Final Regs Revise Rules for Debt Instruments with OID

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the tax treatment of debt instruments with original issue discount and the imputation of interest on deferred payments under certain contracts for the sale or exchange of property. The final regulations provide needed guidance to holders and issuers of debt instruments with original issue discount and to buyers and sellers of property.

 DATES: The removal of sections 1.163-11T, 1.1275-3T, 1.1275-6T and 1.6050H-2T is effective February 2, 1994. These regulations are effective April 3, 1994.

 For dates of applicability of these regulations, see Effective Dates under Supplementary Information.

 FOR FURTHER INFORMATION CONTACT: William E. Blanchard, 202-622-3950 (not a toll-free); or Andrew C. Kittler, 202-622-3940 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information contained in this final regulation have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1353. The estimated annual burden per respondent varies from .3 hours to .5 hours, depending on individual circumstances, with an estimated average of .4 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the IRS. Individual respondents may require more or less time, depending on their particular circumstances.

 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, PC:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 On December 22, 1992, the IRS published a notice of proposed rulemaking in the Federal Register (57 FR 60750) relating to original issue discount (OID) under section 163(e) and sections 1271 through 1275 of the Internal Revenue Code (Code). The notice also contained proposed amendments to the regulations under sections 446 (relating to the accrual of interest), 483 (relating to unstated interest), 1001 (relating to amount realized), and 1012 (relating to basis). The notice withdrew most of the proposed regulations that were previously published in the Federal Register on April 8, 1986 (51 FR 12022), as amended on May 7, 1991 (56 FR 21112), and July 12, 1991 (56 FR 31887).

 On February 16, 1993, the IRS held a public hearing on the proposed regulations. In addition, the IRS received a number of written comments on the proposed regulations. The proposed regulations, with certain changes to respond to comments, are adopted as final regulations; to permit further comment, section 1.446-2(e)(3) remains outstanding in proposed form. The changes, as well as several comments and suggestions that were not adopted in the final regulations, are discussed below.

EXPLANATION OF PROVISIONS

SECTION 1.163-7 DEDUCTION FOR OID ON CERTAIN DEBT INSTRUMENTS.

 The final regulations retain the rule of the proposed regulations that allows the issuer of a debt instrument to deduct de minimis OID using a straight line method. As requested by a commentator, the final regulations also allow the issuer the choice of deducting de minimis OID at maturity or in proportion to stated interest payments.

 Because the proposed regulations permit flexible accrual periods, a commentator requested guidance on what accrual period controls to determine whether a debt instrument in an applicable high yield debt obligation under section 163(i). The final regulations provide that the issuer's choice of accrual periods governs for purposes of section 163(i).

 A commentator requested that an immediate deduction be allowed for a repurchase premium in a debt-for-debt exchange even if the issue price of the debt instrument received in the exchange is determined under section 1274. The IRS and Treasury, however, believe that taxpayers could inappropriately accelerate deductions in these situations because of the flexibility inherent in section 1274 for determining the issue price of a debt instrument. Thus, the final regulations retain the rule in the proposed regulations.

SECTION 1.446-2 METHOD OF ACCOUNTING FOR INTEREST.

 The proposed regulations provide a special payment allocation rule for certain small transactions. Because of the rule's limited scope and uncertainty regarding its application, the IRS and Treasury believe that the rule should not be finalized. However, to allow further comment on the need for this rule, section 1.446-2(e)(3) is reserved in the final regulations and remains in proposed form.

SECTION 1.483-1 THROUGH 1.484-3 UNSTATED INTEREST.

 The proposed regulations provide that stated or unstated interest under a contract subject to section 483 is taken into account under a taxpayer's regular method of accounting. One commentator suggested that an accrual method taxpayer should account for unstated interest in the year a payment is due, which was the rule in previous final regulations under section 483. The IRS and Treasury, however, believe that it is appropriate to treat stated and unstated interest consistently. Thus, the final regulations retain the rule in the proposed regulations.

SECTIONS 1.1001-1(g) AND 1.1012-1(g) AMOUNT REALIZED AND BASIS.

 If a debt instrument is issued in exchange for property, the proposed regulations provide that the issue price of the debt instrument is used to determine the seller's amount realized and the buyer's basis. The final regulations adopt the rules of the proposed regulations, but clarify the treatment of a debt instrument with an issue price determined under section 1273(b)(4).

SECTION 1.1271-1 SPECIAL RULES APPLICABLE TO AMOUNTS RECEIVED ON RETIREMENT, SALE, OR EXCHANGE OF DEBT INSTRUMENTS.

 As requested by a commentator, the final regulations provide that the intention to call rules do not apply to debt instruments sold pursuant to a private placement memorandum that is distributed to more than ten offerees and that is subject to certain sanctions of the Securities Act of 1933 or the Securities Exchange Act of 1934.

SECTION 1.1272-1 CURRENT INCLUSION OF OID IN INCOME.

 The proposed regulations provide that accrual periods may be of any length and may vary in length over the term of the debt instrument, provided that each accrual period is not longer than one year and that all payments are made at the end of an accrual period. In response to one comment, the final regulations provide that payments also may be made on the first day of an accrual period.

 The rule permitting accrual periods to vary in length was provided in response to commentators who criticized the prior proposed regulations as too mechanical and inflexible. While commentators commended the flexibility of the rule, they noted that the rule raised several technical issues: (1) the accrual periods used to determine whether an instrument is an applicable high yield debt obligation under section 163(i); (2) the accrual periods used by a subsequent holder to determine adjusted issue price for purposes of OID accruals, market discount, and acquisition premium; and (3) the accrual periods used for Form 1099 reporting. As noted above, section 1.163-7 of the final regulations provides that the issuer's determination of accrual periods controls for purposes of determining whether a debt instrument is an applicable high yield debt obligations. In addition, section 1.1275-1(b)(2) of the final regulations provides that a subsequent holder determines adjusted issue price for purposes of OID accruals, market discount, and acquisition premium in any matter consistent with these final regulations. Rules on Form 1099 reporting will be addressed in a separate project. Until guidance regarding Form 1099 reporting is issued, however, an issuer should use the same accrual periods for Form 1099 purposes as it uses for computing OID deductions.

 The proposed regulations provide rules to determine the yield and maturity of a debt instrument with a stated contingency that could result in the acceleration or deferral of payments if the timing and amounts payable upon occurrence of the contingency are fixed. The contingency is ignored unless, based on all the facts and circumstances, the contingency is more likely than not to occur. The final regulations clarify that this rule applies when the contingency, if triggered, would result in an alternative payment schedule as long as the timing and amounts of the payments comprising the alternative payment schedule are known as of the issue date. The final regulations also clarify that these rules apply if the debt instrument is subject to multiple contingencies that result in alternative payment schedules. The final regulations retain the rule in the proposed regulations for determining the yield and the maturity of a debt instrument in the case of a put or call option.

 The final regulations modify the proposed rules regarding subsequent adjustments that are required when a contingency occurs (or does not occur) contrary to the assumption initially made. This modification treats both the acceleration and deferral of payments as a deemed reissuance for purposes of OID accruals. In addition, the subsequent adjustment rules are coordinated with the new pro rata prepayment rule described below in connection with the description of section 1.1275-2.

 Finally, in response to a comment, an example describing the consequences of a pay-in-kind debt instrument issued at par has been included in the final regulations.

SECTION 1.1272-2 TREATMENT OF DEBT INSTRUMENTS PURCHASED AT A PREMIUM.

 The final regulations retain the rules in the proposed regulations for debt instruments purchased at a premium. Thus, the holder's basis in a debt instrument that is acquired in exchange for property and that otherwise would take a substituted basis generally will not exceed the fair market value of the property immediately after the exchange. This rule corresponds to a similar rule in section 171(b)(4) of the Code. The final regulations clarify the application of the rule to a situation in which a debt instrument is received in a distribution from a partnership.

SECTION 1.1272-3 ELECTION BY A HOLDER TO TREAT ALL INTEREST ON A DEBT INSTRUMENT AS OID.

 The proposed regulations permit accrual method holders to treat all interest on a debt instrument as OID. In response to comments, the final regulations extend this election to holders that use the cash receipts and disbursements method of accounting.

SECTION 1.1273-1 DEFINITION OF OID.

 The final regulations retain the definition of qualified stated interest, but clarify that a conversion feature is ignored for purposed of determining whether stated interest is unconditionally payable. In response to a comment, the final regulations provide that if a debt instrument has payment intervals that are equal in length throughout the term of the instrument, except for the first or final payment interval (or both intervals), the interest payment for that interval (or intervals) is considered to be made at a fixed rate if the value of the rate on which the payment is based is adjusted in any reasonable manner to take into account the length of the interval. The final regulations also clarify the determination of qualified stated interest for a debt instrument that provides for an alternative payment schedule (or schedules) upon the occurrence of one or more contingencies. In the case of these debt instruments, each alternative payment schedule (including the stated payment schedule) is treated as if it were the debt instrument's sole payment schedule. Based on this analysis, the debt instrument provides for qualified stated interest to the extent of the lowest fixed rate at which qualified stated interest would be payable under any payment schedule.

 The final regulations also provide rules for a subsequent holder's treatment of a debt instrument issued with de minimis OID. Under these rules, if a subsequent holder purchases the debt instrument at a premium, the subsequent holder does not include any de minimis OID in income. Because the debt instrument is treated as having zero OID under section 1273(a)(3), if a subsequent holder purchases the debt instrument at a discount, the subsequent holder reports the discount under the market discount rules of sections 1276 through 1278 of the Code, rather than under the rules for the minimis OID.

 Finally, the final regulations retain the rule of the proposed regulations that de minimis OID is including in the income of the holder as principal payments are made. Commentators objected to the fact that this rule is written as applying on a loan-by-loan basis because it could preclude a financial institution from using the loan liquidation method. Although the rule is stated in terms of a single loan, the IRS and Treasury recognize that it may be appropriate to permit financial institutions to account for de minimis OID on an aggregate basis. The IRS is reviewing its published position with respect to the loan liquidation method and plans to issue updated guidance that permits financial institutions to use some form of aggregate accounting.

SECTION 1.1273-2 DETERMINATION OF ISSUE PRICE AND ISSUE DATE.

 If an issue of debt instruments sold for money is publicly offered, the proposed regulations provide that the issue price of each debt instrument in the issue is the first price at which a substantial amount of the debt instruments in the issue is sold to the public. However, if the issue is not publicly offered, the issue price of each debt instrument in the issue is the price paid by the first buyer of a debt instrument that is part of the issue. Commentators suggested that the issue price rules should be the same for publicly offered and non-publicly offered issues. In addition, commentators suggested that all debt instruments in an issue should be fungible with other debt instruments in the issue.

 In response to these comments, the definition of issue price has been modified. Under the final regulations, if a substantial amount of debt instruments in an issue is sold for money, the issue price of each instruments in an issue is sold for money, the issue price of each instrument in the issue is the first price at which a substantial amount is sold for money. If an issue is not subject to this rule, but a substantial amount of the instruments in the issue is publicly traded, the issue price of each instrument in the issue is the fair market value of the instrument as of the issue date. If an issue is not subject to either of these rules, but a substantial amount of instruments in the issue is issued in exchange for publicly traded property, the issue price of each instrument in the issue is the fair market value of the property as of the issue date. Finally, if an issue of debt instruments is not described in any of the above rules, the issue price of each debt instrument in the issue is determined as if the instrument were a separate issue.

 The proposed regulations define publicly traded property generally to include exchange listed property, property traded on a board of trade or an interbank market, property appearing on a quotation medium, and debt instruments for which price quotations are readily available. In response to a comment, the final regulations clarify that, for purposes of determining whether an instrument is publicly traded, a quotation medium is limited to a medium that provides a reasonable basis to determine fair market value. One commentator suggested that the rule regarding readily available price quotations should be eliminated. The IRS and Treasury, however, believe that one principal way in which debt instruments are traded is through brokers and dealers from whom price quotations are readily available, that this market is liquid, and that instruments so traded are susceptible to ready valuation. In such a case, it is consistent with the purposes of the rules applicable to publicly traded property that the instruments be considered publicly traded.

 The final regulations clarify the determination of issue price for a debt instrument that is part of an investment unit. In general, the issue price of an investment unit is determined as if the investment unit were a debt instrument. The issue price of the investment unit is then allocated between the debt instrument and the property right that comprise the investment unit based on their relative fair market values. If, however, the issue price of the investment unit is not determined under the rules of paragraph (a)(1), (b)(1), or (c)(1) of section 1.1273-2 (e.g., because the investment unit is not issued for money or publicly traded property), the issue price of the debt instrument included in the investment unit is determined under section 1273(b)(4) or 1274, whichever is applicable.

 To coordinate the definition of issue date with the revised definition of issue price discussed above, the definition of issue date has been moved from section 1.1275-1 of the proposed regulations to section 1.1273-2 of the final regulations.

SECTION 1.1274-1 THROUGH 1.1274-5 DETERMINATION OF ISSUE PRICE IN THE CASE OF CERTAIN DEBT INSTRUMENTS ISSUED FOR PROPERTY.

 The final regulations modify the rule to determine the test rate for purposes of sections 483 and 1274. Under the modified rule, the test rate is generally the lowest of the applicable Federal rates (based on the appropriate compounding period) in effect during either (i) the 3-month period ending with the first month in which there is a binding written contract that substantially sets forth the terms under which the sale or exchange is ultimately consummated, or (ii) the 3-month period ending with the month in which the sale or exchange occurs.

 The proposed regulations generally provide that the imputed principal amount of a contingent payment debt instrument is the sum of the present values of the noncontingent payments and the fair market value of the contingent payments. Several comments and questions were received on this rule, including the comment that the rule should be reserved pending the resolution of the contingent payment rules in regulations under section 1275. To allow further study of this issue and coordination with the contingent payment regulations under section 1275, the final regulations do not adopt the rule in the proposed regulations. Thus, for example, consistent with existing authorities, the value of contingent payments is not taken into account for purposes of determining the basis of property under section 1012. With the publication of the final regulations in the Federal REgister, section 1.1274-2(e) of the proposed regulations, no longer remains as a proposed regulation. Pending resolution of the issue and publication of new proposed regulations, paragraphs (c) and (d) of section 1.1275-4 of the proposed regulations, as proposed in 1986, remain authority under section 6662 of the Code for a nonpublicly traded debt instrument issued in exchange for nonpublicly traded property.

SECTION 1.1274A-1 SPECIAL RULES FOR CERTAIN TRANSACTIONS WHERE STATED PRINCIPAL AMOUNT DOES NOT EXCEED $2,800,000.

 No comments were received on these regulations and no material changes were made to this section.

SECTION 1.1275-1 DEFINITIONS.

 In response to a comment, the definition of issue has been expanded. As a result, debt instruments issued in different markets or for different consideration can be part of the same issue.

SECTION 1.1275-2 SPECIAL RULES RELATING TO DEBT INSTRUMENTS.

 The proposed regulations provide that all payments (other than qualified stated interest payments) consists first of accrued but unpaid OID, then of principal. Several commentators suggested that unscheduled prepayments should be treated as partial retirements of the debt instrument. In response to these comments, the final regulations add new rules for the treatment of pro rata prepayments. In general, a pro rata prepayment is an unscheduled payment made on a debt instrument prior to maturity that results in a substantially pro rata reduction of each payment of principal and interest remaining on the instrument. If a prepayment on a debt instrument is a pro rata prepayment, the prepayment is treated as a payment in retirement of a portion of the instrument, which may result in gain or loss to the holder. The gain or loss is calculated by assuming that the debt instrument consists of two instruments, one that is retired and one that remains outstanding, and by allocating the adjusted issue price, the holder's adjusted basis, and the accrued but unpaid qualified stated interest between the two instrument that is treated as retired by the pro rata prepayment. In the case of a pro rata prepayment, the issuer may realize discharge of indebtedness income (as determined under section 1.61-12) or purchase premium (as determined under section 1.163-7).

 Partial retirement treatment is restricted to pro rata prepayments because the IRS and Treasury believe that this type of prepayment is common. The extension of the rule to non-pro rata prepayments would add undue complexity to the regulations. In addition, extension of the rule to non-pro rata prepayments may cause inappropriate recognition of gain or loss if, in addition to a prepayment, the interest rate or the payment schedule is altered. Furthermore, as noted by one commentator, a rule for non-pro rate prepayments may not be necessary because an unscheduled prepayment may, depending on the circumstance, result in a deemed exchange under section 1001.

 The proposed regulations contain a number of rules that generally require a holder to follow the issuer's treatment of an item, such as whether a debt instrument is issued in a potentially abusive situation. In response to comments, the final regulations provide that the issuer must make information relating to its treatment of the item available to the holder in a reasonable manner.

 Section 1.1275-2T, which is published elsewhere in this issue of the Federal Register, provides for an anti-abuse rule. Under the rule, the Commissioner of Internal Revenue, in certain circumstances, can apply or depart from the final regulations in a manner that ensures a reasonable result in light of the purposes of the statutes governing OID.

SECTION 1.1275-3 OID INFORMATION REPORTING REQUIREMENTS.

 The legending requirements in the final regulations for debt instruments with OID are generally the same as the requirements in the proposed regulations.

SECTION 1.1275-5 VARIABLE RATE DEBT INSTRUMENTS.

 In response to comments that the definition of a variable rate debt instrument contained in the proposed regulations is overly restrictive, the final regulations liberalize the rules in several respects. First, the regulations allow the issue price of a variable rate debt instrument to exceed the total noncontingent principal payments on the instrument, provided that the excess in not greater than a specified amount. Second, the regulations allow a variable rate debt instrument to provide for stated interest at more than two qualified floating rates, at a single fixed rate and one or more qualified floating rates, and at a single fixed rate and an objective rate that is a qualified inverse floating rate. Third, the regulations provide that interest that is stated at an initial fixed rate for a period of not more than one year, followed by a qualified floating rate or an objective rate, is treated as stated at a single qualified floating rate or an objective rate in certain circumstances. This rule applies, for example, if interest for the initial accrual period is set a short time prior to the issue date at a fixed rate chosen to approximate the expected value of the qualified floating rate or objective rate on the issue date. Fourth, the regulations allow certain multiples of a qualified floating rate to be treated as qualified floating rates. Fifth, the regulations expand the definition of an objective rate to include a rate based on the yield of actively traded property, a rate that would be a qualified floating rate if the debt instrument were denominated in a foreign currency, and any combination of objective rates. In addition, the final regulations provide that other rates may be treated as objective rates if designated by revenue ruling or revenue procedure.

 In response to a comment, the definition of an objective rate has been narrowed in two respects. While the proposed regulations permit a rate based on the price of actively traded personal property, the final regulations permit only a rate based on the change in the price of actively traded personal property to be an objective rate. In addition, the final regulations provide a more general rule relating to the frontloading or backloading of interest such that a variable rate is not an objective rate if it results in significant frontloading or backloading of interest.

 The rules in the proposed regulations relating to permissible objective rates on tax-exempt debt instruments have been changed in the final regulations. Under the revised rules, a variable rate on a tax-exempt debt instrument is an objective rate only if it is a qualified inverse floating rate. In general, an objective rate is a qualified inverse floating rate if the rate is equal to a fixed rate minus a qualified floating rate and the rate varies in a manner that inversely reflects contemporaneous variations in the cost of newly borrowed funds.

 The rules in the proposed regulations for determining the accrual of OID and the amount of qualified stated interest on a variable rate debt instrument have been revised and simplified in the final regulations. Under the revised rules, a debt instrument providing for qualified floating rates is converted to an equivalent fixed rate debt instrument by assuming that each qualified floating rate will remain at its value as of the issue date. A debt instrument providing for an objective rate is converted to an equivalent fixed rate debt instrument by assuming that the objective rate will equal a fixed rate that reflects the yield that is reasonably expected for the instrument. The rules applicable to fixed rate debt instruments are then applied to determine the OID accruals and the qualified stated interest payments on the equivalent fixed rate debt instrument. Appropriate adjustments to these amounts are made in each accrual period if the interest actually accrued or paid during the accrual period is greater than or less than the interest assumed to be accrued or paid under the equivalent fixed rate debt instrument.

 In response to a comment, the final regulations provide a special rule for certain variable rate debt instruments (such as auction rate or adjustable rate debt instrument) that provide for a fixed rate of interest for an initial period, followed by a period during which the interest is reset to a rate that will enable the instrument to trade at a fixed amount when the reset becomes effective. Under this special rule, the debt instrument is treated as maturing on the date the reset rate becomes effective and reissued on that date for the fixed amount. As a result of this rule, for example, if a debt instrument is issued at a discount (i.e., the issue price of the debt instrument is less than its par value) and is reset to par after an initial period, the discount on the instrument will be accrued entirely in the initial period rather than over the full term of the instrument.

EFFECTIVE DATES.

 These regulations apply to debt instruments issued on or after April 3, 1994, and to lending transactions, sales, and exchanges that occur on or after April 3, 1994. However, section 1.1272-3 applies to debt instruments acquired on or after April 3, 1994, and section 1.1275-2(d)(2) applies to qualified reopenings that occur on or after March 25, 1992.

RELIANCE ON FINAL REGULATIONS.

 Except for. section 1.1272-3, taxpayers may rely in the final regulations for debt instruments issued after December 21, 1992, and for lending transactions, sales, and exchanges that occur after December 21, 1992.

AUTHORITY UNDER SECTION 6662.

 Although "the final regulations dispose of the underlying proposed regulations (other than section 1.446-2(e)(3)), the IRS will allow taxpayers to treat the proposed regulations as authority under section 6662 "of the Code for debt instruments issued after December 21, 1992, and prior to April 3, 1994, and for lending transactions, sales, and exchanges that occurred after December 21, 1992, and prior to April 3, 1994. The IRS also will allow taxpayers to treat the OID regulations that were proposed in 1986 and 1991 as authority under section 6662 for debt instruments issued prior to December 22, 1992, and for lending transactions, sales, and exchanges that occurred prior to December 22, 1992.

SPECIAL ANALYSES

 It has been determined that these regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking was submitted to the Small Business Administration for comment its impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are William E. Blanchard and Andrew C. Kittler of the Office of Assistant Chief Counsel (Financial Institutions and Products), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

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 removing the entry for "Section 1.1275-3" and adding the following citations in numerical order to read as follows:

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

Sections 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f). * * *

Sections 1.1271-1 through 1.1274-5 also issued under 26 U.S.C. 1275(d).

Section 1.1274A-1 also issued under 26 U.S.C. 1274A(e) and 26-U.S.C. 1275(d).

Sections 1.1275-1 through 1.1275-5 also issued under 26 U.S.C. 1275(d). * * *

Par. 2. Section 1.163-7 is added to read as follows:

SECTION 1.163-7 DEDUCTION FOR OID ON CERTAIN DEBT INSTRUMENTS.

(a) GENERAL RULE. Except as otherwise provided in paragraph (b) of this section, an issuer (including a transferee) determines the amount of OID that is deductible each year under section 163(e)(1) by using the constant yield method described in section 1.1272-1(b). This determination, however, is made without regard to section 1272(a)(7) (relating to acquisition premium) and section 1.1273-1(d) (relating to de minimis OID). An issuer is permitted a deduction under section 163(e)(1) only to the extent the issuer is primarily liable on the debt instrument. For certain limitations on the deductibility of OID, see sections 163(e) and 1275(b)(2)

(b) SPECIAL RULES FOR DE MINIMIS OID -- (1) STATED INTEREST. If a debt instrument has a de minimis amount of OID (within the meaning of section 1.1273-1(d)), the issuer treats all stated interest on the debt instrument as qualified stated interest. See sections 1.446-2(b) and 1.461-1 for the treatment of qualified stated interest.

(2) DEDUCTION OF DE MINIMIS OID ON OTHER THAN A CONSTANT YIELD BASIS. In lieu of deducting de minimis OID under the general rule of paragraph (a) of this section, an issuer of a debt instrument with a de minimis amount of OID (other than a de minimis amount treated as qualified stated interest under paragraph (b)(1) of this section) may choose to deduct the OID at maturity, on a straight-line basis over the term of the debt instrument, or in proportion to stated interest payments. The issuer makes this choice by reporting the minimis OID in a manner consistent with the method chosen on the issuer's timely filed Federal income tax return for the taxable year in which the debt instrument is issued.

(c) DEDUCTION UPON REPURCHASE. Except to the extent disallowed by any other section of the Internal Revenue Code (e.g., section 249) or this paragraph (c), if a debt instrument is repurchased by the issuer for a price in excess of its adjusted issue price (as defined in section 1.1275.1(b), the excess (repurchase premium) is deductible as interest for the taxable year in which the repurchase occurs. If the issuer repurchases a debt instrument in a debt-for-debt exchange, the repurchase price is the issue price of the newly issued debt instrument (reduced by any unstated interest within the meaning of section 483). However, if the issue price of the newly issued debt instrument is determined under either section 1273(b)(4) or section 1274, any repurchase premium is not deductible in the year of the repurchase, but is amortized over the term of the newly issued debt instrument in the same manner as if it were OID.

(d) CHOICE OF ACCRUAL PERIODS TO DETERMINE WHETHER A DEBT INSTRUMENT IS AN APPLICABLE HIGH YIELD DISCOUNT OBLIGATION (AHYDO). Section 163(e)(5) affects an issuer's OID deductions for certain high yield debt instruments that have significant OID. For purposes of section 163(i)(2), which defines significant OID, the issuer's choice of accrual periods to determine OID accruals is used to determine whether a debt instrument has significant OID. See section 1.1275-2(e) for rules relating to the issuer's obligation to disclose certain information to holders.

(e) EFFECTIVE DATE. This section applies to debt instruments issued on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994]. Taxpayers, however, may rely on this section for debt instruments issued after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994].

Section 1.163-11T [Removed]

Par. 3. Section 1.163-11T is removed as of [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER-February 2, 1994].

Par 4. Section 1.446-2 is added to read as follows:

SECTION 1.446-2 METHOD OF ACCOUNTING FOR INTEREST.

(a) APPLICABILITY -- (1) IN GENERAL. This section provides rules for determining the amount of interest that accrues during and accrual period (other than interest described in paragraph (a)(2) of this section) and for determining the portion of a payment that consists of accrued interest. For purposes of this section, interest includes original issue discount and amounts treated as interest (whether stated or unstated) in any lending or deferred payment transaction. Accrued interest determined under this section is taken into account by a taxpayer under the taxpayer's regular method of accounting (e.g., an accrual method or the cash receipts and disbursements method). Application of an exception described in paragraph (a)(2) of this section to one party to a transaction does not affect the application of this section to any other party to the transaction.

(2) EXCEPTIONS -- (i) INTEREST INCLUDED OR DEDUCTED UNDER CERTAIN OTHER PROVISIONS. This section does not apply to interest that is taken into account under --

(A) Sections 1272(a), 1275, and 163(e) (income and deductions relating to original issue discount);

(B) Section 467(a)(2) (certain payments for the use of property or services);

(C) Sections 1276 through 1278 (market discount);

(D) Sections 1281 through 1283 (discount on certain short-term obligations);

(E) Section 7872(a) (certain loans with below-market interest rates); or

(F) Section 1.1272-3 (an election by a holder to treat all interest on a debt instrument as original issue discount)

(ii) DE MINIMIS ORIGINAL ISSUE DISCOUNT. This section does not apply to de minimis original issue discount (other than de minimis original issue discount treated as qualified stated interest) as determined under section 1.1273-1(d). See section 1.163-7 for the treatment of de minimis original issue discount by the issuer and sections 1.1273-1(d) and 1.1272-3 for the treatment of de minimis original issue discount by the holder.

(b) ACCRUAL OF QUALIFIED STATED INTEREST. Qualified stated interest (as defined in section 1.1273-1(c)) accrues ratably over the accrual period (or periods) to which it is attributable and accrues at the stated rate for the period (or periods).

(c) ACCRUAL OF INTEREST OTHER THAN QUALIFIED STATED INTEREST. Subject to the modifications in paragraph (d) of this section, the amount of interest (other than qualified stated interest) that accrues for any accrual period is determined under rules similar to those in the regulations under sections 1272 and 1275 for the accrual of original issue discount. The preceding sentence applies regardless of any contrary formula agreed to by the parties.

(d) MODIFICATIONS -- (1) ISSUE PRICE. The issue price of the loan or contract is equal to --

(i) In the case of a contract for the safe or exchange of property to which section 483 applies, the amount described in section 1.483-2(a)(1)(i) or (ii), whichever is applicable;

(ii) In the case of a contract for the sale or exchange of property to which section 483 does not apply, the stated principal amount; or

(iii) In any other case, the amount loaned.

(2) PRINCIPAL PAYMENTS THAT ARE NOT DEFERRED PAYMENTS. In the case of a contract to which section 483 applies, principal payments that are not deferred payments are ignored for purposes of determining yield and adjusted issue price.

(e) ALLOCATION OF INTEREST TO PAYMENTS -- (1) IN GENERAL. Except as provided in paragraphs (e)(2), (e)(3) and (e)(4) of this section, each payment under a loan (other than payments of additional interest or similar charges provided with respect to amounts that are not paid when due) is treated as a payment of interest to the extent of the accrued and unpaid interest determined under paragraphs (b) and (c) of this section as of the date the payment becomes due.

(2) SPECIAL RULE FOR POINTS DEDUCTIBLE UNDER SECTION 461(g) (2) If a payment of points is deductible by the borrower under section 461(g)(2), the payment is treated by the borrower as a payment of interest.

(3) ALLOCATION RESPECTED IN CERTAIN SMALL TRANSACTIONS. [Reserved]

(4) PRO RATA PREPAYMENTS. Accrued but unpaid interest is allocated to a pro rata prepayment under rules similar to those for allocating accrued but unpaid original issue discount to a pro rata prepayment under section 1.1275-2(f). For purposes of the preceding sentence, a pro rata prepayment is a payment that is made prior to maturity that --

(i) Is not made pursuant to the contract's payment schedule; and

(ii) Results in a substantially pro rata reduction of each payment remaining to be paid on the contract.

(f) AGGREGATION RULE. For purposes of this section, all contracts calling for deferred payments arising from the same transaction (or a series of related transactions) are treated as a single contract. This rule, however, generally only applies to contracts involving a single borrower and a single lender.

(g) DEBT INSTRUMENTS DENOMINATED IN A CURRENCY OTHER THAN THE U.S. DOLLAR. This section applies to a debt instrument that provides for all payments denominated in, or determined by reference to, the functional currency of the taxpayer or qualified business unit of the taxpayer (even if that currency is other than the U.S. dollar). See section 1.988-2(b) to determine interest income or expense for debt instruments that provide for payments denominated in, or determined by reference to, a nonfunctional currency.

(h) EXAMPLE. The following example illustrates the rules of this section.

EXAMPLE. ALLOCATION OF UNSTATED INTEREST TO DEFERRED PAYMENTS -- (i) FACTS. On July 1, 1996, A sells his personal residence to B for a stated purchase price of $1,297,143.66. The property is not personal use property (within the meaning of section 1275(b)(3)) in the hands of B. Under the loan agreement, B is required to make two installment payments of $648,571.83 each, the first due on June 30, 1998, and the second due on June 30, 2000. Both A and B use the cash receipts and disbursements method of accounting and use a calendar year for their taxable year.

(ii) AMOUNT OF UNSTATED INTEREST. Under section 483, the agreement does not provide for adequate stated interest. Thus, the loan's yield is the test rate of interest determined under section 1.483-3. Assume that both A and B use annual accrual periods and that the test rate of interest is 9.2 percent, compounded annually. Under section 1.483-2, the present value of the deferred payments is $1,000,000. Thus, thee agreement has unstated interest of $297,143.66.

(iii) FIRST TWO ACCRUAL PERIODS. Under paragraph (d)(1) of this section, the issue price at the beginning of the first accrual period is $1,000,000 (the amount described in section 1.483-2(a)(1)(i)). Under paragraph (c) of this section, the amount of interest that accrues for the first accrual period is $92,000 ($1,000,000 x .092) and the amount of interest that accrues for the second accrual period is $100,464 ($1,092,000 x .092). Thus, $192,464 of interest has accrued as of the end of the second accrual period. Under paragraph (e)(1) of this section, the $648,571.83 payment made on June 30, 1998, is treated first as a payment of interest to the extent of $192,464. The remainder of the payment ($456,107.83) is treated as a payment of principal. Both A and B take the payment of interest ($192,464) into account in 1998.

(iv) SECOND TWO ACCRUAL PERIODS. The adjusted issue price at the beginning of the third accrual period is $543,892.17 ($1,092,000 + $100,464 - $648,571.83). The amount of interest that accrues for the third accrual period is $50,038.08 ($543,892.17 x .092) and the amount of interest that accrues for the final accrual period is $54,641.58, the excess of the amount payable at maturity ($648,571.83), over the adjusted issue price at the beginning of the accrual period ($593,930.25). As of the date the second payment becomes due, $104,679.66 of interest has accrued. Thus, of the $648,571.83 payment made on June 30, 2000, $104,679.66 is treated as interest and $543,892.17 is treated as principal. Both A and B take the payment of interest ($104,679.66) into account in 2000.

(i) [Reserved]

(j) EFFECTIVE DATE. This section applies to debt instruments issued on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994], and to lending transactions, sales, and exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994]. Taxpayers, however, may rely on this section for debt instruments issued after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER], and for lending transactions, sales, and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994].

Par. 5. Sections 1.483-1 and 1.483-2 are revised to read as follows:

SECTION 1.483-1 INTEREST ON CERTAIN DEFERRED PAYMENTS.

(a) AMOUNT CONSTITUTING INTEREST IN CERTAIN DEFERRED PAYMENT TRANSACTIONS -- (1) IN GENERAL. Except as provided in paragraph (c) of this section, section 483 applies to a contract for the sale or exchange of property if the contract provides for one or more payments due more than 1 year after the date of the sale or exchange, and the contract does not provide for adequate stated interest. In general, a contract has adequate stated interest if the contract provides for a stated rate of interest that is at least equal to the test rate (determined under section 1.483-3) and the interest is paid or compounded at least annually. Section 483 may apply to a contract whether the contract is express (written or oral) or implied. For purposes of section 483, a sale or exchange is any transaction treated as a sale or exchange for tax purposes. In addition, for purposes of section 483, property includes debt instruments and investment units, but does not include money, services, or the right to use property. for the treatment of certain obligations given in exchange for services or the use of property, see sections 404 and 467. For purposes of this paragraph (a), money includes functional currency and, in certain circumstances, nonfunctional currency. See section 1.988-2(b)(2) for circumstances when nonfunctional currency is treated as money rather than as property.

(2) TREATMENT OF CONTRACTS TO WHICH SECTION 483 APPLIES -- (i) TREATMENT OF UNSTATED INTEREST. If section 483 applies to a contract, unstated interest under the contract is treated as interest for tax purposes. Thus, for example, unstated interest is not treated as part of the amount realized from the sale or exchange of property (in the case of the seller), and is not included in the purchaser's basis in the property acquired in the sale or exchange.

(ii) METHOD OF ACCOUNTING FOR INTEREST ON CONTRACTS SUBJECT TO SECTION 483. Any stated or unstated interest on a contract subject to section 483 is taken into account by a taxpayer under the taxpayer's regular method of accounting (e.g., an accrual method or the cash receipts and disbursements method). See sections 1.446-1, 1.451-1, and 1.461-1. For purposes of the preceding sentence, the amount of interest (including unstated interest) allocable to a payment under a contract to which section 483 applies is determined under section 1.446-2(e).

(b) DEFINITIONS -- (1) DEFERRED PAYMENTS. For purposes of the regulations under section 483, a deferred payment means any payment that constitutes all or a part of thee sales price (as defined in paragraph (b)(2) of this section), and that is due more than 6 months after the date of the sale or exchange. Except as provided in section 483(c)(2) (relating to the treatment of a debt instrument of the purchaser), a payment may be made in the form of cash, stock or securities, or other property.

(2) SALES PRICE. For purposes of section 483, the sales prince for any sale or exchange is the sum of the amount due under the contract (other than stated interest) and the amount of any liability included in the amount realized from the sale or exchange. See section 1.1001-2. Thus, the sales price for any sale or exchange includes any amount of unstated interest under the contract.

(c) EXCEPTIONS TO AND LIMITATIONS ON THE APPLICATION OF SECTION 483 -- (1) IN GENERAL. Sections 483(d), 1274(c)(4), and 1275(b) contain exceptions to and limitations on the application of section 483.

(2) Sales price of $3,000 or less. Section 483(d)(2) applies only if it can be determined at the time of the sale or exchange that the sales price cannot exceed $3,000, regardless of whether the sales price eventually paid for the property is less than $3,000.

(3) OTHER EXCEPTIONS AND LIMITATIONS -- (i) CERTAIN TRANSFERS SUBJECT TO SECTION 1041. Section 483 does not apply to any transfer of property subject to section 1041 (relating to transfers of property between spouses or incident to divorce).

(ii) TREATMENT OF CERTAIN OBLIGEES. Section 483 does not apply to an obligee under a contract for the sale or exchange of personal use property (within the meaning of section 1275(b)(3)) in the hands of the obligor and that evidences a below market loan described in section 7872(c)(1).

(iii) TRANSACTIONS INVOLVING CERTAIN DEMAND LOANS. Section 483 does not apple to any payment under a contract that evidences a demand loan that is a below-market loan described in section 7872(c)(1).

(iv) TRANSACTIONS INVOLVING CERTAIN ANNUITY CONTRACTS. Section 483 does not apple to any payment under an annuity contract described in section 1275(a)(1)(B) (relating to annuity contracts excluded from the definition of debt instrument).

(v) OPTIONS. Section 483 does not apply to any payment under an option to buy or sell property.

(d) ASSUMPTIONS. If a debt instrument is assumed, or property is taken subject to a debt instrument, in connection with a sale or exchange of property, the debt instrument is treated for purposes of section 483 in a manner consistent with the rules of section 1.1274-5.

(e) AGGREGATION RULE. For purposes of section 483, all sales or exchanges that are part of the same transaction (or a series of related transactions) are treated as a single sale or exchange, and all contracts calling for deferred payments arising from the same transaction (or a series of related transactions) are treated as a single contract. This rule, however, generally only applies to contracts and to sales or exchanges involving a single buyer and a single seller.

(f) EFFECTIVE DATE. This section applies to sales and exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER]. Taxpayers, however, may rely on this section for sales and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

SECTION 1.483-2 UNSTATED INTEREST.

(a) IN GENERAL -- (1) ADEQUATE STATED INTEREST. For purposes of section 483, a contract has unstated interest if the contract does not provide for adequate stated interest. A contract does not provide for adequate stated interest if the sum of the deferred payments exceeds --

(i) The sum of the present values of the deferred payments and the present values of any stated interest payments due under the contract; or

(ii) In the case of a cash method debt instrument (within the meaning of section 1274A(c)(2)) received in exchange for property in a potentially abusive situation (as defined in section 1.1274-3), the fair market value of the property reduced by the fair market value of any consideration other than the debt instrument, and reduced by the sum of all principal payments that are not deferred payments.

(2) AMOUNT OF UNSTATED INTEREST. For purposes of section 483, unstated interest means an amount equal to the excess of the sum of the deferred payments over the amount described in paragraph (a)(1)(i) or (a)(1)(ii) of this section, whichever is applicable.

(b) OPERATIONAL RULES -- (1) IN GENERAL. For purposes of paragraph (a) of this section, rules similar to those in section 1.1274-2 apply to determine whether a contract has adequate stated interest and the amount of unstated interest, if any, on the contract.

(2) PRESENT VALUE. For purposes of paragraph (a) of this section, the present value of any deferred payment or interest payment is determined by discounting the payment from the date it becomes due to the date of the sale or exchange at the test rate of interest applicable to the contract in accordance with section 1.483-3.

(c) EXAMPLES. The following examples illustrate the rules of this section.

EXAMPLE 1. CONTRACT THAT DOES NOT HAVE ADEQUATE STATED INTEREST. On January 1, 1995, A sells B nonpublicly traded property under a contract that calls for a $100,000 payment of principal on January 1, 2005, and 10 annual interest payments of $9,000 on January 1 of each year, beginning on January 1, 1996. Assume that the test rate of interest is 9.2 percent, compounded annually. The contract does not provide for adequate stated interest because it does not provide for interest equal to 9.2 percent, compounded annually. The present value of the deferred payments is $98,727.69. As a result, the contract has unstated interest of $1,272.31 ($100,000 - $98,727.69).

EXAMPLE 2. CONTRACT THAT DOES NOT HAVE ADEQUATE STATED INTEREST; NO INTEREST FOR INITIAL SHORT PERIOD. On May 1, 1996, A sells B nonpublicly traded property under a contract that calls for B to make a principal payment of $200,000 on December 31, 1998, and semiannual interest payments of $9,000, payable on June 30 and December 31 of each year, beginning on December 31, 1996. Assume that the test rate of interest is 9 percent, compounded semiannually. Even though the contract calls for a stated rate of interest no lower than the test rate of interest, the contract does not provide for adequate stated interest because the stated rate of interest does not apply for the short period from May 1, 1996, through June 30, 1996.

EXAMPLE 3. POTENTIALLY ABUSIVE SITUATION -- (i) FACTS. In a potentially abusive situation, a contract for the sale of nonpublicly traded personal property calls for the issuance of a cash method debt instrument (as defined in section 1274A(c)(2)) with a stated principal amount of $700,000, payable in 5 years. No other consideration is given. The debt instrument calls for annual payments of interest over its entire term at a rate of 9.2 percent, compounded annually (the test rate of interest applicable to the debt instrument). Thus, the present value of the deferred payment and the interest payments is $700,000. Assume that the fair market value of the property is $500,000.

(ii) AMOUNT OF UNSTATED INTEREST. A cash method debt instrument received in exchange for property in a potentially abusive situation provides for adequate stated interest only if the sum of the deferred payments under the instrument does not exceed the fair market value of the property. Because the deferred payment ($700,000) exceeds the fair market value of the property ($500,000), the debt instrument does not provide for adequate stated interest. Therefore, the debt instrument has unstated interest of $200,000.

EXAMPLE 4. VARIABLE RATE DEBT INSTRUMENT WITH ADEQUATE STATED INTEREST, VARIABLE RATE AS OF THE ISSUE DATE GREATER THAN THE TEST RATE -- (i) FACTS. A contract for the sale of nonpublicly traded property calls for the issuance of a debt instrument in the principal amount of $75,000 due in 10 years. The debt instrument calls for interest payable semiannually at a rate of 3 percentage points above the yield on 6-month Treasury bills at the mid-point of the semiannual period immediately preceding each interest payment date. Assume that the interest rate is a qualified floating rate and that the debt instrument is a variable rate debt instrument within the meaning of section 1.1275-5.

(ii) ADEQUATE STATED INTEREST. Under paragraph (b)(1) of this section, rules similar to those in section 1.1274-2(f) apply to determine whether the debt instrument has adequate stated interest. Assume that the test rate of interest applicable to the debt instrument is 9 percent, compounded semiannually. Assume also that the yield on 6-month Treasury bills on the date of the sale is 8.89 percent, which is greater than the yield on 6-month Treasury bills on the first date on which there is a binding written contract that substantially sets forth the terms under which the sale is consummated. Under section 1.1274-2(f), the debt instrument is tested for adequate stated interest as if it provided for a stated rate of interest of 11.89 percent (3 percent plus 8.89 percent), compounded semiannually, payable over its entire term. Because the test rate of interest is 9 percent, compounded semiannually, and the debt instrument is treated as providing for stated interest of 11.89 percent, compounded semiannually, the debt instrument provides for adequate stated interest.

(d) EFFECTIVE DATE. This section applies to sales and exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994]. Taxpayers, however, may rely on this section for sales and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994].

Par. 6. Section 1.483-3 is added to read as follows:

SECTION 1 483-3 TEST RATE OF INTEREST APPLICABLE TO A CONTRACT.

(a) GENERAL RULE. For purposes of section 483, the test rate of interest for a contract is the same as the test rate that would apply under section 1.1274-4 if the contract were a debt instrument. Paragraph (b) of this section, however, provides for a lower test rate in the case of certain sales or exchanges of land between related individuals.

(b) LOWER RATE FOR CERTAIN SALES OR EXCHANGES OF LAND BETWEEN RELATED INDIVIDUALS -- (1) TEST RATE. In the case of a qualified sale or exchange of land between related individuals (described in section 483(e)), the test rate is not greater than 6 percent, compounded semiannually, or an equivalent rate based on an appropriate compounding period.

(2) SPECIAL RULES. The following rules and definitions apply in determining whether a sale or exchange is a qualified sale under section 483(e):

(i) DEFINITION OF FAMILY MEMBERS. The members of an individual's family are determined as of the date of the sale or exchange. The members of an individual's family include those individuals described in section 267(c)(4) and the spouses of those individuals. In addition, for purposes of section 267(c)(4), full effect is given to a legal adoption, ancestor means parents and grandparents, and lineal descendants means children and grandchildren.

(ii) $500,000 LIMITATION. Section 483(e) does not apply to the extent that the stated principal amount of the debt instrument issued in the sale or exchange, when added to the aggregate stated principal amount of any other debt instruments to which section 483(e) applies that were issued in prior qualified sales between the same two individuals during the same calendar year, exceeds $500,000. See Example 3 of paragraph (b)(3) of this section.

(iii) OTHER LIMITATIONS. Section 483(e) does not apply if the parties to a contract include persons other than the related individuals and the parties enter into the contract with an intent to circumvent the purposes of section 483(e). In addition, if the property sold or exchanged includes any property other than land, section 483(e) applies only to the extent that the stated principal amount of the debt instrument issued in the sale or exchange is attributable to the land (based on the relative fair market values of the land and the other property).

(3) EXAMPLES. The following examples illustrate the rules of this paragraph (b).

EXAMPLE 1. On January 1, 1995, A sells land to B, A's child, for $650,000. The contract for sale calls for B to make a $250,000 down payment and issue a debt instrument with a stated principal amount of $400,000. Because the stated principal amount of the debt instrument is less than $500,000, the sale is a qualified sale and section 483(e) applies to the debt instrument.

Example 2. The facts are the same as in EXAMPLE 1 of paragraph (b)(3) of this section, except that on June 1, 1995, A sells additional land to B under a contract that calls for B to issue a debt instrument with a stated principal amount of $100,000. The stated principal amount of this debt instrument ($100,000) when added to the stated principal amount of the prior debt instrument ($400,000) does not exceed $500,000. Thus, section 483(e) applies to both debt instruments.

EXAMPLE 3. The facts are the same as in EXAMPLE 1 of paragraph (b)(3) of this section, except that on June 1, 1995, A sells additional land to B under a contract that calls for B to issue a debt instrument with a stated principal amount of $150,000. The stated principal amount of this debt instrument when added to the stated principal amount of the prior debt instrument ($400,000) exceeds $500,000. Thus, for purposes of section 483(e), the debt instrument issued in the sale of June 1, 1995, is treated as two separate debt instruments: a $100,000 debt instrument (to which section 483(e) applies) and a $50,000 debt instrument (to which section 1274, if otherwise applicable, applies).

(c) EFFECTIVE DATE. This section applies to sales and exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER]. Taxpayers, however, may rely on this section for sales and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

Par. 7. In section 1.1001-1, paragraph (g) is revised to read as follows:

SECTION 1 1001-1 COMPUTATION OF GAIN OR LOSS.

* * * * *

(g) DEBT INSTRUMENTS ISSUED IN EXCHANGE FOR PROPERTY. If a debt instrument is issued in exchange for property, the amount realized attributable to the debt instrument is the issue price of the debt instrument as determined under section 1.1273-2 or section 1.1274-2(b), whichever is applicable. If, however, the issue price of the debt instrument is determined under section 1273(b)(4), the amount realized attributable to the debt instrument is its stated principal amount reduced by any unstated interest (as determined under section 483). This paragraph (g) applies to sales or exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994]. Taxpayers, however, may rely on this paragraph (g) for sales and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLIcATION OF THIS DOCUMENT IN THE FEDERAL REGISTER--February 2, 1994].

Par. 8. In section 1.1012-1, paragraph (f) is amended by removing the last sentence and paragraph (g) is added to read as follows:

SECTION 1.1012-1 BASIS OF PROPERTY.

* * * * *

(g) DEBT INSTRUMENTS ISSUED IN EXCHANGE FOR PROPERTY. For purposes of paragraph (a) of this section, if a debt instrument is issued in exchange for property, the cost of the property that is attributable to the debt instrument is the issue price of the debt instrument as determined under section 1.1273-2 or section 1.1274-2(b), whichever is applicable. If, however, the issue price of the debt instrument is determined under section 1273(b)(4), the cost of the property attributable to the debt instrument is its stated principal amount reduced by any unstated interest (as determined under section 483). This paragraph (g) applies to sales or exchanges that occur on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER]. Taxpayers, however, may rely on this paragraph (g) for sales and exchanges that occur after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

Par. 9. Sections 1.1271-0 through 1.1274-3 are added to read as follows:

SECTION 1.1271-0 ORIGINAL ISSUE DISCOUNT; EFFECTIVE DATE; TABLE OF CONTENTS.

(a) EFFECTIVE DATE. Except as otherwise provided, sections 1.1271-1 through 1.1275-5 apply to debt instruments issued on or after [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER]. Taxpayers, however, may rely on these sections for debt instruments issued after December 21, 1992, and before [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

(b) TABLE OF CONTENTS. This section lists captioned paragraphs contained in sections 1.1271-1 through 1.1275-5.

 SECTION 1.1271-1 SPECIAL RULES APPLICABLE TO AMOUNTS RECEIVED ON RETIREMENT, SALE, OR

(a) INTENTION TO CALL BEFORE MATURITY -- (1) IN GENERAL. For purposes of section 1271(a)(2), all or a portion of gain realized on a sale or exchange of a debt instrument to which section 1271 applies is treated as interest income if there was an intention to call the debt instrument before maturity. An intention to call a debt instrument before maturity means a written or oral agreement or understanding not provided for in the debt instrument between the issuer and the original holder of the debt instrument that the issuer will redeem the debt instrument before maturity. In the case of debt instruments that are part of an issue, the agreement or understanding must be between the issuer and the original holders of a substantial amount of the debt instruments in the issue. An intention to call before maturity can exist even if the intention is conditional (e.g., the issuer's decision to call depends on the financial condition of the issuer on the potential call date) or is not legally binding. For purposes of this section, original holder means the first holder (other than an underwriter or dealer that purchased the debt instrument for resale in the ordinary course of its trade or business).

(2) EXCEPTIONS. In addition to the exceptions provided in sections 1271(a)(2)(B) and 1271(b), section 1271(a)(2) does not apply to --

(i) A debt instrument that is publicly offered (as defined in section 1.1275-1(h));

(ii) A debt instrument to which section 1272(a)(6) applies (relating to certain interests in or mortgages held by a REMIC, and certain other debt instruments with payments subject to acceleration); or

(iii) A debt instrument sold pursuant to a private placement memorandum that is distributed to more than ten offerees and that is subject to the sanctions of section 12(2) of the Securities Act of 1933 (15 U.S.C. 771) or the prohibitions of section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j).

(b) SHORT-TERM OBLIGATIONS -- (1) IN GENERAL. Under sections 1271(a)(3) and (a)(4), all or a portion of the gain realized on the sale or exchange of a short-term government or nongovernment obligation is treated as interest income. Sections 1271(a)(3) and (a)(4), however, do not apply to any short-term obligation subject to section 1281. See section 1.1272-1(f) for rules to determine if an obligation is a short-term obligation.

(2) METHOD OF MAKING ELECTIONS. Elections to accrue on a constant yield basis under sections 1271(a)(3)(E) and (a)(4)(D) are made on an obligation-by-obligation basis by reporting the transaction on the basis of daily compounding on the taxpayer's timely filed Federal income tax return for the year of the sale or exchange. These elections are irrevocable.

(3) COUNTING CONVENTIONS. In computing the ratable share of acquisition discount under section 1271(a)(3) or OID under section 1271(a)(4), any reasonable counting convention may be used (e.g., 30 days per month/360 days per year).

SECTION 1.1272-1 CURRENT INCLUSION OF OID IN INCOME.

(a) OVERVIEW -- (1) IN GENERAL. Under section 1272(a)(1), a holder of a debt instrument includes accrued OID in gross income (as interest), regardless of the holder's regular method of accounting. A holder includes qualified stated interest (as defined in section 1.1273-1(c)) in income under the holder's regular method of accounting. See sections 1.446-2 and 1.451-1.

(2) DEBT INSTRUMENTS NOT SUBJECT TO OID INCLUSION RULES. Sections 1272(a)(2) and 1272(c) list exceptions to the general inclusion rule of section 1272(a)(1). For purposes of section 1272(a)(2)(E) (relating to certain loans between natural persons), a loan does not include a stripped bond or stripped coupon within the meaning of section 1286(e), and the rule in section 1272(a)(2)(E)(iii), which treats a husband and wife as 1 person, does not apply to loans made between a husband and wife.

(b) ACCRUAL OF OID -- (1) CONSTANT YIELD METHOD. Except as provided in paragraphs (b)(2) and (b)(3) of this section, the amount of OID includible in the income of a holder of a debt instrument for any taxable year is determined using the constant yield method as described under this paragraph (b)(1).

(i) STEP ONE: DETERMINE THE DEBT INSTRUMENT'S YIELD TO MATURITY. The yield to maturity or yield of a debt instrument is the discount rate that, when used in computing the present value of all principal and interest payments to be made under the debt instrument, produces an amount equal to the issue price of the debt instrument. The yield must be constant over the term of the debt instrument and, when expressed as a percentage, must be calculated to at least two decimal places. See paragraph (c) of this section for rules relating to the yield of certain debt instruments subject to contingencies.

(ii) STEP TWO: DETERMINE THE ACCRUAL PERIODS. An accrual period is an interval of time over which the accrual of OID is measured. Accrual periods may be of any length and may vary in length over the term of the debt instrument, provided that each accrual period is no longer than 1 year and each scheduled payment of principal or interest occurs either on the final day of an accrual period or on the first day of an accrual period. In general, the computation of OID is simplest if accrual periods correspond to the intervals between payment dates provided by the terms of the debt instrument. In computing the length of accrual periods, any reasonable counting convention may be used (e.g., 30 days per month/360 days per year).

(iii) STEP THREE: DETERMINE THE OID ALLOCABLE TO EACH ACCRUAL PERIOD. Except as provided in paragraph (b)(4) of this section, the OID allocable to an accrual period equals the product of the adjusted issue price of the debt instrument (as defined in section 1.1275-1(b)) at the beginning of the accrual period and the yield of the debt instrument, less the amount of any qualified stated interest allocable to the accrual period. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period. Example 1 in paragraph (j) of this section provides a formula for converting a yield based upon an accrual period of one length to an equivalent yield based upon an accrual period of a different length.

(iv) STEP FOUR: DETERMINE THE DAILY PORTIONS OF OID. The daily portions of OID are determined by allocating to each day in an accrual period the ratable portion of the OID allocable to the accrual period. The holder of the debt instrument includes in income the daily portions of OID for each day during the taxable year on which the holder held the debt instrument.

(2) EXCEPTIONS. Paragraph (b)(1) of this section does not apply to --

(i) A debt instrument to which section 1272(a)(6) applies (certain interests in or mortgages held by a REMIC, and certain other debt instruments with payments subject to acceleration);

(ii) A debt instrument that provides for contingent payments, except as provided in paragraph (c) of this section or in regulations under section 1275(d); or

(iii) A variable rate debt instrument to which section 1.1275-5 applies, except as provided in section 1.1275-5.

(3) MODIFICATIONS. The amount of OID includible in income by a holder under paragraph (b)(1) of this section is adjusted if --

(i) The holder purchased the debt instrument at a premium or an acquisition premium (within the meaning of section 1.1272-2); or

(ii) The holder made an election for the debt instrument under section 1.1272-3 to treat all interest as OID.

(4) SPECIAL RULES FOR DETERMINING THE OID ALLOCABLE TO AN ACCRUAL PERIOD. The following rules apply to determine the OID allocable to an accrual period under paragraph (b)(1)(iii) of this section.

(i) UNPAID QUALIFIED STATED INTEREST ALLOCABLE TO AN ACCRUAL PERIOD. In determining the OID allocable to an accrual period, if an interval between payments of qualified stated interest contains more than 1 accrual period --

(A) The amount of qualified stated interest payable at the end of the interval (including any qualified stated interest that is payable on the first day of the accrual period immediately following the interval) is allocated on a pro rata basis to each accrual period in the interval; and

(B) The adjusted issue price at the beginning of each accrual period in the interval must be increased by the amount of any qualified stated interest that has accrued prior to the first day of the accrual period but that is not payable until the end of the interval. See EXAMPLE 2 of paragraph (j) of this section for an example illustrating the rules in this paragraph (b)(4)(i).

(ii) FINAL ACCRUAL PERIOD. The OID allocable to the final accrual period is the difference between the amount payable at maturity (other than a payment of qualified stated interest) and the adjusted issue price at the beginning of the final accrual period.

(iii) INITIAL SHORT ACCRUAL PERIOD. If all accrual periods are of equal length, except for either an initial shorter accrual period or an initial and a final shorter accrual period, the amount of OID allocable to the initial accrual period may be computed using any reasonable method. See Example 3 in paragraph (j) of this section.

(iv) PAYMENT ON FIRST DAY OF AN ACCRUAL PERIOD. The adjusted issue price at the beginning of an accrual period is reduced by the amount of any payment (other than a payment of qualified stated interest) that is made on the first day of the accrual period.

(c) YIELD AND MATURITY OF CERTAIN DEBT INSTRUMENTS SUBJECT TO CONTINGENCIES -- (1) APPLICABILITY. This paragraph (c) provides rules to determine the yield and maturity of a debt instrument that provides for an alternative payment schedule (or schedules) applicable upon the occurrence of a contingency (or contingencies). This paragraph (c) applies, however, only if the timing and amounts of the payments that comprise each payment schedule are known as of the issue date. A debt instrument does not provide for an alternative payment schedule merely because there is a possibility of impairment of a payment (or payments) by insolvency, default, or similar circumstances. See regulations under section 1275(d) for the treatment of debt instruments with payments that are otherwise contingent as to timing or amount. See section 1.1273-1(c) to determine whether stated interest on a debt instrument subject to this paragraph (c) is qualified stated interest.

(2) GENERAL RULE. In general, the yield and maturity of a debt instrument subject to this paragraph (c) are determined by assuming that the payments will be made according to the instrument's stated payment schedule.

(3) CONTINGENCIES THAT ARE LIKELY TO OCCUR -- (i) CONTINGENCY TAKEN INTO ACCOUNT. Notwithstanding the rule in paragraph (c)(2) of this section, if, based on all the facts and circumstances as of the issue date, it is more likely than not that the debt instrument's stated payment schedule will not occur, then the yield and maturity of the debt instrument are computed based on the payment schedule most likely to occur.

(ii) MANDATORY SINKING FUND PROVISION. Paragraph (c)(3)(i) of this section does not apply to a mandatory sinking fund provision if the use and terms of the provision meet reasonable commercial standards. For purposes of the preceding sentence, a mandatory sinking fund provision is a provision that requires the issuer to redeem a certain amount of debt instruments in an issue prior to maturity, provided that the debt instruments actually redeemed are chosen by lot or purchased by the issuer either in the open market or pursuant to an offer made to all holders (with any proration determined by lot), and provided that on the issue date the specific debt instruments that will be redeemed on any date prior to maturity cannot be identified.

(4) CONSISTENCY RULE. The payment schedule determined by the issuer under paragraphs (c)(2) and (c)(3) of this section is binding on all holders of the debt instrument. However, the issuer's determination is not binding on a holder that explicitly discloses that its determination of the yield and maturity of the debt instrument is different from the issuer's determination. Unless otherwise prescribed by the Commissioner, the disclosure must be made on a statement attached to the holder's timely filed Federal income tax return for the taxable year that includes the acquisition date of the debt instrument. See section 1.1275-2(e) for rules relating to the issuer's obligation to disclose certain information to holders.

(5) TREATMENT OF CERTAIN OPTIONS. Notwithstanding paragraphs (c)(2) and (c)(3) of this section, the rules of this paragraph (c)(5) determine the yield and maturity of a debt instrument that provides the holder or issuer with an unconditional option or options, exercisable on one or more dates during the term of the debt instrument, that, if exercised, require payments to be made on the debt instrument under an alternative payment schedule or schedules (e.g., an option to extend or an option to call a debt instrument at a fixed premium). Under this paragraph (c)(5), an issuer will be deemed to exercise or not exercise an option or combination of options in a manner that minimizes the yield on the debt instrument, and a holder will be deemed to exercise or not exercise an option or combination of options in a manner that maximizes the yield on the debt instrument. If both the issuer and the holder have options, the rules of this paragraph (c)(5) are applied to the options in the order that they may be exercised. Thus, the deemed exercise of one option may eliminate other options that are later in time. See EXAMPLE 5 through EXAMPLE 8 in paragraph (j) of this section.

(6) SUBSEQUENT ADJUSTMENTS. If a contingency described in this paragraph (c) (including the exercise of an option described in paragraph (c)(5) of this section) actually occurs or does not occur, contrary to the assumption made pursuant to this paragraph (c) (a change in circumstances), then, solely for purposes of the accrual of OID, the yield and maturity of the debt instrument are redetermined by treating the debt instrument as reissued on the date of the change in circumstances for an amount equal to its adjusted issue price on that date. See Example 5 and Example 7 in paragraph (j) of this section. If, however, the change in circumstances results in a substantially contemporaneous pro rata prepayment as defined in section 1.1275-2(f)(2) (e.g., because a partial put or call option treated under paragraph (c)(5) of this section as not exercised is, in fact, exercised), the pro rata prepayment is treated as a payment in retirement of a portion of the debt instrument, which may result in gain or loss to the holder. See EXAMPLE 6 and EXAMPLE 8 in paragraph (j) of this section.

(d) CERTAIN DEBT INSTRUMENTS THAT PROVIDE FOR PRINCIPAL PAYMENTS UNCERTAIN AS TO TIME. The yield of a debt instrument with principal payments that are fixed in total amount but that are uncertain as to time (such as a demand loan) is the stated interest rate if the issue price of the instrument is equal to the stated principal amount and interest is paid or compounded at a fixed rate over the entire term of the debt instrument at intervals of 1 year or less.

(e) CONVERTIBLE DEBT INSTRUMENTS. For purposes of section 1272, an option is ignored if it is an option to convert a debt instrument into the stock of the issuer, into the stock or debt of a related party (within the meaning of section 267(b) or 707(b)(1)), or into cash or other property in an amount equal to the approximate value of such stock or debt.

(f) SPECIAL RULES TO DETERMINE WHETHER A DEBT INSTRUMENT IS A SHORT-TERM OBLIGATION -- (1) COUNTING OF EITHER THE ISSUE DATE OR MATURITY DATE. For purposes of determining whether a debt instrument is a short-term obligation (i.e., a debt instrument with a fixed maturity date that is not more than 1 year from the date of issue), the term of the debt instrument includes either the issue date or the maturity date, but not both dates.

(2) COORDINATION WITH PARAGRAPH (C) OF THIS SECTION FOR CERTAIN SECTIONS OF THE INTERNAL REVENUE CODE. Notwithstanding paragraph (c) of this section, solely for purposes of determining whether a debt instrument is a short-term obligation under sections 871(g)(1)(B)(i), 881, 1271(a)(3), 1271(a)(4), 1272(a)(2)(C), and 1283(a)(1), the maturity date of a debt instrument is the last possible date that the instrument could be outstanding under the terms of the instrument.

(g) BASIS ADJUSTMENT. The basis of a debt instrument in the hands of the holder is increased by the amount of OID included in the holder's gross income and decreased by the amount of any payment from the issuer to the holder under the debt instrument other than a payment of qualified stated interest. See, however, section 1.1275-2(f) for rules regarding basis adjustments on a pro rata prepayment.

(h) DEBT INSTRUMENTS DENOMINATED IN A CURRENCY OTHER THAN THE U.S. DOLLAR. Section 1272 and this section apply to a debt instrument that provides for all payments denominated in, or determined by reference to, the functional currency of the taxpayer or qualified business unit of the taxpayer (even if that currency is other than the U.S. dollar). See section 1.988-2(b) to determine interest income or expense for debt instruments that provide for payments denominated in, or determined by reference to, a nonfunctional currency.

(i) [Reserved]

(j) EXAMPLES. The following examples illustrate the rules of this section. Each example assumes that all taxpayers use the calendar year as the taxable year. In addition, each example assumes a 30 day month, 360-day year, and that the initial accrual period begins on the issue date and the final accrual period ends on the day before the stated maturity date. Although, for purposes of simplicity, the yield as stated is rounded to two decimal places, the computations do not reflect any such rounding convention.

EXAMPLE 1. ACCRUAL OF OID ON ZERO COUPON DEBT INSTRUMENT; CHOICE OF ACCRUAL PERIODS -- (i) FACTS. On July 1, 1994, A purchases at original issue, for $675,564.17, a debt instrument that matures on July 1, 1999, and provides for a single payment of $1,000,000 at maturity.

(ii) DETERMINATION OF YIELD. Under paragraph (b)(1)(i) of this section, the yield of the debt instrument is 8 percent, compounded semiannually.

(iii) DETERMINATION OF ACCRUAL PERIOD. Under paragraph (b)(1)(ii) of this section, accrual periods may be of any length, provided that each accrual period is no longer than 1 year and each scheduled payment of principal or interest occurs either on the first or final day of an accrual period. The yield to maturity to be used in computing OID accruals in any accrual period, however, must reflect the length of the accrual period chosen. A yield based on compounding b times per year is equivalent to a yield based on compounding c times per year as indicated by the following formula:

r = c[((1 + i/b)(to the b/c power)) - 1]

In which:

i = The yield based on compounding b times per year expressed as a decimal

r = The equivalent yield based on compounding c times per year expressed as a decimal

b = The number of compounding periods in a year on which i is based (for example, 12, if i is based on monthly compounding)

c = The number of compounding periods in a year on which r is based

(iv) DETERMINATION OF OID ALLOCABLE TO EACH ACCRUAL PERIOD. Assume that A decides to compute OID on the debt instrument using semiannual accrual periods. Under paragraph (b)(1)(iii) of this section, the OID allocable to the first semiannual accrual period is $27,022.56: the product of the issue price ($675,564.17) and the yield properly adjusted for the length of the accrual period (8 percent/2), less qualified stated interest allocable to the accrual period ($0). The daily portion of OID for the first semiannual accrual period is $150.13 ($27,022.56/180).

(v) DETERMINATION OF OID IF MONTHLY ACCRUAL PERIODS ARE USED. Alternatively, assume that A decides to compute OID on the debt instrument using monthly accrual periods. Using the above formula, the yield on the debt instrument reflecting monthly compounding is 7.87 percent, compounded monthly (12[((1 + .08/2)(to the 2/12 power) - 1)]. Under paragraph (b)(1)(iii) of this section, the OID allocable to the first monthly accrual period is $4,430.48: the product of the issue price ($675,564.17) and the yield properly adjusted for the length of the accrual period (7.87 percent/12), less qualified stated interest allocable to the accrual period ($0). The daily portion of OID for the first monthly accrual period is $147.68 ($4,430.48/30).

EXAMPLE 2. ACCRUAL OF OID ON DEBT INSTRUMENT WITH QUALIFIED STATED INTEREST -- (i) FACTS. On September 1, 1994, A purchases at original issue, for $90,000, B corporation's debt instrument that matures on September 1, 2004, and has a stated principal amount of $100,000, payable on that date. The debt instrument provides for semiannual payments of interest of $3,000, payable on September 1 and March 1 of each year, beginning on March 1, 1995.

(ii) DETERMINATION OF YIELD. The debt instrument is a 10- year debt instrument with an issue price of $90,000 and a stated redemption price at maturity of $100,000. The semiannual payments of $3,000 are qualified stated interest payments. Under paragraph (b)(1)(i) of this section, the yield is 7.44 percent, compounded semiannually.

(iii) ACCRUAL OF OID IF SEMIANNUAL ACCRUAL PERIODS ARE USED. Assume that A decides to compute OID on the debt instrument using semiannual accrual periods. Under paragraph (b)(1)(iii) of this section, the OID allocable to the first semiannual accrual period equals the product of the issue price ($90,000) and the yield properly adjusted for the length of the accrual period (7.44 percent/2), less qualified stated interest allocable to the accrual period ($3,000). Therefore, the amount of OID for the first semiannual accrual period is $345.78 ($3,345.78 - $3,000).

(iv) ADJUSTMENT FOR ACCRUED BUT UNPAID QUALIFIED STATED INTEREST IF MONTHLY ACCRUAL PERIODS ARE USED. Assume, alternatively, that A decides to compute OID on the debt instrument using monthly accrual periods. The yield, compounded monthly, is 7.32 percent. Under paragraph (b)(1)(iii) of this section, the OID allocable to the first monthly accrual period is the product of the issue price ($90,000) and the yield properly adjusted for the length of the accrual period (7.32 percent/12), less qualified stated interest allocable to the accrual period. Under paragraph (b)(4)(i)(A) of this section, the qualified stated interest allocable to the first monthly accrual period is the pro rata amount of qualified stated interest allocable to the interval between payment dates ($3,000 x 1/6, or $500). Therefore, the amount of OID for the first monthly accrual period is $49.18 ($549.18 - $500). Under paragraph (b)(4)(i)(B) of this section, the adjusted issue price of the debt instrument for purposes of determining the amount of OID for the second monthly accrual period is $90,549.18 ($90,000 + $49.18 + $500). Although the adjusted issue price of the debt instrument for this purpose includes the amount of qualified stated interest allocable to the first monthly accrual period, A includes the qualified stated interest in income based on A's regular method of accounting (e.g., an accrual method or the cash receipts and disbursements method).

EXAMPLE 3. ACCRUAL OF OID FOR DEBT INSTRUMENT WITH INITIAL SHORT ACCRUAL PERIOD -- (i) FACTS. On May 1, 1994, G purchases at original issue, for $80,000, H corporation's debt instrument maturing on July 1, 2004. The debt instrument provides for a single payment at maturity of $250,000. G computes its OID using 6-month accrual periods ending on January 1 and July 1 of each year and an initial short 2-month accrual period from May 1, 1994, through June 30, 1994.

(ii) DETERMINATION OF YIELD. The yield on the debt instrument is 11.53 percent, compounded semiannually.

(iii) DETERMINATION OF OID ALLOCABLE TO INITIAL SHORT ACCRUAL PERIOD. Under paragraph (b)(4)(iii) of this section, G may use any reasonable method to compute OID for the initial short accrual period. One reasonable method is to calculate the amount of OID pursuant to the following formula:

OID short = IP x (i/k) x f

In which:

OID short = The amount of OID allocable to the initial short accrual period

 IP      = The issue price of the debt instrument

(v) ALTERNATIVE METHOD. Another reasonable method is to calculate the amount of OID for the initial short accrual period using the yield based on bi-monthly compounding, computed pursuant to the formula set forth in Example 1 of paragraph (j) of this section. Under this method, the amount of OID for the initial short accrual period is $1,508.38 ($80,000 x (11.31 percent/6)).

EXAMPLE 4. IMPERMISSIBLE ACCRUAL OF OID USING A METHOD OTHER THAN CONSTANT YIELD METHOD -- (i) FACTS. On July 1, 1994, B purchases at original issue, for $100,000, C corporation's debt instrument that matures on July 1, 1999, and has a stated principal amount of $100,000. The debt instrument provides for a single payment at maturity of $148,024.43. The yield of the debt instrument is 8 percent, compounded semiannually.

(ii) DETERMINATION OF YIELD. Assume that C uses 6 monthly accrual periods to compute its OID for 1994. The yield must reflect monthly compounding (as determined using the formula described in Example 1 of paragraph (j) of this section). As a result, the monthly yield of the debt instrument is 7.87 percent, divided by 12. C may not compute its monthly yield for the last 6 months in 1994 by dividing 8 percent by 12.

EXAMPLE 5. DEBT INSTRUMENT SUBJECT TO PUT OPTION -- (i) FACTS. On January 1, 1995, G purchases at original issue, for $70,000, H corporation's debt instrument maturing on January 1, 2010, with a stated principal amount of $100,000, payable at maturity. The debt instrument provides for semiannual payments of interest of $4,000, payable on January 1 and July 1 of each year, beginning on July 1, 1995. The debt instrument gives G an unconditional right to put the bond back to H, exercisable on January 1, 2005, in return for $85,000 (exclusive of the $4,000 of stated interest payable on that date).

(ii) DETERMINATION OF YIELD AND MATURITY. Yield determined without regard to the put option is 12.47 percent, compounded semiannually. Yield determined by assuming that the put option is exercised (i.e., by using January 1, 2005, as the maturity date and $85,000 as the stated principal amount payable on that date) is 12.56 percent, compounded semiannually. Thus, under paragraph (c)(5) of this section, it is assumed that G will exercise the put option, because exercise of the option would increase the yield of the debt instrument. Thus, for purposes of calculating OID, the debt instrument is assumed to be a 10-year debt instrument with an issue price of $70,000, a stated redemption price at maturity of $85,000, and a yield of 12.56 percent, compounded semiannually.

(iii) CONSEQUENCES IF PUT OPTION IS, IN FACT, NOT EXERCISED. If the put option is, in fact, not exercised, then, under paragraph (c)(6) of this section, the debt instrument is treated, solely for purposes of determining yield and maturity, as if it were reissued on January 1, 2005, for an amount equal to its adjusted issue price on that date, $85,000. The new debt instrument matures on January 1, 2010, with a stated principal amount of $100,000 payable on that date and provides for semiannual payments of interest of $4,000. The yield of the new debt instrument is 12.08 percent, compounded semiannually.

EXAMPLE 6. DEBT INSTRUMENT SUBJECT TO PARTIAL CALL OPTION - - (i) FACTS. On January 1, 1995, H purchases at original issue, for $95,000, J corporation's debt instrument that matures on January 1, 2000, and has a stated principal amount of $100,000, payable on that date. The debt instrument provides for semiannual payments of interest of $4,000, payable on January 1 and July 1 of each year, beginning on July 1, 1995. On January 1, 1998, J has an unconditional right to call 50 percent of the principal amount of the debt instrument for $55,000 (exclusive of the $4,000 of stated interest payable on that date). If the call is exercised, the semiannual payments of interest made after the call date will be reduced to $2,000.

(ii) DETERMINATION OF YIELD AND MATURITY. Yield determined without regard to the call option is 9.27 percent, compounded semiannually. Yield determined by assuming J exercises its call option is 10.75 percent, compounded semiannually. Thus, under paragraph (c)(5) of this section, it is assumed that J will not exercise the call option because exercise of the option would increase the yield of the debt instrument. Thus, for purposes of calculating OID, the debt instrument is assumed to be a 5-year debt instrument with a single principal payment at maturity of $100,000, and a yield of 9.27 percent, compounded semiannually.

(iii) CONSEQUENCES IF THE CALL OPTION IS, IN FACT, EXERCISED. If the call option is, in fact, exercised, then under paragraph (c)(6) of this section, the debt instrument is treated as if the issuer made a pro rata prepayment of $55,000 that is subject to section 1.1275-2(f). Consequently, under section 1.1275-2(f)(1), the instrument is treated as consisting of two debt instruments, one that is retired on the call date and one that remains outstanding after the call date. The adjusted issue price, adjusted basis in the hands of the holder, and accrued OID of the original debt instrument is allocated between the two instruments based on the portion of the original instrument treated as retired. Since each payment remaining to be made after the call date is reduced by one-half, one-half of the adjusted issue price, adjusted basis, and accrued OID is allocated to the debt instrument that is treated as retired. The adjusted issue price of the original debt instrument immediately prior to the call date is $97,725.12, which equals the issue price of the original debt instrument ($95,000) increased by the OID previously includible in gross income ($2,725.12). One-half of this adjusted issue price is allocated to the debt instrument treated as retired, and the other half is allocated to the debt instrument that is treated as remaining outstanding. Thus, the debt instrument treated as remaining outstanding has an adjusted issue price immediately after the call date of $97,725.12/2, or $48,862.56. The yield of this debt instrument continues to be 9.27 percent, compounded semiannually. In addition, the portion of H's adjusted basis allocated to the debt instrument treated as retired is $97,725.12/2 or $48,862.56. Accordingly, under section 1271, H realizes a gain on the deemed retirement equal to $6,137.44 ($55,000 - $48,862.56).

EXAMPLE 7. DEBT INSTRUMENT ISSUED AT PAR THAT PROVIDES FOR PAYMENT OF INTEREST IN KIND -- (i) FACTS. On January 1, 1995, A purchases at original issue, for $100,000, X corporation's debt instrument maturing on January 1, 2000, at a stated principal amount of $100,000, payable on that date. The debt instrument provides for annual payments of interest of $6,000 on January 1 of each year, beginning on January 1, 1996. The debt instrument gives X the unconditional right to issue, in lieu of the first interest payment, a second debt instrument (PIK instrument) maturing on January 1, 2000, with a stated principal amount of $6,000. The PIK instrument, if issued, would provide for annual payments of interest of $360 on January 1 of each year, beginning on January 1, 1997.

(ii) AGGREGATION OF PIK INSTRUMENT WITH ORIGINAL DEBT INSTRUMENT. Under section 1.1275-2(c)(3), the issuance of the PIK instrument is not considered a payment made on the original debt instrument, and the PIK instrument is aggregated with the original debt instrument. The issue date of the PIK instrument is the same as the original debt instrument.

(iii) DETERMINATION OF YIELD AND MATURITY. The right to issue the PIK instrument is treated as an option to defer the initial interest payment until maturity. Yield determined without regard to the option is 6 percent, compounded annually. Yield determined by assuming X exercises the option is 6 percent, compounded annually. Thus, under paragraph (c)(5) of this section, it is assumed that X will not exercise the option by issuing the PIK instrument because exercise of the option would not decrease the yield of the debt instrument. For purposes of calculating OID, the debt instrument is assumed to be a 5-year debt instrument with a single principal payment at maturity of $100,000 and ten semiannual interest payments of $6,000, beginning on January 1, 1996. As a result, the debt instrument's yield is 6 percent, compounded annually.

(iv) DETERMINATION OF OID. Under the payment schedule that would result if the option was exercised, none of the interest on the debt instrument would be qualified stated interest. Accordingly, under section 1.1273-1(c)(2), no payments on the debt instrument are qualified stated interest payments. Thus, $6,000 of OID accrues during the first annual accrual period. If the PIK instrument is not issued, $6,000 of OID accrues during each annual accrual period.

(v) CONSEQUENCES IF THE PIK INSTRUMENT IS ISSUED. Under paragraph (c)(6) of this section, if X issues the PIK instrument on January 1, 1996, the issuance of the PIK instrument is not a payment on the debt instrument. Solely for purposes of determining yield and maturity, the debt instrument is deemed reissued on January 1, 1996, for an issue price of $106,000. The recomputed yield is 6 percent, compounded annually. The OID for the first annual accrual period after the deemed reissuance is $6,360. The adjusted issue price of the debt instrument at the beginning of the next annual accrual period is $106,000 ($106,000 + $6,360 - $6,360). The OID for each of the four remaining annual accrual periods is $6,360.

EXAMPLE 8. DEBT INSTRUMENT ISSUED AT A DISCOUNT THAT PROVIDES FOR PAYMENT OF INTEREST IN KIND -- (i) FACTS. On January 1, 1995, T purchases at original issue, for $75,500, U corporation's debt instrument maturing on January 1, 2000, at a stated principal amount of $100,000, payable on that date. The debt instrument provides for annual payments of interest of $4,000 on January 1 of each year, beginning on January 1, 1996. The debt instrument gives U the unconditional right to issue, in lieu of the first interest payment, a second debt instrument (PIK instrument) maturing on January 1, 2000, with a stated principal amount of $4,000. The PIK instrument, if issued, would provide for annual payments of interest of $160 on January 1 of each year, beginning on January 1, 1997.

(ii) AGGREGATION OF PIK INSTRUMENT WITH ORIGINAL DEBT INSTRUMENT. Under section 1.1275-2(c)(3), the issuance of the PIK instrument is not considered a payment made on the original debt instrument, and the PIK instrument is aggregated with the original debt instrument. The issue date of the PIK instrument is the same as the original debt instrument.

(iii) DETERMINATION OF YIELD AND MATURITY. The right to issue the pIK instrument is treated as an option to defer the initial interest payment until maturity. Yield determined without regard to the option is 10.55 percent, compounded annually. Yield determined by assuming U exercises the option is 10.32 percent, compounded annually. Thus, under paragraph (c)(5) of this section, it is assumed that U will exercise the option by issuing the PIK instrument because exercise of the option would decrease the yield of the debt instrument. For purposes of calculating OID, the debt instrument is assumed to be a 5-year debt instrument with a single principal payment at maturity of $104,000 and four annual interest payments of $4,160, beginning on January 1, 1997. As a result, the yield is 10.32 percent, compounded annually.

(iv) CONSEQUENCES IF THE PIK INSTRUMENT IS NOT ISSUED. Assume that T chooses to compute OID accruals on the basis of an annual accrual period. On January 1, 1996, the adjusted issue price of the debt instrument, and T's adjusted basis in the instrument, is $83,295.15. Under paragraph (c)(6) of this section, if U actually makes the $4,000 interest payment on January 1, 1996, the debt instrument is treated as if U made a pro rata prepayment (within the meaning of section 1.1275-2(f)(2)) of $4,000, which reduces the amount of each payment remaining on the instrument by a factor of 4/104, or 1/26. Thus, under section 1.1275-2(f)(1) and section 1271, T realizes a gain of $796.34 ($4,000 - ($83,295.15/26)). The adjusted issue price of the debt instrument and T's adjusted basis immediately after the payment is $80,091.49 ($83,295.15 x 25/26) and the yield continues to be 10.32 percent, compounded annually.

EXAMPLE 9. DEBT INSTRUMENT WITH STEPPED INTEREST RATE -- (i) FACTS. On July 1, 1994, G purchases at original issue, for $85,000, H corporation's debt instrument maturing on July 1, 2004. The debt instrument has a stated principal amount of $100,000, payable on the maturity date and provides for semiannual interest payments on January 1 and July 1 of each year, beginning on January 1, 1995. The amount of each payment is $2,000 for the first 5 years and $5,000 for the final 5 years.

(ii) DETERMINATION OF OID. Assume that G computes its OID using 6-month accrual periods ending on January 1 and July 1 of each year. The yield of the debt instrument, determined under paragraph (b)(1)(i) of this section, is 8.65 percent, compounded semiannually. Interest is unconditionally payable at a fixed rate of at least 4 percent, compounded semiannually, for the entire term of the debt instrument. Consequently, under section 1.1273-1(c)(1), the semiannual payments are qualified stated interest payments to the extent of $2,000. The amount of OID for the first 6-month accrual period is $1,674.34 (the issue price of the debt instrument ($85,000) times the yield of the debt instrument for that accrual period (.0865/2) less the amount of any qualified stated interest allocable to that accrual period ($2,000)).

EXAMPLE 10. DEBT INSTRUMENT PAYABLE ON DEMAND THAT PROVIDES FOR INTEREST AT A CONSTANT RATE -- (i) FACTS. On January 1, 1995, V purchases at original issue, for $100,000, W corporation's debt instrument. The debt instrument calls for interest to accrue at a rate of 9 percent, compounded annually. The debt instrument is redeemable at any time at the option of V for an amount equal to $100,000, plus accrued interest. V uses annual accrual periods to accrue OID on the debt instrument.

(ii) AMOUNT OF OID. Pursuant to paragraph (d) of this section, the yield of the debt instrument is 9 percent, compounded annually. If the debt instrument is not redeemed during 1995, the amount of OID allocable to the year is $9,000.

SECTION 1.1272-2 TREATMENT OF DEBT INSTRUMENTS PURCHASED AT A PREMIUM.

(a) IN GENERAL. Under section 1272(c)(1), if a holder purchases a debt instrument at a premium, the holder does not include any OID in gross income. Under section 1272(a)(7), if a holder purchases a debt instrument at an acquisition premium, the holder reduces the amount of OID includible in gross income by the fraction determined under paragraph (b)(4) of this section.

(b) DEFINITIONS AND SPECIAL RULES -- (1) PURCHASE. For purposes of section 1272 and this section, purchase means any acquisition of a debt instrument, including the acquisition of a newly issued debt instrument in a debt-for-debt exchange or the acquisition of a debt instrument from a donor.

(2) PREMIUM. A debt instrument is purchased at a premium if its adjusted basis, immediately after its purchase by the holder (including a purchase at original issue), exceeds the sum of all, amounts payable on the instrument after the purchase date other than payments of qualified stated interest (as defined in section 1.1273-1(c)).

(3) ACQUISITION PREMIUM. A debt instrument is purchased at an acquisition premium if its adjusted basis, immediately after its purchase (including a purchase at original issue), is --

(i) Less than or equal to the sum of all amounts payable on the instrument after the purchase date other than payments of qualified stated interest (as defined in section 1.1273-1(c)); and

(ii) Greater than the instrument's adjusted issue price (as defined in section 1.1275-1(b)).

(4) ACQUISITION PREMIUM FRACTION. In applying section 1272(a)(7), the cost of a debt instrument is its adjusted basis immediately after its acquisition by the purchaser. Thus, the numerator of the fraction determined under section 1272(a)(7)(B) is the excess of the adjusted basis of the debt instrument immediately after its acquisition by the purchaser over the adjusted issue price of the debt instrument. The denominator of the fraction determined under section 1272(a)(7)(B) is the excess of the sum of all amounts payable on the debt instrument after the purchase date, other than payments of qualified stated interest, over the instrument's adjusted issue price.

(5) ELECTION TO ACCRUE DISCOUNT ON A CONSTANT YIELD BASIS. Rather than applying the acquisition premium fraction, a holder of a debt instrument purchased at an acquisition premium may elect under section 1.1272-3 to compute OID accruals by treating the purchase as a purchase at original issuance and applying the mechanics of the constant yield method.

(6) SPECIAL RULES FOR DETERMINING BASIS -- (i) DEBT INSTRUMENTS ACQUIRED IN EXCHANGE FOR OTHER PROPERTY. For purposes of section 1272(a)(7), section 1272(c)(1), and this section, if a debt instrument is acquired in an exchange for other property (other than in a reorganization defined in section 368) and the basis of the debt instrument is determined, in whole or in part, by reference to the basis of the other property, the basis of the debt instrument may not exceed its fair market value immediately after the exchange. For example, if a debt instrument is distributed by a partnership to a partner in a liquidating distribution and the partner's basis in the debt instrument would otherwise be determined under section 732, the partner's basis in the debt instrument may not exceed its fair market value for purposes of this section.

(ii) ACQUISITION BY GIFT. For purposes of this section, a donee's adjusted basis in a debt instrument is the donee's basis for determining gain under section 1015(a).

(c) EXAMPLES. The following examples illustrate the rules of this section.

EXAMPLE 1. DEBT INSTRUMENT PURCHASED AT AN ACQUISITION PREMIUM -- (i) FACTS. On July 1, 1994, A purchased at original issue, for $500, a debt instrument issued by Corporation X. The debt instrument matures on July 1, 1999, and calls for a single payment at maturity of $1,000. Under section 1273(a), the debt instrument has a stated redemption price at maturity of $1,000 and, thus, OID of $500. On July 1, 1996, when the debt instrument's adjusted issue price is $659.75, A sells the debt instrument to B for $750 in cash.

(ii) ACQUISITION PREMIUM FRACTION. Because the cost to B of the debt instrument is less than the amount payable on the debt instrument after the purchase date, but is greater than the debt instrument's adjusted issue price, B has paid an acquisition premium for the debt instrument. Accordingly, the daily portion of OID for any day that B holds the debt instrument is reduced by a fraction, the numerator of which is $90.25 (the excess of the cost of the debt instrument over its adjusted issue price) and the denominator of which is $340.25 (the excess of the sum of all payments after the purchase date over its adjusted issue price).

EXAMPLE 2. DEBT-FOR-DEBT EXCHANGE WHERE HOLDER IS CONSIDERED TO PURCHASE NEW DEBT INSTRUMENT AT A PREMIUM -- (i) FACTS. On January 1, 1995, H purchases at original issue, for $1,000, a debt instrument issued by Corporation X. On July 1, 1997, when H's adjusted basis in the debt instrument is $1,000, Corporation X issues a new debt instrument with a stated redemption price at maturity of $750 to H in exchange for the old debt instrument. Assume that the issue price of the new debt instrument is $600. Thus, under section 1273(a), the debt instrument has OID of $150. The exchange qualifies as a recapitalization under section 368(a)(1)(E), with the consequence that, under sections 354 and 358, H recognizes no loss on the exchange and has an adjusted basis in the new debt instrument of $1,000.

(ii) APPLICATION OF SECTION 1272(c)(1). Under paragraphs (b)(l) and (b)(2) of this section, H purchases the new debt instrument at a premium of $250. Accordingly, under section 1272(c)(1), H is not required to include OID in income with respect to the new debt instrument.

EXAMPLE 3. DEBT-FOR-DEBT EXCHANGE WHERE HOLDER IS CONSIDERED TO PURCHASE NEW DEBT INSTRUMENT AT AN ACQUISITION PREMIUM -- (i) FACTS. The facts are the same as in Example 2 of paragraph (c) of this section, except that H purchases the old debt instrument from another holder on July 1, 1995, and on July 1, 1997, H's adjusted basis in the old debt instrument is $700. Under section 1273(a), the new debt instrument is issued with OID of $150.

(ii) APPLICATION OF SECTION 1272(a)(7). Under paragraphs (b)(1) and (b)(3) of this section, H purchases the new debt instrument at an acquisition premium of $100. Accordingly, the daily portion of OID that is includible in H's income is reduced by the fraction determined under Section 1272(a)(7).

EXAMPLE 4. TREATMENT OF ACQUISITION PREMIUM FOR DEBT INSTRUMENT ACQUIRED BY GIFT -- (i) FACTS. On July 1, 1994, D receives as a gift a debt instrument with a stated redemption price at maturity of $1,000 and an adjusted issue price of $800. On that date, the fair market value of the debt instrument is $900 and the donor's adjusted basis in the debt instrument is $950.

(ii) APPLICATION OF SECTION 1272(a)(7). Under paragraphs (b)(1), (b)(3), and (b)(6)(ii) of this section, D is considered to have purchased the debt instrument at an acquisition premium of $150. Accordingly, the daily portion of OID that is includible in D's income is reduced by the fraction determined under section 1272(a)(7).

SECTION 1.1272-3 ELECTION BY A HOLDER TO TREAT ALL INTEREST ON A DEBT INSTRUMENT AS OID.

(a) ELECTION. A holder of a debt instrument may elect to include in gross income all interest that accrues on the instrument by using the constant yield method described in paragraph (c) of this section. For purposes of this election, interest includes stated interest, acquisition discount, OID, de minimis OID, market discount, de minimis market discount, and unstated interest, as adjusted by any amortizable bond premium or acquisition premium.

(b) SCOPE OF ELECTION -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section, a holder may make the election for any debt instrument.

(2) EXCEPTIONS, LIMITATIONS, AND SPECIAL RULES -- (i) DEBT INSTRUMENT WITH AMORTIZABLE BOND PREMIUM (AS DETERMINED UNDER SECTION 171). (A) A holder may make the election for a debt instrument with amortizable bond premium only if the instrument qualifies as a bond under section 171(d).

(B) If a holder makes the election under this section for a debt instrument with amortizable bond Premium, the holder is deemed to have made the election under section 171(c)(2) for the taxable year in which the instrument was acquired. If the holder has previously made the election under section 171(c)(2), the requirements of that election with respect to any debt instrument are satisfied by electing to amortize the bond premium under the rules provided by this section.

(ii) DEBT INSTRUMENT WITH MARKET DISCOUNT. (A) A holder may make the election under this section for a debt instrument with market discount only if the holder is eligible to make an election under section 1278(b).

(B) If a holder makes the election under this section for a debt instrument with market discount, the holder is deemed to have made both the election under section 1276(b)(2) for that instrument and the election under section 1278(b) for the taxable year in which the instrument was acquired. If the holder has previously made the election under section 1278(b), the requirements of that election with respect to any debt instrument are satisfied by electing to include the market discount in income in accordance with the rules provided by this section.

(iii) TAX-EXEMPT DEBT INSTRUMENT. A holder may not make the election for a tax-exempt obligation as defined in section 1275(a)(3).

(c) MECHANICS OF THE CONSTANT YIELD METHOD -- (1) IN GENERAL. For purposes of this section, the amount of interest that accrues during an accrual period is determined under rules similar to those under section 1272 (the constant yield method). In applying the constant yield method, however, a debt instrument subject to the election is treated as if --

(i) The instrument is issued for the holder's adjusted basis immediately after its acquisition by the holder;

(ii) The instrument is issued on the holder's acquisition date; and

(iii) None of the interest payments provided for in the instrument are qualified stated interest payments.

(2) SPECIAL RULES TO DETERMINE ADJUSTED BASIS. For purposes of paragraph (c)(1)(i) of this section --

(i) If the debt instrument is acquired in an exchange for other property (other than in a reorganization defined in section 368) and the basis of the debt instrument is determined, in whole or in part, by reference to the basis of the other property, the adjusted basis of the debt instrument may not exceed its fair market value immediately after the exchange; and

(ii) If the debt instrument was acquired with amortizable bond premium (as determined under section 171), the adjusted basis of the debt instrument is reduced by an amount equal to the value attributable to any conversion feature.

(d) TIME AND MANNER OF MAKING THE ELECTION. The election must be made for the taxable year in which the holder acquires the debt instrument. A holder makes the election by attaching to the holder's timely filed Federal income tax return a statement that the holder is making an election under this section and that identifies the debt instruments subject to the election. A holder may make the election for a class or group of debt instruments by attaching a statement describing the type or types of debt instruments being designated for the election.

(e) REVOCATION OF ELECTION. The election may not be revoked unless approved by the Commissioner.

(f) EFFECTIVE DATE. This section applies to debt instruments acquired on or after [INSERT DATE THAT IS SO DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

SECTION 1.1273-1 DEFINITION OF OID.

(a) IN GENERAL. Section 1273(a)(1) defines OID as the excess of a debt instrument's stated redemption price at maturity over its issue price. Section 1.1273-2 defines issue price, and paragraph (b) of this section defines stated redemption price at maturity. Paragraph (d) of this section provides rules for de minimis amounts of OID. Although the total amount of OID for a debt instrument may be indeterminate, section 1.1272-1(d) provides a rule to determine OID accruals on certain debt instruments that provide for principal payments uncertain as to time. See EXAMPLE 10 in section 1.1272-1(j).

(b) STATED REDEMPTION PRICE AT MATURITY. A debt instrument's stated redemption price at maturity is the sum of all payments provided by the debt instrument other than qualified stated interest payments. If the payment schedule of a debt instrument is determined under section 1.1272-1(c) (relating to certain debt instruments subject to contingencies), that payment schedule is used to determine the instrument's stated redemption price at maturity.

(c) QUALIFIED STATED INTEREST -- (1) DEFINITION -- (i) IN GENERAL. Qualified stated interest is stated interest that is unconditionally payable in cash or in property (other than debt instruments of the issuer), or that will be constructively received under section 451, at least annually at a single fixed rate (within the meaning of paragraph (c)(1)(iii) of this section).

(ii) UNCONDITIONALLY PAYABLE. Interest is unconditionally payable only if late payment (other than a late payment that occurs within a reasonable grace period) or nonpayment is expected to be penalized or reasonable remedies exist to compel payment. Notwithstanding the preceding sentence, interest is not unconditionally payable if the lending transaction does not reflect arm's length dealing and the holder does not intend to enforce such remedies. For purposes of determining whether interest is unconditionally payable, the possibility of nonpayment due to default, insolvency, or similar circumstances, or due to the exercise of a conversion right described in section 1.1272-1(e) is ignored.

(iii) SINGLE FIXED RATE -- (A) IN GENERAL. Interest is payable at a single fixed rate only if the rate appropriately takes into account the length of the interval between payments. Thus, if the interval between payments varies during the term of the debt instrument, the value of the fixed rate on which a payment is based generally must be adjusted to reflect a compounding assumption that is consistent with the length of the interval preceding the payment. See Example 1 in paragraph (f) of this section.

(B) SPECIAL RULE FOR CERTAIN FIRST AND FINAL PAYMENT INTERVALS. Notwithstanding paragraph (c)(1)(iii)(A) of this section, if a debt instrument provides for payment intervals that are equal in length throughout the term of the instrument, except that the first or final payment interval differs in length from the other payment intervals, the first or final interest payment is considered to be made at a fixed rate if the value of the rate on which the payment is based is adjusted in any reasonable manner to take into account the length of the interval. See EXAMPLE 2 of paragraph (f) of this section. The rule in this paragraph (c)(1)(iii)(B) also applies if the lengths of both the first and final payment intervals differ from the length of the other payment intervals.

(2) DEBT INSTRUMENTS SUBJECT TO CONTINGENCIES. The determination of whether a debt instrument described in section 1.1272-1(c) (a debt instrument providing for an alternative payment schedule (or schedules) upon the occurrence of one or more contingencies) provides for qualified stated interest is made by analyzing each alternative payment schedule (including the stated payment schedule) as if it were the debt instrument's sole payment schedule. Under this analysis, the debt instrument provides for qualified stated interest to the extent of the lowest fixed rate at which qualified stated interest would be payable under any payment schedule. See EXAMPLE (4) of paragraph (f) of this section.

(3) VARIABLE RATE DEBT INSTRUMENT. In the case of a variable rate debt instrument, qualified stated interest is determined under section 1.1275-5(e).

(4) STATED INTEREST IN EXCESS OF QUALIFIED STATED INTEREST. To the extent that stated interest payable under a debt instrument exceeds qualified stated interest, the excess is included in the debt instrument's stated redemption price at maturity.

(5) SHORT-TERM OBLIGATIONS. In the case of a debt instrument with a term that is not more than 1 year from the date of issue, no payments of interest are treated as qualified stated interest payments.

(d) DE MINIMIS OID -- (1) IN GENERAL. If the amount of OID with respect to a debt instrument is less than the de minimis amount, the amount of OID is treated as zero, and all stated interest (including stated interest that would otherwise be characterized as OID) is treated as qualified stated interest.

(2) DE MINIMIS AMOUNT. The de minimis amount is an amount equal to 0.0025 multiplied by the product of the stated redemption price at maturity and the number of complete years to maturity from the issue date.

(3) INSTALLMENT OBLIGATIONS. In the case of an installment obligation (as defined in paragraph (e)(1) of this section), paragraph (d)(2) of this section is applied by substituting for the number of complete years to maturity the weighted average maturity (as defined in paragraph (e)(3) of this section). Alternatively, in the case of a debt instrument that provides for payments of principal no more rapidly than a self-amortizing installment obligation (as defined in paragraph (e)(2) of this section), the de minimis amount defined in paragraph (d)(2) of this section may be calculated by substituting 0.00167 for 0.0025.

(4) SPECIAL RULE FOR INTEREST HOLIDAYS, TEASER RATES, AND OTHER INTEREST SHORTFALLS -- (i) IN GENERAL. This paragraph (d)(4) provides a special rule to determine whether a debt instrument with a teaser rate (or rates), an interest holiday, or any other interest shortfall has de minimis OID. This rule applies if --

(A) The amount of OID on the debt instrument is more than the de minimis amount as otherwise determined under paragraph (d) of this section; and

(B) All stated interest provided for in the debt instrument would be qualified stated interest under paragraph (c) of this section except that for 1 or more accrual periods the interest rate is below the rate applicable for the remainder of the instrument's term (e.g., if as a result of an interest holiday, none of the stated interest is qualified stated interest).

(ii) REDETERMINATION OF OID FOR PURPOSES OF THE DE MINIMIS TEST. For purposes of determining whether a debt instrument described in paragraph (d)(4)(i) of this section has de minimis OID, the instrument's stated redemption price at maturity is treated as equal to the instrument's issue price plus the greater of the amount of foregone interest or the excess (if any) of the instrument's stated principal amount over its issue price. The amount of foregone interest is the amount of additional stated interest that would be required to be payable on the debt instrument during the period of the teaser rate, holiday, or shortfall so that all stated interest would be qualified stated interest under paragraph (c) of this section. See EXAMPLE 5 and EXAMPLE 6 of paragraph (f) of this section. In addition, for purposes of computing the de minimis amount of OID, the weighted average maturity of the debt instrument is determined by treating all stated interest payments as qualified stated interest payments.

(5) TREATMENT OF DE MINIMIS OID BY HOLDERS -- (i) ALLOCATION OF DE MINIMIS OID TO PRINCIPAL PAYMENTS. The holder of a debt instrument includes any de minimis OID (other than de minimis OID treated as qualified stated interest under paragraph (d)(l) of this section, such as de minimis OID attributable to a teaser rate or interest holiday) in income as stated principal payments are made. The amount includible in income with respect to each principal payment equals the product of the total amount of de minimis OID on the debt instrument and a fraction, the numerator of which is the amount of the principal payment made and the denominator of which is the stated principal amount of the instrument.

(ii) CHARACTER OF DE MINIMIS OID -- (A) DE MINIMIS OID TREATED AS GAIN RECOGNIZED ON RETIREMENT. Any amount of de minimis OID includible in income under this paragraph (d)(5) is treated as gain recognized on retirement of the debt instrument. See section 1271 to determine whether a retirement is treated as an exchange of the debt instrument.

(B) TREATMENT OF DE MINIMIS OID ON SALE OR EXCHANGE. Any gain attributable to de minimis OID that is recognized on the sale or exchange of a debt instrument is capital gain if the debt instrument is a capital asset in the hands of the seller.

(iii) TREATMENT OF SUBSEQUENT HOLDERS. If a subsequent holder purchases a debt instrument issued with de minimis OID at a premium (as defined in section 1.1272-2(b)(2)), the subsequent holder does not include the de minimis OID in income. Otherwise, a subsequent holder includes any discount in income under the market discount rules (sections 1276 through 1278) rather than under the rules of this paragraph (d)(5).

(iv) CROSS-REFERENCE. See section 1.1272-3 for an election by a holder to treat de minimis OID as OID.

(e) DEFINITIONS -- (1) INSTALLMENT OBLIGATION. An installment obligation is a debt instrument that provides for the payment of any amount other than qualified stated interest before maturity.

(2) SELF-AMORTIZING INSTALLMENT OBLIGATION. A self-amortizing installment obligation is an obligation that provides for equal payments composed of principal and qualified stated interest that are unconditionally payable at least annually during the entire term of the debt instrument with no significant additional payment required at maturity.

(3) WEIGHTED AVERAGE MATURITY. The weighted average maturity of a debt instrument is the sum of the following amounts determined for each payment under the instrument (other than a payment of qualified stated interest) --

(i) The number of complete years from the issue date until the payment is made; multiplied by

(ii) A fraction, the numerator of which is the amount of the payment and the denominator of which is the debt instrument's stated redemption price at maturity.

(f) EXAMPLES. The following examples illustrate the rules of this section.

EXAMPLE 1. QUALIFIED STATED INTEREST -- (i) FACTS. On January 1, 1995, A purchases at original issue, for $100,000, a debt instrument that matures on January 1, 1999, and has a stated principal amount of $100,000, payable at maturity. The debt instrument provides for interest payments of $8,000 on January 1, 1996, and January 1, 1997, and quarterly interest payments of $1,942.65, beginning on April 1, 1997.

(ii) AMOUNT OF QUALIFIED STATED INTEREST. The annual payments of $8,000 and the quarterly payments of $1,942.65 are payable at a single fixed rate because 8 percent, compounded annually, is equivalent to 7.77 percent, compounded quarterly. Consequently, all stated interest payments under the debt instrument are qualified stated interest payments.

EXAMPLE 2. QUALIFIED STATED INTEREST WITH SHORT INITIAL PAYMENT INTERVAL. On October 1, 1994, A purchases at original issue, for $100,000, a debt instrument that matures on January 1, 1998, and has a stated principal amount of $100,000, payable at maturity. The debt instrument provides for an interest payment of $2,000 on January 1, 1995, and interest payments of $8,000 on January 1, 1996, January 1, 1997, and January 1, 1998. Under paragraph (c)(1)(iii)(B) of this section, all stated interest payments on the debt instrument are computed at a single fixed rate and are qualified stated interest payments.

EXAMPLE 3. STATED INTEREST IN EXCESS OF QUALIFIED STATED INTEREST -- (i) FACTS. On January 1, 1995, B purchases at original issue, for $100,000, C corporation's 5-year debt instrument. The debt instrument provides for a principal payment of $100,000, payable at maturity, and calls for annual interest payments of $10,000 for the first 3 years and annual interest payments of $10,600 for the last 2 years.

(ii) PAYMENTS IN EXCESS OF QUALIFIED STATED INTEREST. All of the first three interest payments and $10,000 of each of the last two interest payments are qualified stated interest payments within the meaning of paragraph (c)(1) of this section. Under paragraph (c)(4) of this section, the remaining $600 of each of the last two interest payments is included in the stated redemption price at maturity, so that the stated redemption price at maturity is $101,200. Pursuant to paragraph (e)(3) of this section, the weighted average maturity of the debt instrument is 4.994 years [(4 years x $600/$101,200) + (5 years x $100,600/$101,200)]. The de minimis amount, or one-fourth of 1 percent of the stated redemption price at maturity multiplied by the weighted average maturity, is $1,263.50. Because the actual amount of discount, $1,200, is less than the de minimis amount, the instrument is treated as having no OID, and, under paragraph (d)(1) of this section, all of the interest payments are treated as qualified stated interest payments.

EXAMPLE 4. QUALIFIED STATED INTEREST ON A DEBT INSTRUMENT THAT IS SUBJECT TO A CONTINGENCY -- (i) FACTS. On January 1, 1995, A issues, for $100,000, a 10-year debt instrument that provides for a $100,000 principal payment at maturity and for annual interest payments of $10,000. Under the terms of the debt instrument, however, the interest payments for each of the final five years will be reduced to $5,000 if a specified annual level of earnings is not attained by A by the end of year five.

(ii) AMOUNT OF QUALIFIED STATED INTEREST. If the payment schedule determined by assuming that the specified earnings level will be attained is treated as the debt instrument's sole payment schedule, the instrument would provide for annual qualified stated interest payments of $10,000. If the payment schedule determined by assuming that the specified earnings level will not be attained is treated as the instrument's sole payment schedule, however, only $5,000 of each annual interest payment would constitute qualified stated interest. Accordingly, under paragraph (c)(2) of this section, only $5,000 of each annual interest payment constitutes qualified stated interest. Any excess of each annual interest payment over $5,000 is included in the debt instrument's stated redemption price at maturity.

EXAMPLE 5. DE MINIMIS OID; INTEREST HOLIDAY -- (i) FACTS. On January 1, 1995, C purchases at original issue, for $97,561, a debt instrument that matures on January 1, 2007, and has a stated principal amount of $100,000, payable at maturity. The debt instrument provides for an initial interest holiday of 1 quarter and quarterly interest payments of $2,500 thereafter (beginning on July 1, 1995). The issue price of the debt instrument is $97,561. C chooses to accrue OID based on quarterly accrual periods.

(ii) DE MINIMIS AMOUNT OF OID. But for the interest holiday, all stated interest on the debt instrument would be qualified stated interest. Under paragraph (d)(4) of this section, for purposes of determining whether the debt instrument has de minimis OID, the stated redemption price at maturity of the instrument is $100,061 ($97,561 (issue price) plus $2,500 (the greater of the amount of foregone interest ($2,500) and the amount equal to the excess of the instrument's stated principal amount over its issue price ($2,439)). Thus, the debt instrument is treated as having OID of $2,500 ($100,061 minus $97,561). Because this amount is less than the de minimis amount of $3,001.83 (0.0025 multiplied by $100,061 multiplied by 12 complete years to maturity), the debt instrument is treated as having no OID, and all stated interest is treated as qualified stated interest.

EXAMPLE 6. DE MINIMIS OID; TEASER RATE -- (i) FACTS. The facts are the same as in EXAMPLE 5 of this paragraph (f) except that C uses an initial semiannual accrual period rather than an initial quarterly accrual period.

(ii) DE MINIMIS AMOUNT OF OID. The debt instrument provides for an initial teaser rate because the interest rate for the semiannual accrual period is less than the interest rate applicable to the subsequent quarterly accrual periods. But for the initial teaser rate, all stated interest on the debt instrument would be qualified stated interest. Under paragraph (d)(4) of this section, for purposes of determining whether the debt instrument has de minimis OID, the stated redemption price at maturity of the instrument is $100,123.50 ($97,561 (issue price) plus $2,562.50 (the greater of the amount of foregone interest ($2,562.50) and the amount equal to the excess of the instrument's stated principal amount over its issue price ($2,439)). Thus, the debt instrument is treated as having OID of $2,562.50 ($100,123.50 minus $97,561). Because this amount is less than the de minimis amount of $3,003.71 (0.0025 multiplied by $100,123.50 multiplied by 12 complete years to maturity), the debt instrument is treated as having no OID, and all stated interest is treated as qualified stated interest.

SECTION 1.1273-2 DETERMINATION OF ISSUE PRICE AND ISSUE DATE.

(a) DEBT INSTRUMENTS ISSUED FOR MONEY -- (1) ISSUE PRICE. If a substantial amount of the debt instruments in an issue is issued for money, the issue price of each debt instrument in the issue is the first price at which a substantial amount of the debt instruments is sold for money. Thus, if an issue consists of a single debt instrument that is issued for money, the issue price of the debt instrument is the amount paid for the instrument. For example, in the case of a debt instrument evidencing a loan to a natural person, the issue price of the instrument is the amount loaned. See section 1.1275-2(d) for rules regarding Treasury securities. For purposes of this paragraph (a), money includes functional currency and, in certain circumstances, nonfunctional currency. See section 1.988-2(b)(2) for circumstances when nonfunctional currency is treated as money rather than as property.

(2) ISSUE DATE. The issue date of an issue described in paragraph (a)(1) of this section is the first settlement date or closing date, whichever is applicable, on which a substantial amount of the debt instruments in the issue is sold for money.

(b) PUBLICLY TRADED DEBT INSTRUMENTS ISSUED FOR PROPERTY -- (1) ISSUE PRICE. If a substantial amount of the debt instruments in an issue is traded on an established market (within the meaning of paragraph (f) of this section) and the issue is not described in paragraph (a)(1) of this section, the issue price of each debt instrument in the issue is the fair market value of the debt instrument, determined as of the issue date (as defined in paragraph (b)(2) of this section).

(2) ISSUE DATE. The issue date of an issue described in paragraph (b)(1) of this section is the first date on which a substantial amount of the traded debt instruments in the issue is issued.

(c) DEBT INSTRUMENTS ISSUED FOR PUBLICLY TRADED PROPERTY -- (1) ISSUE PRICE. If a substantial amount of the debt instruments in an issue is issued for property that is traded on an established market (within the meaning of paragraph (f) of this section) and the issue is not described in paragraph (a)(1) or (b)(1) of this section, the issue price of each debt instrument in the issue is the fair market value of the property, determined as of the issue date (as defined in paragraph (c)(2) of this section). For purposes of the preceding sentence, property means a debt instrument, stock, security, contract, commodity, or nonfunctional currency. But see section 1.988-2(b)(2) for circumstances when nonfunctional currency is treated as money rather than as property.

(2) ISSUE DATE. The issue date of an issue described in paragraph (c)(1) of this section is the first date on which a substantial amount of the debt instruments in the issue is issued for traded property.

(d) OTHER DEBT INSTRUMENTS -- (1) Issue price. If an issue of debt instruments is not described in paragraph (a)(1), (b)(1), or (c)(1) of this section, the issue price of each debt instrument in the issue is determined as if the debt instrument were a separate issue. If the issue price of a debt instrument that is treated as a separate issue under the preceding sentence is not determined under paragraph (a)(1), (b)(1), or (c)(1) of this section, and if section 1274 applies to the debt instrument, the issue price of the instrument is determined under section 1274. Otherwise, the issue price of the debt instrument is its stated redemption price at maturity under section 1273(b)(4). See section 1274(c) and section 1.1274-1 to determine if section 1274 applies to a debt instrument.

(2) ISSUE DATE. The issue date of an issue described in paragraph (d)(1) of this section is the date on which the debt instrument is issued for money or in a sale or exchange.

(e) SPECIAL RULE FOR CERTAIN SALES TO BOND HOUSES, BROKERS, OR SIMILAR PERSONS. For purposes of determining the issue price and issue date of a debt instrument under this section, sales to bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents, or wholesalers are ignored.

(f) TRADED ON AN ESTABLISHED MARKET (PUBLICLY TRADED) -- (1) IN GENERAL. Property (including a debt instrument described in paragraph (b)(1) of this section) is traded on an established market for purposes of this section if, at any time during the 60-day period ending 30 days after the issue date, the property is described in paragraph (f)(2), (f)(3), (f)(4), or (f)(5) of this section.

(2) EXCHANGE LISTED PROPERTY. Property is described in this paragraph (f)(2) if it is listed on --

(i) A national securities exchange registered under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f);

(ii) An interdealer quotation system sponsored by a national securities association registered under section 15A of the Securities Exchange Act of 1934 (15 U.S.C. 780-3); or

(iii) The International Stock Exchange of the United Kingdom and the Republic of Ireland, Limited, the Frankfurt Stock Exchange, the Tokyo Stock Exchange, or any other foreign exchange or board of trade that is designated by the Commissioner in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii) of this chapter).

(3) MARKET TRADED PROPERTY. Property is described in this paragraph (f)(3) if it is property of a kind that is traded either on a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market.

(4) PROPERTY APPEARING ON A QUOTATION MEDIUM. Property is described in this paragraph (f)(4) if it appears on a system of general circulation (including a computer listing disseminated to subscribing brokers, dealers, or traders) that provides a reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent sales transactions (a quotation medium). A quotation medium does not include a directory or listing of brokers, dealers, or traders for specific securities, such as yellow sheets, that provides neither price quotations nor actual prices of recent sales transactions.

(5) READILY QUOTABLE DEBT INSTRUMENTS -- (i) IN GENERAL. A debt instrument is described in this paragraph (f)(5) if price quotations are readily available from dealers, brokers, or traders.

(ii) SAFE HARBORS. A debt instrument is not considered to be described in paragraph (f)(5)(i) of this section if --

(A) No other outstanding debt instrument of the issuer (or of any person who guarantees the debt instrument) is described in paragraph (f)(2), (f)(3), or (f)(4) of this section (other traded debt);

(B) The original stated principal amount of the issue that includes the debt instrument does not exceed $25 million;

(C) The conditions and covenants relating to the issuer's performance with respect to the debt instrument are materially less restrictive than the conditions and covenants included in all of the issuer's other traded debt (e.g., the debt instrument is subject to an economically significant subordination provision whereas the issuer's other traded debt is senior); or

(D) The maturity date of the debt instrument is more than 3 years after the latest maturity date of the issuer's other traded debt.

(6) EFFECT OF CERTAIN TEMPORARY RESTRICTIONS ON TRADING. If there is any temporary restriction on trading a purpose of which is to avoid the characterization of the property as one that is traded on an established market for Federal income tax purposes, then the property is treated as traded on an established market. For purposes of the preceding sentence, a temporary restriction on trading need not be imposed by the issuer.

(7) CONVERTIBLE DEBT INSTRUMENTS. A debt instrument is not treated as traded on an established market solely because the debt instrument is convertible into property that is so traded.

(g) TREATMENT OF CERTAIN CASH PAYMENTS INCIDENT TO LENDING TRANSACTIONS -- (1) APPLICABILITY. The provisions of this paragraph (g) apply to cash payments made incident to private lending transactions (including seller financing).

(2) PAYMENTS FROM BORROWER TO LENDER -- (i) MONEY LENDING TRANSACTION. In a lending transaction to which section 1273(b)(2) applies, a payment from the borrower to the lender (other than a payment for property or for services provided by the lender, such as commitment fees or loan processing costs) reduces the issue price of the debt instrument evidencing the loan. However, solely for purposes of determining the tax consequences to the borrower, the issue price is not reduced if the payment is deductible under section 461(g)(2).

(ii) SECTION 1274 TRANSACTION. In a lending transaction to which section 1274 applies, a payment from the buyer-borrower to the seller-lender that is designated as interest or points reduces the stated principal amount of the debt instrument evidencing the loan, but is included in the purchase price of the property. If the payment is deductible under section 461(g)(2), however, the issue price of the debt instrument (as otherwise determined under section 1274 and the rule in the preceding sentence) is increased by the amount of the payment to compute the buyer-borrower's interest deductions under section 163.

(3) PAYMENTS FROM LENDER TO BORROWER. A payment from the lender to the borrower in a lending transaction is treated as an amount loaned.

(4) PAYMENTS BETWEEN LENDER AND THIRD PARTY. If, as part of a lending transaction, a party other than the borrower (the third party) makes a payment to the lender, that payment is treated in appropriate circumstances as made from the third party to the borrower followed by a payment in the same amount from the borrower to the lender and governed by the provisions of paragraph (g)(2) of this section. If, as part of a lending transaction, the lender makes a payment to a third party, that payment is treated in appropriate circumstances as an additional amount loaned to the borrower and then paid by the borrower to the third party. The character of the deemed payment between the borrower and the third party depends on the substance of the transaction.

(5) EXAMPLES. The following examples illustrate the rules of this paragraph (g).

EXAMPLE 1. PAYMENTS FROM BORROWER TO LENDER IN A CASH TRANSACTION -- (i) FACTS. A lends $100,000 to B for a term of 10 years. At the time the loan is made, B pays $4,000 in points to A. Assume that the points are not deductible by B under section 461(g)(2) and that the stated redemption price at maturity of the debt instrument is $100,000.

(ii) PAYMENT RESULTS IN OID. Under paragraph (g)(2)(i) of this section, the issue price of B's debt instrument evidencing the loan is $96,000. Because the amount of OID on the debt instrument ($4,000) is more than a de minimis amount of OID, A accounts for the OID under section 1.1272-1. B accounts for the OID under section 1.163-7.

EXAMPLE 2. PAYMENTS FROM BORROWER TO LENDER IN A SECTION 1274 TRANSACTION -- (i) FACTS. A sells property to B for $1,000,000 in a transaction that is not a potentially abusive situation (within the meaning of section 1.1274-3). In consideration for the property, B gives A $300,000 and issues a 5-year debt instrument that has a stated principal amount of $700,000, payable at maturity, and that calls for semiannual payments of interest at a rate of 8.5 percent. In addition to the cash downpayment, B pays A $14,000 designated as points on the loan. Assume that the points are not deductible under section 461(g)(2).

(ii) ISSUE PRICE. Under paragraph (g)(2)(ii) of this section, the stated principal amount of B's debt instrument is $686,000 ($700,000 minus $14,000). Assuming a test rate of 9 percent, compounded semiannually, the imputed principal amount of B's debt instrument under section 1.1274-2(c)(1) is $686,153. Under section 1.1274-2(b)(1), the issue price of B's debt instrument is the stated principal amount of $686,000. Because the amount of OID on the debt instrument ($700,000 - $686,000, or $14,000) is more than a de minimis amount of OID, A accounts for the OID under section 1.1272-1 and B accounts for the OID under section 1.163-7. B's basis in the property purchased is $1,000,000 ($686,000 debt instrument plus $314,000 cash payments).

EXAMPLE 3. PAYMENTS BETWEEN LENDER AND THIRD PARTY (SELLER- PAID POINTS) -- (i) FACTS. A sells real property to B for $500,000 in a transaction that is not a potentially abusive situation (within the meaning of section 1.1274-3). B makes a cash down payment of $100,000 and borrows $400,000 of the purchase price from a lender, L, repayable in annual installments over a term of 15 years calling for interest at a rate of 9 percent, compounded annually. As part of the transaction, A makes a payment of $8,000 to L to facilitate the loan to B.

(ii) PAYMENT RESULTS IN A DE MINIMIS AMOUNT OF OID. Under the provisions of paragraphs (g)(2)(i) and (g)(4) of this section, B is treated as having made an $8,000 payment directly to L and a payment of only $492,000 to A for the property. Thus, B's basis in the property is $492,000. The payment to L reduces the issue price of B's debt instrument to $392,000, resulting in $8,000 of OID ($400,000 - $392,000). Because the amount of OID is de minimis under section 1.1273-1(d), L accounts for the de minimis OID under section 1.1273-1(d)(5). But see section 1.1272-3 (election to treat de minimis OID as OID). B accounts for the de minimis OID under section 1.163-7.

(h) INVESTMENT UNITS -- (i) IN GENERAL. Under section 1273(c)(2), an investment unit is treated as if the investment unit were a debt instrument. The issue price of the investment unit is determined under paragraph (a)(1), (b)(1), or (c)(1) of this section, if applicable. The issue price of the investment unit is then allocated between the debt instrument and the property right (or rights) that comprise the unit based on their relative fair market values. If paragraphs (a)(1), (b)(1), and (c)(1) of this section are not applicable, however, the issue price of the debt instrument that is part of the investment unit is determined under section 1273(b)(4) or 1274, whichever is applicable.

(2) CONSISTENT ALLOCATION BY HOLDERS AND ISSUER. The issuer's allocation of the issue price of the investment unit is binding on all holders of the investment unit. However, the issuer's determination is not binding on a holder that explicitly discloses that its allocation is different from the issuer's allocation. Unless otherwise provided by the Commissioner, the disclosure must be made on a statement attached to the holder's timely filed Federal income tax return for the taxable year that includes the acquisition date of the investment unit. See section 1.1275-2(e) for rules relating to the issuer's obligation to disclose certain information to holders.

(i) [Reserved]

(j) CONVERTIBLE DEBT INSTRUMENTS. The issue price of a debt instrument includes any amount paid for an option to convert the instrument into stock (or another debt instrument) of either the issuer or 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 instrument).

(k) BELOW-MARKET LOANS SUBJECT TO SECTION 7872(b). The issue price of a below-market loan subject to section 7872(b) (a term loan other than a gift loan) is the issue price determined under this section, reduced by the excess amount determined under section 7872(b)(1).

(l) [Reserved]

(m) TREATMENT OF AMOUNTS REPRESENTING PRE-ISSUANCE ACCRUED INTEREST -- (i) APPLICABILITY. Paragraph (m)(2) of this section provides an alternative to the general rule of this section for determining the issue price of a debt instrument if --

(i) A portion of the initial purchase price of the instrument is allocable to interest that has accrued prior to the issue date (pre- issuance accrued interest); and

(ii) The instrument provides for a payment of stated interest on the first payment date within 1 year of the issue date that equals or exceeds the amount of the pre-issuance accrued interest.

(2) EXCLUSION OF PRE-ISSUANCE ACCRUED INTEREST FROM ISSUE PRICE. If a debt instrument meets the requirements of paragraph (m)(1) of this section, the instrument's issue price may be computed by subtracting from the issue price (as otherwise computed under this section) the amount of pre-issuance accrued interest. If the issue price of the debt instrument is computed in this manner, a portion of the stated interest payable on the first payment date must be treated as a return of the excluded pre-issuance accrued interest, rather than as an amount payable on the instrument.

(3) EXAMPLE. The following example illustrates the rule of paragraph (m) of this section.

EXAMPLE. (i) FACTS. On January 15, 1995, A purchases at original issue, for $1,005, B corporation's debt instrument. The debt instrument provides for a payment of principal of $1,000 on January 1, 2005, and provides for semiannual interest payments of $60 on January 1 and July 1 of each year, beginning on July 1, 1995.

(ii) DETERMINATION OF PRE-ISSUANCE ACCRUED INTEREST. Under paragraphs (m)(1) and (m)(2) of this section, $5 of the $1,005 initial purchase price of the debt instrument is allocable to pre-issuance accrued interest. Accordingly, the debt instrument's issue price may be computed by subtracting the amount of pre-issuance accrued interest ($5) from the issue price otherwise computed under this section ($1,005), resulting in an issue price of $1,000. If the issue price is computed in this manner, $5 of the $60 payment made on July 1, 1995, must be treated as a repayment by B of the pre-issuance accrued interest.

SECTION 1.1274-1 DEBT INSTRUMENTS TO WHICH SECTION 1274 APPLIES.

(a) IN GENERAL. Subject to the exceptions and limitations in paragraph (b) of this section, section 1274 and this section apply to any debt instrument issued in consideration for the sale or exchange of property. For purposes of section 1274, property includes debt instruments and investment units, but does not include money, services, or the right to use property. For the treatment of certain obligations given in exchange for services or the use of property, see sections 404 and 467. For purposes of this paragraph (a), money includes functional currency and, in certain circumstances, nonfunctional currency. See section 1.988-2(b)(2) for circumstances when nonfunctional currency is treated as money rather than as property.

(b) EXCEPTIONS -- (1) DEBT INSTRUMENT WITH ADEQUATE STATED INTEREST AND NO OID. Section 1274 does not apply to a debt instrument if --

(i) All interest payable on the instrument is qualified stated interest;

(ii) The stated rate of interest is at least equal to the test rate of interest (as defined in section 1.1274-4);

(iii) The debt instrument is not issued in a potentially abusive situation (as defined in section 1.1274-3); and

(iv) No payment from the buyer-borrower to the seller-lender designated as points or interest is made at the time of issuance of the debt instrument.

(2) EXCEPTIONS UNDER SECTIONS 1274(c)(1)(B), 1274(c)(3), 1274A(c), AND 1275(b)(1) -- (i) IN GENERAL. Sections 1274(c)(1)(B), 1274(c)(3), 1274A(c), and 1275(b)(1) describe certain transactions to which section 1274 does not apply. This paragraph (b)(2) provides certain rules to be used in applying those exceptions.

(ii) SPECIAL RULES FOR CERTAIN EXCEPTIONS UNDER SECTION 1274(c)(3) -- (A) DETERMINATION OF SALES PRICE FOR CERTAIN SALES OF FARMS. For purposes of section 1274(c)(3)(A), the determination as to whether the sales price cannot exceed $1,000,000 is made without regard to any other exception to, or limitation on, the applicability of section 1274 (e.g., without regard to the special rules regarding sales of principal residences and land transfers between related persons). In addition, the sales price is determined without regard to section 1274 and without regard to any stated interest. The sales price includes the amount of any liability included in the amount realized from the sale or exchange. See section 1.1001-2.

(B) SALES INVOLVING TOTAL PAYMENTS OF $250,000 OR LESS. Under section 1274(c)(3)(C), the determination of the amount of payments due under all debt instruments and the amount of other consideration to be received is made as of the date of the sale or exchange or, if earlier, the contract date. If the precise amount due under any debt instrument or the precise amount of any other consideration to be received cannot be determined as of that date, section 1274(c)(3)(C) applies only if it can be determined that the maximum of the aggregate amount of payments due under the debt instruments and other consideration to be received cannot exceed $250,000. For purposes of section 1274(c)(3)(C), if a liability is assumed or property is taken subject to a liability, the aggregate amount of payments due includes the outstanding principal balance or adjusted issue price (in the case of an obligation originally issued at a discount) of the obligation.

(C) COORDINATION WITH SECTION 1273 AND SECTION 1.1273-2. In accordance with section 1274(c)(3)(D), section 1274 and this section do not apply if the issue price of a debt instrument issued in consideration for the sale or exchange of property is determined under paragraph (a)(1), (b)(1), or (c)(1) of section 1.1273-2.

(3) OTHER EXCEPTIONS TO SECTION 1274 -- (i) HOLDERS OF CERTAIN BELOW-MARKET INSTRUMENTS. Section 1274 does not apply to any holder of a debt instrument that is issued in consideration for the sale or exchange of personal use property (within the meaning of section 1275 (b)(3)) in the hands of the issuer and that evidences a below-market loan described in section 7872(c)(1).

(ii) TRANSACTIONS INVOLVING CERTAIN DEMAND LOANS. Section 1274 does not apply to any debt instrument that evidences a demand loan that is a below-market loan described in section 7872(c)(1).

(iii) CERTAIN TRANSFERS SUBJECT TO SECTION 1041. Section 1274 does not apply to any debt instrument issued in consideration for a transfer of property subject to section 1041 (relating to transfers of property between spouses or incident to divorce).

(c) EXAMPLES. The following examples illustrate the rules of this section.

EXAMPLE 1. SINGLE STATED RATE PAID SEMIANNUALLY. A debt instrument issued in consideration for the sale of nonpublicly traded property in a transaction that is not a potentially abusive situation calls for the payment of a principal amount of $1,000,000 at the end of a 10-year term and 20 semiannual interest payments of $60,000. Assume that the test rate of interest is 12 percent, compounded semiannually. The debt instrument is not subject to section 1274 because it provides for interest equal to the test rate and all interest payable on the instrument is qualified stated interest.

EXAMPLE 2. SALE OF FARM FOR DEBT INSTRUMENT WITH CONTINGENT INTEREST -- (i) FACTS. On July 1, 1995, A, an individual, sells to B land used as a farm within the meaning of section 6420(c)(2). As partial consideration for the sale, B issues a debt instrument calling for a single $500,000 payment due in 10 years unless profits from the land in each of the 10 years preceding maturity of the debt instrument exceed a specified amount, in which case B is to make a payment of $1,200,000. The debt instrument does not provide for interest.

(ii) TOTAL PAYMENTS MAY EXCEED $1,000,000. Even though the total payments ultimately payable under the contract may be less than $1,000,000, at the time of the sale or exchange it cannot be determined that the sales price cannot exceed $1,000,000. Thus, the sale of the land used as a farm is not an excepted transaction described in section 1274(c)(3)(A).

EXAMPLE 3. SALE BETWEEN RELATED PARTIES SUBJECT TO SECTION 483(e) -- (i) FACTS. On July 1, 1995, A, an individual, sells land (not used as a farm within the meaning of section 6420(c)(2)) to A's child B for $650,000. In consideration for the sale, B issues a 10-year debt instrument to A that calls for a payment of $650,000. No other consideration is given. The debt instrument does not provide for interest.

(ii) TREATMENT OF DEBT INSTRUMENT. For purposes of section 483(e), the $650,000 debt instrument is treated as two separate debt instruments: a $500,000 debt instrument and a $150,000 debt instrument. The $500,000 debt instrument is subject to section 483(e), and accordingly is covered by the exception from section 1274 described in section 1274(c)(3)(F). Because the amount of the payments due as consideration for the sale exceeds $250,000, however, the $150,000 debt instrument is subject to section 1274.

SECTION 1.1274-2 ISSUE PRICE OF DEBT INSTRUMENTS TO WHICH SECTION 1274 APPLIES.

(a) IN GENERAL. If section 1274 applies to a debt instrument, section 1274 and this section determine the issue price of the debt instrument. For rules relating to the determination of the amount and timing of OID to be included in income, see section 1272 and the regulations thereunder.

(b) ISSUE PRICE -- (1) DEBT INSTRUMENTS THAT PROVIDE FOR ADEQUATE STATED INTEREST; STATED PRINCIPAL AMOUNT. The issue price of a debt instrument that provides for adequate stated interest is the stated principal amount of the debt instrument. For purposes of section 1274, the stated principal amount of a debt instrument is the aggregate amount of all payments due under the debt instrument, excluding any amount of stated interest. Under section 1.1273-2(g)(2)(ii), however, the stated principal amount of a debt instrument is reduced by any payment from the buyer-borrower to the seller-lender that is designated as interest or points. See Example 2 of section 1.1273-2(g)(5).

(2) DEBT INSTRUMENTS THAT DO NOT PROVIDE FOR ADEQUATE STATED INTEREST; IMPUTED PRINCIPAL AMOUNT. The issue price of a debt instrument that does not provide for adequate stated interest is the imputed principal amount of the debt instrument.

(3) DEBT INSTRUMENTS ISSUED IN A POTENTIALLY ABUSIVE SITUATION; FAIR MARKET VALUE. Notwithstanding paragraphs (b)(1) and (b)(2) of this section, in the case of a debt instrument issued in a potentially abusive situation (as defined in section 1.1274-3), the issue price of the debt instrument is the fair market value of the property received in exchange for the debt instrument, reduced by the fair market value of any consideration other than the debt instrument issued in consideration for the sale or exchange.

(c) DETERMINATION OF WHETHER A DEBT INSTRUMENT PROVIDES FOR ADEQUATE STATED INTEREST -- (1) IN GENERAL. A debt instrument provides for adequate stated interest if its stated principal amount is less than or equal to its imputed principal amount. Imputed principal amount means the sum of the present values, as of the issue date, of all payments, including payments of stated interest, due under the debt instrument (determined by using a discount rate equal to the test rate of interest as determined under section 1.1274-4). If a debt instrument has a single fixed rate of interest that is paid or compounded at least annually, and that rate is equal to or greater than the test rate, the debt instrument has adequate stated interest.

(2) DETERMINATION OF PRESENT VALUE. The present value of a payment is determined by discounting the payment from the date it becomes due to the date of the sale or exchange at the test rate of interest. To determine present value, a compounding period must be selected, and the test rate must be based on the same compounding period.

(d) TREATMENT OF CERTAIN OPTIONS. This paragraph (d) provides rules for determining the issue price of a debt instrument to which section 1274 applies (other than a debt instrument issued in a potentially abusive situation) that is subject to one or more options described in both paragraphs (c)(1) and (c)(5) of section 1.1272-1. Under this paragraph (d), an issuer will be deemed to exercise or not exercise an option or combination of options in a manner that minimizes the instrument's imputed principal amount, and a holder will be deemed to exercise or not exercise an option or combination of options in a manner that maximizes the instrument's imputed principal amount. If both the issuer and the holder have options, the rules of this paragraph (d) 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. See section 1.1272-1(c)(5) to determine the debt instrument's yield and maturity for purposes of determining the accrual of OID with respect to the instrument.

(e) MANDATORY SINKING FUNDS. In determining the issue price of a debt instrument to which section 1274 applies (other than a debt instrument issued in a potentially abusive situation) and that is subject to a mandatory sinking fund provision described in section 1.1272-1(c)(3)(ii), the mandatory sinking fund provision is ignored.

(f) TREATMENT OF VARIABLE RATE DEBT INSTRUMENTS -- (1) STATED INTEREST AT A QUALIFIED FLOATING RATE -- (i) IN GENERAL. For purposes of paragraph (c) of this section, the imputed principal amount of a variable rate debt instrument (within the meaning of section 1.1275-5(a)) that provides for stated interest at a qualified floating rate (or rates) is determined by assuming that the instrument provides for a fixed rate of interest for each accrual period to which a qualified floating rate applies. For purposes of the preceding sentence, the assumed fixed rate in each accrual period is the greater of --

(A) The value of the applicable qualified floating rate as of the first date on which there is a binding written contract that substantially sets forth the terms under which the sale or exchange is ultimately consummated; or

(B) The value of the applicable qualified floating rate as of the date on which the sale or exchange occurs.

(ii) INTEREST RATE RESTRICTIONS. Notwithstanding paragraph (f)(1)(i) of this section, if, as a result of interest rate restrictions (such as an interest rate cap), the expected yield of the debt instrument taking the restrictions into account is significantly less than the expected yield of the debt instrument without regard to the restrictions, the interest payments on the debt instrument (other than any fixed interest payments) are treated as contingent payments. Reasonably symmetric interest rate caps and floors, or reasonably symmetric governors, that are fixed throughout the term of the debt instrument do not result in the debt instrument being subject to this rule.

(2) STATED INTEREST AT A SINGLE OBJECTIVE RATE. For purposes of paragraph (c) of this section, the imputed principal amount of a variable rate debt instrument (within the meaning of section 1.1275-5(a)) that provides for stated interest at a single objective rate is determined by treating the interest payments as contingent payments.

(g) CONTINGENT PAYMENTS. [Reserved]

(h) EXAMPLES. The following examples illustrate the rules of this section. Each example assumes a 30-day month, 360-day year. In addition, each example assumes that the debt instrument is not a qualified debt instrument (as defined in section 1274A(b)) and is not issued in a potentially abusive situation.

EXAMPLE 1. DEBT INSTRUMENT WITHOUT A FIXED RATE OVER ITS ENTIRE TERM -- (i) FACTS. On January 1, 1995, A sells nonpublicly traded property to B for a stated purchase price of $3,500,000. In consideration for the sale, B makes a down payment of $500,000 and issues a 10-year debt instrument with a stated principal amount of $3,000,000, payable at maturity. The debt instrument calls for no interest in the first 2 years and interest at a rate of 15 percent payable annually over the remaining 8 years of the debt instrument. The first interest payment of $450,000 is due on December 31, 1997, and the last interest payment is due on December 31, 2004, together with the $3,000,000 payment of principal. Assume that the test rate of interest applicable to the debt instrument is 10.5 percent, compounded annually.

(ii) APPLICABILITY OF SECTION 1274. Because the debt instrument does not provide for any interest during the first 2 years, none of the interest on the debt instrument is qualified stated interest. Therefore, the issue price of the debt instrument is determined under section 1274. See section 1.1274-1(b)(1). If the debt instrument has adequate stated interest, the issue price of the instrument is its stated principal amount. Otherwise, the issue price of the debt instrument is its imputed principal amount. The debt instrument has adequate stated interest only if the stated principal amount is less than or equal to the imputed principal amount.

(iii) DETERMINATION OF IMPUTED PRINCIPAL AMOUNT. To compute the imputed principal amount of the debt instrument, all payments due under the debt instrument are discounted back to the issue date at 10.5 percent, compounded annually, as follows:

(A) The present value of the $3,000,000 principal payment payable on December 31, 2004, is $1,105,346.59, determined as follows:

$1,105,346.59 = $3,000,000/(1 + .105/1)(to the 10th power)

(B) The present value of the eight interest payments of $450,000 as of January 1, 1997, is $2,357,634.55, determined as follows:

 $2,357,634.55 = $450,000 x (1 - (1 + .105/1)(to the -8 power))/(.105/1)

$1,930,865.09 = $2,357,634.55/(1 + .105/1)(squared)

(iv) DETERMINATION OF ISSUE PRICE. The debt instrument's imputed principal amount (that is, the present value of all payments due under the debt instrument) is $3,036,211.68 ($1,105,346.59 + $1,930,865.09). Because the stated principal amount ($3,000,000) is less than the imputed principal amount, the debt instrument provides for adequate stated interest. Therefore, the issue price of the debt instrument is its stated principal amount ($3,000,000).

EXAMPLE 2. DEBT INSTRUMENT SUBJECT TO ISSUER CALL OPTION -- (i) FACTS. On January 1, 1995, in partial consideration for the sale of nonpublicly traded property, H corporation issues to G a 10-year debt instrument, maturing on January 1, 2005, with a stated principal amount of $10,000,000, payable on that date. The debt instrument provides for annual payments of interest of 8 percent for the first 5 years and 14 percent for the final 5 years, payable on January 1 of each year, beginning on January 1, 1996. In addition, the debt instrument provides H with the unconditional option to call (prepay) the debt instrument at the end of 5 years for its stated principal amount of $10,000,000. Assume that the Federal mid-term and long-term rates applicable to the sale based on annual compounding are 9 percent and 10 percent, respectively.

(ii) OPTION PRESUMED EXERCISED. Assuming exercise of the call option, the imputed principal amount as determined under paragraph (d) of this section is $9,611,034.87 (the present value of all of the payments due within a 5-year term discounted at a test rate of 9 percent, compounded annually). Assuming nonexercise of the call option, the imputed principal amount is $10,183,354.78 (the present value of all of the payments due within a 10-year term discounted at a test rate of 10 percent, compounded annually). For purposes of determining the imputed principal amount, the option is presumed exercised because the imputed principal amount, assuming exercise of the option, is less than the imputed principal amount, assuming the option is not exercised. Because the option is presumed exercised, the debt instrument fails to provide for adequate stated interest because the imputed principal amount ($9,611,034.87) is less than the stated principal amount ($10,000,000). Thus, the issue price of the debt instrument is $9,611,034.87.

EXAMPLE 3. VARIABLE RATE DEBT INSTRUMENT WITH A SINGLE RATE OVER ITS ENTIRE TERM -- (i) FACTS. On January 1, 1995, A sells B nonpublicly traded property. In partial consideration for the sale, B issues a debt instrument in the principal amount of $1,000,000, payable in 5 years. The debt instrument calls for interest payable monthly at a rate of 1 percentage point above the average prime lending rate of a major bank for the month preceding the month of the interest payment. Assume that the test rate of interest applicable to the debt instrument is 10.5 percent, compounded monthly. Assume also that 1 percentage point above the prime lending rate of the designated bank on the date of the sale is 12.5 percent, compounded monthly, which is greater than 1 percentage point above the prime lending rate of the designated bank on the first date on which there is a binding written contract that substantially sets forth the terms under which the sale is consummated.

(ii) DEBT INSTRUMENT HAS ADEQUATE STATED INTEREST. The debt instrument is a variable rate debt instrument (within the meaning of section 1.1275-5) that provides for stated interest at a qualified floating rate. Under paragraph (f)(1)(i) of this section, the debt instrument is treated as if it provided for a fixed rate of interest equal to 12.5 percent, compounded monthly. Because the test rate of interest is 10.5 percent, compounded monthly, the debt instrument provides for adequate stated interest.

EXAMPLE 4. DEBT INSTRUMENT WITH A CAPPED VARIABLE RATE. On July 1, 1995, A sells nonpublicly traded property to B in return for a debt instrument with a stated principal amount of $10,000,000, payable on July 1, 2005. Interest is payable on July 1 of each year, beginning on July 1, 1996, at the Federal short-term rate for June of the same year. The debt instrument provides, however, that the interest rate cannot rise above 8.5 percent, compounded annually. Assume that, as of the date the test rate of interest for the debt instrument is determined, the Federal short-term rate is 8 percent, compounded annually. Assume further that, as a result of the interest rate cap of 8.5 percent, compounded annually, the expected yield of the debt instrument is significantly less than the expected yield of the debt instrument if it did not include the interest rate cap. Under paragraph (f)(1)(ii) of this section, the variable payments are treated as contingent payments for purposes of this section.

SECTION 1.1274-3 POTENTIALLY ABUSIVE SITUATIONS DEFINED.

(a) IN GENERAL. For purposes of section 1274, a potentially abusive situation means --

(1) A tax shelter (as defined in section 6662(d)(2)(C)(ii)) ; or

(2) Any other situation involving --

(i) A recent sales transaction;

(ii) Nonrecourse financing;

(iii) Financing with a term in excess of the useful life of the property; or

(iv) A debt instrument with clearly excessive interest.

(b) OPERATING RULES -- (1) DEBT INSTRUMENT EXCHANGED FOR NONRECOURSE FINANCING. Nonrecourse financing does not include an exchange of a nonrecourse debt instrument for an outstanding recourse or nonrecourse debt instrument.

(2) NONRECOURSE DEBT WITH SUBSTANTIAL DOWN PAYMENT. Nonrecourse financing does not include a sale or exchange of a real property interest financed by a nonrecourse debt instrument if, in addition to the nonrecourse debt instrument, the purchaser makes a down payment in money that equals or exceeds 20 percent of the total stated purchase price of the real property interest. For purposes of the preceding sentence, a real property interest means any interest, other than an interest solely as a creditor, in real property.

(3) CLEARLY EXCESSIVE INTEREST. Interest on a debt instrument is clearly excessive if the interest, in light of the terms of the debt instrument and the creditworthiness of the borrower, is clearly greater than the arm's length amount of interest that would have been charged in a cash lending transaction between the same two parties.

(c) OTHER SITUATIONS TO BE SPECIFIED BY COMMISSIONER. The Commissioner may designate in the Internal Revenue Bulletin situations that, although described in paragraph (a)(2) of this section, will not be treated as potentially abusive because they do not have the effect of significantly misstating basis or amount realized (see section 601.601(d)(2)(ii) of this chapter).

(d) CONSISTENCY RULE. The issuer's determination that the debt instrument is or is not issued in a potentially abusive situation is binding on all holders of the debt instrument. However, the issuer's determination is not binding on a holder who explicitly discloses a position that is inconsistent with the issuer's determination. Unless otherwise prescribed by the Commissioner, the disclosure must be made on a statement attached to the holder's timely filed Federal income tax return for the taxable year that includes the acquisition date of the debt instrument. See section 1.1275-2(e) for rules relating to the issuer's obligation to disclose certain information to holders.

SECTIONS 1.1274-3T AND 1.1274-6T [Removed]

Par. 10. Sections 1.1274-3T and 1.1274-6T are removed as of [INSERT DATE THAT IS 60 DAYS AFTER PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

Par. 11. Sections 1.1274-4 and 1.1274-5 are added to read as follows:

SECTION 1.1274-4 TEST RATE.

(a) DETERMINATION OF TEST RATE OF INTEREST -- (1) IN GENERAL -- (i) TEST RATE IS THE 3-MONTH RATE. Except as provided in paragraph (a)(2) of this section, the test rate of interest for a debt instrument issued in consideration for the sale or exchange of property is the 3-month rate.

(ii) THE 3-MONTH RATE. Except as provided in paragraph (a)(1)(iii) of this section, the 3 month rate is the lower of --

(A) The lowest applicable Federal rate (based on the appropriate compounding period) in effect during the 3 month period ending with the first month in which there is a binding written contract that substantially sets forth the terms under which the sale or exchange is ultimately consummated; or

(B) The lowest applicable Federal rate (based on the appropriate compounding period) in effect during the 3 month period ending with the month in which the sale or exchange occurs.

(iii) SPECIAL RULE IF THERE IS NO BINDING WRITTEN CONTRACT. If there is no binding written contract that substantially sets forth the terms under which the sale or exchange is ultimately consummated, the 3-month rate is the lowest applicable Federal rate (based on the appropriate compounding period) in effect during the 3-month period ending with the month in which the sale or exchange occurs.

(2) TEST RATE FOR CERTAIN DEBT INSTRUMENTS -- (i) SALE-LEASEBACK TRANSACTIONS. Under section 1274(e) (relating to certain sale- leaseback transactions), the test rate is 110 percent of the 3-month rate determined under paragraph (a)(1) of this section. For purposes of section 1274(e)(3), related party means a person related to the transferor within the meaning of section 267(b) or 707(b)(1).

(ii) QUALIFIED DEBT INSTRUMENT. Under section 1274A(a), the test rate for a qualified debt instrument is no greater than 9 percent, compounded semiannually, or an equivalent rate based on an appropriate compounding period.

(iii) ALTERNATIVE TEST RATE FOR SHORT-TERM OBLIGATIONS -- (A) REQUIREMENTS. This paragraph (a)(2)(iii)(A) provides an alternative test rate under section 1274(d)(1)(D) for a debt instrument with a maturity of 1 year or less. This alternative test rate applies, however, only if the debt instrument provides for adequate stated interest using the alternative test rate, the issuer provides on the face of the debt instrument that the instrument qualifies as having adequate stated interest under section 1274(d)(1)(D), and the issuer and holder treat or agree to treat the instrument as having adequate stated interest.

(B) ALTERNATIVE TEST RATE. For purposes of paragraph (a)(2)(iii)(A), the alternative test rate is the market yield on U.S. Treasury bills with the same maturity date as the debt instrument. If the same maturity date is not available, the market yield on U.S. Treasury bills that mature in the same week or month as the debt instrument is used. The alternative test rate is determined as of the date on which there is a binding written contract that substantially sets forth the terms under which the sale or exchange is ultimately consummated or as of the date of the sale or exchange, whichever date results in a lower rate. If there is no binding written contract, however, the alternative test rate is determined as of the date of the sale or exchange.

(b) APPLICABLE FEDERAL RATE. Except as otherwise provided in this section, the applicable Federal rate for a debt instrument is based on the term of the instrument (i.e., short-term, mid-term, or long-term). See section 1274(d)(1). The Internal Revenue Service publishes the applicable Federal rates for each month in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii) of this chapter). The applicable Federal rates are based on the yield to maturity of outstanding marketable obligations of the United States of similar maturities during the one month period ending on the 14th day of the month preceding the month for which the rates are applicable.

(c) SPECIAL RULES TO DETERMINE THE TERM OF A DEBT INSTRUMENT FOR PURPOSES OF DETERMINING THE APPLICABLE FEDERAL RATE -- (1) INSTALLMENT OBLIGATION. If a debt instrument is an installment obligation (as defined in section 1.1273-1(e)(1)), the term of the instrument is the instrument's weighted average maturity (as defined in section 1.1273-1(e)(3)).

(2) CERTAIN VARIABLE RATE DEBT INSTRUMENTS -- (i) IN GENERAL. Except as otherwise provided in paragraph (c)(2)(ii) of this section, if a variable rate debt instrument (as defined in section 1.1275-5(a)) provides for stated interest at a qualified floating rate (or rates), the term of the instrument is determined by reference to the longest interval between interest adjustment dates, or, if the variable rate debt instrument provides for a fixed rate, the interval between the issue date and the last day on which the fixed rate applies, if this interval is longer.

(ii) RESTRICTIONS ON ADJUSTMENTS. If, due to significant restrictions on variations in a qualified floating rate or the use of certain formulae pursuant to section 1.1275-5(b)(2) (e.g., 15 percent of 1-year LIBOR, plus 800 basis points), the rate in substance resembles a fixed rate, the applicable Federal rate is determined by reference to the term of the debt instrument.

(3) COUNTING OF EITHER THE ISSUE DATE OR THE MATURITY DATE. The term of a debt instrument includes either the issue date or the maturity date, but not both dates.

(4) CERTAIN DEBT INSTRUMENTS THAT PROVIDE FOR PRINCIPAL PAYMENTS UNCERTAIN AS TO TIME. If a debt instrument provides for principal payments that are fixed in total amount but uncertain as to time, the term of the instrument is determined by reference to the latest possible date on which a principal payment can be made or, in the case of an installment obligation, by reference to the longest weighted average maturity under any possible payment schedule.

(d) FOREIGN CURRENCY LOANS. If all of the payments of a debt instrument are denominated in, or determined by reference to, a currency other than the U.S. dollar, the applicable Federal rate for the debt instrument is a foreign currency rate of interest that is analogous to the applicable Federal rate described in this section. For this purpose, an analogous rate of interest is a rate based on yields (with the appropriate compounding period) of the highest grade of outstanding marketable obligations denominated in such currency (excluding any obligations that benefit from special tax exemptions or preferential tax rates not available to debt instruments generally) with due consideration given to the maturities of the obligations.

(e) EXAMPLES. The following examples illustrate the rules of this section.

EXAMPLE 1. VARIABLE RATE DEBT INSTRUMENT THAT LIMITS THE AMOUNT OF INCREASE AND DECREASE IN THE RATE -- (i) FACTS. On July 1, 1996, A sells nonpublicly traded property to B in return for a 5-year debt instrument that provides for interest to be paid on July 1 of each year, beginning on July 1, 1997, based on the prime rate of a local bank on that date. However, the interest rate cannot increase or decrease from one year to the next by more than .25 percentage points (25 basis points).

(ii) SIGNIFICANT RESTRICTION. The debt instrument is a variable rate debt instrument (as defined in section 1.1275-5) that provides for stated interest at a qualified floating rate. Assume that based on all the facts and circumstances, the restriction is a significant restriction on the variations in the rate of interest. Under paragraph (c)(2)(ii) of this section, the applicable Federal rate is determined by reference to the term of the debt instrument, and the applicable Federal rate is the Federal mid-term rate.

EXAMPLE 2. INSTALLMENT OBLIGATION -- (i) FACTS. On January 1, 1996, A sells nonpublicly traded property to B in exchange for a debt instrument that calls for a payment of $500,000 on January 1, 2001, and a payment of $1,000,000 on January 1, 2006. The debt instrument does not provide for any stated interest.

(ii) DETERMINATION OF TERM. The debt instrument is an installment obligation. Under paragraph (c)(1) of this section, the term of the debt instrument is its weighted average maturity (as defined in section 1.1273-1(e)(3)). The debt instrument's weighted average maturity is 8.33 years, which is the sum of (A) the ratio of the first payment to total payments (500,000/1,500,000), multiplied by the number of complete years from the issue date until the payment is due (5 years), and (B) the ratio of the second payment to total payments (1,000,000/1,500,000), multiplied by the number of complete years from the issue date until the second payment is due (10 years).

(iii) APPLICABLE FEDERAL RATE. Based on the calculation in paragraph (ii) of this example, the term of the debt instrument is treated as 8.33 years. Consequently, the applicable Federal rate is the Federal mid-term rate.

SECTION 1.1274-5 ASSUMPTIONS.

(a) IN GENERAL. Section 1274 does not apply to a debt instrument if the debt instrument is assumed, or property is taken subject to the debt instrument, in connection with a sale or exchange of property, unless the terms of the debt instrument, as part of the sale or exchange, are modified in a manner that would constitute an exchange under section 1001.

(b) MODIFICATIONS OF DEBT INSTRUMENTS -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section, if a debt instrument is assumed, or property is taken subject to a debt instrument, in connection with a sale or exchange of property, the terms of the debt instrument are modified as part of the sale or exchange, and the modification triggers an exchange under section 1001, the modification is treated as a separate transaction taking place immediately before the sale or exchange and is attributed to the seller of the property. For purposes of this paragraph (b), a debt instrument is not considered to be modified as part of the sale or exchange unless the seller knew or had reason to know about the modification.

(2) ELECTION TO TREAT BUYER AS MODIFYING THE DEBT INSTRUMENT -- (i) IN GENERAL. Rather than having the rules in paragraph (b)(1) of this section apply, the seller and buyer may jointly elect to treat the transaction as one in which the buyer first assumed the original (unmodified) debt instrument and then subsequently modified the debt instrument. For this purpose, the modification is treated as a separate transaction taking place immediately after the sale or exchange.

(ii) TIME AND MANNER OF MAKING THE ELECTION. The buyer and seller make the election under paragraph (b)(2)(i) of this section by jointly signing a statement that includes the names, addresses, and taxpayer identification numbers of the seller and buyer, and a clear indication that the election is being made under paragraph (b)(2)(i) of this section. Both the buyer and the seller must sign this statement not later than the earlier of the last day (including extensions) for filing the Federal income tax return of the buyer or seller for the taxable year in which the sale or exchange of the property occurs. The buyer and seller should attach this signed statement (or a copy thereof) to their timely filed Federal income tax returns.

(c) WRAPAROUND INDEBTEDNESS. For purposes of paragraph (a) of this section, the issuance of wraparound indebtedness is not considered an assumption.

(d) CONSIDERATION ATTRIBUTABLE TO ASSUMED DEBT. If, as part of the consideration for the sale or exchange of property, the buyer assumes, or takes the property subject to, an indebtedness that was issued with OID (including a debt instrument issued in a prior sale or exchange to which section 1274 applied), the portion of the buyer's basis in the property and the seller's amount realized attributable to the debt instrument equals the adjusted issue price of the debt instrument as of the date of the sale or exchange.

Par. 12. Sections 1.1274A-1, 1.1275-1 and 1.1275-2 are added to read as follows:

SECTION 1.1274A-1 SPECIAL RULES FOR CERTAIN TRANSACTIONS WHERE STATED PRINCIPAL AMOUNT DOES NOT EXCEED $2,800,000.

(a) IN GENERAL. Section 1274A allows the use of a lower test rate for purposes of sections 483 and 1274 in the case of a qualified debt instrument (as defined in section 1274A(b)) and, if elected by the borrower and the lender, the use of the cash receipts and disbursements method of accounting for interest on a cash method debt instrument (as defined in section 1274A(c)(2)). This section provides special rules for qualified debt instruments and cash method debt instruments.

(b) RULES FOR BOTH QUALIFIED AND CASH METHOD DEBT INSTRUMENTS -- (1) SALE-LEASEBACK TRANSACTIONS. A debt instrument issued in a sale- leaseback transaction (within the meaning of section 1274(e)) cannot be either a qualified debt instrument or a cash method debt instrument.

(2) DEBT INSTRUMENTS CALLING FOR CONTINGENT PAYMENTS. A debt instrument that provides for contingent payments cannot be a qualified debt instrument unless it can be determined at the time of the sale or exchange that the maximum stated principal amount due under the debt instrument cannot exceed the amount specified in section 1274A(b). Similarly, a debt instrument that provides for contingent payments cannot be a cash method debt instrument unless it can be determined at the time of the sale or exchange that the maximum stated principal amount due under the debt instrument cannot exceed the amount specified in section 1274A(c)(2)(A).

(3) AGGREGATION OF TRANSACTIONS -- (i) GENERAL RULE. The aggregation rules of section 1274A(d)(1) are applied using a facts and circumstances test.

(ii) EXAMPLES. The following examples illustrate the application of section 1274A(d)(1) and paragraph (b)(3)(i) of this section.

EXAMPLE 1. AGGREGATION OF TWO SALES TO A SINGLE PERSON. In two transactions evidenced by separate sales agreements, A sells undivided half interests in Blackacre to B. The sales are pursuant to a plan for the sale of a 100 percent interest in Blackacre to B. These sales or exchanges are part of a series of related transactions and, thus, are treated as a single sale for purposes of section 1274A.

EXAMPLE 2. AGGREGATION OF TWO PURCHASES BY UNRELATED INDIVIDUALS. Pursuant to a plan, unrelated individuals X and Y purchase undivided half interests in Blackacre from A and subsequently contribute these interests to a partnership in exchange for equal interests in the partnership. These purchases are treated as part of the same transaction and, thus, are treated as a single sale for purposes of section 1274A.

EXAMPLE 3. AGGREGATION OF SALES MADE PURSUANT TO A TENDER OFFER. Fifteen unrelated individuals own all of the stock of X Corporation. Y Corporation makes a tender offer to these 15 shareholders. The terms offered to each shareholder are identical. Shareholders holding a majority of the shares of X Corporation elect to tender their shares pursuant to Y Corporation's offer. These sales are part of the same transaction and, thus, are treated as a single sale for purposes of section 1274A.

EXAMPLE 4. NO AGGREGATION FOR SEPARATE SALES OF SIMILAR PROPERTY TO UNRELATED PERSONS. Pursuant to a newspaper advertisement, X Corporation offers for sale similar condominiums in a single building. The prices of the units vary due to a variety of factors, but the financing terms offered by X Corporation to all buyers are identical. The units are purchased by unrelated buyers who decided whether to purchase units in the building at the price and on the terms offered by X Corporation, without regard to the actions of other buyers. Because each buyer acts individually, the sales are not part of the same transaction or a series of related transactions and, thus, are treated as separate sales.

(4) INFLATION ADJUSTMENT OF DOLLAR AMOUNTS. Under section 1274A(d)(2), the dollar amounts specified in sections 1274A(b) and 1274A(c)(2)(A) are adjusted for inflation. The dollar amounts, adjusted for inflation, are published in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii) of this chapter).

(c) RULES FOR CASH METHOD DEBT INSTRUMENTS -- (1) TIME AND MANNER OF MAKING CASH METHOD ELECTION. The borrower and lender make the election described in section 1274A(c)(2)(D) by jointly signing a statement that includes the names, addresses, and taxpayer identification numbers of the borrower and lender, a clear indication that an election is being made under section 1274A(c)(2), and a declaration that the debt instrument with respect to which the election is being made fulfills the requirements of a cash method debt instrument. Both the borrower and the lender must sign this statement not later than the earlier of the last day (including extensions) for filing the Federal income tax return of the borrower or lender for the taxable year in which the debt instrument is issued. The borrower and lender should attach this signed statement (or a copy thereof) to their timely filed Federal income tax returns.

(2) SUCCESSORS OF ELECTING PARTIES. Except as otherwise provided in this paragraph (c)(2), the cash method election under section 1274A(c) applies to any successor of the electing lender or borrower. Thus, for any period after the transfer of a cash method debt instrument, the successor takes into account the interest (including unstated interest) on the instrument under the cash receipts and disbursements method of accounting. Nevertheless, if the lender (or any successor thereof) transfers the cash method debt instrument to a taxpayer who uses an accrual method of accounting, section 1272 rather than section 1274A(c) applies to the successor of the lender with respect to the debt instrument for any period after the date of the transfer. The borrower (or any successor thereof), however, remains on the cash receipts and disbursements method of accounting with respect to the cash method debt instrument.

(3) MODIFIED DEBT INSTRUMENT. In the case of a debt instrument issued in a debt-for-debt exchange that qualifies as an exchange under section 1001, the debt instrument is eligible for the election to be a cash method debt instrument if the other prerequisites to making the election in section 1274A(c) are met. However, if a principal purpose of the modification is to defer interest income or deductions through the use of the election, then the debt instrument is not eligible for the election.

(4) DEBT INCURRED OR CONTINUED TO PURCHASE OR CARRY A CASH METHOD DEBT INSTRUMENT. If a debt instrument is incurred or continued to purchase or carry a cash method debt instrument, rules similar to those under section 1277 apply to determine the timing of the interest deductions for the debt instrument. For purposes of the preceding sentence, rules similar to those under section 265(a)(2) apply to determine whether a debt instrument is incurred or continued to purchase or carry a cash method debt instrument.

SECTION 1.1275-1 DEFINITIONS.

(a) APPLICABILITY. The definitions contained in this section apply for purposes of sections 163(e) and 1271 through 1275 and the regulations thereunder.

(b) ADJUSTED ISSUE PRICE -- (1) IN GENERAL. The adjusted issue price of a debt instrument at the beginning of the first accrual period is the issue price. Thereafter, the adjusted issue price of the debt instrument is the issue price of the debt instrument --

(i) Increased by the amount of OID previously includible in the gross income of any holder (determined without regard to section 1272(a)(7) and section 1272(c)(1)); and

(ii) Decreased by the amount of any payment previously made on the debt instrument other than a payment of qualified stated interest. See section 1.1275-2(f) for rules regarding adjustments to adjusted issue price on a pro rata prepayment.

(2) ADJUSTED ISSUE PRICE FOR SUBSEQUENT HOLDERS. For purposes of calculating OID accruals, acquisition premium, or market discount, a holder (other than a purchaser at original issuance) determines adjusted issue price in any manner consistent with the regulations under sections 1271 through 1275.

(c) OID. OID means original issue discount (as defined in section 1273(a) and section 1.1273-1).

(d) DEBT INSTRUMENT. Except as provided in section 1275(a)(1)(B) (relating to certain annuity contracts), debt instrument means any instrument or contractual arrangement that constitutes indebtedness under general principles of Federal income tax law (including, for example, a certificate of deposit or a loan). Nothing in the regulations under sections 163(e), 483, and 1271 through 1275, however, shall influence whether an instrument constitutes indebtedness for Federal income tax purposes.

(e) TAX-EXEMPT OBLIGATIONS. For purposes of section 1275(a)(3)(B), exempt from tax means exempt from Federal income tax.

(f) ISSUE. Two or more debt instruments are part of the same issue if they have the same credit and payment terms and are sold reasonably close in time either pursuant to a common plan or as part of a single transaction or a series of related transactions. See section 1.1275-2(d)(2) for special rules relating to reopenings of Treasury securities.

(g) DEBT INSTRUMENTS ISSUED BY A NATURAL PERSON. If an entity is a primary obligor under a debt instrument, the debt instrument is considered to be issued by the entity and not by a natural person even if a natural person is a co-maker and is jointly liable for the debt instrument's repayment. A debt instrument issued by a partnership is considered to be issued by the partnership as an entity even if the partnership is composed entirely of natural persons.

(h) PUBLICLY OFFERED DEBT INSTRUMENT. A debt instrument is publicly offered if it is part of an issue of debt instruments the initial offering of which --

(1) Is registered with the Securities and Exchange Commission; or

(2) Would be required to be registered under the Securities Act of 1933 (15 U.S.C. 77a et seq.) but for an exemption from registration --

(i) Under section 3 of the Securities Act of 1933 (relating to exempted securities);

(ii) Under any law (other than the Securities Act of 1933) because of the identity of the issuer or the nature of the security; or

(iii) Because the issue is intended for distribution to persons who are not United States persons.

SECTION 1.1275-2 SPECIAL RULES RELATING TO DEBT INSTRUMENTS.

(a) PAYMENT ORDERING RULE -- (1) IN GENERAL. Except as provided in paragraph (a)(2) of this section, each payment under a debt instrument is treated first as a payment of OID to the extent of the OID that has accrued as of the date the payment is due and has not been allocated to prior payments, and second as a payment of principal. Thus, no portion of any payment is treated as prepaid interest.

(2) EXCEPTIONS. The rule in paragraph (a)(1) of this section does not apply to --

(i) A payment of qualified stated interest;

(ii) A payment of points deductible under section 461(g)(2), in the case of the issuer;

(iii) A pro rata prepayment described in paragraph (f)(2) of this section; or

(iv) A payment of additional interest or a similar charge provided with respect to amounts that are not paid when due.

(b) DEBT INSTRUMENTS DISTRIBUTED BY CORPORATIONS WITH RESPECT TO STOCK -- (1) TREATMENT OF DISTRIBUTION. For purposes of determining the issue price of a debt instrument distributed by a corporation with respect to its stock, the instrument is treated as issued by the corporation for property. See section 1275(a)(4). Thus, under section 1273(b)(3), the issue price of a distributed debt instrument that is traded on an established market is its fair market value. The issue price of a distributed debt instrument that is not traded on an established market is determined under section 1274 or section 1273(b)(4).

(2) ISSUE DATE. The issue date of a debt instrument distributed by a corporation with respect to its stock is the date of the distribution.

(c) AGGREGATION OF DEBT INSTRUMENTS -- (1) GENERAL RULE. Except as provided in paragraph (c)(2) of this section, debt instruments issued in connection with the same transaction or related transactions (determined based on all the facts and circumstances) are treated as a single debt instrument for purposes of sections 1271 through 1275 and the regulations thereunder. This rule ordinarily applies only to debt instruments of a single issuer that are issued to a single holder. The Commissioner may, however, aggregate debt instruments that are issued by more than one issuer or that are issued to more than one holder if the debt instruments are issued in an arrangement that is designed to avoid the aggregation rule (e.g., debt instruments issued by or to related parties or debt instruments originally issued to different holders with the understanding that the debt instruments will be transferred to a single holder).

(2) EXCEPTION IF SEPARATE ISSUE PRICE ESTABLISHED. Paragraph (c)(1) of this section does not apply to a debt instrument if --

(i) The debt instrument is part if an issue a substantial portion of which is traded on an established market within the meaning of section 1.1273-2(f); or

(ii) The debt instrument is part of an issue a substantial portion of which is issued for money (or for property traded on an established market within the meaning of section 1.1273-2(f)) to parties who are not related to the issuer or holder and who do not purchase other debt instruments of the same issuer in connection with the same transaction or related transactions.

(3) SPECIAL RULE FOR DEBT INSTRUMENTS THAT PROVIDE FOR THE ISSUANCE OF ADDITIONAL DEBT INSTRUMENTS. If, under the terms of a debt instrument (the original debt instrument), the holder may receive one or more additional debt instruments of the issuer, the additional debt instrument or instruments are aggregated with the original debt instrument. Thus, the payments made pursuant to an additional debt instrument are treated as made on the original debt instrument, and the distribution by the issuer of the additional debt instrument is not considered to be a payment made on the original debt instrument. This paragraph (c)(3) applies regardless of whether the right to receive an additional debt instrument is fixed as of the issue date or is contingent upon subsequent events. See section 1.1272-1(c) for the treatment of certain rights to issue additional debt instruments in lieu of cash payments.

(4) EXAMPLES. The following examples illustrate the rules set forth in paragraphs (c)(1) and (c)(2) of this section.

EXAMPLE 1. EXCEPTION FOR DEBT INSTRUMENTS ISSUED SEPARATELY TO OTHER PURCHASERS. On January 1, 1995, Corporation M issues two series of bonds, Series A and Series B. The two series are sold for cash and have different terms. Although some holders purchase bonds from both series, a substantial portion of the bonds is issued to different holders. H purchases bonds from both series. Under the exception in paragraph (c)(2)(ii) of this section, the Series A and Series B bonds purchased by H are not aggregated.

EXAMPLE 2. TIERED REMICS. Z forms a dual tier real estate mortgage investment conduit (REMIC). In the dual tier structure, Z forms REMIC A to acquire a pool of real estate mortgages and to issue a residual interest and several classes of regular interests. Contemporaneously, Z forms REMIC B to acquire as qualified mortgages all of the regular interests in REMIC A. REMIC B issues several classes of regular interests and a residual interest, and Z sells all of those interests to unrelated parties in a public offering. Under the general rule set out in paragraph (c)(1) of this section, all of the regular interests issued by REMIC A and held by REMIC B are treated as a single debt instrument for purposes of sections 1271 through 1275.

(d) SPECIAL RULES FOR TREASURY SECURITIES -- (1) ISSUE PRICE AND ISSUE DATE. The issue price of an issue of Treasury securities is the average price of the debt instruments sold. The issue date of an issue of Treasury securities is the first settlement date on which a substantial amount of the securities in the issue is sold.

(2) REOPENINGS OF TREASURY SECURITIES -- (i) TREATMENT OF ADDITIONAL TREASURY SECURITIES. Additional Treasury securities issued in a qualified reopening are part of the same issue as the original Treasury securities and have the same issue date as the original Treasury securities. The issue price of both the original Treasury securities and the additional Treasury securities is the average price at which the original Treasury securities were sold. This paragraph (d)(2) applies to qualified reopenings that occur on or after March 25, 1992.

(ii) DEFINITIONS -- (A) ADDITIONAL TREASURY SECURITIES. Additional Treasury securities are Treasury securities with terms that are in all respects identical to the terms of the original Treasury securities and that are issued (without regard to paragraph (d)(2)(i) of this section) not more than 12 months after the original Treasury securities were first issued to the public.

(B) ORIGINAL TREASURY SECURITIES. Original Treasury securities are securities comprising any issue of outstanding Treasury securities.

(C) QUALIFIED REOPENING. A qualified reopening is a reopening of Treasury securities intended to alleviate an acute, protracted shortage of the original Treasury securities.

(e) DISCLOSURE OF CERTAIN INFORMATION TO HOLDERS. Certain provisions of the regulations under section 163(e) and sections 1271 through 1275 provide that the issuer's determination of an item controls the holder's treatment of the item. In such a case, the issuer must provide the relevant information to the holder in a reasonable manner. For example, the issuer may provide the name or title and either the address or telephone number of a representative of the issuer who will make available to holders upon request the information required for holders to comply with these provisions of the regulations.

(f) TREATMENT OF PRO RATA PREPAYMENTS -- (1) TREATMENT AS RETIREMENT OF SEPARATE DEBT INSTRUMENT. A pro rata prepayment is treated as a payment in retirement of a portion of a debt instrument, which may result in a gain or loss to the holder. Generally, the gain or loss is calculated by assuming that the original debt instrument consists of two instruments, one that is retired and one that remains outstanding. The adjusted issue price, holder's adjusted basis, and accrued but unpaid OID of the original debt instrument, determined immediately before the pro rata prepayment, are allocated between these two instruments based on the portion of the instrument that is treated as retired by the pro rata prepayment.

(2) DEFINITION OF PRO RATA PREPAYMENT. For purposes of paragraph (f)(1) of this section, a pro rata prepayment is a payment on a debt instrument made prior to maturity that --

(i) Is not made pursuant to the instrument's payment schedule (including a payment schedule determined under section 1.1272-1(c)); and

(ii) Results in a substantially pro rata reduction of each payment remaining to be paid on the instrument.

(g) ANTI-ABUSE RULE. [Reserved]

Par. 13. In section 1.1275-3, the section heading and paragraphs (a) and (b) are revised to read as follows:

SECTION 1.1275-3 OID INFORMATION REPORTING REQUIREMENTS.

(a) IN GENERAL. This section provides legending and information reporting requirements intended to facilitate the reporting of OID.

(b) INFORMATION REQUIRED TO BE SET FORTH ON FACE OF DEBT INSTRUMENTS THAT ARE NOT PUBLICLY OFFERED -- (1) IN GENERAL. Except as provided in paragraph (b)(4) or paragraph (d) of this section, this paragraph (b) applies to any debt instrument that is not publicly offered (within the meaning of section 1.1275-1(h)), is issued in physical form, and has OID. The issuer of any such debt instrument must legend the instrument by stating on the face of the instrument that the debt instrument was issued with OID. In addition, the issuer must either --

(i) Set forth on the face of the debt instrument the issue price, the amount of OID, the issue date, and the yield to maturity; or

(ii) Provide the name or title and either the address or telephone number of a representative of the issuer who will, beginning no later than 10 days after the issue date, promptly make available to holders upon request the information described in paragraph (b)(1)(i) of this section.

(2) TIME FOR LEGENDING. An issuer may satisfy the requirements of this paragraph (b) by legending the debt instrument when it is first issued in physical form. Legending is not required, however, before the first holder of the debt instrument disposes of the instrument.

(3) LEGEND MUST SURVIVE REISSUANCE UPON TRANSFER. Any new physical security that is issued (for example, upon registration of transfer of ownership) must contain any required legend.

(4) EXCEPTIONS. Paragraph (b)(1) of this section does not apply to debt instruments described in section 1272(a)(2) (relating to debt instruments not subject to the periodic OID inclusion rules), debt instruments issued by natural persons (as defined in section 1.6049-4(f)(2)), REMIC regular interests or other debt instruments subject to section 1272(a)(6), or stripped bonds and coupons within the meaning of section 1286.

* * * * *

SECTION 1.1275-3T [REMOVED]

Par. 14. Section 1.1275-3T is removed as of [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

Par. 15. Section 1.1275-5 is added to read as follows:

SECTION 1.1275-5 VARIABLE RATE DEBT INSTRUMENTS.

(a) APPLICABILITY -- (1) IN GENERAL. This section provides rules for variable rate debt instruments. For purposes of section 163(e) and sections 1271 through 1275, a variable rate debt instrument is a debt instrument that meets the conditions described in paragraphs (a)(2), (a)(3), and (a)(4) of this section.

(2) PRINCIPAL PAYMENTS. The issue price of the debt instrument must not exceed the total noncontingent principal payments by more than an amount equal to the lesser of --

(i) .015 multiplied by the product of the total noncontingent principal payments and the number of complete years to maturity from the issue date (or, in the case of an installment obligation, the weighted average maturity as defined in section 1.1273-1(e)(3)); or

(ii) 15 percent of the total noncontingent principal payments.

(3) STATED INTEREST -- (i) GENERAL RULE. The debt instrument must provide for stated interest (compounded or paid at least annually) at --

(A) One or more qualified floating rates;

(B) A single fixed rate and one or more qualified floating rates;

(C) A single objective rate; or

(D) A single fixed rate and a single objective rate that is a qualified inverse floating rate.

(ii) CERTAIN DEBT INSTRUMENTS BEARING INTEREST AT A FIXED RATE FOR AN INITIAL PERIOD. If interest on a debt instrument is stated at a fixed rate for an initial period of less than l year followed by a variable rate that is either a qualified floating rate or an objective rate for a subsequent period, and the value of the variable rate on the issue date is intended to approximate the fixed rate, the fixed rate and the variable rate together constitute a single qualified floating rate or objective rate. A fixed rate and a variable rate will be conclusively presumed to meet the requirements of the preceding sentence if the value of the variable rate on the issue date does not differ from the value of the fixed rate by more than .25 percentage points (25 basis points).

(4) CURRENT VALUE. The debt instrument must provide that a qualified floating rate or objective rate in effect at any time during the term of the instrument is set at a current value of that rate. A current value is the value of the rate on any day that is no earlier than 3 months prior to the first day on which that value is in effect and no later than 1 year following that first day.

(b) QUALIFIED FLOATING RATE -- (1) IN GENERAL. A variable rate is a qualified floating rate if variations in the value of the rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the currency in which the debt instrument is denominated. The rate may measure contemporaneous variations in borrowing costs for the issuer of the debt instrument or for issuers in general. Except as provided in paragraph (b)(2) of this section, a multiple of a qualified floating rate is not a qualified floating rate. If a debt instrument provides for two or more qualified floating rates that can reasonably be expected to have approximately the same values throughout the term of the instrument, the qualified floating rates together constitute a single qualified floating rate. Two or more qualified floating rates will be conclusively presumed to meet the requirements of the preceding sentence if the values of all rates on the issue date are within .25 percentage points (25 basis points) of each other.

(2) CERTAIN RATES BASED ON A QUALIFIED FLOATING RATE. A variable rate is a qualified floating rate if it is equal to either --

(i) The product of a qualified floating rate described in paragraph (b)(1) of this section and a fixed multiple that is greater than zero but not more than 1.35; or

(ii) The product of a qualified floating rate described in paragraph (b)(1) of this section and a fixed multiple that is greater than zero but not more than 1.35, increased or decreased by a fixed rate.

(3) RESTRICTIONS ON THE STATED RATE OF INTEREST. A variable rate is not a qualified floating rate if it is subject to a restriction or restrictions on the maximum stated interest rate (cap), a restriction or restrictions on the minimum stated interest rate (floor), a restriction or restrictions on the amount of increase or decrease in the stated interest rate (governor), or other similar restrictions. Notwithstanding the preceding sentence, the following restrictions will not cause a variable rate to fail to be a qualified floating rate --

(i) A cap, floor, or governor that is fixed throughout the term of the debt instrument;

(ii) A cap or similar restriction that is not reasonably expected as of the issue date to cause the yield on the debt instrument to be significantly less than the expected yield determined without the cap;

(iii) A floor or similar restriction that is not reasonably expected as of the issue date to cause the yield on the debt instrument to be significantly more than the expected yield determined without the floor; or

(iv) A governor or similar restriction that is not reasonably expected as of the issue date to cause the yield on the debt instrument to be significantly more or significantly less than the expected yield determined without the governor.

(c) OBJECTIVE RATE -- (1) IN GENERAL. An objective rate is a rate (other than a qualified floating rate) that is determined using a single fixed formula and that is based on --

(i) One or more qualified floating rates;

(ii) One or more rates where each rate would be a qualified floating rate for a debt instrument denominated in a currency other than the currency in which the debt instrument is denominated;

(iii) The yield or changes in the price of one or more items of personal property (other than stock or debt of the issuer or a related party within the meaning of section 267(b) or 707(b)(1)), provided each item of property is actively traded within the meaning of section 1092(d)(1) (determined without regard to section 1092(d)(3)); or

(iv) A combination of rates described in paragraphs (c)(1)(i), (c)(1)(ii), and (c)(1)(iii) of this section.

(2) OTHER OBJECTIVE RATES TO BE SPECIFIED BY COMMISSIONER. The Commissioner may designate in the Internal Revenue Bulletin variable rates other than those described in paragraph (c)(1) of this section that will be treated as objective rates (see section 601.601(d)(2)(ii) of this chapter).

(3) QUALIFIED INVERSE FLOATING RATE. An objective rate described in paragraph (c)(1) of this section is a qualified inverse floating rate if --

(i) The rate is equal to a fixed rate minus a qualified floating rate; and

(ii) The variations in the rate can reasonably be expected to inversely reflect contemporaneous variations in the cost of newly borrowed funds (disregarding any restrictions on the rate that are described in paragraphs (b)(3)(i), (b)(3)(ii), (b)(3)(iii), and (b)(3)(iv) of this section).

(4) SIGNIFICANT FRONT-LOADING OR BACK-LOADING OF INTEREST. Notwithstanding paragraph (c)(1) of this section, a variable rate of interest on a debt instrument is not an objective rate if it is reasonably expected that the average value of the rate during the first half of the instrument's term will be either significantly less than or significantly greater than the average value of the rate during the final half of the instrument's term.

(5) TAX-EXEMPT DEBT. Notwithstanding paragraph (c)(1) of this section, in the case of any tax-exempt obligation (within the meaning of section 1275(a)(3)), a variable rate is an objective rate only if it is a qualified inverse floating rate.

(d) EXAMPLES. The following examples illustrate the rules of paragraphs (b) and (c) of this section. For purposes of these examples, assume that paragraphs (c)(4) and (c)(5) of this section do not apply.

EXAMPLE 1. RATE BASED ON LIBOR. X issues a debt instrument that provides for annual payments of interest at a rate equal to the value of the 1-year London Interbank Offered Rate (LIBOR) at the end of each year. Variations in the value of 1-year LIBOR over the term of the debt instrument can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds over that term. Accordingly, the rate is a qualified floating rate.

EXAMPLE 2. RATE INCREASED BY A FIXED AMOUNT. X issues a debt instrument that provides for annual payments of interest at a rate equal to 200 basis points (2 percent) plus the current value, at the end of each year, of the average yield on 1-year Treasury securities as published in Federal Reserve bulletins. Variations in the value of this interest rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds. Accordingly, the rate is a qualified floating rate.

EXAMPLE 3. RATE BASED ON COMMERCIAL PAPER RATE. X issues a debt instrument that provides for a rate of interest that is periodically adjusted to equal the current interest rate of Bank's commercial paper. Variations in the value of this interest rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds. Accordingly, the rate is a qualified floating rate.

EXAMPLE 4. RATE BASED ON CHANGES IN THE VALUE OF A COMMODITY INDEX. X issues a debt instrument that provides for annual interest payments at the end of each year at a rate equal to the percentage increase, if any, in the value of an index for the year immediately preceding the payment. The index is based on the prices of several actively traded commodities. Variations in the value of this interest rate cannot reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds. Accordingly, the rate is not a qualified floating rate. However, because the rate is based on changes in the prices of actively traded property, the rate is an objective rate.

EXAMPLE 5. RATE BASED ON A PERCENTAGE OF S&P 500 INDEX. X issues a debt instrument that provides for annual interest payments at the end of each year based on a fixed percentage of the value of the S&P 500 Index. Variations in the value of this interest rate cannot reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds and, therefore, the rate is not a qualified floating rate. In addition, because the interest rate is based on the value of the S&P 500 Index rather than on changes in that value, the rate is not an objective rate.

EXAMPLE 6. RATE BASED ON ISSUER'S PROFITS. Z issues a debt instrument that provides for annual interest payments equal to 20 percent of Z's net profits earned during the year immediately preceding the payment. Variations in the value of this interest rate cannot reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds. Accordingly, the rate is not a qualified floating rate. In addition, because the stated rate is neither based on the yield or changes in the price of actively traded property nor based on a qualified floating rate, the rate is not an objective rate.

EXAMPLE 7. RATE BASED ON A MULTIPLE OF AN INTEREST INDEX. Z issues a debt instrument with annual interest payments at a rate equal to two times the value of 1-year LIBOR as of the payment date. Because the rate is a multiple greater than 1.35 times a qualified floating rate, the rate is not a qualified floating rate. However, because the stated rate is based on a qualified floating rate using a single fixed formula, the rate is an objective rate.

EXAMPLE 8. VARIABLE RATE BASED ON THE COST OF BORROWED FUNDS IN A FOREIGN CURRENCY. Y issues a 5-year dollar denominated debt instrument that provides for annual interest payments at a rate equal to the value of 1-year French franc LIBOR as of the payment date. Variations in the value of French franc LIBOR do not measure contemporaneous changes in the cost of newly borrowed funds in dollars. As a result, the rate is not a qualified floating rate for an instrument denominated in dollars. However, because French franc LIBOR is a qualified floating rate for a debt instrument denominated in French francs, the rate is an objective rate.

EXAMPLE 9. QUALIFIED INVERSE FLOATING RATE. X issues a debt instrument that provides for annual interest payments at the end of each year at a rate equal to 12 percent minus the value of 1-year LIBOR as of the payment date. On the issue date, the value of 1-year LIBOR is 6 percent. Because the rate can reasonably be expected to inversely reflect contemporaneous variations in the cost of newly borrowed funds, it is a qualified inverse floating rate. However, if the value of 1-year LIBOR on the issue date was 11 percent rather than 6 percent, the rate would not be a qualified inverse floating rate because the rate could not reasonably be expected to inversely reflect contemporaneous variations in the cost of newly borrowed funds.

(e) QUALIFIED STATED INTEREST AND OID WITH RESPECT TO A VARIABLE RATE DEBT INSTRUMENT -- (1) IN GENERAL. This paragraph (e) provides rules to determine the amount and accrual of OID and qualified stated interest on a variable rate debt instrument. In general, the rules convert the debt instrument into a fixed rate debt instrument and then apply the general OID rules to the debt instrument. The issue price of a variable rate debt instrument, however, is not determined under this paragraph (e). See sections 1.1273-2 and 1.1274-2 to determine the issue price of a variable rate debt instrument.

(2) VARIABLE RATE DEBT INSTRUMENT THAT PROVIDES FOR ANNUAL PAYMENTS OF INTEREST AT A SINGLE VARIABLE RATE. If a variable rate debt instrument provides for stated interest at a single qualified floating rate or objective rate that is unconditionally payable in cash or in property (other than debt instruments of the issuer), or that will be constructively received under section 451, at least annually --

(i) All stated interest with respect to the debt instrument is qualified stated interest; and

(ii) The amount of OID, if any, is determined under the rules applicable to fixed rate debt instruments by assuming that the variable rate is a fixed rate equal to --

(A) In the case of a qualified floating rate or qualified inverse floating rate, the value, as of the issue date, of the qualified floating rate or qualified inverse floating rate; or

(B) In the case of an objective rate (other than a qualified inverse floating rate), a fixed rate that reflects the yield that is reasonably expected for the debt instrument.

(3) ALL OTHER VARIABLE RATE DEBT INSTRUMENTS EXCEPT FOR THOSE THAT PROVIDE FOR A FIXED RATE. If a variable rate debt instrument is not described in paragraph (e)(2) of this section and does not provide for interest payable at a fixed rate (other than an initial fixed rate described in paragraph (a)(3)(ii) of this section), the amount of interest and OID accruals for the instrument are determined under this paragraph (e)(3).

(i) STEP ONE: DETERMINE THE FIXED RATE SUBSTITUTE FOR EACH VARIABLE RATE PROVIDED UNDER THE DEBT INSTRUMENT -- (A) QUALIFIED FLOATING RATE. The fixed rate substitute for each qualified floating rate provided for in the debt instrument is the value of each rate as of the issue date. If, however, a variable rate debt instrument provides for two or more qualified floating rates with different intervals between interest adjustment dates, the fixed rate substitutes for the rates must be based on intervals that are equal in length. For example, if a 4-year debt instrument provides for 24 monthly interest payments based on the value of the 30-day commercial paper rate on each payment date followed by 8 quarterly interest payments based on the value of quarterly LIBOR on each payment date, the fixed rate substitutes may be based on the values, as of the issue date, of the 90-day commercial paper rate and quarterly LIBOR. Alternatively, the fixed rate substitutes may be based on the values, as of the issue date, of the 30-day commercial paper rate and monthly LIBOR.

(B) QUALIFIED INVERSE FLOATING RATE. The fixed rate substitute for a qualified inverse floating rate is the value of the qualified inverse floating rate as of the issue date.

(C) OBJECTIVE RATE. The fixed rate substitute for an objective rate (other than a qualified inverse floating rate) is a fixed rate that reflects the yield that is reasonably expected for the debt instrument.

(ii) STEP TWO: CONSTRUCT THE EQUIVALENT FIXED RATE DEBT INSTRUMENT. The equivalent fixed rate debt instrument has terms that are identical to those provided under the variable rate debt instrument, except that the equivalent fixed rate debt instrument provides for the fixed rate substitutes (determined in paragraph (e)(3)(i) of this section) in lieu of the qualified floating rates or objective rate provided under the variable rate debt instrument.

(iii) STEP THREE: DETERMINE THE AMOUNT OF QUALIFIED STATED INTEREST AND OID WITH RESPECT TO THE EQUIVALENT FIXED RATE DEBT INSTRUMENT. The amount of qualified stated interest and OID, if any, are determined for the equivalent fixed rate debt instrument under the rules applicable to fixed rate debt instruments and are taken into account as if the holder held the equivalent fixed rate debt instrument.

(iv) STEP FOUR: MAKE APPROPRIATE ADJUSTMENTS FOR ACTUAL VARIABLE RATES. Qualified stated interest or OID allocable to an accrual period must be increased (or decreased) if the interest actually accrued or paid during an accrual period exceeds (or is less than) the interest assumed to be accrued or paid during the accrual period under the equivalent fixed rate debt instrument. This increase or decrease is an adjustment to qualified stated interest for the accrual period if the equivalent fixed rate debt instrument (as determined under paragraph (e)(3)(ii) of this section) provides for qualified stated interest and the increase or decrease is reflected in the amount actually paid during the accrual period. Otherwise, this increase or decrease is an adjustment to OID for the accrual period.

(v) EXAMPLES. The following examples illustrate the rules in paragraph (e)(3) of this section.

EXAMPLE 1. EQUIVALENT FIXED RATE DEBT INSTRUMENT -- (i) FACTS. X purchases at original issue a 6-year variable rate debt instrument that provides for semiannual payments of interest. For the first 3 years, the rate of interest is the value of 6-month LIBOR on the payment date. For the final 3 years, the rate is the value of the 6-month T-bill rate on the payment date. On the issue date, the value of 6-month LIBOR is 3 percent, compounded semiannually, and the 6-month T-bill rate is 2 percent, compounded semiannually.

(ii) DETERMINATION OF EQUIVALENT FIXED RATE DEBT INSTRUMENT. Under paragraph (e)(3)(i) of this section, the fixed rate substitute for 6-month LIBOR is 3 percent, compounded semiannually, and the fixed rate substitute for the 6-month T- bill rate is 2 percent, compounded semiannually. Under paragraph (e)(3)(ii) of this section, the equivalent fixed rate debt instrument is a 6-year debt instrument that provides for semiannual payments of interest at 3 percent, compounded semiannually, for the first 3 years followed by 2 percent, compounded semiannually, for the final 3 years.

EXAMPLE 2. EQUIVALENT FIXED RATE DEBT INSTRUMENT WITH DE MINIMIS OID -- (i) FACTS. Y purchases at original issue, for $100,000, a 4-year variable rate debt instrument that has a stated principal amount of $100,000, payable at maturity. The debt instrument provides for monthly payments of interest at the end of each month. For the first year, the interest rate is the monthly commercial paper rate and for the last 3 years, the interest rate is the monthly commercial paper rate plus 100 basis points. On the issue date, the monthly commercial paper rate is 3 percent, compounded monthly.

(ii) EQUIVALENT FIXED RATE DEBT INSTRUMENT. Under paragraph (e)(3)(ii) of this section, the equivalent fixed rate debt instrument for the variable rate debt instrument is a 4-year debt instrument that has an issue price and stated principal amount of $100,000. The equivalent fixed rate debt instrument provides for monthly payments of interest at 3 percent, compounded monthly, for the first year ($250 per month) and monthly payments of interest at 4 percent, compounded monthly, for the last 3 years ($333.33 per month).

(iii) DE MINIMIS OID. Under section 1.1273-1(a), because a portion (100 basis points) of each interest payment in the final 3 years is not a qualified stated interest payment, the equivalent fixed rate debt instrument has OID of $2,999.88 ($102,999.88 - $100,000). However, under section 1.1273-1(d)(4) (the de minimis rule relating to teaser rates and interest holidays), the stated redemption price at maturity of the equivalent fixed rate debt instrument is $100,999.96 ($100,000 (issue price) plus $999.96 (the greater of the amount of foregone interest ($999.96) and the amount equal to the excess of the instrument's stated principal amount over its issue price ($0)). Thus, the equivalent fixed rate debt instrument is treated as having OID of $999.96 ($100,999.96 - $100,000) . Because this amount is less than the de minimis amount of $1,010 (0.0025 multiplied by $100,999.96 multiplied by 4 complete years to maturity), the equivalent fixed rate debt instrument has de minimis OID. Therefore, the variable rate debt instrument has zero OID and all stated interest payments are qualified stated interest payments.

EXAMPLE 3. ADJUSTMENT TO QUALIFIED STATED INTEREST FOR ACTUAL PAYMENT OF INTEREST -- (i) FACTS. On January 1, 1995, Z purchases at original issue, for $90,000, a variable rate debt instrument that matures on January 1, 1997, and has a stated principal amount of $100,000, payable at maturity. The debt instrument provides for annual payments of interest on January 1 of each year, beginning on January 1, 1996. The amount of interest payable is the value of annual LIBOR on the payment date. The value of annual LIBOR on January 1, 1995, and January 1, 1996, is 5 percent, compounded annually. The value of annual LIBOR on January 1, 1997, is 7 percent, compounded annually.

(ii) EQUIVALENT FIXED RATE DEBT INSTRUMENT. Under paragraph (e)(3)(ii) of this section, the equivalent fixed rate debt instrument for the variable rate debt instrument is a 2-year debt instrument that has an issue price of $90,000 and a stated principal amount of $100,000. The equivalent fixed rate debt instrument provides for interest payments of $5,000 at the end of each year.

(iii) ACCRUAL OF OID AND QUALIFIED STATED INTEREST. Under section 1.1273-1, the equivalent fixed rate debt instrument has $10,000 of OID and the annual interest payments of $5,000 are qualified stated interest payments. Under section 1.1272-1, the equivalent fixed rate debt instrument has a yield of 10.82 percent, compounded annually. The amount of OID allocable to the first annual accrual period (assuming Z uses annual accrual periods) is $4,743.25 (($90,000 x .1082) - $5,000), and the amount of OID allocable to the second annual accrual period is $5,256.75 ($100,000 - $94,743.25). Under paragraph (e)(3)(iv) of this section, the $2,000 difference between the $7,000 interest payment actually made at maturity and the $5,000 interest payment assumed to be made at maturity under the equivalent fixed rate debt instrument is treated as additional qualified stated interest for the period.

(4) VARIABLE RATE DEBT INSTRUMENT THAT PROVIDES FOR A SINGLE FIXED RATE -- (i) GENERAL RULE. If a variable rate debt instrument provides for stated interest either at one or more qualified floating rates or at a qualified inverse floating rate and in addition provides for stated interest at a single fixed rate (other than an initial fixed rate described in paragraph (a)(3)(ii) of this section), the amount of interest and OID are determined using the method of paragraph (e)(3) of this section, as modified by this paragraph (e)(4). For purposes of paragraphs (e)(3)(i) through (e)(3)(iii) of this section, the variable rate debt instrument is treated as if it provided for a qualified floating rate (or a qualified inverse floating rate, if the debt instrument provides for a qualified inverse floating rate), rather than the fixed rate. The qualified floating rate (or qualified inverse floating rate) replacing the fixed rate must be such that the fair market value of the variable rate debt instrument as of the issue date would be approximately the same as the fair market value of an otherwise identical debt instrument that provides for the qualified floating rate (or qualified inverse floating rate) rather than the fixed rate.

(ii) EXAMPLE. The following example illustrates the rule in paragraph (e)(4)(i) of this section.

EXAMPLE. VARIABLE RATE DEBT INSTRUMENT THAT PROVIDES FOR A SINGLE FIXED RATE -- (i) FACTS. On January 1, 1995, X purchases at original issue, for $100,000, a variable rate debt instrument that matures on January 1, 2001, and that has a stated principal amount of $100,000. The debt instrument provides for payments of interest on January 1 of each year, beginning on January 1, 1996. For the first 4 years, the interest rate is 4 percent, compounded annually, and for the last 2 years the interest rate is the value of 1-year LIBOR, as of the payment date, plus 200 basis points. On January 1, 1995, the value of 1-year LIBOR is 2 percent, compounded annually. In addition, assume that on January 1, 1995, the variable rate debt instrument has approximately the same fair market value as an otherwise identical debt instrument that provides for an interest rate equal to the value of 1-year LIBOR, as of the payment date, for the first 4 years.

(ii) EQUIVALENT FIXED RATE DEBT INSTRUMENT. Under paragraph (e)(4)(i) of this section, for purposes of paragraphs (e)(3)(i) through (e)(3)(iii) of this section, the variable rate debt instrument is treated as if it provided for an interest rate equal to the value of 1-year LIBOR, as of the payment date, for the first 4 years. Under paragraph (e)(3)(ii) of this section, the equivalent fixed rate debt instrument for the variable rate debt instrument is a 6-year debt instrument that has an issue price and stated principal amount of $100,000. The equivalent fixed rate debt instrument provides for interest payments of $2,000 for the first 4 years and $4,000 for the last 2 years.

(iii) ACCRUAL OF OID AND QUALIFIED STATED INTEREST. Under section 1.1273-1, the equivalent fixed rate debt instrument has OID of $4,000 because a portion (200 basis points) of each interest payment in the last 2 years is not a qualified stated interest payment. The $4,000 of OID is allocable over the 6-year term of the debt instrument under section 1.1272-1. Under paragraph (e)(3)(iv) of this section, the difference between the $4,000 payment made in the first 4 years and the $2,000 payment assumed to be made on the equivalent fixed rate debt instrument in those years is an adjustment to qualified stated interest. In addition, any difference between the amount actually paid in each of the last 2 years and the $4,000 payment assumed to be made on the equivalent fixed rate debt instrument is an adjustment to qualified stated interest.

(f) SPECIAL RULE FOR CERTAIN RESET BONDS. Notwithstanding paragraph (e) of this section, this paragraph (f) provides a special rule for a variable rate debt instrument that provides for stated interest at a fixed rate for an initial interval, and provides that on the date immediately following the end of the initial interval (the effective date) the stated interest rate will be a rate determined under a procedure (such as an auction procedure) so that the fair market value of the instrument on the effective date will be a fixed amount (the reset value). Solely for purposes of calculating the accrual of OID, the variable rate debt instrument is treated as --

(i) Maturing on the date immediately preceding the effective date for an amount equal to the reset value; and

(ii) Reissued on the effective date for an amount equal to the reset value.

SECTION 1.1275-6T [REMOVED]

Par. 16. Section 1.1275-6T is removed as of [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

SECTION 1.6050H-2T [REMOVED]

Par. 17. Section 1.6050H-2T is removed as of [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 18. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 19. Section 602.101(c) is amended as follows:

1. Removing the following entries from the table:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

 (c) * * *

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

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