Revised Rules for Amortizable Bond Premium

 [4830-01-u]

[2] ACTION: Final regulations.

[3] SUMMARY: This document contains final regulations relating to the federal income tax treatment of bond premium and bond issuance premium. The regulations reflect changes to the law made by the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988. The regulations will provide needed guidance to holders and issuers of debt instruments.

[4] DATES: EFFECTIVE DATE: March 2, 1998.

[5] APPLICABILITY DATES: For dates of applicability of the final regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

[6] FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

[7] The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1491. Responses to these collections of information are required by the IRS to determine whether a holder of a bond has elected to amortize bond premium and whether an issuer or a holder has changed its method of accounting for premium.

[8] An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

[9] The estimated annual burden per respondent varies from 0.25 hours to 0.75 hours, depending on individual circumstances, with an estimated average of 0.5 hours.

[10] Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

[11] Books or records relating to the collections of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

BACKGROUND

[12] Sections 1.171-1 through 1.171-4 of the Income Tax Regulations were promulgated in 1957 and last amended in 1968. In the Tax Reform Act of 1986, section 171(b) was amended to require that bond premium be amortized by reference to a constant yield. In the Technical and Miscellaneous Revenue Act of 1988, section 171(e) was amended to require that amortizable bond premium be treated as an offset to interest income.

[13] On June 27, 1996, the IRS published a notice of proposed rulemaking in the Federal Register (61 FR 33396) relating to the federal income tax treatment of bond premium and bond issuance premium. A public hearing was not held because no one requested to speak at the hearing that had been scheduled for October 23, 1996. The IRS did receive a few comments on the proposed regulations. The proposed regulations, with certain changes to respond to the comments, are adopted as final regulations.

EXPLANATION OF PROVISIONS

[14] In general, bond premium arises when a holder acquires a bond for more than the principal amount of the bond. Similarly, bond issuance premium arises when an issuer issues a bond for more than the principal amount of the bond. A holder will purchase, and an issuer will issue, a bond for more than its principal amount when the stated interest rate on the bond is higher than the current market yield for the bond.

[15] The holder's treatment of bond premium is addressed in sections 1.171-1 through 1.171-5. The issuer's treatment of bond issuance premium is addressed in section 1.163-13. In each case, the amortization of premium is based on constant yield principles. For this reason, the final regulations use concepts and definitions from the original issue discount (OID) regulations (in general, see sections 1.1271-1 through 1.1275-7T).

DETERMINATION OF BOND PREMIUM

[16] Under the proposed regulations, bond premium is defined as the excess of a holder's basis in a bond over the sum of the remaining amounts payable on the bond other than payments of qualified stated interest. The holder generally determines the amount of bond premium as of the date the holder acquires the bond.

[17] The proposed regulations provide special rules that limit a holder's basis solely for purposes of determining bond premium. For example, if a bond is convertible into stock of the issuer at the holder's option, for purposes of determining bond premium, the holder must reduce its basis in the bond by the value of the conversion option. This reduction prevents the holder from inappropriately amortizing the cost of the embedded conversion option.

[18] The final regulations adopt the rules of the proposed regulations for determining the amount of bond premium, if any, on a bond. However, in response to comments, the final regulations clarify the determination of basis in the case of a convertible bond acquired in a transferred basis transaction.

AMORTIZATION OF BOND PREMIUM

(a) In general

[19] Under section 171, the holder of a taxable bond acquired at a premium may elect to amortize bond premium. The holder of a tax- exempt bond acquired at a premium must amortize the premium. As premium is amortized, the holder's basis in the bond is reduced by a corresponding amount under section 1016(a)(5).

[20] Under the proposed regulations, a holder amortizes bond premium by offsetting qualified stated interest income with bond premium. An offset is calculated for each accrual period using constant yield principles. However, the offset for an accrual period is only taken into account when the holder takes qualified stated interest into account under the holder's regular method of accounting. Thus, a holder using the cash receipts and disbursements method of accounting does not take bond premium into account until a qualified stated interest payment is received.

[21] The final regulations adopt the rules in the proposed regulations for amortizing bond premium.

(b) Excess premium

[22] For certain bonds (for example, bonds that pay a variable rate of interest or that provide for an interest holiday), the amount of bond premium allocable to an accrual period could exceed the amount of qualified stated interest allocable to that period. The proposed regulations address this situation by providing that the excess bond premium is not allowed as a deduction but is carried forward to future accrual periods.

[23] Several commentators stated that this excess premium should be allowable as a current deduction for the accrual period in which the excess occurs. In response to these comments, the final regulations adopt rules for excess premium that are similar to the rules for negative adjustments on contingent payment debt instruments and deflation adjustments on inflation-indexed debt instruments. Under the final regulations, any excess bond premium allocable to an accrual period is deductible by the holder under section 171(a)(1) for the accrual period. The amount deductible, however, is limited by the amount of the holder's prior income inclusions on the bond. If any of the excess bond premium is not deductible under section 171(a)(1), this amount is carried forward to the next accrual period and is treated as bond premium allocable to that period.

BONDS SUBJECT TO CERTAIN CONTINGENCIES

[24] If a bond provides for one or more alternative payment schedules, the yield of the bond cannot be determined without making assumptions about the actual payment schedule. The OID regulations provide rules for making these assumptions. For example, the rules assume that an issuer will exercise a call option if doing so would minimize the yield of the debt instrument and that a holder will exercise a put option if doing so would maximize the yield of the debt instrument.

[25] The proposed regulations under section 171 generally use similar assumptions to determine the holder's yield on a bond that provides for alternative payment schedules. However, in the case of an issuer's option on a taxable bond, the proposed regulations reverse the assumption in the OID regulations by assuming that the issuer will exercise the option only if doing so would increase the yield on the bond. See section 171(b)(1)(B)(ii). Thus, under the proposed regulations, a holder generally must amortize bond premium on a taxable bond by reference to the stated maturity date, even if it appears likely the bond will be called. In this case, if the bond is actually called, the proposed regulations provide that the holder may deduct the unamortized premium. If the bond is partially called and the partial call is not a pro-rata prepayment, the proposed regulations do not allow the holder to deduct a portion of the unamortized premium. Instead, the holder must recompute the yield of the bond on the date of the partial call and amortize the remaining premium by reference to the recomputed yield.

[26] In general, the final regulations adopt the rules of the proposed regulations. In response to a comment, the final regulations limit the issuer rule for taxable bonds to call options.

BOND ISSUANCE PREMIUM

[27] Under existing section 1.61-12(c), a corporate issuer treats premium received upon issuance of a bond as a separate item of income. Over the term of the bond, the premium is taken into income, and the full amount of the stated interest is deducted. The proposed regulations revise the treatment of bond issuance premium. Under the proposed regulations, bond issuance premium is amortized as an offset to the issuer's otherwise allowable interest deduction, not as a separate item of income. The amount of bond issuance premium amortized in any period is based on a constant yield. In addition, the proposed regulations apply to all issuers, not just corporate issuers.

[28] In general, the final regulations adopt the rules in the proposed regulations for bond issuance premium. However, the final regulations contain several important changes from the proposed regulations. First, in response to comments, the final regulations clarify the treatment of a debt instrument subject to an alternative payment schedule by explicitly cross-referencing section 1.1272-1(c). Second, the final regulations provide that, in the case of a debt instrument subject to a mandatory sinking fund provision, the issuer must determine the payment schedule by assuming that a pro rata portion of the debt instrument will be called under the sinking fund provision. This rule produces more economic interest accruals than the accruals determined by ignoring the sinking fund provision as under the proposed regulations. Third, the final regulations adopt rules for excess bond issuance premium allocable to an accrual period. These rules are similar to the rules for excess bond premium described above.

AGGREGATION RULES

[29] Although the proposed regulations do not provide for an aggregate method of accounting for premium, comments were requested on the need for an aggregate method. Because no comments were received, the final regulations do not provide rules for an aggregate method of accounting for premium.

BONDS NOT SUBJECT TO THE FINAL REGULATIONS

[30] The final regulations generally apply to bonds acquired or issued at a premium. Certain bonds, however, are excluded from the application of the final regulations. For example, the final regulations exclude debt instruments described in section 1272(a)(6)(C) (regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration). No inference is intended regarding the treatment of debt instruments described in section 1272(a)(6)(C).

EFFECTIVE DATES

[31] The final regulations relating to bond premium are effective for bonds acquired on or after March 2, 1998. However, if a holder makes the election to amortize bond premium for the taxable year containing March 2, 1998, or any subsequent taxable year, the regulations apply to bonds held on or after the first day of the taxable year in which the election is made.

[32] The final regulations relating to bond issuance premium apply to debt instruments issued on or after March 2, 1998.

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

SPECIAL ANALYSES

[34] It is hereby certified that these regulations do not have significant economic impact on a substantial number of small entities. This certification is based upon the fact that the regulations merely require a taxpayer to attach to the taxpayer's return a statement that indicates whether the taxpayer is making an election under section 171 or is changing its accounting method for bond premium or bond issuance premium. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

[35] It has been determined that this Treasury Decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

[36] Several persons from the Office of Assistant Chief Counsel (Financial Institutions and Products) and the Treasury Department participated in the development of these regulations.

LIST OF SUBJECTS

26 CFR Part 1

[37] Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

[38] Reporting and recordkeeping requirements.

Treasury Decision 8746

ADOPTION OF AMENDMENTS TO THE REGULATIONS

[39] Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read as follows:

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

Section 1.171-2 also issued under 26 U.S.C. 171(e).

Section 1.171-3 also issued under 26 U.S.C. 171(e).

Section 1.171-4 also issued under 26 U.S.C. 171(c). * * *

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

SECTION 1.61-12 INCOME FROM DISCHARGE OF INDEBTEDNESS.

* * * * *

(c) ISSUANCE AND REPURCHASE OF DEBT INSTRUMENTS -- (1) ISSUANCE. An issuer does not realize gain or loss upon the issuance of a debt instrument. For rules relating to an issuer's interest deduction for a debt instrument issued with bond issuance premium, see section 1.163-13.

(2) REPURCHASE -- (i) IN GENERAL. An issuer does not realize gain or loss upon the repurchase of a debt instrument. However, if a debt instrument provides for payments denominated in, or determined by reference to, a nonfunctional currency, an issuer may realize a currency gain or loss upon the repurchase of the instrument. See section 988 and the regulations thereunder. For purposes of this paragraph (c)(2), the term REPURCHASE includes the retirement of a debt instrument, the conversion of a debt instrument into stock of the issuer, and the exchange (including an exchange under section 1001) of a newly issued debt instrument for an existing debt instrument.

(ii) REPURCHASE AT A DISCOUNT. An issuer realizes income from the discharge of indebtedness upon the repurchase of a debt instrument for an amount less than its adjusted issue price (within the meaning of section 1.1275-1(b)). The amount of discharge of indebtedness income is equal to the excess of the adjusted issue price over the repurchase price. See section 108 and the regulations thereunder for additional rules relating to income from discharge of indebtedness. For example, to determine the repurchase price of a debt instrument that is repurchased through the issuance of a new debt instrument, see section 108(e)(10).

(iii) REPURCHASE AT A PREMIUM. An issuer may be entitled to a repurchase premium deduction upon the repurchase of a debt instrument for an amount greater than its adjusted issue price (within the meaning of section 1.1275-1(b)). See section 1.163-7(c) for the treatment of repurchase premium.

(iv) EFFECTIVE DATE. This paragraph (c)(2) applies to debt instruments repurchased on or after March 2, 1998.

* * * * *

Par. 3. Section 1.163-13 is added to read as follows:

SECTION 1.163-13 TREATMENT OF BOND ISSUANCE PREMIUM.

(a) GENERAL RULE. If a debt instrument is issued with bond issuance premium, this section limits the amount of the issuer's interest deduction otherwise allowable under section 163(a). In general, the issuer determines its interest deduction by offsetting the interest allocable to an accrual period with the bond issuance premium allocable to that period. Bond issuance premium is allocable to an accrual period based on a constant yield. The use of a constant yield to amortize bond issuance premium is intended to generally conform the treatment of debt instruments having bond issuance premium with those having original issue discount. Unless otherwise provided, the terms used in this section have the same meaning as those terms in section 163(e), sections 1271 through 1275, and the corresponding regulations. Moreover, unless otherwise provided, the provisions of this section apply in a manner consistent with those of section 163(e), sections 1271 through 1275, and the corresponding regulations. In addition, the anti-abuse rule in section 1.1275-2(g) applies for purposes of this section. For rules dealing with the treatment of bond premium by a holder, see sections 1.171-1 through 1.171-5.

(b) EXCEPTIONS. This section does not apply to --

(1) A debt instrument described in section 1272(a)(6)(C) (regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration); or

(2) A debt instrument to which section 1.1275-4 applies (relating to certain debt instruments that provide for contingent payments).

(c) BOND ISSUANCE PREMIUM. Bond issuance premium is the excess, if any, of the issue price of a debt instrument over its stated redemption price at maturity. For purposes of this section, the issue price of a convertible bond (as defined in section 1.171-1(e)(1)(iii)(C)) does not include an amount equal to the value of the conversion option (as determined under section 1.171-1(e)(1)(iii)(A)).

(d) OFFSETTING QUALIFIED STATED INTEREST WITH BOND ISSUANCE PREMIUM -- (1) IN GENERAL. An issuer amortizes bond issuance premium by offsetting the qualified stated interest allocable to an accrual period with the bond issuance premium allocable to the accrual period. This offset occurs when the issuer takes the qualified stated interest into account under its regular method of accounting.

(2) QUALIFIED STATED INTEREST ALLOCABLE TO AN ACCRUAL PERIOD. See section 1.446-2(b) to determine the accrual period to which qualified stated interest is allocable and to determine the accrual of qualified stated interest within an accrual period.

(3) BOND ISSUANCE PREMIUM ALLOCABLE TO AN ACCRUAL PERIOD. The bond issuance premium allocable to an accrual period is determined under this paragraph (d)(3). Within an accrual period, the bond issuance premium allocable to the period accrues ratably.

(i) STEP ONE: DETERMINE THE DEBT INSTRUMENT'S YIELD TO MATURITY. The yield to maturity of a debt instrument is determined under the rules of section 1.1272-1(b)(1)(i).

(ii) STEP TWO: DETERMINE THE ACCRUAL PERIODS. The accrual periods are determined under the rules of section 1.1272-1(b)(1)(ii).

(iii) STEP THREE: DETERMINE THE BOND ISSUANCE PREMIUM ALLOCABLE TO THE ACCRUAL PERIOD. The bond issuance premium allocable to an accrual period is the excess of the qualified stated interest allocable to the accrual period over the product of the adjusted issue price at the beginning of the accrual period and the yield. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period. Principles similar to those in section 1.1272-1(b)(4) apply in determining the bond issuance premium allocable to an accrual period.

(4) BOND ISSUANCE PREMIUM IN EXCESS OF QUALIFIED STATED INTEREST -- (1) ORDINARY INCOME. If the bond issuance premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is treated as ordinary income by the issuer for the accrual period. However, the amount treated as ordinary income is limited to the amount by which the issuer's total interest deductions on the debt instrument in prior accrual periods exceed the total amount treated by the issuer as ordinary income on the debt instrument in prior accrual periods.

(ii) CARRYFORWARD. If the bond issuance premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as ordinary income for the accrual period under paragraph (d)(4)(i) of this section, the excess is carried forward to the next accrual period and is treated as bond issuance premium allocable to that period. If a carryforward exists on the date the debt instrument is retired, the carryforward is treated as ordinary income on that date.

(e) SPECIAL RULES -- (1) VARIABLE RATE DEBT INSTRUMENTS. An issuer determines bond issuance premium on a variable rate debt instrument by reference to the stated redemption price at maturity of the equivalent fixed rate debt instrument constructed for the variable rate debt instrument. The issuer also allocates any bond issuance premium among the accrual periods by reference to the equivalent fixed rate debt instrument. The issuer constructs the equivalent fixed rate debt instrument, as of the issue date, by using the principles of section 1.1275-5(e).

(2) INFLATION-INDEXED DEBT INSTRUMENTS. An issuer determines bond issuance premium on an inflation-indexed debt instrument by assuming that there will be no inflation or deflation over the term of the instrument. The issuer also allocates any bond issuance premium among the accrual periods by assuming that there will be no inflation or deflation over the term of the instrument. The bond issuance premium allocable to an accrual period offsets qualified stated Interest allocable to the period. Notwithstanding paragraph (d)(4) of this section, if the bond issuance premium allocable to an accrual period exceeds the qualified stated interest allocable to the period, the excess is treated as a deflation adjustment under section 1.1275-7T(f)(1)(ii) See section 1.1275-7T for other rules relating to inflation-indexed debt instruments.

(3) CERTAIN DEBT INSTRUMENTS SUBJECT TO CONTINGENCIES -- (i) IN GENERAL. Except as provided in paragraph (e)(3)(ii) of this section, the rules of section 1.1272-1(c) apply to determine a debt instrument's payment schedule for purposes of this section. For example, an issuer uses the payment schedule determined under section 1.1272-1(c) to determine the amount, if any, of bond issuance premium on the debt instrument, the yield and maturity of the debt instrument, and the allocation of bond issuance premium to an accrual period.

(ii) MANDATORY SINKING FUND PROVISION. Notwithstanding paragraph (e)(3)(i) of this section, if a debt instrument is subject to a mandatory sinking fund provision described in section 1.1272-1(c)(3), the issuer must determine the payment schedule by assuming that a pro rata portion of the debt instrument will be called under the sinking fund provision.

(4) REMOTE AND INCIDENTAL CONTINGENCIES. For purposes of determining the amount of bond issuance premium and allocating bond issuance premium among accrual periods, if a bond provides for a contingency that is remote or incidental (within the meaning of section 1.1275-2(h)), the issuer takes the contingency into account under the rules for remote and incidental contingencies in section 1.1275-2(h).

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

 EXAMPLE -- (i) FACTS. On February 1, 1999, X issues for

(h) ACCOUNTING METHOD CHANGES -- (1) CONSENT TO CHANGE. An issuer required to change its method of accounting for bond issuance premium to comply with this section must secure the consent of the Commissioner in accordance with the requirements of section 1.446-1(e). Paragraph (h)(2) of this section provides the Commissioner's automatic consent for certain changes.

(2) AUTOMATIC CONSENT. The Commissioner grants consent for an issuer to change its method of accounting for bond issuance premium on debt instruments issued on or after March 2, 1998. Because this change is made on a cut-off basis, no items of income or deduction are omitted or duplicated and, therefore, no adjustment under section 481 is allowed. The consent granted by this paragraph (h)(2) applies provided --

(i) The change is made to comply with this section;

(ii) The change is made for the first taxable year for which the issuer must account for a debt instrument under this section; and

(iii) The issuer attaches to its federal income tax return for the taxable year containing the change a statement that it has changed its method of accounting under this section.

Par. 4. Sections 1.171-1 through 1.171-4 are revised to read as follows:

SECTION 1.171-1 BOND PREMIUM.

(a) OVERVIEW -- (1) IN GENERAL. This section and sections 1.171-2 through 1.171-5 provide rules for the determination and amortization of bond premium by a holder. In general, a holder amortizes bond premium by offsetting the interest allocable to an accrual period with the premium allocable to that period. Bond premium is allocable to an accrual period based on a constant yield. The use of a constant yield to amortize bond premium is intended to generally conform the treatment of bond premium to the treatment of original issue discount under sections 1271 through 1275. Unless otherwise provided, the terms used in this section and sections 1.171-2 through 1.171-5 have the same meaning as those terms in sections 1271 through 1275 and the corresponding regulations. Moreover, unless otherwise provided, the provisions of this section and sections 1.171-2 through 1.171-5 apply in a manner consistent with those of sections 1271 through 1275 and the corresponding regulations. In addition, the anti-abuse rule in section 1.1275-2(g) applies for purposes of this section and sections 1.171-2 through 1.171-5.

(2) CROSS-REFERENCES. For rules dealing with the adjustments to a holder's basis to reflect the amortization of bond premium, see section 1.1016-5(b). For rules dealing with the treatment of bond issuance premium by an issuer, see section 1.163-13.

(b) SCOPE -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section and section 1.171-5, this section and sections 1.171-2 through 1.171-4 apply to any bond that, upon its acquisition by the holder, is held with bond premium. For purposes of this section and sections 1.171-2 through 1.171-5, the term BOND has the same meaning as the term DEBT INSTRUMENT in section 1.1275-1(d).

(2) EXCEPTIONS. This section and sections 1.171-2 through 1.171-5 do not apply to --

(i) A bond described in section 1272(a)(6)(C) (regular interests in a REMIC, qualified mortgages held by a REMIC, and certain other debt instruments, or pools of debt instruments, with payments subject to acceleration);

(ii) A bond to which section 1.1275-4 applies (relating to certain debt instruments that provide for contingent payments);

(iii) A bond held by a holder that has made a section 1.1272-3 election with respect to the bond;

(iv) A bond that is stock in trade of the holder, a bond of a kind that would properly be included in the inventory of the holder if on hand at the close of the taxable year, or a bond held primarily for sale to customers in the ordinary course of the holder's trade or business; or

(v) A bond issued before September 28, 1985, unless the bond bears interest and was issued by a corporation or by a government or political subdivision thereof.

(c) GENERAL RULE -- (1) TAX-EXEMPT OBLIGATIONS. A holder must amortize bond premium on a bond that is a tax-exempt obligation. See section 1.171-2(c) Example 4.

(2) TAXABLE BONDS. A holder may elect to amortize bond premium on a taxable bond. Except as provided in paragraph (c)(3) of this section, a taxable bond is any bond other than a tax-exempt obligation. See section 1.171-4 for rules relating to the election to amortize bond premium on a taxable bond.

(3) BONDS THE INTEREST ON WHICH IS PARTIALLY EXCLUDABLE. For purposes of this section and sections 1.171-2 through 1.171-5, a bond the interest on which is partially excludable from gross income is treated as two instruments, a tax-exempt obligation and a taxable bond. The holder's basis in the bond and each payment on the bond are allocated between the two instruments based on a reasonable method.

(d) DETERMINATION OF BOND PREMIUM -- (1) IN GENERAL. A holder acquires a bond at a premium if the holder's basis in the bond immediately after its acquisition by the holder exceeds the sum of all amounts payable on the bond after the acquisition date (other than payments qualified stated interest). This excess is bond premium, which is amortizable under section 1.171-2.

(2) ADDITIONAL RULES FOR AMOUNTS PAYABLE ON CERTAIN BONDS. Additional rules apply to determine the amounts payable on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond that provides for remote or incidental contingencies. See section 1.171-3.

(e) BASIS. A holder determines its basis in a bond under this paragraph (e). This determination of basis applies only for purposes of this section and sections 1.171-2 through 1.171-5. Because of the application of this paragraph (e), the holder's basis in the bond for purposes of these sections may differ from the holder's basis for determining gain or loss on the sale or exchange of the bond.

(1) DETERMINATION OF BASIS -- (i) IN GENERAL. In general, the holder's basis in the bond is the holder's basis for determining loss on the sale or exchange of the bond.

(ii) BONDS ACQUIRED IN CERTAIN EXCHANGES. If the holder acquired the bond in exchange for other property (other than in a reorganization defined in section 368) and the holder's basis in the bond is determined in whole or in part by reference to the holder's basis in the other property, the holder's basis in the bond may not exceed its fair market value immediately after the exchange. See paragraph (f) Example 1 of this section. If the bond is acquired in a reorganization, see section 171(b)(4)(B).

(iii) CONVERTIBLE BONDS -- (A) GENERAL RULE. If the bond is a convertible bond, the holder's basis in the bond is reduced by an amount equal to the value of the conversion option. The value of the conversion option may be determined under any reasonable method. For example, the holder may determine the value of the conversion option by comparing the market price of the convertible bond to the market prices of similar bonds that do not have conversion options. See paragraph (f) Example 2 of this section.

(B) CONVERTIBLE BONDS ACQUIRED IN CERTAIN EXCHANGES. If the bond is a convertible bond acquired in a transaction described in paragraph (e)(1)(ii) of this section, the holder's basis in the bond may not exceed its fair market value immediately after the exchange reduced by the value of the conversion option.

(C) DEFINITION OF CONVERTIBLE BOND. A convertible bond is a bond that provides the holder with an option to convert the bond into stock of the issuer, stock or debt of a related party (within the meaning of section 267(b) or 707(b)(1)), or into cash or other property in an amount equal to the approximate value of such stock or debt.

(2) BASIS IN BONDS HELD BY CERTAIN TRANSFEREES. Notwithstanding paragraph (e)(1) of this section, if the bond is transferred basis property (as defined in section 7701(a)(43)) and the transferor had acquired the bond at a premium, the holder's basis in the bond is --

(i) The holder's basis for determining loss on the sale or exchange of the bond; reduced by

(ii) Any amounts that the transferor could not have amortized under this paragraph (e) or under section 1.171-4(c), except to the extent that the holder's basis already reflects a reduction attributable to such nonamortizable amounts.

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

 EXAMPLE 1. BOND RECEIVED IN LIQUIDATION OF A PARTNERSHIP

(a) OFFSETTING QUALIFIED STATED INTEREST WITH PREMIUM -- (1) IN GENERAL. A holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the accrual period. This offset occurs when the holder takes the qualified stated interest into account under the holder's regular method of accounting.

(2) QUALIFIED STATED INTEREST ALLOCABLE TO AN ACCRUAL PERIOD. See section 1.446-2(b) to determine the accrual period to which qualified stated interest is allocable and to determine the accrual of qualified stated interest within an accrual period.

(3) BOND PREMIUM ALLOCABLE TO AN ACCRUAL PERIOD. The bond premium allocable to an accrual period is determined under this paragraph (a)(3). Within an accrual period, the bond premium allocable to the period accrues ratably.

(i) STEP ONE: DETERMINE THE HOLDER'S YIELD. The holder's yield is the discount rate that, when used in computing the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to the holder's basis in the bond as determined under section 1.171-1(e). For this purpose, the remaining payments include only payments to be made after the date the holder acquires the bond. The yield is calculated as of the date the holder acquires the bond, must be constant over the term of the bond, and must be calculated to at least two decimal places when expressed as a percentage.

(ii) STEP TWO: DETERMINE THE ACCRUAL PERIODS. A holder determines the accrual periods for the bond under the rules of section 1.1272-1(b)(1)(ii).

(iii) STEP THREE: DETERMINE THE BOND PREMIUM ALLOCABLE TO THE ACCRUAL PERIOD. The bond premium allocable to an accrual period is the excess of the qualified stated interest allocable to the accrual period over the product of the holder's adjusted acquisition price (as defined in paragraph (b) of this section) at the beginning of the accrual period and the holder's yield. In performing this calculation, the yield must be stated appropriately taking into account the length of the particular accrual period. Principles similar to those in section 1.1272-1(b)(4) apply in determining the bond premium allocable to an accrual period.

(4) BOND PREMIUM IN EXCESS OF QUALIFIED STATED INTEREST -- (i) TAXABLE BONDS -- (A) BOND PREMIUM DEDUCTION. In the case of a taxable bond, if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is treated by the holder as a bond premium deduction under section 171(a)(1) for the accrual period. However, the amount treated as a bond premium deduction is limited to the amount by which the holder's total interest inclusions on the bond in prior accrual periods exceed the total amount treated by the holder as a bond premium deduction on the bond in prior accrual periods. A deduction determined under this paragraph (a)(4)(i)(A) is not subject to section 67 (the 2-percent floor on miscellaneous itemized deductions). See Example 1 of section 1.171-3(e).

(B) CARRYFORWARD. If the bond premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as a deduction for the accrual period under paragraph (a)(4)(i)(A) of this section, the excess is carried forward to the next accrual period and is treated as bond premium allocable to that period.

(ii) TAX-EXEMPT OBLIGATIONS. In the case of a tax-exempt obligation, if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the excess is a nondeductible loss. If a regulated investment company (RIC) within the meaning of section 851 has excess bond premium for an accrual period that would be a nondeductible loss under the prior sentence, the RIC must use this excess bond premium to reduce its tax-exempt interest income on other tax-exempt obligations held during the accrual period.

(5) ADDITIONAL RULES FOR CERTAIN BONDS. Additional rules apply to determine the amortization of bond premium on a variable rate debt instrument, an inflation-indexed debt instrument, a bond that provides for certain alternative payment schedules, and a bond that provides for remote or incidental contingencies. See section 1.171-3.

(b) ADJUSTED ACQUISITION PRICE. The adjusted acquisition price of a bond at the beginning of the first accrual period is the holder's basis as determined under section 1.171-1(e). Thereafter, the adjusted acquisition price is the holder's basis in the bond decreased by --

(1) The amount of bond premium previously allocable under paragraph (a)(3) of this section; and

(2) The amount of any payment previously made on the bond other than a payment of qualified stated interest.

(c) EXAMPLES. The following examples illustrate the rules of this section. Each example assumes the holder uses the calendar year as its taxable year and has elected to amortize bond premium, effective for all relevant taxable years. In addition, each example assumes a 30-day month and 360-day year. Although, for purposes of simplicity, the yield as stated is rounded to two decimal places, the computations do not reflect this rounding convention. The examples are as follows:

 EXAMPLE 1. TAXABLE BOND -- (i) FACTS. On February 1, 1999,

(a) VARIABLE RATE DEBT INSTRUMENTS. A holder determines bond premium on a variable rate debt instrument by reference to the stated redemption price at maturity of the equivalent fixed rate debt instrument constructed for the variable rate debt instrument. The holder also allocates any bond premium among the accrual periods by reference to the equivalent fixed rate debt instrument. The holder constructs the equivalent fixed rate debt instrument, as of the date the holder acquires the variable rate debt instrument, by using the principles of section 1.1275-5(e). See paragraph (e) Example 1 of this section.

(b) INFLATION-INDEXED DEBT INSTRUMENTS. A holder determines bond premium on an inflation-indexed debt instrument by assuming that there will be no inflation or deflation over the remaining term of the instrument. The holder also allocates any bond premium among the accrual periods by assuming that there will be no inflation or deflation over the remaining term of the instrument. The bond premium allocable to an accrual period offsets qualified stated interest allocable to the period. Notwithstanding section 1.171-2(a)(4), if the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the period, the excess is treated as a deflation adjustment under section 1.1275-7T(f)(1)(i). See section 1.1275-7T for other rules relating to inflation-indexed debt instruments.

(c) YIELD AND REMAINING PAYMENT SCHEDULE OF CERTAIN BONDS SUBJECT TO CONTINGENCIES -- (1) APPLICABILITY. This paragraph (c) provides rules that apply in determining the yield and remaining payment schedule of certain bonds that provide for an alternative payment schedule (or schedules) applicable upon the occurrence of a contingency (or contingencies). This paragraph (c) applies, however, only if the timing and amounts of the payments that comprise each payment schedule are known as of the date the holder acquires the bond (the acquisition date) and the bond is subject to paragraph (c)(2), (3), or (4) of this section. A bond does not provide for an alternative payment schedule merely because there is a possibility of impairment of a payment (or payments) by insolvency, default, or similar circumstances. See section 1.1275-4 for the treatment of a bond that provides for a contingency that is not described in this paragraph (c).

(2) REMAINING PAYMENT SCHEDULE THAT IS SIGNIFICANTLY MORE LIKELY THAN NOT TO OCCUR. If, based on all the facts and circumstances as of the acquisition date, a single remaining payment schedule for a bond is significantly more likely than not to occur, this remaining payment schedule is used to determine and amortize bond premium under sections 1.171-1 and 1.171-2.

(3) MANDATORY SINKING FUND PROVISION. Notwithstanding paragraph (c)(2) of this section, if a bond is subject to a mandatory sinking fund provision described in section 1.1272-1(c)(3), the provision is ignored for purposes of determining and amortizing bond premium under sections 1.171-1 and 1.171-2.

(4) TREATMENT OF CERTAIN OPTIONS -- (i) APPLICABILITY. Notwithstanding paragraphs (c)(2) and (3) of this section, the rules of this paragraph (c)(4) determine the remaining payment schedule of a bond that provides the holder or issuer with an unconditional option or options, exercisable on one or more dates during the remaining term of the bond, to alter the bond's remaining payment schedule.

(ii) OPERATING RULES. A holder determines the remaining payment schedule of a bond by assuming that each option will (or will not) be exercised under the following rules:

(A) ISSUER OPTIONS. In general, the issuer is deemed to exercise or not exercise an option or combination of options in the manner that minimizes the holder's yield on the obligation. However, the issuer of a taxable bond is deemed to exercise or not exercise a call option or combination of call options in the manner that maximizes the holder's yield on the bond.

(B) HOLDER OPTIONS. A holder is deemed to exercise or not exercise an option or combination of options in the manner that maximizes the holder's yield on the bond.

(C) MULTIPLE OPTIONS. If both the issuer and the holder have options, the rules of paragraphs (c)(4)(ii)(A) and (B) of this section are applied to the options in the order that they may be exercised. Thus, the deemed exercise of one option may eliminate other options that are later in time.

(5) SUBSEQUENT ADJUSTMENTS -- (i) IN GENERAL. Except as provided in paragraph (c)(5)(ii) of this section, if a contingency described in this paragraph (c) (including the exercise of an option described in paragraph (c)(4) of this section) actually occurs or does not occur, contrary to the assumption made pursuant to paragraph (c) of this section (a change in circumstances), then solely for purposes of section 171, the bond is treated as retired and reacquired by the holder on the date of the change in circumstances for an amount equal to the adjusted acquisition price of the bond as of that date. If, however, the change in circumstances results in a substantially contemporaneous pro-rata prepayment as defined in section 1.1275-2(f)(2), the pro-rata prepayment is treated as a payment in retirement of a portion of the bond. See paragraph (e) Example 2 of this section.

(ii) BOND PREMIUM DEDUCTION ON THE ISSUER'S CALL OF A TAXABLE BOND. If a change in circumstances results from an issuer's call of a taxable bond or a partial call that is a pro-rata prepayment, the holder may deduct as bond premium an amount equal to the excess, if any, of the holder's adjusted acquisition price of the bond over the greater of --

(A) The amount received on redemption; and

(B) The amounts that would have been payable under the bond (other than payments of qualified stated interest) if no change in circumstances had occurred.

(d) REMOTE AND INCIDENTAL CONTINGENCIES. For purposes of determining and amortizing bond premium, if a bond provides for a contingency that is remote or incidental (within the meaning of section 1.1275-2(h)), the holder takes the contingency into account under the rules for remote and incidental contingencies in section 1.1275-2(h).

(e) EXAMPLES. The following examples illustrate the rules of this section. Each example assumes the holder uses the calendar year as its taxable year and has elected to amortize bond premium, effective for all relevant taxable years. In addition, each example assumes a 30-day month and 360-day year. Although, for purposes of simplicity, the yield as stated is rounded to two decimal places, the computations do not reflect this rounding convention. The examples are as follows:

 EXAMPLE 1. VARIABLE RATE DEBT INSTRUMENT -- (i) FACTS. On

(a) TIME AND MANNER OF MAKING THE ELECTION -- (1) IN GENERAL. A holder makes the election to amortize bond premium by offsetting interest income with bond premium in the holder's timely filed federal income tax return for the first taxable year to which the holder desires the election to apply. The holder should attach to the return a statement that the holder is making the election under this section.

(2) COORDINATION WITH OID ELECTION. If a holder makes an election under section 1.1272-3 for a bond with bond premium, the holder is deemed to have made the election under this section.

(b) SCOPE OF ELECTION. The election under this section applies to all taxable bonds held during or after the taxable year for which the election is made.

(c) ELECTION TO AMORTIZE MADE IN A SUBSEQUENT TAXABLE YEAR -- (1) IN GENERAL. If a holder elects to amortize bond premium and holds a taxable bond acquired before the taxable year for which the election is made, the holder may not amortize amounts that would have been amortized in prior taxable years had an election been in effect for those prior years.

(2) EXAMPLE. The following example illustrates the rule of this paragraph (c):

 EXAMPLE -- (i) FACTS. On May 1, 1999, C purchases for

Par. 5. Section 1.171-5 is added to read as follows:

SECTION 1.171-5 EFFECTIVE DATE AND TRANSITION RULES.

(a) EFFECTIVE DATE -- (1) IN GENERAL. Sections 1.171-1 through 1.171-4 apply to bonds acquired on or after March 2, 1998. However, if a holder makes the election under section 1.171-4 for the taxable year containing March 2, 1998, or any subsequent taxable year, sections 1.171-1 through 1.171-4 apply to bonds held on or after the first day of the taxable year in which the election is made.

(2) TRANSITION RULE FOR USE OF CONSTANT YIELD.

Notwithstanding paragraph (a)(1) of this section, section 1.171-2(a)(3)(providing that the bond premium allocable to an accrual period is determined with reference to a constant yield) does not apply to a bond issued before September 28, 1985.

(b) COORDINATION WITH EXISTING ELECTION. A holder is deemed to have made the election under section 1.171-4 for the taxable year containing March 2, 1998, if the holder elected to amortize bond premium under section 171 and that election is effective on March 2, 1998. If the holder is deemed to have made the election under section 1.171-4 for the taxable year containing March 2, 1998, sections 1.171-1 through 1.171-4 apply to bonds acquired on or after the first day of that taxable year. See section 1.171-4(d) for rules relating to a revocation of an election under section 171.

(c) ACCOUNTING METHOD CHANGES -- (1) CONSENT TO CHANGE. A holder required to change its method of accounting for bond premium to comply with sections 1.171-1 through 1.171-3 must secure the consent of the Commissioner in accordance with the requirements of section 1.446-1(e). Paragraph (c)(2) of this section provides the Commissioner's automatic consent for certain changes. A holder making the election under section 1.171-4 does not need the Commissioner's consent to make the election.

(2) AUTOMATIC CONSENT. The Commissioner grants consent for a holder to change its method of accounting for bond premium with respect to taxable bonds to which sections 1.171-1 through 1.171-3 apply. Because this change is made on a cut-off basis, no items of income or deduction are omitted or duplicated and, therefore, no adjustment under section 481 is allowed. The consent granted by this paragraph (c)(2) applies provided --

(i) The holder elected to amortize bond premium under section 171 for a taxable year prior to the taxable year containing March 2, 1998, and that election has not been revoked;

(ii) The change is made for the first taxable year for which the holder must account for a bond under sections 1.171-1 through 1.171-3; and

(iii) The holder attaches to its return for the taxable year containing the change a statement that it has changed its method of accounting under this section.

Par. 6. Section 1.249-1 is amended by revising paragraph (c) and the first sentence of paragraph (d)(2) to read as follows:

SECTION 1.249-1 LIMITATION ON DEDUCTION OF BOND PREMIUM ON REPURCHASE.

(c) REPURCHASE PREMIUM. For purposes of this section, the term REPURCHASE PREMIUM means the excess of the repurchase price paid or incurred to repurchase the obligation over its adjusted issue price (within the meaning of section 1.1275-1(b)) as of the repurchase date. For the general rules applicable to the deductibility of repurchase premium, see section 1.163-7(c). This paragraph (c) applies to convertible obligations repurchased on or after March 2, 1998.

(d) * * *

(2) * * * For a convertible obligation repurchased on or after March 2, 1998, a call premium specified in dollars under the terms of the obligation is considered to be a normal call premium on a nonconvertible obligation if the call premium applicable when the obligation is repurchased does not exceed an amount equal to the interest (including original issue discount) that otherwise would be deductible for the taxable year of repurchase (determined as if the obligation were not repurchased). * * *

* * * * *

Par. 7. Section 1.1016-5 is amended by revising paragraph (b) to read as follows:

SECTION 1.1016-5 MISCELLANEOUS ADJUSTMENTS TO BASIS.

* * * * *

(b) AMORTIZABLE BOND PREMIUM -- (1) IN GENERAL. A holder's basis in a bond is reduced by the amount of bond premium used to offset qualified stated interest income under section 1.171-2. This reduction occurs when the holder takes the qualified stated interest into account under the holder's regular method of accounting.

(2) SPECIAL RULES FOR TAXABLE BONDS. A holder's basis in a taxable bond is reduced by the amount of bond premium allowed as a deduction under section 1.171-3(c)(5)(ii)(relating to the issuer's call of a taxable bond) or under section 1.171-2(a)(4)(i)(A)(relating to excess bond premium).

(3) SPECIAL RULE FOR TAX-EXEMPT OBLIGATIONS. A holder's basis in a tax-exempt obligation is reduced by the amount of excess bond premium that is treated as a nondeductible loss under section 1.171-2(a)(4)(ii).

* * * * *

SECTION 1.1016-9 [REMOVED]

Par. 8. Section 1.1016-9 is removed.

Par. 9. Section 1.1275-1 is amended by:

1. Redesignating paragraph (b)(2) as paragraph (b)(3).

2. Adding a new paragraph (b)(2).

The addition reads as follows:

SECTION 1.1275-1 DEFINITIONS.

* * * * *

(b) * * *

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

* * * * *

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

Par. 10. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 11. Section 602.101, paragraph (c) is amended by:

1. Removing the following entry from the table:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

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SECTION 602.101. OMB CONTROL NUMBERS.

* * * * *

(c) * * *

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