 1.171-1(e)(1)(iii)(C)) does not
include an amount equal to the value of the conversion option (as
determined under Sec. 1.171-1(e)(1)(iii)(A)).
(d) Offsetting qualified stated interest with bond issuance
premium--(1) In general. An issuer amortizes bond issuance premium by
offsetting the qualified stated interest allocable to an accrual period
with the bond issuance premium allocable to the accrual period. This
offset occurs when the issuer takes the qualified stated interest into
account under its regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See
Sec. 1.446-2(b) to determine the accrual period to which qualified
stated interest is allocable and to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond issuance premium allocable to an accrual period. The bond
issuance premium allocable to an accrual period is determined under
this paragraph (d)(3). Within an accrual period, the bond issuance
premium allocable to the period accrues ratably.
(i) Step one: Determine the debt instrument's yield to maturity.
The yield to maturity of a debt instrument is determined under the
rules of Sec. 1.1272-1(b)(1)(i).
(ii) Step two: Determine the accrual periods. The accrual periods
are determined under the rules of Sec. 1.1272-1(b)(1)(ii).
(iii) Step three: Determine the bond issuance premium allocable to
the accrual period. The bond issuance premium allocable to an accrual
period is the excess of the qualified stated interest allocable to the
accrual period over the product of the adjusted issue price at the
beginning of the accrual period and the yield. In performing this
calculation, the yield must be stated appropriately taking into account
the length of the particular accrual period. Principles similar to
those in Sec. 1.1272-1(b)(4) apply in determining the bond issuance
premium allocable to an accrual period.
(4) Bond issuance premium in excess of qualified stated interest--
(i) Ordinary income. If the bond issuance premium allocable to an
accrual period exceeds the qualified stated interest allocable to the
accrual period, the excess is treated as ordinary income by the issuer
for the accrual period. However, the amount treated as ordinary income
is limited to the amount by which the issuer's total interest
deductions on the debt instrument in prior accrual periods exceed the
total amount treated by the issuer as ordinary income on the debt
instrument in prior accrual periods.
(ii) Carryforward. If the bond issuance premium allocable to an
accrual period exceeds the sum of the qualified stated interest
allocable to the accrual period and the amount treated as ordinary
income for the accrual period under paragraph (d)(4)(i) of this
section, the excess is carried forward to the next accrual period and
is treated as bond issuance premium allocable to that period. If a
carryforward exists on the date the debt instrument is retired, the
carryforward is treated as ordinary income on that date.
(e) Special rules--(1) Variable rate debt instruments. An issuer
determines bond issuance premium on a variable rate debt instrument by
reference to the stated redemption price at maturity of the equivalent
fixed rate debt instrument constructed for the variable rate debt
instrument. The issuer also allocates any bond issuance premium among
the accrual periods by reference to the equivalent fixed rate debt
instrument. The issuer constructs the equivalent fixed rate debt
instrument, as of the issue date, by using the principles of
Sec. 1.1275-5(e).
(2) Inflation-indexed debt instruments. An issuer determines bond
issuance premium on an inflation-indexed debt instrument by assuming
that there will be no inflation or deflation over the term of the
instrument. The issuer also allocates any bond issuance premium among
the accrual periods by assuming that there will be no inflation or
deflation over the term of the instrument. The bond issuance premium
allocable to an accrual period offsets qualified stated interest
allocable to the period. Notwithstanding paragraph (d)(4) of this
section, if the bond issuance premium allocable to an accrual period
exceeds the qualified stated interest allocable to the period, the
excess is treated as a deflation adjustment under Sec. 1.1275-
7T(f)(1)(ii). See Sec. 1.1275-7T for other rules relating to inflation-
indexed debt instruments.
(3) Certain debt instruments subject to contingencies--(i) In
general. Except as provided in paragraph (e)(3)(ii) of this section,
the rules of Sec. 1.1272-1(c) apply to determine a debt instrument's
payment schedule for purposes of this section. For example, an issuer
uses the payment schedule determined under Sec. 1.1272-1(c) to
determine the amount, if any, of bond issuance premium on the debt
instrument, the yield and maturity of the debt instrument, and the
allocation of bond issuance premium to an accrual period.
(ii) Mandatory sinking fund provision. Notwithstanding paragraph
(e)(3)(i) of this section, if a debt instrument is subject to a
mandatory sinking fund provision described in Sec. 1.1272-1(c)(3), the
issuer must determine the payment schedule by assuming that a pro rata
portion of the debt instrument will be called under the sinking fund
provision.
(4) Remote and incidental contingencies. For purposes of
determining the amount of bond issuance premium and allocating bond
issuance premium among accrual periods, if a bond provides for a
[[Page 68177]]
contingency that is remote or incidental (within the meaning of
Sec. 1.1275-2(h)), the issuer takes the contingency into account under
the rules for remote and incidental contingencies in Sec. 1.1275-2(h).
(f) Example. The following example illustrates the rules of this
section:
Example--(i) Facts. On February 1, 1999, X issues for $110,000 a
debt instrument maturing on February 1, 2006, with a stated
principal amount of $100,000, payable at maturity. The debt
instrument provides for unconditional payments of interest of
$10,000, payable on February 1 of each year. X uses the calendar
year as its taxable year, X uses the cash receipts and disbursements
method of accounting, and X decides to use annual accrual periods
ending on February 1 of each year. X's calculations assume a 30-day
month and 360-day year.
(ii) Amount of bond issuance premium. The issue price of the
debt instrument is $110,000. Because the interest payments on the
debt instrument are qualified stated interest, the stated redemption
price at maturity of the debt instrument is $100,000. Therefore, the
amount of bond issuance premium is $10,000 ($110,000-$100,000).
(iii) Bond issuance premium allocable to the first accrual
period. Based on the payment schedule and the issue price of the
debt instrument, the yield of the debt instrument is 8.07 percent,
compounded annually. (Although, for purposes of simplicity, the
yield as stated is rounded to two decimal places, the computations
do not reflect this rounding convention.) The bond issuance premium
allocable to the accrual period ending on February 1, 2000, is the
excess of the qualified stated interest allocable to the period
($10,000) over the product of the adjusted issue price at the
beginning of the period ($110,000) and the yield (8.07 percent,
compounded annually). Therefore, the bond issuance premium allocable
to the accrual period is $1,118.17 ($10,000-$8,881.83).
(iv) Premium used to offset interest. Although X makes an
interest payment of $10,000 on February 1, 2000, X only deducts
interest of $8,881.83, the qualified stated interest allocable to
the period ($10,000) offset with the bond issuance premium allocable
to the period ($1,118.17).
(g) Effective date. This section applies to debt instruments
issued on or after March 2, 1998.
(h) Accounting method changes--(1) Consent to change. An issuer
required to change its method of accounting for bond issuance premium
to comply with this section must secure the consent of the Commissioner
in accordance with the requirements of Sec. 1.446-1(e). Paragraph
(h)(2) of this section provides the Commissioner's automatic consent
for certain changes.
(2) Automatic consent. The Commissioner grants consent for an
issuer to change its method of accounting for bond issuance premium on
debt instruments issued on or after March 2, 1998. Because this change
is made on a cut-off basis, no items of income or deduction are omitted
or duplicated and, therefore, no adjustment under section 481 is
allowed. The consent granted by this paragraph (h)(2) applies
provided--
(i) The change is made to comply with this section;
(ii) The change is made for the first taxable year for which the
issuer must account for a debt instrument under this section; and
(iii) The issuer attaches to its federal income tax return for the
taxable year containing the change a statement that it has changed its
method of accounting under this section.
Par. 4. Sections 1.171-1 through 1.171-4 are revised to read as
follows:
Sec. 1.171-1 Bond premium.
(a) Overview--(1) In general. This section and Secs. 1.171-2
through 1.171-5 provide rules for the determination and amortization of
bond premium by a holder. In general, a holder amortizes bond premium
by offsetting the interest allocable to an accrual period with the
premium allocable to that period. Bond premium is allocable to an
accrual period based on a constant yield. The use of a constant yield
to amortize bond premium is intended to generally conform the treatment
of bond premium to the treatment of original issue discount under
sections 1271 through 1275. Unless otherwise provided, the terms used
in this section and Secs. 1.171-2 through 1.171-5 have the same meaning
as those terms in sections 1271 through 1275 and the corresponding
regulations. Moreover, unless otherwise provided, the provisions of
this section and Secs. 1.171-2 through 1.171-5 apply in a manner
consistent with those of sections 1271 through 1275 and the
corresponding regulations. In addition, the anti-abuse rule in
Sec. 1.1275-2(g) applies for purposes of this section and Secs. 1.171-2
through 1.171-5.
(2) Cross-references. For rules dealing with the adjustments to a
holder's basis to reflect the amortization of bond premium, see
Sec. 1.1016-5(b). For rules dealing with the treatment of bond issuance
premium by an issuer, see Sec. 1.163-13.
(b) Scope--(1) In general. Except as provided in paragraph (b)(2)
of this section and Sec. 1.171-5, this section and Secs. 1.171-2
through 1.171-4 apply to any bond that, upon its acquisition by the
holder, is held with bond premium. For purposes of this section and
Secs. 1.171-2 through 1.171-5, the term bond has the same meaning as
the term debt instrument in Sec. 1.1275-1(d).
(2) Exceptions. This section and Secs. 1.171-2 through 1.171-5 do
not apply to--
(i) A bond described in section 1272(a)(6)(C) (regular interests in
a REMIC, qualified mortgages held by a REMIC, and certain other debt
instruments, or pools of debt instruments, with payments subject to
acceleration);
(ii) A bond to which Sec. 1.1275-4 applies (relating to certain
debt instruments that provide for contingent payments);
(iii) A bond held by a holder that has made a Sec. 1.1272-3
election with respect to the bond;
(iv) A bond that is stock in trade of the holder, a bond of a kind
that would properly be included in the inventory of the holder if on
hand at the close of the taxable year, or a bond held primarily for
sale to customers in the ordinary course of the holder's trade or
business; or
(v) A bond issued before September 28, 1985, unless the bond bears
interest and was issued by a corporation or by a government or
political subdivision thereof.
(c) General rule--(1) Tax-exempt obligations. A holder must
amortize bond premium on a bond that is a tax-exempt obligation. See
Sec. 1.171-2(c) Example 4.
(2) Taxable bonds. A holder may elect to amortize bond premium on a
taxable bond. Except as provided in paragraph (c)(3) of this section, a
taxable bond is any bond other than a tax-exempt obligation. See
Sec. 1.171-4 for rules relating to the election to amortize bond
premium on a taxable bond.
(3) Bonds the interest on which is partially excludable. For
purposes of this section and Secs. 1.171-2 through 1.171-5, a bond the
interest on which is partially excludable from gross income is treated
as two instruments, a tax-exempt obligation and a taxable bond. The
holder's basis in the bond and each payment on the bond are allocated
between the two instruments based on a reasonable method.
(d) Determination of bond premium--(1) In general. A holder
acquires a bond at a premium if the holder's basis in the bond
immediately after its acquisition by the holder exceeds the sum of all
amounts payable on the bond after the acquisition date (other than
payments of qualified stated interest). This excess is bond premium,
which is amortizable under Sec. 1.171-2.
(2) Additional rules for amounts payable on certain bonds.
Additional rules apply to determine the amounts payable on a variable
rate debt instrument, an inflation-indexed debt
[[Page 68178]]
instrument, a bond that provides for certain alternative payment
schedules, and a bond that provides for remote or incidental
contingencies. See Sec. 1.171-3.
(e) Basis. A holder determines its basis in a bond under this
paragraph (e). This determination of basis applies only for purposes of
this section and Secs. 1.171-2 through 1.171-5. Because of the
application of this paragraph (e), the holder's basis in the bond for
purposes of these sections may differ from the holder's basis for
determining gain or loss on the sale or exchange of the bond.
(1) Determination of basis--(i) In general. In general, the
holder's basis in the bond is the holder's basis for determining loss
on the sale or exchange of the bond.
(ii) Bonds acquired in certain exchanges. If the holder acquired
the bond in exchange for other property (other than in a reorganization
defined in section 368) and the holder's basis in the bond is
determined in whole or in part by reference to the holder's basis in
the other property, the holder's basis in the bond may not exceed its
fair market value immediately after the exchange. See paragraph (f)
Example 1 of this section. If the bond is acquired in a reorganization,
see section 171(b)(4)(B).
(iii) Convertible bonds--(A) General rule. If the bond is a
convertible bond, the holder's basis in the bond is reduced by an
amount equal to the value of the conversion option. The value of the
conversion option may be determined under any reasonable method. For
example, the holder may determine the value of the conversion option by
comparing the market price of the convertible bond to the market prices
of similar bonds that do not have conversion options. See paragraph (f)
Example 2 of this section.
(B) Convertible bonds acquired in certain exchanges. If the bond is
a convertible bond acquired in a transaction described in paragraph
(e)(1)(ii) of this section, the holder's basis in the bond may not
exceed its fair market value immediately after the exchange reduced by
the value of the conversion option.
(C) Definition of convertible bond. A convertible bond is a bond
that provides the holder with an option to convert the bond into stock
of the issuer, stock or debt of a related party (within the meaning of
section 267(b) or 707(b)(1)), or into cash or other property in an
amount equal to the approximate value of such stock or debt.
(2) Basis in bonds held by certain transferees. Notwithstanding
paragraph (e)(1) of this section, if the bond is transferred basis
property (as defined in section 7701(a)(43)) and the transferor had
acquired the bond at a premium, the holder's basis in the bond is--
(i) The holder's basis for determining loss on the sale or exchange
of the bond; reduced by
(ii) Any amounts that the transferor could not have amortized under
this paragraph (e) or under Sec. 1.171-4(c), except to the extent that
the holder's basis already reflects a reduction attributable to such
nonamortizable amounts.
(f) Examples. The following examples illustrate the rules of this
section:
Example 1. Bond received in liquidation of a partnership
interest--(i) Facts. PR is a partner in partnership PRS. PRS does
not have any unrealized receivables or inventory items as defined in
section 751. On January 1, 1998, PRS distributes to PR a taxable
bond, issued by an unrelated corporation, in liquidation of PR's
partnership interest. At that time, the fair market value of PR's
partnership interest is $40,000 and the basis is $100,000. The fair
market value of the bond is $40,000.
(ii) Determination of basis. Under section 732(b), PR's basis in
the bond is equal to PR's basis in the partnership interest.
Therefore, PR's basis for determining loss on the sale or exchange
of the bond is $100,000. However, because the distribution is
treated as an exchange for purposes of section 171(b)(4), PR's basis
in the bond is $40,000 for purposes of this section and Secs. 1.171-
2 through 1.171-5. See paragraph (e)(1)(ii) of this section.
Example 2. Convertible bond--(i) Facts. On January 11, 1998, A
purchases for $1,100 B corporation's bond maturing on January 1,
2001, with a stated principal amount of $1,000, payable at maturity.
The bond provides for unconditional payments of interest of $30 on
January 1 and July 1 of each year. In addition, the bond is
convertible into 15 shares of B corporation stock at the option of
the holder. On January 1, 1998, B corporation's nonconvertible,
publicly-traded, three-year debt with a similar credit rating trades
at a price that reflects a yield of 6.75 percent, compounded
semiannually.
(ii) Determination of basis. A's basis for determining loss on
the sale or exchange of the bond is $1,100. As of January 1, 1998,
discounting the remaining payments on the bond at the yield at which
B's similar nonconvertible bonds trade (6.75 percent, compounded
semiannually) results in a present value of $980. Thus, the value of
the conversion option is $120. Under paragraph (e)(1)(iii)(A) of
this section, A's basis is $980 ($1,100-$120) for purposes of this
section and Secs. 1.171-2 through 1.171-5. The sum of all amounts
payable on the bond other than qualified stated interest is $1,000.
Because A's basis (as determined under paragraph (e)(1)(iii)(A) of
this section) does not exceed $1,000, A does not acquire the bond at
a premium.
Sec. 1.171-2 Amortization of bond premium.
(a) Offsetting qualified stated interest with premium--(1) In
general. A holder amortizes bond premium by offsetting the qualified
stated interest allocable to an accrual period with the bond premium
allocable to the accrual period. This offset occurs when the holder
takes the qualified stated interest into account under the holder's
regular method of accounting.
(2) Qualified stated interest allocable to an accrual period. See
Sec. 1.446-2(b) to determine the accrual period to which qualified
stated interest is allocable and to determine the accrual of qualified
stated interest within an accrual period.
(3) Bond premium allocable to an accrual period. The bond premium
allocable to an accrual period is determined under this paragraph
(a)(3). Within an accrual period, the bond premium allocable to the
period accrues ratably.
(i) Step one: Determine the holder's yield. The holder's yield is
the discount rate that, when used in computing the present value of all
remaining payments to be made on the bond (including payments of
qualified stated interest), produces an amount equal to the holder's
basis in the bond as determined under Sec. 1.171-1(e). For this
purpose, the remaining payments include only payments to be made after
the date the holder acquires the bond. The yield is calculated as of
the date the holder acquires the bond, must be constant over the term
of the bond, and must be calculated to at least two decimal places when
expressed as a percentage.
(ii) Step two: Determine the accrual periods. A holder determines
the accrual periods for the bond under the rules of Sec. 1.1272-
1(b)(1)(ii).
(iii) Step three: Determine the bond premium allocable to the
accrual period. The bond premium allocable to an accrual period is the
excess of the qualified stated interest allocable to the accrual period
over the product of the holder's adjusted acquisition price (as defined
in paragraph (b) of this section) at the beginning of the accrual
period and the holder's yield. In performing this calculation, the
yield must be stated appropriately taking into account the length of
the particular accrual period. Principles similar to those in
Sec. 1.1272-1(b)(4) apply in determining the bond premium allocable to
an accrual period.
(4) Bond premium in excess of qualified stated interest--(i)
Taxable bonds--(A) Bond premium deduction. In the case of a taxable
bond, if the bond premium allocable to an accrual period exceeds the
qualified stated interest allocable to the accrual period, the excess
is treated by the holder as a bond premium deduction under section
171(a)(1) for the accrual period. However, the amount treated as a bond
[[Page 68179]]
premium deduction is limited to the amount by which the holder's total
interest inclusions on the bond in prior accrual periods exceed the
total amount treated by the holder as a bond premium deduction on the
bond in prior accrual periods. A deduction determined under this
paragraph (a)(4)(i)(A) is not subject to section 67 (the 2-percent
floor on miscellaneous itemized deductions). See Example 1 of
Sec. 1.171-3(e).
(B) Carryforward. If the bond premium allocable to an accrual
period exceeds the sum of the qualified stated interest allocable to
the accrual period and the amount treated as a deduction for the
accrual period under paragraph (a)(4)(i)(A) of this section, the excess
is carried forward to the next accrual period and is treated as bond
premium allocable to that period.
(ii) Tax-exempt obligations. In the case of a tax-exempt
obligation, if the bond premium allocable to an accrual period exceeds
the qualified stated interest allocable to the accrual period, the
excess is a nondeductible loss. If a regulated investment company (RIC)
within the meaning of section 851 has excess bond premium for an
accrual period that would be a nondeductible loss under the prior
sentence, the RIC must use this excess bond premium to reduce its tax-
exempt interest income on other tax-exempt obligations held during the
accrual period.
(5) Additional rules for certain bonds. Additional rules apply to
determine the amortization of bond premium on a variable rate debt
instrument, an inflation-indexed debt instrument, a bond that provides
for certain alternative payment schedules, and a bond that provides for
remote or incidental contingencies. See Sec. 1.171-3.
(b) Adjusted acquisition price. The adjusted acquisition price of a
bond at the beginning of the first accrual period is the holder's basis
as determined under Sec. 1.171-1(e). Thereafter, the adjusted
acquisition price is the holder's basis in the bond decreased by--
(1) The amount of bond premium previously allocable under paragraph
(a)(3) of this section; and
(2) The amount of any payment previously made on the bond other
than a payment of qualified stated interest.
(c) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and has elected to amortize bond premium, effective for
all relevant taxable years. In addition, each example assumes a 30-day
month and 360-day year. Although, for purposes of simplicity, the yield
as stated is rounded to two decimal places, the computations do not
reflect this rounding convention. The examples are as follows:
Example 1. Taxable bond--(i) Facts. On February 1, 1999, A
purchases for $110,000 a taxable bond maturing on February 1, 2006,
with a stated principal amount of $100,000, payable at maturity. The
bond provides for unconditional payments of interest of $10,000,
payable on February 1 of each year. A uses the cash receipts and
disbursements method of accounting, and A decides to use annual
accrual periods ending on February 1 of each year.
(ii) Amount of bond premium. The interest payments on the bond
are qualified stated interest. Therefore, the sum of all amounts
payable on the bond (other than the interest payments) is $100,000.
Under Sec. 1.171-1, the amount of bond premium is $10,000
($110,000-$100,000).
(iii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the bond and A's basis in the
bond, A's yield is 8.07 percent, compounded annually. The bond
premium allocable to the accrual period ending on February 1, 2000,
is the excess of the qualified stated interest allocable to the
period ($10,000) over the product of the adjusted acquisition price
at the beginning of the period ($110,000) and A's yield (8.07
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $1,118.17 ($10,000-$8,881.83).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest allocable to the
period ($10,000) offset with bond premium allocable to the period
($1,118.17). Under Sec. 1.1016-5(b), A's basis in the bond is
reduced by $1,118.17 on February 1, 2000.
Example 2. Alternative accrual periods--(i) Facts. The facts are
the same as in Example 1 of this paragraph (c) except that A decides
to use semiannual accrual periods ending on February 1 and August 1
of each year.
(ii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the bond and A's basis in the
bond, A's yield is 7.92 percent, compounded semiannually. The bond
premium allocable to the accrual period ending on August 1, 1999, is
the excess of the qualified stated interest allocable to the period
($5,000) over the product of the adjusted acquisition price at the
beginning of the period ($110,000) and A's yield, stated
appropriately taking into account the length of the accrual period
(7.92 percent/2). Therefore, the bond premium allocable to the
accrual period is $645.29 ($5,000-$4,354.71). Although the accrual
period ends on August 1, 1999, the qualified stated interest of
$5,000 is not taken into income until February 1, 2000, the date it
is received. Likewise, the bond premium of $645.29 is not taken into
account until February 1, 2000. The adjusted acquisition price of
the bond on August 1, 1999, is $109,354.71 (the adjusted acquisition
price at the beginning of the period ($110,000) less the bond
premium allocable to the period ($645.29)).
(iii) Bond premium allocable to the second accrual period.
Because the interval between payments of qualified stated interest
contains more than one accrual period, the adjusted acquisition
price at the beginning of the second accrual period must be adjusted
for the accrued but unpaid qualified stated interest. See paragraph
(a)(3)(iii) of this section and Sec. 1.1272-1(b)(4)(i)(B).
Therefore, the adjusted acquisition price on August 1, 1999, is
$114,354.71 ($109,354.71 + $5,000). The bond premium allocable to
the accrual period ending on February 1, 2000, is the excess of the
qualified stated interest allocable to the period ($5,000) over the
product of the adjusted acquisition price at the beginning of the
period ($114,354.71) and A's yield, stated appropriately taking into
account the length of the accrual period (7.92 percent/2).
Therefore, the bond premium allocable to the accrual period is
$472.88 ($5,000-$4,527.12).
(iv) Premium used to offset interest. Although A receives an
interest payment of $10,000 on February 1, 2000, A only includes in
income $8,881.83, the qualified stated interest of $10,000 ($5,000
allocable to the accrual period ending on August 1, 1999, and $5,000
allocable to the accrual period ending on February 1, 2000) offset
with bond premium of $1,118.17 ($645.29 allocable to the accrual
period ending on August 1, 1999, and $472.88 allocable to the
accrual period ending on February 1, 2000). As indicated in Example
1 of this paragraph (c), this same amount would be taken into income
at the same time had A used annual accrual periods.
Example 3. Holder uses accrual method of accounting--(i) Facts.
The facts are the same as in Example 1 of this paragraph (c) except
that A uses an accrual method of accounting. Thus, for the accrual
period ending on February 1, 2000, the qualified stated interest
allocable to the period is $10,000, and the bond premium allocable
to the period is $1,118.17. Because the accrual period extends
beyond the end of A's taxable year, A must allocate these amounts
between the two taxable years.
(ii) Amounts allocable to the first taxable year. The qualified
stated interest allocable to the first taxable year is $9,166.67
($10,000 x \11/12\). The bond premium allocable to the first
taxable year is $1,024.99 ($1,118.17 x \11/12\).
(iii) Premium used to offset interest. For 1999, A includes in
income $8,141.68, the qualified stated interest allocable to the
period ($9,166.67) offset with bond premium allocable to the period
($1,024.99). Under Sec. 1.1016-5(b), A's basis in the bond is
reduced by $1,024.99 in 1999.
(iv) Amounts allocable to the next taxable year. The remaining
amounts of qualified stated interest and bond premium allocable to
the accrual period ending on February 1, 2000, are taken into
account for the taxable year ending on December 31, 2000.
Example 4. Tax-exempt obligation--(i) Facts. On January 15,
1999, C purchases for $120,000 a tax-exempt obligation maturing on
January 15, 2006, with a stated principal amount of $100,000,
payable at maturity. The obligation provides for unconditional
payments of interest of $9,000, payable on
[[Page 68180]]
January 15 of each year. C uses the cash receipts and disbursements
method of accounting, and C decides to use annual accrual periods
ending on January 15 of each year.
(ii) Amount of bond premium. The interest payments on the
obligation are qualified stated interest. Therefore, the sum of all
amounts payable on the obligation (other than the interest payments)
is $100,000. Under Sec. 1.171-1, the amount of bond premium is
$20,000 ($120,000--$100,000).
(iii) Bond premium allocable to the first accrual period. Based
on the remaining payment schedule of the obligation and C's basis in
the obligation, C's yield is 5.48 percent, compounded annually. The
bond premium allocable to the accrual period ending on January 15,
2000, is the excess of the qualified stated interest allocable to
the period ($9,000) over the product of the adjusted acquisition
price at the beginning of the period ($120,000) and C's yield (5.48
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $2,420.55 ($9,000-$6,579.45).
(iv) Premium used to offset interest. Although C receives an
interest payment of $9,000 on January 15, 2000, C only receives tax-
exempt interest income of $6,579.45, the qualified stated interest
allocable to the period ($9,000) offset with bond premium allocable
to the period ($2,420.55). Under Sec. 1.1016-5(b), C's basis in the
obligation is reduced by $2,420.55 on January 15, 2000.
Sec. 1.171-3 Special rules for certain bonds.
(a) Variable rate debt instruments. A holder determines bond
premium on a variable rate debt instrument by reference to the stated
redemption price at maturity of the equivalent fixed rate debt
instrument constructed for the variable rate debt instrument. The
holder also allocates any bond premium among the accrual periods by
reference to the equivalent fixed rate debt instrument. The holder
constructs the equivalent fixed rate debt instrument, as of the date
the holder acquires the variable rate debt instrument, by using the
principles of Sec. 1.1275-5(e). See paragraph (e) Example 1 of this
section.
(b) Inflation-indexed debt instruments. A holder determines bond
premium on an inflation-indexed debt instrument by assuming that there
will be no inflation or deflation over the remaining term of the
instrument. The holder also allocates any bond premium among the
accrual periods by assuming that there will be no inflation or
deflation over the remaining term of the instrument. The bond premium
allocable to an accrual period offsets qualified stated interest
allocable to the period. Notwithstanding Sec. 1.171-2(a)(4), if the
bond premium allocable to an accrual period exceeds the qualified
stated interest allocable to the period, the excess is treated as a
deflation adjustment under Sec. 1.1275-7T(f)(1)(i). See Sec. 1.1275-7T
for other rules relating to inflation-indexed debt instruments.
(c) Yield and remaining payment schedule of certain bonds subject
to contingencies--(1) Applicability. This paragraph (c) provides rules
that apply in determining the yield and remaining payment schedule of
certain bonds that provide for an alternative payment schedule (or
schedules) applicable upon the occurrence of a contingency (or
contingencies). This paragraph (c) applies, however, only if the timing
and amounts of the payments that comprise each payment schedule are
known as of the date the holder acquires the bond (the acquisition
date) and the bond is subject to paragraph (c)(2), (3), or (4) of this
section. A bond does not provide for an alternative payment schedule
merely because there is a possibility of impairment of a payment (or
payments) by insolvency, default, or similar circumstances. See
Sec. 1.1275-4 for the treatment of a bond that provides for a
contingency that is not described in this paragraph (c).
(2) Remaining payment schedule that is significantly more likely
than not to occur. If, based on all the facts and circumstances as of
the acquisition date, a single remaining payment schedule for a bond is
significantly more likely than not to occur, this remaining payment
schedule is used to determine and amortize bond premium under
Secs. 1.171-1 and 1.171-2.
(3) Mandatory sinking fund provision. Notwithstanding paragraph
(c)(2) of this section, if a bond is subject to a mandatory sinking
fund provision described in Sec. 1.1272-1(c)(3), the provision is
ignored for purposes of determining and amortizing bond premium under
Secs. 1.171-1 and 1.171-2.
(4) Treatment of certain options--(i) Applicability.
Notwithstanding paragraphs (c)(2) and (3) of this section, the rules of
this paragraph (c)(4) determine the remaining payment schedule of a
bond that provides the holder or issuer with an unconditional option or
options, exercisable on one or more dates during the remaining term of
the bond, to alter the bond's remaining payment schedule.
(ii) Operating rules. A holder determines the remaining payment
schedule of a bond by assuming that each option will (or will not) be
exercised under the following rules:
(A) Issuer options. In general, the issuer is deemed to exercise or
not exercise an option or combination of options in the manner that
minimizes the holder's yield on the obligation. However, the issuer of
a taxable bond is deemed to exercise or not exercise a call option or
combination of call options in the manner that maximizes the holder's
yield on the bond.
(B) Holder options. A holder is deemed to exercise or not exercise
an option or combination of options in the manner that maximizes the
holder's yield on the bond.
(C) Multiple options. If both the issuer and the holder have
options, the rules of paragraphs (c)(4)(ii)(A) and (B) of this section
are applied to the options in the order that they may be exercised.
Thus, the deemed exercise of one option may eliminate other options
that are later in time.
(5) Subsequent adjustments--(i) In general. Except as provided in
paragraph (c)(5)(ii) of this section, if a contingency described in
this paragraph (c) (including the exercise of an option described in
paragraph (c)(4) of this section) actually occurs or does not occur,
contrary to the assumption made pursuant to paragraph (c) of this
section (a change in circumstances), then solely for purposes of
section 171, the bond is treated as retired and reacquired by the
holder on the date of the change in circumstances for an amount equal
to the adjusted acquisition price of the bond as of that date. If,
however, the change in circumstances results in a substantially
contemporaneous pro-rata prepayment as defined in Sec. 1.1275-2(f)(2),
the pro-rata prepayment is treated as a payment in retirement of a
portion of the bond. See paragraph (e) Example 2 of this section.
(ii) Bond premium deduction on the issuer's call of a taxable bond.
If a change in circumstances results from an issuer's call of a taxable
bond or a partial call that is a pro-rata prepayment, the holder may
deduct as bond premium an amount equal to the excess, if any, of the
holder's adjusted acquisition price of the bond over the greater of--
(A) The amount received on redemption; and
(B) The amounts that would have been payable under the bond (other
than payments of qualified stated interest) if no change in
circumstances had occurred.
(d) Remote and incidental contingencies. For purposes of
determining and amortizing bond premium, if a bond provides for a
contingency that is remote or incidental (within the meaning of
Sec. 1.1275-2(h)), the holder takes the contingency into account under
the rules for remote and incidental contingencies in Sec. 1.1275-2(h).
(e) Examples. The following examples illustrate the rules of this
section. Each example assumes the holder uses the calendar year as its
taxable year and has
[[Page 68181]]
elected to amortize bond premium, effective for all relevant taxable
years. In addition, each example assumes a 30-day month and 360-day
year. Although, for purposes of simplicity, the yield as stated is
rounded to two decimal places, the computations do not reflect this
rounding convention. The examples are as follows:
Example 1. Variable rate debt instrument--(i) Facts. On March 1,
1999, E purchases for $110,000 a taxable bond maturing on March 1,
2007, with a stated principal amount of $100,000, payable at
maturity. The bond provides for unconditional payments of interest
on March 1 of each year based on the percentage appreciation of a
nationally-known commodity index. On March 1, 1999, it is reasonably
expected that the bond will yield 12 percent, compounded annually. E
uses the cash receipts and disbursements method of accounting, and E
decides to use annual accrual periods ending on March 1 of each
year. Assume that the bond is a variable rate debt instrument under
Sec. 1.1275-5.
(ii) Amount of bond premium. Because the bond is a variable rate
debt instrument, E determines and amortizes its bond premium by
reference to the equivalent fixed rate debt instrument constructed
for the bond as of March 1, 1999. Because the bond provides for
interest at a single objective rate that is reasonably expected to
yield 12 percent, compounded annually, the equivalent fixed rate
debt instrument for the bond is an eight-year bond with a principal
amount of $100,000, payable at maturity. It provides for annual
payments of interest of $12,000. E's basis in the equivalent fixed
rate debt instrument is $110,000. The sum of all amounts payable on
the equivalent fixed rate debt instrument (other than payments of
qualified stated interest) is $100,000. Under Sec. 1.171-1, the
amount of bond premium is $10,000 ($110,000 -$100,000).
(iii) Bond premium allocable to each accrual period. E allocates
bond premium to the remaining accrual periods by reference to the
payment schedule on the equivalent fixed rate debt instrument. Based
on the payment schedule of the equivalent fixed rate debt instrument
and E's basis in the bond, E's yield is 10.12 percent, compounded
annually. The bond premium allocable to the accrual period ending on
March 1, 2000, is the excess of the qualified stated interest
allocable to the period for the equivalent fixed rate debt
instrument ($12,000) over the product of the adjusted acquisition
price at the beginning of the period ($110,000) and E's yield (10.12
percent, compounded annually). Therefore, the bond premium allocable
to the accrual period is $870.71 ($12,000-$11,129.29). The bond
premium allocable to all the accrual periods is listed in the
following schedule:
------------------------------------------------------------------------
Adjusted
acquisition Premium
Accrual period ending price at allocable
beginning of to accrual
accrual period period
------------------------------------------------------------------------
3/1/00..................................... $110,000.00 $870.71
3/1/01..................................... 109,129.29 958.81
3/1/02..................................... 108,170.48 1,055.82
3/1/03..................................... 107,114.66 1,162.64
3/1/04..................................... 105,952.02 1,280.27
3/1/05..................................... 104,671.75 1,409.80
3/1/06..................................... 103,261.95 1,552.44
3/1/07..................................... 101,709.51 1,709.51
----------------------------
10,000.00
------------------------------------------------------------------------
(iv) Qualified stated interest for each accrual period. Assume
the bond actually pays the following amounts of qualified stated
interest:
------------------------------------------------------------------------
Qualified
Accrual period ending stated
interest
------------------------------------------------------------------------
3/1/00..................................................... $2,000.00
3/1/01..................................................... 0.00
3/1/02..................................................... 0.00
3/1/03..................................................... 10,000.00
3/1/04..................................................... 8,000.00
3/1/05..................................................... 12,000.00
3/1/06..................................................... 15,000.00
3/1/07..................................................... 8,500.00
------------------------------------------------------------------------
(v) Premium used to offset interest. E's interest income for
each accrual period is determined by offsetting the qualified stated
interest allocable to the period with the bond premium allocable to
the period. For the accrual period ending on March 1, 2000, E
includes in income $1,129.29, the qualified stated interest
allocable to the period ($2,000) offset with the bond premium
allocable to the period ($870.71). For the accrual period ending on
March 1, 2001, the bond premium allocable to the accrual period
($958.81) exceeds the qualified stated interest allocable to the
period ($0) and, therefore, E does not have interest income for this
accrual period. However, under Sec. 1.171-2(a)(4)(i)(A), E may
deduct as bond premium $958.81, the excess of the bond premium
allocable to the accrual period ($958.81) over the qualified stated
interest allocable to the accrual period ($0). For the accrual
period ending on March 1, 2002, the bond premium allocable to the
accrual period ($1,055.82) exceeds the qualified stated interest
allocable to the accrual period ($0) and, therefore, E does not have
interest income for the accrual period. Under Sec. 1.171-
2(a)(4)(i)(A), E's deduction for bond premium for the accrual period
is limited to $170.48, the excess of E's total interest inclusions
on the bond in prior accrual periods ($1,129.29) over the total
amount treated by E as a bond premium deduction in prior accrual
periods ($958.81). Under Sec. 1.171-2(a)(4)(i)(B), E must carry
forward the remaining $885.34 of bond premium allocable to the
period ending March 1, 2002, and treat it as bond premium allocable
to the period ending March 1, 2003. The amount E includes in income
for each accrual period is shown in the following schedule:
----------------------------------------------------------------------------------------------------------------
Premium
Qualified allocable Interest Premium Premium
Accrual period ending stated to accrual income deduction carryforward
interest period
----------------------------------------------------------------------------------------------------------------
3/1/00........................................ $2,000.00 $870.71 $1,129.29 ........... ............
3/1/01........................................ 0.00 958.81 0.00 $958.81 ............
3/1/02........................................ 0.00 1,055.82 0.00 170.48 $885.34
3/1/03........................................ 10,000.00 1,162.64 7,951.93 ........... ............
3/1/04........................................ 8,000.00 1,280.27 6,719.73 ........... ............
3/1/05........................................ 12,000.00 1,409.80 10,590.20 ........... ............
3/1/06........................................ 15,000.00 1,552.44 13,447.56 ........... ............
3/1/07........................................ 8,500.00 1,709.51 6,790.49
-------------
........... 10,000.00 ........... ........... ............
----------------------------------------------------------------------------------------------------------------
Example 2. Partial call that results in a pro-rata prepayment--
(i) Facts. On April 1, 1999, M purchases for $110,000 N's taxable
bond maturing on April 1, 2006, with a stated principal amount of
$100,000, payable at maturity. The bond provides for unconditional
payments of interest of $10,000, payable on April 1 of each year. N
has the option to call all or part of the bond on April 1, 2001, at
a 5 percent premium over the principal amount. M uses the cash
receipts and disbursements method of accounting.
(ii) Determination of yield and the remaining payment schedule.
M's yield determined without regard to the call option is 8.07
percent, compounded annually. M's yield determined by assuming N
exercises its call option is 6.89 percent, compounded annually.
Under paragraph (c)(4)(ii)(A) of this section, it is assumed N will
not exercise the call option because exercising the option would
minimize M's yield. Thus, for purposes of determining and amortizing
[[Page 68182]]
bond premium, the bond is assumed to be a seven-year bond with a
single principal payment at maturity of $100,000.
(iii) Amount of bond premium. The interest payments on the bond
are qualified stated interest. Therefore, the sum of all amounts
payable on the bond (other than the interest payments) is $100,000.
Under Sec. 1.171-1, the amount of bond premium is $10,000
($110,000-$100,000).
(iv) Bond premium allocable to the first two accrual periods.
For the accrual period ending on April 1, 2000, M includes in income
$8,881.83, the qualified stated interest allocable to the period
($10,000) offset with bond premium allocable to the period
($1,118.17). The adjusted acquisition price on April 1, 2000, is
$108,881.83 ($110,000-$1,118.17). For the accrual period ending on
April 1, 2001, M includes in income $8,791.54, the qualified stated
interest allocable to the period ($10,000) offset with bond premium
allocable to the period ($1,208.46). The adjusted acquisition price
on April 1, 2001, is $107,673.37 ($108,881.83-$1,208.46).
(v) Partial call. Assume N calls one-half of M's bond for
$52,500 on April 1, 2001. Because it was assumed the call would not
be exercised, the call is a change in circumstances. However, the
partial call is also a pro-rata prepayment within the meaning of
Sec. 1.1275-2(f)(2). As a result, the call is treated as a
retirement of one-half of the bond. Under paragraph (c)(5)(ii) of
this section, M may deduct $1,336.68, the excess of its adjusted
acquisition price in the retired portion of the bond ($107,673.37/2,
or $53,836.68) over the amount received on redemption ($52,500). M's
adjusted basis in the portion of the bond that remains outstanding
is $53,836.68 ($107,673.37-$53,836.68).
Sec. 1.171-4 Election to amortize bond premium on taxable bonds.
(a) Time and manner of making the election--(1) In general. A
holder makes the election to amortize bond premium by offsetting
interest income with bond premium in the holder's timely filed federal
income tax return for the first taxable year to which the holder
desires the election to apply. The holder should attach to the return a
statement that the holder is making the election under this section.
(2) Coordination with OID election. If a holder makes an election
under Sec. 1.1272-3 for a bond with bond premium, the holder is deemed
to have made the election under this section.
(b) Scope of election. The election under this section applies to
all taxable bonds held during or after the taxable year for which the
election is made.
(c) Election to amortize made in a subsequent taxable year--(1) In
general. If a holder elects to amortize bond premium and holds a
taxable bond acquired before the taxable year for which the election is
made, the holder may not amortize amounts that would have been
amortized in prior taxable years had an election been in effect for
those prior years.
(2) Example. The following example illustrates the rule of this
paragraph (c):
Example--(i) Facts. On May 1, 1999, C purchases for $130,000 a
taxable bond maturing on May 1, 2006, with a stated principal amount
of $100,000, payable at maturity. The bond provides for
unconditional payments of interest of $15,000, payable on May 1 of
each year. C uses the cash receipts and disbursements method of
accounting and the calendar year as its taxable year. C has not
previously elected to amortize bond premium, but does so for 2002.
(ii) Amount to amortize. C's basis for determining loss on the
sale or exchange of the bond is $130,000. Thus, under Sec. 1.171-1,
the amount of bond premium is $30,000. Under Sec. 1.171-2, if a bond
premium election were in effect for the prior taxable years, C would
have amortized $3,257.44 of bond premium on May 1, 2000, and
$3,551.68 of bond premium on May 1, 2001, based on annual accrual
periods ending on May 1. Thus, for 2002 and future years to which
the election applies, C may amortize only $23,190.88
($30,000-$3,257.44-$3,551.68).
(d) Revocation of election. The election under this section may not
be revoked unless approved by the Commissioner. Because a revocation of
the election is a change in accounting method, a taxpayer must follow
the rules under Sec. 1.446-1(e)(3)(i) to request the Commissioner's
consent to revoke the election. A revocation of the election applies to
all taxable bonds held during or after the taxable year for which the
revocation is effective. The holder may not amortize any remaining bond
premium on bonds held at the beginning of the taxable year for which
the revocation is effective. Therefore, no adjustment under section 481
is allowed upon the revocation of the election because no items of
income or deduction are omitted or duplicated.
Par. 5. Section 1.171-5 is added to read as follows:
Sec. 1.171-5 Effective date and transition rules.
(a) Effective date--(1) In general. Sections 1.171-1 through 1.171-
4 apply to bonds acquired on or after March 2, 1998. However, if a
holder makes the election under Sec. 1.171-4 for the taxable year
containing March 2, 1998, or any subsequent taxable year, Secs. 1.171-1
through 1.171-4 apply to bonds held on or after the first day of the
taxable year in which the election is made.
(2) Transition rule for use of constant yield. Notwithstanding
paragraph (a)(1) of this section, Sec. 1.171-2(a)(3) (providing that
the bond premium allocable to an accrual period is determined with
reference to a constant yield) does not apply to a bond issued before
September 28, 1985.
(b) Coordination with existing election. A holder is deemed to have
made the election under Sec. 1.171-4 for the taxable year containing
March 2, 1998, if the holder elected to amortize bond premium under
section 171 and that election is effective on March 2, 1998. If the
holder is deemed to have made the election under Sec. 1.171-4 for the
taxable year containing March 2, 1998, Secs. 1.171-1 through 1.171-4
apply to bonds acquired on or after the first day of that taxable year.
See Sec. 1.171-4(d) for rules relating to a revocation of an election
under section 171.
(c) Accounting method changes--(1) Consent to change. A holder
required to change its method of accounting for bond premium to comply
with Secs. 1.171-1 through 1.171-3 must secure the consent of the
Commissioner in accordance with the requirements of Sec. 1.446-1(e).
Paragraph (c)(2) of this section provides the Commissioner's automatic
consent for certain changes. A holder making the election under
Sec. 1.171-4 does not need the Commissioner's consent to make the
election.
(2) Automatic consent. The Commissioner grants consent for a holder
to change its method of accounting for bond premium with respect to
taxable bonds to which Secs. 1.171-1 through 1.171-3 apply. Because
this change is made on a cut-off basis, no items of income or deduction
are omitted or duplicated and, therefore, no adjustment under section
481 is allowed. The consent granted by this paragraph (c)(2) applies
provided--
(i) The holder elected to amortize bond premium under section 171
for a taxable year prior to the taxable year containing March 2, 1998,
and that election has not been revoked;
(ii) The change is made for the first taxable year for which the
holder must account for a bond under Secs. 1.171-1 through 1.171-3; and
(iii) The holder attaches to its return for the taxable year
containing the change a statement that it has changed its method of
accounting under this section.
Par. 6. Section 1.249-1 is amended by revising paragraph (c) and
the first sentence of paragraph (d)(2) to read as follows:
Sec. 1.249-1 Limitation on deduction of bond premium on repurchase.
* * * * *
(c) Repurchase premium. For purposes of this section, the term
repurchase premium means the excess
[[Page 68183]]
of the repurchase price paid or incurred to repurchase the obligation
over its adjusted issue price (within the meaning of Sec. 1.1275-1(b))
as of the repurchase date. For the general rules applicable to the
deductibility of repurchase premium, see Sec. 1.163-7(c). This
paragraph (c) applies to convertible obligations repurchased on or
after March 2, 1998.
(d) * * *
(2) * * * For a convertible obligation repurchased on or after
March 2, 1998, a call premium specified in dollars under the terms of
the obligation is considered to be a normal call premium on a
nonconvertible obligation if the call premium applicable when the
obligation is repurchased does not exceed an amount equal to the
interest (including original issue discount) that otherwise would be
deductible for the taxable year of repurchase (determined as if the
obligation were not repurchased). * * *
* * * * *
Par. 7. Section 1.1016-5 is amended by revising paragraph (b) to
read as follows:
Sec. 1.1016-5 Miscellaneous adjustments to basis.
* * * * *
(b) Amortizable bond premium--(1) In general. A holder's basis in a
bond is reduced by the amount of bond premium used to offset qualified
stated interest income under Sec. 1.171-2. This reduction occurs when
the holder takes the qualified stated interest into account under the
holder's regular method of accounting.
(2) Special rules for taxable bonds. A holder's basis in a taxable
bond is reduced by the amount of bond premium allowed as a deduction
under Sec. 1.171-3(c)(5)(ii) (relating to the issuer's call of a
taxable bond) or under Sec. 1.171-2(a)(4)(i)(A) (relating to excess
bond premium).
(3) Special rule for tax-exempt obligations. A holder's basis in a
tax-exempt obligation is reduced by the amount of excess bond premium
that is treated as a nondeductible loss under Sec. 1.171-2(a)(4)(ii).
* * * * *
Sec. 1.1016-9 [Removed]
Par. 8. Section 1.1016-9 is removed.
Par. 9. Section 1.1275-1 is amended by:
1. Redesignating paragraph (b)(2) as paragraph (b)(3).
2. Adding a new paragraph (b)(2).
The addition reads as follows:
Sec. 1.1275-1 Definitions.
* * * * *
(b) * * *
(2) Bond issuance premium. If a debt instrument is issued with bond
issuance premium (as defined in Sec. 1.163-13(c)), for purposes of
determining the issuer's adjusted issue price, the adjusted issue price
determined under paragraph (b)(1) of this section is also decreased by
the amount of bond issuance premium previously allocable under
Sec. 1.163-13(d)(3).
* * * * *
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 10. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 11. Section 602.101, paragraph (c) is amended by:
1. Removing the following entry from the table:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.171-3.................................................... 1545-0172
* * * * *
------------------------------------------------------------------------
2. Adding entries in numerical order to the table to read as
follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.163-13................................................... 1545-1491
* * * * *
1.171-4.................................................... 1545-1491
1.171-5.................................................... 1545-1491
* * * * *
------------------------------------------------------------------------
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Approved: December 15, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-33647 Filed 12-30-97; 8:45 am]
BILLING CODE 4830-01-P
