Internal Revenue Bulletin 1996-28 (PDF rendition): IRS Announcements

us-irs-announcements-irb-1996-28-pdfInternal Revenue Bulletin 1996-28 (PDF rendition): IRS AnnouncementsGuidance

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

SEQ 0001 JOB IRS28-001-005 PAGE-0003 COVER
REVISED 29JUL96 AT 23:01 BY LR DEPTH: 66.04 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-001
3
Bulletin No. 1996–28
July 8, 1996
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
INCOME TAX
Rev. Rul. 96–34, page 4.
Federal rates; adjusted federal rates; adjusted federal long-
term rate, and the long-term exempt rate. For purposes of
sections 1274, 1288, 382, and other sections of the
Code, tables set forth the rates for July 1996.
T.D. 8674, page 7.
Final regulations under section 1275 of the Code relate
to the tax treatment of debt instruments that provide
for one or more contingent payments.
IA–292–84, page 38.
Proposed regulations under section 467 of the Code
relate to the treatment of rent and interest under
certain agreements for the lease of tangible property. A
public hearing will be held on September 25, 1996.
TAX CONVENTIONS
Page 36.
The bilateral agreements between the U.S. and Lux-
embourg, providing for the reciprocal tax exemption of
income from the international operation of ships and/or
aircraft, are set forth.
ADMINISTRATIVE
Announcement 96–62, page 53.
Taxpayers can use the current Forms 706, 706–A,
706–NA, 709, 709–A, and their instructions until the
new revisions are available.
Finding Lists begin on page 59.
Announcement of Disbarments and Suspensions begins on page 56.

SEQ 0002 JOB IRS28-002-002 PAGE-0002 MISSION
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-002
2
Mission of the Service
The purpose of the Internal Revenue Service is to
collect the proper amount of tax revenue at the least
cost; serve the public by continually improving the
quality of our products and services; and perform in a
manner warranting the highest degree of public
confidence in our integrity, efficiency and fairness.
Statement of Principles
of Internal Revenue
Tax Administration
The function of the Internal Revenue Service is to
administer the Internal Revenue Code. Tax policy
for raising revenue is determined by Congress.
With this in mind, it is the duty of the Service to
carry out that policy by correctly applying the laws
enacted by Congress; to determine the reasonable
meaning of various Code provisions in light of the
Congressional purpose in enacting them; and to
perform this work in a fair and impartial manner,
with neither a government nor a taxpayer point of
view.
At the heart of administration is interpretation of the
Code. It is the responsibility of each person in the
Service, charged with the duty of interpreting the
law, to try to find the true meaning of the statutory
provision and not to adopt a strained construction in
the belief that he or she is ‘‘protecting the revenue.’’
The revenue is properly protected only when we as-
certain and apply the true meaning of the statute.
The Service also has the responsibility of applying
and administering the law in a reasonable,
practical manner. Issues should only be raised by
examining officers when they have merit, never
arbitrarily or for trading purposes. At the same
time, the examining officer should never hesitate
to raise a meritorious issue. It is also important
that care be exercised not to raise an issue or to
ask a court to adopt a position inconsistent with
an established Service position.
Administration should be both reasonable and
vigorous. It should be conducted with as little
delay as possible and with great courtesy and
considerateness. It should never try to overreach,
and should be reasonable within the bounds of law
and sound administration. It should, however, be
vigorous in requiring compliance with law and it
should be relentless in its attack on unreal tax
devices and fraud.

SEQ 0003 JOB IRS28-002-002 PAGE-0003 MISSION
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-002
3
Introduction
The Internal Revenue Bulletin is the authoritative
instrument of the Commissioner of Internal Revenue for
announcing official rulings and procedures of the
Internal Revenue Service and for publishing Treasury
Decisions, Executive Orders, Tax Conventions, legisla-
tion, court decisions, and other items of general
interest. It is published weekly and may be obtained
from the Superintendent of Documents on a subscrip-
tion basis. Bulletin contents of a permanent nature are
consolidated semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin
all substantive rulings necessary to promote a uniform
application of the tax laws, including all rulings that
supersede, revoke, modify, or amend any of those
previously published in the Bulletin. All published
rulings apply retroactively unless otherwise indicated.
Procedures relating solely to matters of internal
management are not published; however, statements of
internal practices and procedures that affect the rights
and duties of taxpayers are published.
Revenue rulings represent the conclusions of the
Service on the application of the law to the pivotal facts
stated in the revenue ruling. In those based on
positions taken in rulings to taxpayers or technical
advice to Service field offices, identifying details and
information of a confidential nature are deleted to
prevent unwarranted invasions of privacy and to comply
with statutory requirements.
Rulings and procedures reported in the Bulletin do not
have the force and effect of Treasury Department
Regulations, but they may be used as precedents.
Unpublished rulings will not be relied on, used, or cited
as precedents by Service personnel in the disposition of
other cases. In applying published rulings and proce-
dures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be
considered, and Service personnel and others con-
cerned are cautioned against reaching the same
conclusions in other cases unless the facts and
circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—1986 Code.
This part includes rulings and decisions based on
provisions of the Internal Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows:
Subpart A, Tax Conventions, and Subpart B, Legislation
and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to
these subjects are contained in the other Parts and
Subparts. Also included in this part are Bank Secrecy
Act Administrative Rulings. Bank Secrecy Act Admin-
istrative Rulings are issued by the Department of the
Treasury’s Office of the Assistant Secretary
(Enforcement).
Part IV.—Items of General Interest.
With the exception of the Notice of Proposed Rulemak-
ing and the disbarment and suspension list included in
this part, none of these announcements are consoli-
dated in the Cumulative Bulletins.
The first Bulletin for each month includes an index for
the matters published during the preceding month.
These monthly indexes are cumulated on a quarterly
and semiannual basis, and are published in the first
Bulletin of the succeeding quarterly and semi-annual
period, respectively.
The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

SEQ 0004 JOB IRS28-003-007 PAGE-0004 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
4
Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 42.—Low-Income Housing
Credit
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 280G.—Golden Parachute
Payments
Federal short-term, mid-term, and long-term
rates are set forth for the month of July 1996.
See Rev. Rul. 96–34, on this page.
Section 382.—Limitation on Net
Operating Loss Carryforwards and
Certain Built-In Losses Following
Ownership Change
The adjusted federal long-term rate is set forth
for the month of July 1996. See Rev. Rul. 96–34,
on this page.
Section 412.—Minimum Funding
Standards
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 467.—Certain Payments for
the Use of Property or Services
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 468.—Special Rules for
Mining and Solid Waste Reclamation
and Closing Costs
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 483.—Interest on Certain
Deferred Payments
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 807.—Rules for Certain
Reserves
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 846.—Discounted Unpaid
Losses Defined
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34, on
this page.
Section 1274.—Determination of
Issue Price in the Case of Certain
Debt Instruments Issued for Property
(Also Sections 42, 280G, 382, 412, 467, 468,
482, 483, 807, 846, 1288, 7520, 7872.)
Federal rates; adjusted federal
rates; adjusted federal long-term rate,
and the long-term exempt rate. For
purposes of sections 1274, 1288, 382,
and other sections of the Code, tables
set forth the rates for July 1996.
Rev. Rul. 96–34
This revenue ruling provides various
prescribed rates for federal income tax
purposes for July 1996 (the current
month.) Table 1 contains the short-
term, mid-term, and long-term applica-
ble federal rates (AFR) for the current
month for purposes of section 1274(d)
of the Internal Revenue Code. Table 2
contains the short-term, mid-term, and
long-term adjusted applicable federal
rates (adjusted AFR) for the current
month for purposes of section 1288(b).
Table 3 sets forth the adjusted federal
long-term rate and the long-term tax-
exempt rate described in section 382(f).
Table 4 contains the appropriate per-
centages for determining the low-
income housing credit described in
section 42(b)(2) for buildings placed in
service during the current month. Table
5 contains the federal rate for determin-
ing the present value of an annuity, an
interest for life or for a term of years,
or a remainder or a reversionary
interest for purposes of section 7520.
Finally, Table 6 contains the blended
annual rate for purposes of section
7872.

SEQ 0005 JOB IRS28-003-007 PAGE-0005 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 45.01 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
5
REV. RUL. 96–34 TABLE 1
Applicable Federal Rates (AFR) for July 1996
Period for Compounding
AnnualSemiannualQuarterlyMonthly
Short-Term
AFR6.04%5.95%5.91%5.88%
110% AFR6.66%6.55%6.50%6.46%
120% AFR7.27%7.14%7.08%7.04%
130% AFR7.89%7.74%7.67%7.62%
Mid-Term
AFR6.74%6.63%6.58%6.54%
110% AFR7.42%7.29%7.22%7.18%
120% AFR8.12%7.96%7.88%7.83%
130% AFR8.81%8.62%8.53%8.47%
150% AFR10.20%9.95%9.83%9.75%
175% AFR11.94%11.60%11.44%11.33%
Long-Term
AFR7.12%7.00%6.94%6.90%
110% AFR7.85%7.70%7.63%7.58%
120% AFR8.58%8.40%8.31%8.26%
130% AFR9.31%9.10%9.00%8.93%
REV. RUL. 96–34 TABLE 2
Adjusted AFR for July 1996
Period for Compounding
AnnualSemiannualQuarterlyMonthly
Short-term
adjusted AFR3.88%3.84%3.82%3.81%
Mid-term
adjusted AFR4.83%4.77%4.74%4.72%
Long-term
adjusted AFR5.78%5.70%5.66%5.63%

SEQ 0006 JOB IRS28-003-007 PAGE-0006 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
6
REV. RUL. 96–34 TABLE 3
Rates Under Section 382 for July 1996
Adjusted federal long-term rate for the current month5.78%
Long-term tax-exempt rate for ownership changes during the current month (the highest of the
adjusted federal long-term rates for the current month and the prior two months.)5.78%
REV. RUL. 96–34 TABLE 4
Appropriate Percentages Under Section 42(b)(2) for July 1996
Appropriate percentage for the 70% present value low-income housing credit8.63%
Appropriate percentage for the 30% present value low-income housing credit3.70%
REV. RUL. 96–34 TABLE 5
Rate Under Section 7520 for July 1996
Applicable federal rate for determining the present value of an annuity, an interest for life or
a term of years, or a remainder or reversionary interest8.2%
REV. RUL. 96–34 TABLE 6
Blended Annual Rate for 1996
Section 7872(e)(2) blended annual rate for 19965.77%

SEQ 0007 JOB IRS28-003-007 PAGE-0007 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
7
Section 1275.—Other Definitions and
Special Rules
26 CFR 1.1275–4: Contingent payment debt
instruments.
T.D. 8674
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Debt Instruments with Original Issue
Discount; Contingent Payments; Anti-
Abuse Rule
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations relating to the tax
treatment of debt instruments that
provide for one or more contingent
payments. This document also contains
final regulations that treat a debt
instrument and a related hedge as an
integrated transaction. In addition, this
document contains amendments to the
original issue discount regulations, and
finalizes the anti-abuse rule relating to
those regulations. The final regulations
in this document provide needed guid-
ance to holders and issuers of con-
tingent payment debt instruments.
DATES: Except as noted below, the
regulations are effective August 13,
1996. The amendments to §1.1275–5
are effective June 14, 1996, except for
paragraphs (a)(6), (b)(2), and (c)(1),
which are effective August 13, 1996.
The removal of §1.483–2T is effective
June 14, 1996. The removal of
§1.1275–2T is effective August 13,
1996.
For dates of applicability of these
regulations, see Effective Dates under
Supplementary Information.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations
(other than §1.1275–6), William E.
Blanchard, (202) 622-3950, or Jeffrey
W. Maddrey, (202) 622-3940; or con-
cerning §1.1275–6, Michael S. Novey,
(202) 622-3900 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in these final regulations have
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork Reduc-
tion Act (44 U.S.C. 3507) under
control number 1545–1450. Responses
to these collections of information are
required to determine a taxpayer’s
interest income or deductions on a
contingent payment debt instrument.
An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information
displays a valid control number.
The estimated annual burden per
respondent/recordkeeper varies from .3
hours to .5 hours, depending on indi-
vidual circumstances, with an estimated
average of .47 hours.
Comments concerning the accuracy
of this burden estimate and suggestions
for reducing this burden should be sent
to the Internal Revenue Service, Attn:
IRS Reports Clearance Officer, T:FP,
Washington, DC 20224, and to the
Office of Management and Budget,
Attn: Desk Officer for the Department
of the Treasury, Office of Information
and Regulatory Affairs, Washington,
DC 20503.
Books or records relating to the
collections of information must be
retained as long as their contents may
become material in the administration
of any internal revenue law. Generally,
tax returns and tax return information
are confidential, as required by 26
U.S.C. 6103.
Background
Section 1275(d) of the Internal Reve-
nue Code (Code) grants the Secretary
the authority to prescribe regulations
under the original issue discount (OID)
provisions of the Code (sections 163(e)
and 1271 through 1275), including
regulations relating to debt instruments
that provide for contingent payments.
On February 2, 1994, the IRS pub-
lished final OID regulations in the
Federal Register (59 FR 4799 [TD
8517, 1994–1 C.B. 38]). However, the
final OID regulations did not contain
rules for contingent payment debt
instruments.
On December 16, 1994, the IRS
published a notice of proposed
rulemaking in the Federal Register (59
FR 62884 [FI–59–91, 1995–1 C.B.
894]) relating to the tax treatment of
debt instruments that provide for one or
more contingent payments. The notice
also contained proposed amendments to
the regulations under sections 483
(relating to unstated interest), 1001
(relating to the amount realized on a
sale, exchange, or other disposition of
property), 1272 (relating to the accrual
of OID), 1274 (relating to debt instru-
ments issued for nonpublicly traded
property), and 1275(c) (relating to OID
information reporting requirements),
and to §1.1275–5 (relating to variable
rate debt instruments). In addition, the
notice contained proposed regulations
relating to the integration of a con-
tingent payment or variable rate debt
instrument with a related hedge. The
notice withdrew the proposed regula-
tions relating to contingent payment
debt instruments that were previously
published in the Federal Register on
April 8, 1986 (51 FR 12087), and
February 28, 1991 (56 FR 8308).
On March 16, 1995, the IRS held a
public hearing on the proposed regula-
tions. In addition, the IRS received a
number of written comments on the
proposed regulations. The proposed
regulations, with certain changes to
respond to comments, are adopted as
final regulations. In addition, certain
clarifying and conforming amendments
are made to the OID regulations that
were published in the Federal Register
on February 2, 1994. The comments
and significant changes are discussed
below.
Explanation of Provisions
Section 1.1275–4 Contingent payment
debt instruments
A. Noncontingent bond method
Under the noncontingent bond
method in the proposed regulations, a
taxpayer computes interest accruals on
a contingent payment debt instrument
by setting a payment schedule as of the
issue date and applying the OID rules
to the payment schedule. The payment
schedule consists of all fixed payments
on the debt instrument and a projected
amount for each contingent payment.
For market-based contingencies (i.e.,
contingencies for which price quotes
are readily available), the projected
amount is the forward price of the
contingency. For other contingencies,
the issuer first determines a reasonable
yield for the debt instrument and then
sets projected amounts equal to the
relative expected payments on the

SEQ 0008 JOB IRS28-003-007 PAGE-0008 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
8
contingencies so that the payment
schedule produces the reasonable yield.
These rules were designed to produce a
yield similar to the yield the issuer
would obtain on a fixed rate debt
instrument.
Commentators suggested that the
regulations could be simplified if they
used the same basic methodology for
both market-based and non-market-
based contingencies. In addition, com-
mentators suggested that forward price
quotes would be variable or manipul-
able and that taxpayers will set more
appropriate payment schedules if they
first determine yield and then set the
payment schedule to fit the yield.
The final regulations adopt these
suggestions and generally conform the
treatment of debt instruments that
provide for either market-based or non-
market-based contingent payments.
Thus, for any contingent payment debt
instrument subject to the noncontingent
bond method, a taxpayer first deter-
mines the yield on the instrument and
then sets the payment schedule to fit
the yield. The yield is determined by
the yield at which the issuer would
issue a fixed rate debt instrument with
terms and conditions similar to the
contingent payment debt instrument
(the comparable yield). Relevant terms
and conditions include the level of
subordination, term, timing of pay-
ments, and general market conditions.
For example, if a hedge is available
such that the issuer or holder could
integrate the debt instrument and the
hedge into a synthetic fixed-rate debt
instrument under the rules of §1.1275–
6, the comparable yield is the yield that
the synthetic fixed-rate debt instrument
would have. If a §1.1275–6 hedge (or
the substantial equivalent) is not avail-
able, but similar fixed rate debt instru-
ments of the issuer trade at a price that
reflects a spread above a benchmark
rate, the comparable yield is the sum of
the value of the benchmark rate on the
issue date and the spread. In all cases,
the yield must be a reasonable yield for
the issuer and may not be less than the
applicable Federal rate (AFR).
Once the comparable yield is deter-
mined, the payment schedule is set to
produce the comparable yield. The final
regulations retain the general approach
of the proposed regulations in deter-
mining the payment schedule. Thus, for
market-based payments, the projected
payment is the forward price of the
payment. For non-market-based pay-
ments, the projected payment is the
expected amount of the payment as of
the issue date.
Commentators were concerned that a
taxpayer could overstate the yield on a
contingent payment debt instrument
and, therefore, claim excess interest
deductions during the term of the in-
strument. They were particularly con-
cerned about a long-term debt instru-
ment that has non-market-based
payments because the taxpayer’s deter-
mination would be hard to verify and
any excess interest deductions would
not be recaptured for a long time.
The final regulations address this
concern by providing that the compar-
able yield for a debt instrument is
presumed to be the AFR if the
instrument provides for a non-market-
based payment and is part of an issue
that is marketed or sold in substantial
part to tax-exempt investors or other
investors for whom the treatment of the
debt instrument is not expected to have
a substantial effect on their U.S. tax
liability. A taxpayer may overcome this
presumption only with clear and con-
vincing evidence that the comparable
yield for the debt instrument should be
a specific yield that is higher than the
AFR. Appraisals and other valuations
of nonpublicly traded property cannot
be used to overcome the presumption,
nor can references to general market
rates. An issuer may, for example,
overcome the presumption by showing
that recently issued similar debt instru-
ments of the issuer trade at a price that
reflects a specific yield.
One commentator suggested that the
use of the term projected payment
schedule caused securities law prob-
lems because the issuer could be seen
as making representations to the holder
about the expected payments. The
comparable yield and projected pay-
ment schedule determined under these
regulations are for tax purposes only
and are not assurances by the issuer
with respect to the payments. The final
regulations retain the term projected
payment schedule, but an issuer may
use a different term to describe the
payment schedule (e.g., payment sched-
ule determined under §1.1275–4) if the
language used by the issuer is clear.
Under the proposed regulations, pro-
jected payments rather than actual
payments are used to determine the
adjusted issue price of a debt instru-
ment, the holder’s basis in a debt
instrument, and the amount of any
contingent payment treated as made on
the scheduled retirement of a debt
instrument. One commentator ques-
tioned the use of projected payments to
make these determinations. The ap-
proach in the proposed regulations is
appropriate, however, because a posi-
tive or negative adjustment is used to
take into account the difference be-
tween the actual amount and the
projected amount of a contingent pay-
ment. This difference would be counted
twice if the adjusted issue price, the
holder’s basis, and the amount deemed
paid on retirement were based on the
actual amount rather than the projected
amount of a contingent payment. Thus,
the approach used in the proposed
regulations is retained in the final
regulations.
B. Tax-exempt obligations
In response to comments, the rules
contained in §1.1275–4(d) relating to
tax-exempt contingent payment obliga-
tions have been revised. Under the
proposed regulations, tax-exempt obli-
gations are generally subject to the
noncontingent bond method, with the
following modifications: (1) The yield
on which interest accruals are based
may not exceed the greater of the yield
on the obligation, determined without
regard to the non-market-based con-
tingent payments, and the tax-exempt
AFR that applies to the obligation; (2)
Positive adjustments are treated as gain
from the sale or exchange of the
obligation rather than as interest; and
(3) Negative adjustments reduce the
amount of tax-exempt interest, and,
therefore, are generally not taken into
account as deductible losses. These
modifications to the noncontingent
bond method for tax-exempt obliga-
tions were added because the IRS and
Treasury believe that when a property
right is embedded in a tax-exempt
obligation it is generally inappropriate
to treat payments on the right as
interest on an obligation of a state or
political subdivision.
Several commentators suggested that
the proposed regulations relating to tax-
exempt obligations are overly restric-
tive. These commentators questioned
the reason for limiting the rate of
accrual to the tax-exempt AFR and
characterizing positive adjustments as
taxable gain rather than interest. They
also questioned the fairness of treating
negative adjustments as nondeductible
adjustments to tax-exempt interest
when positive adjustments are treated

SEQ 0009 JOB IRS28-003-007 PAGE-0009 PT 1 PGS 4-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-003
9
as taxable gain. Some of the commen-
tators suggested that, at a minimum,
the interest limitations should not apply
to contingent obligations that pay inter-
est based on interest rate formulas that
reflect the cost of funds rather than
changes in the value of embedded
property rights. Finally, commentators
noted that programs involving munici-
pal refinancings of real estate projects
(for example, low-income multi-family
housing projects) would be jeopardized
by the proposed regulations because
payments on tax-exempt obligations
issued to finance these projects are in
certain cases contingent in part on the
revenues or appreciation in value of the
project.
The IRS and Treasury continue to
believe that gain from a property right
should not be recharacterized as tax-
exempt interest merely because the
property right is embedded in a tax-
exempt obligation. The IRS and Treas-
ury nevertheless recognize that certain
types of traditional tax-exempt financ-
ings should not be subject to the
interest limitations of the proposed
regulations (e.g., financings on which
interest is computed in a manner that
relates to the cost of funds). Accord-
ingly, §1.1275–4(d) has been revised to
include a category of tax-exempt obli-
gations that will be subject to the
noncontingent bond method without the
tax-exempt interest limitations con-
tained in the proposed regulations. This
category of tax-exempt obligations in-
cludes (1) obligations that would
qualify as variable rate debt instru-
ments (VRDIs) except for the failure to
meet certain of the technical require-
ments of the VRDI definition (such as
the cap and floor limitations, or the
requirement that interest be paid or
compounded at least annually), and (2)
certain obligations issued to refinance
an obligation, the proceeds of which
were used to finance a project.
For other tax-exempt obligations, the
interest restrictions of the proposed
regulations are adopted in final form.
Section 1.1275–4(d) has been revised,
however, to provide that a negative
adjustment is treated as a taxable loss
from the sale or exchange of the
obligation, rather than as a nondeduct-
ible adjustment to tax-exempt interest.
C. Prepaid tuition plans
A number of commentators asked
whether contracts issued under state-
sponsored prepaid tuition plans are
subject to §1.1275–4. Although the
terms of the contracts vary, the con-
tracts generally are issued pursuant to a
plan created by a state to enable the
participants in the plan to save for
post-secondary education for them-
selves or other designated beneficiaries.
In addition, the plans generally provide
protection against increases in the costs
of higher education or otherwise subsi-
dize these costs, often by providing for
contingent payments that are linked to
the future costs of post-secondary
education.
T h e c o m m e n t a t o r s a r g u e t h a t
§1.1275–4 does not apply to the
contracts because the contracts are not
debt instruments for federal income tax
purposes. In addition, the commentators
argue that, even if the contracts are
debt instruments, the noncontingent
bond method would be unduly burden-
some and inappropriate for contracts of
this type.
The final regulations under §1.1275–
4 do not affect the treatment of
contracts issued pursuant to state-
sponsored prepaid tuition plans,
whether or not the contracts are debt
instruments. The final regulations, like
the proposed regulations, only apply to
debt instruments. Thus, the final reg-
ulations do not apply to contracts
issued pursuant to a plan created by a
state to enable participants to save for
post-secondary education if the con-
tracts are not debt instruments. In
addition, the final regulations provide
an exception for any debt instrument
issued pursuant to a state-sponsored
prepaid tuition plan.
This exception applies to a contract
issued pursuant to a plan or arrange-
ment if: The plan or arrangement is
created by a state statute; the plan or
arrangement has a primary objective of
enabling the participants to pay for the
costs of post-secondary education for
themselves or their designated benefici-
aries; and the contingencies under the
contract are related to such purpose.
These characteristics are intended to
describe all existing state-sponsored
prepaid tuition plans. Therefore, the
final regulations do not change the tax
treatment of a contract issued pursuant
to these plans. As a result, if the
contract is a debt instrument, the
contingent payments on the contract are
not taken into account by an individual
until the payments are made.
The exception in the final regulations
is intended to apply only to the existing
state-sponsored prepaid tuition plans
and to any future plans that are sub-
stantially similar to the existing plans.
In addition, no inference is intended as
to whether contracts issued by any
state-sponsored prepaid tuition plan are
debt instruments.
D.Debt instruments subject to
section 1274
The proposed regulations provide a
method for contingent payment debt
instruments not subject to the noncon-
tingent bond method (i.e., a non-
publicly traded debt instrument issued
in a sale or exchange of nonpublicly
traded property). Under the method, a
debt instrument’s noncontingent pay-
ments are treated as a separate debt
instrument, which is generally taxed
under the rules for noncontingent debt
instruments. The debt instrument’s con-
tingent payments are taken into account
when made. A portion of each con-
tingent payment is treated as principal,
based on the amount determined by
discounting the payment at the AFR
from the payment date to the issue
date, and the remainder is treated as
interest. Special rules are provided if a
contingent payment becomes fixed
more than 6 months before it is due.
The final regulations generally adopt
the method in the proposed regulations.
In addition, the final regulations con-
tain rules for a holder whose basis in a
debt instrument is different from the
instrument’s adjusted issue price (e.g.,
a subsequent holder).
E. Inflation-indexed bonds
The Treasury recently announced
that it was considering issuing bonds
indexed to inflation (61 FR 25164).
Depending on their ultimate structure,
the noncontingent bond method might
be inappropriate for these bonds. If the
Treasury issues these bonds, the Treas-
ury and IRS may issue regulations to
provide a simplified tax treatment for
the bonds. The treatment would require
current accrual of the inflation
component.
Other amendments to the OID
regulations
A.Alternative payment schedules
under §1.1272–1(c)
Section 1.1272–1(c) provides rules to
determine the yield and maturity of

SEQ 0011 JOB IRS28-004-005 PAGE-0010 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
10
certain debt instruments that provide
for one or more alternative payment
schedules applicable upon the occur-
rence of a contingency (or contingen-
cies), provided that the timing and
amounts of the payments that comprise
each payment schedule are known as of
the issue date. Under these rules, the
yield and maturity of a debt instrument
are generally determined by assuming
that the payments will be made under
the payment schedule most likely to
occur (based on all the facts and
circumstances as of the issue date).
Special rules are provided for uncondi-
tional options and mandatory sinking
funds.
The general rules in §1.1272–1(c)
produce a reasonable result when a
debt instrument has one stated payment
schedule that is very likely to occur
and one or more alternative payment
schedules that are unlikely to occur. In
this case, adherence to the stated
payment schedule will result in ac-
cruals on the debt instrument that
reasonably reflect the expected return
on the instrument. The rules can lead to
unreasonable results, however, if a debt
instrument provides for a stated pay-
ment schedule and one or more alterna-
tive payment schedules that differ
significantly and that have a compar-
able likelihood of occurring. In this
case, the accruals based on the payment
schedule identified as most likely to
occur could differ significantly from
the expected return on the debt instru-
ment, which would reflect all the
payment schedules and their relative
probabilities of occurrence.
Because the general rules of
§1.1272–1(c) could produce unreason-
able results, these rules have been
modified. Under the final regulations, if
a single payment schedule is signifi-
cantly more likely than not to occur,
the yield and maturity of the debt
instrument are calculated based on that
payment schedule. As a result, any
other debt instrument that provides for
an alternative payment schedule (other
than because of an unconditional option
or mandatory sinking fund) will gener-
ally be subject to the rules in §1.1275–
4 for contingent payment debt instru-
ments. The final regulations generally
retain the rules for mandatory sinking
funds and unconditional options.
B.Remote and incidental
contingencies
The proposed regulations provide
that a payment subject to a remote or
incidental contingency is not consid-
ered a contingent payment for purposes
of §1.1275–4. In response to a com-
ment, the rule relating to remote and
incidental contingencies has been
broadened, through the addition of new
§1.1275–2(h), to provide that remote
and incidental contingencies are gener-
ally ignored for purposes of sections
163(e) (other than section 163(e)(5))
and 1271 through 1275 and the regula-
tions thereunder. Thus, for example, if
an otherwise fixed payment debt instru-
ment provides for an additional pay-
ment that will be made upon the
occurrence of a contingency and there
is a remote likelihood that the con-
tingency will occur, the contingent
payment is ignored for purposes of
computing OID accruals on the instru-
ment. If the contingency occurs, how-
ever, then, solely for purposes of
sections 1272 and 1273, the debt
instrument is treated as reissued. There-
fore, OID on the debt instrument is
redetermined.
C.Definition of qualified stated
interest
The addition of the rules for remote
or incidental contingencies and the
changes to the rules for alternative
payment schedules allow simplification
of the definition of qualified stated
interest. Under §1.1273–1(c), as pub-
lished in the Federal Register on
February 2, 1994, qualified stated
interest must be unconditionally pay-
able in cash or property at least
annually at a single fixed rate. Interest
is unconditionally payable only if late
payment (other than a late payment that
occurs within a reasonable grace
period) or nonpayment is expected to
be penalized or reasonable remedies
exist to compel payment.
This definition of unconditionally
payable can be read to conflict with the
alternative payment schedule rules. For
example, if a debt instrument has two
alternative payment schedules, one
schedule can be stated as the required
payment schedule and the other sched-
ule can be stated as a penalty if the
required payments are not made. The
required payments might then be
treated as unconditionally payable and,
therefore, as being qualified stated
interest even if they would not be
qualified stated interest if treated under
the alternative payment schedule rules.
Under this treatment, if a payment is
not made, the reissuance rules of the
alternative payment schedule regime do
not apply. Holders can thus argue that
no OID would accrue with respect to
the debt instrument even though OID
would accrue if the instrument were
treated as having an alternative pay-
ment schedule and holders fully expect
any unmade payment to be made in the
future.
The remote or incidental rules in
§1.1275–2(h) provide a better mecha-
nism for determining whether a pay-
ment is qualified stated interest and
determining the treatment if no pay-
ment is made. Thus, the final regula-
tions modify the definition of uncondi-
tionally payable so that interest is
unconditionally payable only if reason-
able legal remedies exist to compel
payment or the debt instrument other-
wise provides terms and conditions that
make the likelihood of late payment
(other than a late payment that occurs
within a reasonable grace period) or
nonpayment remote. If the payment is
not made (other than because of in-
solvency, default, or similar circum-
stances), the final regulations require a
deemed reissuance for OID purposes,
which ensures that OID will accrue.
This approach should simplify the
treatment of many debt instruments and
yet ensure that OID accrues in appro-
priate circumstances.
D. OID anti-abuse rule
On February 2, 1994, the IRS
published in the Federal Register
temporary and proposed regulations
that contained an anti-abuse rule for
purposes of the OID regulations
(§1.1275–2T (59 FR 4831); §1.1275–
2(g) (59 FR 4878)). Under the anti-
abuse rule, the Commissioner can apply
or depart from the regulations under
section 163(e) or sections 1271 through
1275 as necessary to achieve a reason-
able result if a principal purpose in
structuring a debt instrument or engag-
ing in a transaction is to achieve a
result under the regulations that is
unreasonable in light of the applicable
statutes. This rule is adopted as a final
regulation with some clarifying changes
and the addition of an example to
illustrate its application to certain con-
tingent payment debt instruments.
E.Determination of issue price under
section 1274
Under the proposed regulations, the
issue price of a contingent payment

SEQ 0012 JOB IRS28-004-005 PAGE-0011 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
11
debt instrument that is subject to
section 1274 (i.e., a debt instrument
issued in exchange for nonpublicly
traded property) is determined without
taking into account the instrument’s
contingent payments. Thus, the issue
price of the debt instrument (and the
buyer’s initial basis in the property) is
limited to an amount determined by
taking into account only the noncon-
tingent payments. The buyer’s basis in
the property, however, is increased by
the amount of a contingent payment
treated as principal. This approach was
adopted primarily because it is inap-
propriate to allow a buyer a basis in
property that reflects anticipated con-
tingent payments that are uncertain in
amount. In addition, this approach
limits the ability of the buyer to
overstate interest deductions over the
term of the debt instrument. The
approach of the proposed regulations
has been adopted in the final regula-
tions for taxable debt instruments sub-
ject to section 1274. See §1.1274–2(g).
It is not appropriate, however, to
apply this approach to tax-exempt
contingent payment obligations subject
to section 1274. Because the present
value of projected contingent payments
generally is not included in the issue
price of a taxable debt instrument
subject to section 1274, the instrument
is accounted for under §1.1275–4(c).
This regime is not appropriate for tax-
exempt obligations because it does not
distinguish between tax-exempt interest
and gain attributable to an embedded
property right. Thus, in order to permit
tax-exempt obligations to be subject to
the noncontingent bond method under
§1.1275–4(b), the final regulations
provide special rules to determine the
issue price of a tax-exempt contingent
payment obligation subject to section
1274.
Under these rules, the issue price of
a tax-exempt contingent payment obli-
gation subject to section 1274 is equal
to the fair market value of the obliga-
tion on the issue date (or, in the case of
an obligation that provides for interest-
based or revenue-based payments, the
greater of the obligation’s fair market
value or stated principal amount). In
addition, the obligation is subject to the
rules of §1.1275–4(d) (the noncon-
tingent bond method for tax-exempt
contingent payment obligations) rather
than §1.1275–4(c). However, to ensure
that the buyer’s basis is the same as if
the buyer had issued a taxable debt
instrument, the final regulations limit
the buyer’s basis to the present value
of the fixed payments.
§1.1275–6 Integration rules
Commentators generally approved of
the integration rules in the proposed
regulations, and those rules are adopted
with only two significant changes.
First, the final regulations allow (but
do not require) the integration of a
hedge with a fixed rate debt instrument.
For example, a taxpayer may integrate
a fixed rate debt instrument and a swap
into a VRDI. Although the hedging
transaction regulations (§1.446–4)
cover many of these transactions, the
integration rules provide more certain
treatment. The final regulations, how-
ever, do not allow the Commissioner to
integrate a hedge with either a fixed
rate debt instrument or a VRDI that
provides for interest at a qualified
floating rate. In these cases, treating the
hedge and the debt instrument sepa-
rately is a longstanding rule that
generally clearly reflects income.
Second, in limited circumstances, the
final regulations allow a hedge to be
entered into prior to the date the
taxpayer issues or acquires the debt
instrument. In these circumstances,
however, the taxpayer must identify the
hedge as part of an integrated transac-
tion on the day the hedge is entered
into by the taxpayer. Under the final
regulations, if the hedging transaction
has not yet had any cash flows (in-
cluding amounts paid to enter into or
purchase the hedge), the integration
rules work appropriately so that any
built-in gain or loss on the hedge at the
time of integration is included over the
term of the synthetic debt instrument.
Thus, the final regulations put no
restriction on the time the hedging
transaction has to be entered into in
this case. If there have been cash flows
on the hedge, the final regulations
require the hedge to be entered into no
earlier than a date that is substantially
contemporaneous with the date on
which the debt instrument is acquired.
This approach should allow commer-
cially reasonable transactions to be
integrated without the need to create
complex rules to determine the treat-
ment of prior cash flows on the
hedging transaction.
The rules for remote and incidental
contingencies in §1.1275–2(h) apply
for purposes of the integration rules.
Thus, if there is an incidental mismatch
between a §1.1275–6 hedge and a qual-
ifying debt instrument, a taxpayer may
still integrate the hedge and the instru-
ment. The mismatch is dealt with
according to the rules for incidental
contingencies.
The final regulations also clarify the
timing of income, deductions, gains, and
losses from a hedge of a contingent
payment debt instrument not subject to
integration. Under §1.446–4, the in-
come, deductions, gains, and losses must
match the income, deductions, gains,
and losses from the debt instrument.
The final regulations clarify that gain or
loss realized on a transaction that
hedges a contingent payment on a debt
instrument subject to §1.1275–4(c) is
taken into account when the contingent
payment is taken into account under
§1.1275–4(c). This treatment does not
allow the taxpayer to change the timing
of the income, deductions, gains, and
losses from the debt instrument.
Effective Dates
In general, the final regulations apply
to debt instruments issued on or after
August 13, 1996. Section 1.1275–6
applies to a qualifying debt instrument
issued on or after August 13, 1996.
Section 1.1275–6 also applies to a
qualifying debt instrument acquired by
the taxpayer on or after August 13,
1996, if the qualifying debt instrument
is a fixed rate debt instrument or a
VRDI or if the qualifying debt instru-
ment and the §1.1275–6 hedge are
acquired by the taxpayer substantially
contemporaneously. Except as otherwise
provided in the regulations, the changes
to §1.1275–5 apply to debt instruments
issued on or after April 4, 1994.
Debt instruments issued before the
effective date of the final regulations
For a contingent payment debt in-
strument issued before August 13,
1996, a taxpayer may use any reason-
able method to account for the debt
instrument, including a method that
would have been required under the
proposed regulations when the debt
instrument was issued. However, unless
§1.1275–6 applies to the debt instru-
ment, integration is not a reasonable
method to account for the instrument.
Consent to change accounting method
The Commissioner grants consent for
a taxpayer to change its method of

SEQ 0013 JOB IRS28-004-005 PAGE-0012 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
12
accounting to follow the final regula-
tions in this document. This consent is
granted, however, only for a change for
the first taxable year in which the
taxpayer must account for a debt
instrument under the final regulations.
The change is made on a cut-off basis
(i.e., the new method only applies to
debt instruments issued on or after
August 13, 1996). Therefore, no items
of income or deduction are omitted or
duplicated, and no adjustment under
section 481 is allowed.
Special Analyses
It has been determined that this
Treasury decision is not a significant
regulatory action as defined in EO
12866. Therefore, a regulatory assess-
ment 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 Flex-
ibility Act (5 U.S.C. chapter 6) do not
apply to these regulations, and, there-
fore, a Regulatory Flexibility Analysis
is not required. Pursuant to section
7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking
preceding these regulations was submit-
ted to the Small Business Administra-
tion for comment on its impact on
small business.
Drafting Information
Several persons from the Office of
Chief Counsel and the Treasury De-
partment, including Andrew C. Kittler,
formerly of the Office of the Assistant
Chief Counsel (Financial Institutions
and Products), participated in develop-
ing these regulations.
******
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 §1.1275–2T and adding two
entries in numerical order to read as
follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.483–4 also issued under 26
U.S.C. 483(f). * * *
Section 1.1275–6 also issued under 26
U.S.C. 1275(d). * * *
Par. 2. Section 1.163–7 is amended
by adding a sentence at the end of
paragraph (a) to read as follows:
§1.163–7 Deduction for OID on
certain debt instruments.
(a)* * * To determine the amount
of interest (OID) that is deductible each
year on a debt instrument that provides
for contingent payments, see §1.1275–
4.
******
Par. 3. Section 1.446–4 is amended
by:
1.Redesignating paragraphs (a)(2)-
(ii) and (a)(2)(iii) as paragraphs (a)(2)-
(iii) and (a)(2)(iv), respectively.
2.Adding a new paragraph (a)(2)(ii).
3.Adding a sentence at the end of
paragraph (e)(4).
The additions read as follows:
§1.446–4 Hedging transactions.
(a)* * *
(2)* * *
(ii)An integrated transaction subject
to §1.1275–6;
******
(e)* * *
(4)* * * Similarly, gain or loss
realized on a transaction that hedges a
contingent payment on a debt instru-
ment subject to §1.1275–4(c) (a con-
tingent payment debt instrument issued
for nonpublicly traded property) is
taken into account when the contingent
payment is taken into account under
§1.1275–4(c).
******
§1.483–2T [Removed]
Par. 4. Section 1.483–2T is removed
effective June 14, 1996.
Par. 5. Section 1.483–4 is added to
read as follows:
§1.483–4 Contingent payments.
(a)In general. This section applies
to a contract for the sale or exchange
of property (the overall contract) if the
contract provides for one or more
contingent payments and the contract is
subject to section 483. This section
applies even if the contract provides for
adequate stated interest under §1.483–
2. If this section applies to a contract,
interest under the contract is generally
computed and accounted for using rules
similar to those that would apply if the
contract were a debt instrument subject
to §1.1275–4(c). Consequently, all non-
contingent payments under the overall
contract are treated as if made under a
separate contract, and interest accruals
on this separate contract are computed
under rules similar to those contained
in §1.1275–4(c)(3). Each contingent
payment under the overall contract is
characterized as principal and interest
under rules similar to those contained
in §1.1275–4(c)(4). However, any inter-
est, or amount treated as interest, on a
contract subject to this section is taken
into account by a taxpayer under the
taxpayer’s regular method of account-
ing (e.g., an accrual method or the cash
receipts and disbursements method).
(b)Examples. The following exam-
ples illustrate the provisions of para-
graph (a) of this section.
Example 1. Deferred payment sale with
contingent interest—(i) Facts. On December 31,
1996, A sells depreciable personal property to B.
As consideration for the sale, B issues to A a
debt instrument with a maturity date of Decem-
ber 31, 2001. The debt instrument provides for a
principal payment of $200,000 on the maturity
date, and a payment of interest on December 31
of each year, beginning in 1997, equal to a
percentage of the total gross income derived
from the property in that year. However, the total
interest payable on the debt instrument over its
entire term is limited to a maximum of $50,000.
Assume that on December 31, 1996, the short-
term applicable Federal rate is 4 percent,
compounded annually, and the mid-term applica-
ble Federal rate is 5 percent, compounded
annually.
(ii)Treatment of noncontingent payment as
separate contract. Each payment of interest is a
contingent payment. Accordingly, under para-
graph (a) of this section, for purposes of
applying section 483 to the debt instrument, the
right to the noncontingent payment of $200,000
is treated as a separate contract. The amount of
unstated interest on this separate contract is
equal to $43,295, which is the amount by which
the payment ($200,000) exceeds the present
value of the payment ($156,705), calculated
using the test rate of 5 percent, compounded
annually. The $200,000 payment is thus treated
as consisting of a payment of interest of $43,295
and a payment of principal of $156,705. The
interest is includible in A’s gross income, and
deductible by B, under their respective methods
of accounting.
(iii)Treatment of contingent payments. As-
sume that the amount of the contingent payment
that is paid on December 31, 1997, is $20,000.
Under paragraph (a) of this section, the $20,000
payment is treated as a payment of principal of
$19,231 (the present value, as of the date of sale,

SEQ 0014 JOB IRS28-004-005 PAGE-0013 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
13
of the $20,000 payment, calculated using a test
rate equal to 4 percent, compounded annually)
and a payment of interest of $769. The $769
interest payment is includible in A’s gross
income, and deductible by B, in their respective
taxable years in which the payment occurs. The
amount treated as principal gives B additional
basis in the property on December 31, 1997. The
remaining contingent payments on the debt
instrument are accounted for similarly, using a
test rate of 4 percent, compounded annually, for
the payments made on December 31, 1998, and
December 31, 1999, and a test rate of 5 percent,
compounded annually, for the payments made on
December 31, 2000, and December 31, 2001.
Example 2. Contingent stock payout—(i)
Facts. M Corporation and N Corporation each
owns one-half of the stock of O Corporation. On
December 31, 1996, pursuant to a reorganization
qualifying under section 368(a)(1)(B), M ac-
quires the one-half interest of O held by N in
exchange for 30,000 shares of M voting stock
and a non-assignable right to receive up to
10,000 additional shares of M’s voting stock
during the next 3 years, provided the net profits
of O exceed certain amounts specified in the
contract. No interest is provided for in the
contract. No additional shares are received in
1997 or in 1998. In 1999, the annual earnings of
O exceed the specified amount, and, on Decem-
ber 31, 1999, an additional 3,000 M voting
shares are transferred to N. The fair market value
of the 3,000 shares on December 31, 1999, is
$300,000. Assume that on December 31, 1996,
the short-term applicable Federal rate is 4
percent, compounded annually. M and N are
calendar year taxpayers.
(ii)Allocation of interest. Section 1274 does
not apply to the right to receive the additional
shares because the right is not a debt instrument
for federal income tax purposes. As a result, the
transfer of the 3,000 M voting shares to N is a
deferred payment subject to section 483 and a
portion of the shares is treated as unstated
interest under that section. The amount of
interest allocable to the shares is equal to the
excess of $300,000 (the fair market value of the
shares on December 31, 1999) over $266,699
(the present value of $300,000, determined by
discounting the payment at the test rate of 4
percent, compounded annually, from December
31, 1999, to December 31, 1996). As a result,
the amount of interest allocable to the payment
of the shares is $33,301 ($300,000 – $266,699).
Both M and N take the interest into account in
1999.
(c)Effective date. This section ap-
plies to sales and exchanges that occur
on or after August 13, 1996.
Par. 6. Section 1.1001–1 is amended
by revising paragraph (g) to read as
follows:
§1.1001–1 Computation of gain or
loss.
******
(g)Debt instruments issued in ex-
change for property—(1) In general. If
a debt instrument is issued in exchange
for property, the amount realized at-
tributable to the debt instrument is the
issue price of the debt instrument as
d e t e r m i n e d u n d e r § 1 . 1 2 7 3 – 2 o r
§1.1274–2, whichever is applicable. If,
however, the issue price of the debt
instrument is determined under section
1273(b)(4), the amount realized attribu-
table to the debt instrument is its stated
principal amount reduced by any un-
stated interest (as determined under
section 483).
(2)Certain debt instruments that
provide for contingent payments—(i) In
general. Paragraph (g)(1) of this sec-
tion does not apply to a debt instru-
ment subject to either §1.483–4 or
§1.1275–4(c) (certain contingent pay-
ment debt instruments issued for non-
publicly traded property).
(ii)Special rule to determine amount
realized. If a debt instrument subject to
§1.1275–4(c) is issued in exchange for
property, and the income from the
exchange is not reported under the
installment method of section 453, the
amount realized attributable to the debt
instrument is the issue price of the debt
instrument as determined under
§1.1274–2(g), increased by the fair
market value of the contingent pay-
ments payable on the debt instrument.
If a debt instrument subject to §1.483–
4 is issued in exchange for property,
and the income from the exchange is
not reported under the installment
method of section 453, the amount
realized attributable to the debt instru-
ment is its stated principal amount,
reduced by any unstated interest (as
determined under section 483), and
increased by the fair market value of
the contingent payments payable on the
debt instrument. This paragraph
(g)(2)(ii), however, does not apply to a
debt instrument if the fair market value
of the contingent payments is not
reasonably ascertainable. Only in rare
and extraordinary cases will the fair
market value of the contingent pay-
ments be treated as not reasonably
ascertainable.
(3)Coordination with section 453. If
a debt instrument is issued in exchange
for property, and the income from the
exchange is not reported under the
installment method of section 453, this
paragraph (g) applies rather than
§15a.453–1(d)(2) to determine the tax-
payer’s amount realized attributable to
the debt instrument.
(4)Effective date. This paragraph (g)
applies to sales or exchanges that occur
on or after August 13, 1996.
Par. 7. Section 1.1012–1 is amended
by revising paragraph (g) to read as
follows:
§1.1012–1 Basis of property.
******
(g)Debt instruments issued in ex-
change for property—(1) In general.
For purposes of paragraph (a) of this
section, if a debt instrument is issued
in exchange for property, the cost of
the property that is attributable to the
debt instrument is the issue price of the
debt instrument as determined under
§1.1273–2 or §1.1274–2, whichever is
applicable. If, however, the issue price
of the debt instrument is determined
under section 1273(b)(4), the cost of
the property attributable to the debt
instrument is its stated principal
amount reduced by any unstated inter-
est (as determined under section 483).
(2)Certain tax-exempt obligations.
This paragraph (g)(2) applies to a tax-
exempt obligation (as defined in sec-
tion 1275(a)(3)) that is issued in
exchange for property and that has an
issue price determined under §1.1274–
2(j) (concerning tax-exempt contingent
payment obligations and certain tax-
exempt variable rate debt instruments
subject to section 1274). Notwithstand-
ing paragraph (g)(1) of this section, if
this paragraph (g)(2) applies to a tax-
exempt obligation, for purposes of
paragraph (a) of this section, the cost
of the property that is attributable to
the obligation is the sum of the present
values of the noncontingent payments
(as determined under §1.1274–2(c)).
(3)Effective date. This paragraph (g)
applies to sales or exchanges that occur
on or after August 13, 1996.
Par. 8. Section 1.1271–0(b) is
amended by:
1.Revising the entries for para-
graphs (c)(2), (c)(3), (c)(4), and (d) of
§1.1272–1.
2.Adding an entry for paragraph
(c)(7) of §1.1272–1.
3.Revising the entry for paragraph
(g) and adding entries for paragraphs
(i) and (j) of §1.1274–2.
4.Removing the language ‘‘[Re-
served]’’ from the entry for paragraph
(g) and adding entries for paragraphs
(g), (h), (i), and (j) of §1.1275–2.
5 . R e m o v i n g t h e e n t r i e s f o r
§1.1275–2T.
6.Adding entries for §1.1275–4.
7. Adding entries for paragraphs
(a)(5) and (a)(6) of §1.1275–5.
8.Revising the entries for para-
graphs (c)(1) and (c)(5) of §1.1275–5.
9.Adding entries for §1.1275–6.

SEQ 0015 JOB IRS28-004-005 PAGE-0014 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
14
The revisions and additions read as
follows:
§1.1271–0 Original issue discount;
effective date; table of contents.
******
(b)* * *
******
§1.1272–1 Current inclusion of OID
in income.
******
(c)* * *
(2)Payment schedule that is sig-
nificantly more likely than
not to occur.
(3)Mandatory sinking fund pro-
vision.
(4)Consistency rule. [Reserved]
******
(7)Effective date.
(d)Certain debt instruments that
provide for a fixed yield.
******
§1.1274–2 Issue price of debt
instruments to which section 1274
applies.
******
(g)Treatment of contingent payment
debt instruments.
******
(i)[Reserved]
(j)Special rules for tax-exempt
obligations.
(1)Certain variable rate debt in-
struments.
(2)Contingent payment debt in-
struments.
(3)Effective date.
******
§1.1275–2 Special rules relating to
debt instruments.
******
(g)Anti-abuse rule.
(1)In general.
(2)Unreasonable result.
(3)Examples.
(4)Effective date.
(h)Remote and incidental con-
tingencies.
(1)In general.
(2)Remote contingencies.
(3)Incidental contingencies.
(4)Aggregation rule.
(5)Consistency rule.
(6)Subsequent adjustments.
(7)Effective date.
(i)[Reserved]
(j)Treatment of certain modifi-
cations.
******
§1.1275–4 Contingent payment debt
instruments.
(a)Applicability.
(1)In general.
(2)Exceptions.
(3)Insolvency and default.
(4)Convertible debt instruments.
(5)Remote and incidental con-
tingencies.
(b)Noncontingent bond method.
(1)Applicability.
(2)In general.
(3)Description of method.
(4)Comparable yield and pro-
jected payment schedule.
(5)Qualified stated interest.
(6)Adjustments.
(7)Adjusted issue price, adjusted
basis, and retirement.
(8)Character on sale, exchange,
or retirement.
(9)Operating rules.
(c)Method for debt instruments not
subject to the noncontingent
bond method.
(1)Applicability.
(2)Separation into components.
(3)Treatment of noncontingent
payments.
(4)Treatment of contingent pay-
ments.
(5)Basis different from adjusted
issue price.
(6)Treatment of a holder on
sale, exchange, or retirement.
(7)Examples.
(d)Rules for tax-exempt obligations.
(1)In general.
(2)Certain tax-exempt obliga-
tions with interest-based or
revenue-based payments
(3)All other tax-exempt obliga-
tions.
(4)Basis different from adjusted
issue price.
(e)Amounts treated as interest under
this section.
(f)Effective date.
§1.1275–5 Variable rate debt
instruments.
(a)* * *
(5)No contingent principal pay-
ments.
(6)Special rule for debt instru-
ments issued for nonpublicly
traded property.
******
(c)* * *
(1)Definition.
******
(5)Tax-exempt obligations.
******
§1.1275–6 Integration of qualifying
debt instruments.
(a)In general.
(b)Definitions.
(1)Qualifying debt instrument.
(2)Section 1.1275–6 hedge.
(3)Financial instrument.
(4)Synthetic debt instrument.
(c)Integrated transaction.
(1)Integration by taxpayer.
(2)Integration by Commissioner.
(d)Special rules for legging into
and legging out of an integrated
transaction.
(1)Legging into.
(2)Legging out.
(e)Identification requirements.
(f)Taxation of integrated transac-
tions.
(1)General rule.
(2)Issue date.
(3)Term.
(4)Issue price.
(5)Adjusted issue price.
(6)Qualified stated interest.
(7)Stated redemption price at
maturity.
(8)Source of interest income and
allocation of expense.
(9)Effectively connected in-
come.
(10)Not a short-term obligation.
(11)Special rules in the event of
integration by the Commis-
sioner.
(12)Retention of separate transac-
tion rules for certain pur-
poses.
(13) Coordination with consoli-
dated return rules.
(g)Predecessors and successors.
(h)Examples.
(i)[Reserved]
(j)Effective date.
Par. 9. Section 1.1272–1 is amended
by:
1.Revising paragraphs (b)(2)(ii), (c),
and (d).
2.Adding a sentence at the end of
paragraph (f)(2).
3.Removing the language ‘‘deter-
mining yield and maturity’’ from the
first sentence of paragraph (j) Example
5 (iii) and adding the language ‘‘sec-
tions 1272 and 1273’’ in its place.

SEQ 0016 JOB IRS28-004-005 PAGE-0015 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
15
4. Removing the language ‘‘deter-
mining yield and maturity’’ from the
second sentence of paragraph (j) Exam-
ple 7 (v) and adding the language
‘‘sections 1272 and 1273’’ in its place.
The revisions and addition read as
follows:
§1.1272–1 Current inclusion of OID
in income.
******
(b)* * *
(2)* * *
(ii)A debt instrument that provides
for contingent payments, other than a
debt instrument described in paragraph
(c) or (d) of this section or except as
provided in §1.1275–4; or
******
(c)Yield and maturity of certain
debt instruments subject to con-
tingencies—(1) Applicability. This
paragraph (c) provides rules to deter-
mine the yield and maturity of certain
debt instruments that provide for an
alternative payment schedule (or sched-
ules) applicable upon the occurrence of
a contingency (or contingencies). This
paragraph (c) applies, however, only if
the timing and amounts of the pay-
ments that comprise each payment
schedule are known as of the issue date
and the debt instrument is subject to
paragraph (c)(2), (3), or (5) of this
section. A debt instrument does not
provide for an alternative payment
schedule merely because there is a
possibility of impairment of a payment
(or payments) by insolvency, default,
or similar circumstances. See §1.1275–
4 for the treatment of a debt instrument
that provides for a contingency that is
not described in this paragraph (c). See
§1.1273–1(c) to determine whether
stated interest on a debt instrument
subject to this paragraph (c) is qualified
stated interest.
(2)Payment schedule that is signifi-
cantly more likely than not to occur. If,
based on all the facts and circum-
stances as of the issue date, a single
payment schedule for a debt instru-
ment, including the stated payment
schedule, is significantly more likely
than not to occur, the yield and
maturity of the debt instrument are
computed based on this payment
schedule.
(3)Mandatory sinking fund provi-
sion. Notwithstanding paragraph (c)(2)
of this section, if a debt instrument is
subject to a mandatory sinking fund
provision, the provision is ignored for
purposes of computing the yield and
maturity of the debt instrument if the
use and terms of the provision meet
reasonable commercial standards. For
purposes of the preceding sentence, a
mandatory sinking fund provision is a
provision that meets the following
requirements:
(i)The provision requires the issuer
to redeem a certain amount of debt
instruments in an issue prior to
maturity.
(ii)The debt instruments actually
redeemed are chosen by lot or pur-
chased by the issuer either in the open
market or pursuant to an offer made to
all holders (with any proration deter-
mined by lot).
(iii)On the issue date, the specific
debt instruments that will be redeemed
on any date prior to maturity cannot be
identified.
(4)Consistency rule. [Reserved]
(5)Treatment of certain options.
Notwithstanding paragraphs (c)(2) and
(3) of this section, the rules of this
paragraph (c)(5) determine the yield
and maturity of a debt instrument that
provides the holder or issuer with an
unconditional option or options, ex-
ercisable 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 alter-
native payment schedule or schedules
(e.g., an option to extend or an option
to call a debt instrument at a fixed
premium). Under this paragraph (c)(5),
an issuer is deemed to exercise or not
exercise an option or combination of
options in a manner that minimizes the
yield on the debt instrument, and a
holder is deemed to exercise or not
exercise an option or combination of
options in a manner that maximizes the
yield on the debt instrument. If both
the issuer and the holder have options,
the rules of this paragraph (c)(5) are
applied to the options in the order that
they may be exercised. See paragraph
(j) Example 5 through Example 8 of
this section.
(6)Subsequent adjustments. If a
contingency described in this paragraph
(c) (including the exercise of an option
described in paragraph (c)(5) of this
section) actually occurs or does not
occur, contrary to the assumption made
pursuant to this paragraph (c) (a change
in circumstances), then, solely for
purposes of sections 1272 and 1273,
the debt instrument is treated as retired
and then reissued on the date of the
change in circumstances for an amount
equal to its adjusted issue price on that
date. See paragraph (j) Example 5 and
Example 7 of this section. If, however,
the change in circumstances results in a
substantially contemporaneous pro-rata
prepayment as defined in §1.1275–
2(f)(2), the pro-rata prepayment is
treated as a payment in retirement of a
portion of the debt instrument, which
may result in gain or loss to the holder.
See paragraph (j) Example 6 and
Example 8 of this section.
(7)Effective date. This paragraph (c)
applies to debt instruments issued on or
after August 13, 1996.
(d)Certain debt instruments that
provide for a fixed yield. If a debt
instrument provides for one or more
contingent payments but all possible
payment schedules under the terms of
the instrument result in the same fixed
yield, the yield of the debt instrument
is the fixed yield. For example, the
yield of a debt instrument with princi-
pal payments that are fixed in total
amount but that are uncertain as to
time (such as a demand loan) is the
stated interest rate if the issue price of
the instrument is equal to the stated
principal amount and interest is paid or
compounded at a fixed rate over the
entire term of the instrument. This
paragraph (d) applies to debt instru-
ments issued on or after August 13,
1996.
******
(f)* * *
(2)* * * For purposes of the
preceding sentence, the last possible
date that the debt instrument could be
outstanding is determined without re-
gard to §1.1275–2(h) (relating to pay-
ments subject to remote or incidental
contingencies).
******
Par. 10. Section 1.1273–1 is
amended by:
1.Removing the language ‘‘princi-
pal payments uncertain as to time’’ in
the fourth sentence of paragraph (a)
and adding the language ‘‘a fixed
yield’’ in its place.
2.Revising paragraph (c)(1)(ii).
3.Revising paragraph (f) Example 4.
The revisions read as follows:

SEQ 0017 JOB IRS28-004-005 PAGE-0016 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
16
§1.1273–1 Definition of OID.
******
(c)* * * (1)* * *
(ii)Unconditionally payable. Interest
is unconditionally payable only if rea-
sonable legal remedies exist to compel
timely payment or the debt instrument
otherwise provides terms and condi-
tions that make the likelihood of late
payment (other than a late payment that
occurs within a reasonable grace
period) or nonpayment a remote con-
tingency (within the meaning of
§1.1275–2(h)). For purposes of the
preceding sentence, remedies or other
terms and conditions are not taken into
account if the lending transaction does
not reflect arm’s length dealing and the
holder does not intend to enforce the
remedies or other terms and conditions.
For purposes of determining whether
interest is unconditionally payable, the
possibility of nonpayment due to de-
fault, insolvency, or similar circum-
stances, or due to the exercise of a
c o n v e r s i o n o p t i o n d e s c r i b e d i n
§1.1272–1(e) is ignored. This para-
graph (c)(1)(ii) applies to debt instru-
ments issued on or after August 13,
1996.
******
(f)* * *
Example 4. Qualified stated interest on a debt
instrument that is subject to an option—(i)
Facts. On January 1, 1997, A issues, for
$100,000, a 10-year debt instrument that
provides for a $100,000 principal payment at
maturity and for annual interest payments of
$10,000. Under the terms of the debt instrument,
A has the option, exercisable on January 1, 2002,
to lower the annual interest payments to $8,000.
In addition, the debt instrument gives the holder
an unconditional right to put the debt instrument
back to A, exercisable on January 1, 2002, in
return for $100,000.
(ii)Amount of qualified stated interest. Under
paragraph (c)(2) of this section, the debt
instrument provides for qualified stated interest
to the extent of the lowest fixed rate at which
qualified stated interest would be payable under
any payment schedule. If the payment schedule
determined by assuming that the issuer’s option
will be exercised and the put option will not be
exercised were treated as the debt instrument’s
sole payment schedule, only $8,000 of each
annual interest payment would be qualified stated
interest. Under any other payment schedule, the
debt instrument would provide for annual
qualified stated interest payments of $10,000.
Accordingly, only $8,000 of each annual interest
payment is qualified stated interest. Any excess
of each annual interest payment over $8,000 is
included in the debt instrument’s stated redemp-
tion price at maturity.
******
Par. 11. Section 1.1274–2 is
amended by:
1 . R e m o v i n g t h e l a n g u a g e
‘‘§1.1272–1(c)(3)(ii)’’ from paragraph
(e) and adding the language ‘‘§1.1272–
1(c)(3)’’ in its place.
2.Revising paragraph (g).
3.Adding and reserving paragraph
(i) and adding paragraph (j).
The revisions and additions read as
follows:
§1.1274–2 Issue price of debt
instruments to which section 1274
applies.
******
(g)Treatment of contingent payment
debt instruments. Notwithstanding para-
graph (b) of this section, if a debt
instrument subject to section 1274
provides for one or more contingent
payments, the issue price of the debt
instrument is the lesser of the instru-
ment’s noncontingent principal pay-
ments and the sum of the present
values of the noncontingent payments
(as determined under paragraph (c) of
this section). However, if the debt
instrument is issued in a potentially
abusive situation, the issue price of the
debt instrument is the fair market value
of the noncontingent payments. For
additional rules relating to a debt
instrument that provides for one or
m o r e c o n t i n g e n t p a y m e n t s , s e e
§1.1275–4. This paragraph (g) applies
to debt instruments issued on or after
August 13, 1996.
******
(i)[Reserved]
(j)Special rules for tax-exempt
obligations—(1) Certain variable rate
debt instruments. Notwithstanding para-
graph (b) of this section, if a tax-
exempt obligation (as defined in sec-
tion 1275(a)(3)) is a variable rate debt
instrument (within the meaning of
§1.1275–5) that pays interest at an
objective rate and is subject to section
1274, the issue price of the obligation
is the greater of the obligation’s fair
market value and its stated principal
amount.
(2)Contingent payment debt instru-
ments. Notwithstanding paragraphs (b)
and (g) of this section, if a tax-exempt
obligation (as defined in section
1275(a)(3)) is subject to section 1274
and §1.1275–4, the issue price of the
obligation is the fair market value of
the obligation. However, in the case of
a tax-exempt obligation that is subject
to §1.1275–4(d)(2) (an obligation that
provides for interest-based or revenue-
based payments), the issue price of the
obligation is the greater of the obliga-
tion’s fair market value and its stated
principal amount.
(3)Effective date. This paragraph (j)
applies to debt instruments issued on or
after August 13, 1996.
Par. 12. Section 1.1275–2 is
amended by adding the text of para-
graph (g), adding paragraph (h), adding
and reserving paragraph (i), and adding
paragraph (j) to read as follows:
§1.1275–2 Special rules relating to
debt instruments.
******
(g)Anti-abuse rule—(1) In general.
If a principal purpose in structuring a
debt instrument or engaging in a trans-
action is to achieve a result that is
unreasonable in light of the purposes of
section 163(e), sections 1271 through
1275, or any related section of the
Code, the Commissioner can apply or
depart from the regulations under the
applicable sections as necessary or
appropriate to achieve a reasonable
result. For example, if this paragraph
(g) applies to a debt instrument that
provides for a contingent payment, the
Commissioner can treat the con-
tingency as if it were a separate
position.
(2)Unreasonable result. Whether a
result is unreasonable is determined
based on all the facts and circum-
stances. In making this determination, a
significant fact is whether the treatment
of the debt instrument is expected to
have a substantial effect on the issuer’s
or a holder’s U.S. tax liability. In the
case of a contingent payment debt
instrument, another significant fact is
whether the result is obtainable without
the application of §1.1275–4 and any
related provisions (e.g., if the debt
instrument and the contingency were
entered into separately). A result will
not be considered unreasonable, how-
ever, in the absence of an expected
substantial effect on the present value
of a taxpayer’s tax liability.
(3)Examples. The following exam-
ples illustrate the provisions of this
paragraph (g).
Example 1. A issues a current-pay, increasing-
rate note that provides for an early call option.
Although the option is deemed exercised on the
call date under §1.1272–1(c)(5), the option is not
expected to be exercised by A. In addition, a

SEQ 0018 JOB IRS28-004-005 PAGE-0017 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
17
principal purpose of including the option in the
terms of the note is to limit the amount of
interest income includible by the holder in the
period prior to the call date by virtue of the
option rules in §1.1272–1(c)(5). Moreover, the
application of the option rules is expected to
substantially reduce the present value of the
holder’s tax liability. Based on these facts, the
application of §1.1272–1(c)(5) produces an un-
reasonable result. Therefore, under this paragraph
(g), the Commissioner can apply the regulations
(in whole or in part) to the note without regard
to §1.1272–1(c)(5).
Example 2. C, a foreign corporation not
subject to U.S. taxation, issues to a U.S. holder a
debt instrument that provides for a contingent
payment. The debt instrument is issued for cash
and is subject to the noncontingent bond method
in §1.1275–4(b). Six months after issuance, C
and the holder modify the debt instrument so that
there is a deemed reissuance of the instrument
under section 1001. The new debt instrument is
subject to the rules of §1.1275–4(c) rather than
§1.1275–4(b). The application of §1.1275–4(c) is
expected to substantially reduce the present value
of the holder’s tax liability as compared to the
application of §1.1275–4(b). In addition, a
principal purpose of the modification is to
substantially reduce the present value of the
holder’s tax liability through the application of
§1.1275–4(c). Based on these facts, the applica-
tion of §1.1275–4(c) produces an unreasonable
result. Therefore, under this paragraph (g), the
Commissioner can apply the noncontingent bond
method to the modified debt instrument.
Example 3. D issues a convertible debt
instrument rather than an economically
equivalent investment unit consisting of a debt
instrument and a warrant. The convertible debt
instrument is issued at par and provides for
annual payments of interest. D issues the
convertible debt instrument rather than the
investment unit so that the debt instrument would
not have OID. See §1.1273–2(j). In general, this
is a reasonable result in light of the purposes of
the applicable statutes. Therefore, the Commis-
sioner generally will not use the authority under
this paragraph (g) to depart from the application
of §1.1273-2(j) in this case.
(4)Effective date. This paragraph (g)
applies to debt instruments issued on or
after August 13, 1996.
(h)Remote and incidental con-
tingencies—(1) In general. This para-
graph (h) applies to a debt instrument
if one or more payments on the
instrument are subject to either a
remote or incidental contingency.
Whether a contingency is remote or
incidental is determined as of the issue
date of the debt instrument, including
any date there is a deemed reissuance
of the debt instrument under paragraph
(h)(6)(ii) or (j) of this section or
§1.1272–1(c)(6). Except as otherwise
provided, the treatment of the con-
tingency under this paragraph (h) ap-
plies for all purposes of sections 163(e)
(other than section 163(e)(5)) and 1271
through 1275 and the regulations there-
under. For purposes of this paragraph
(h), the possibility of impairment of a
payment by insolvency, default, or
s i m i l a r c i r c u m s t a n c e s i s n o t a
contingency.
(2)Remote contingencies. A con-
tingency is remote if there is a remote
likelihood either that the contingency
will occur or that the contingency will
not occur. If there is a remote likeli-
hood that the contingency will occur, it
is assumed that the contingency will
not occur. If there is a remote likeli-
hood that the contingency will not
occur, it is assumed that the con-
tingency will occur.
(3)Incidental contingencies—(i)
Contingency relating to amount. A
contingency relating to the amount of a
payment is incidental if, under all
reasonably expected market conditions,
the potential amount of the payment is
insignificant relative to the total ex-
pected amount of the remaining pay-
ments on the debt instrument. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(i), the payment
is ignored until the payment is made.
However, see paragraph (h)(6)(i)(B) of
this section for the treatment of the
debt instrument if a change in circum-
stances occurs prior to the date the
payment is made.
(ii)Contingency relating to time. A
contingency relating to the timing of a
payment is incidental if, under all
reasonably expected market conditions,
the potential difference in the timing of
the payment (from the earliest date to
the latest date) is insignificant. If a
payment on a debt instrument is subject
to an incidental contingency described
in this paragraph (h)(3)(ii), the payment
is treated as made on the earliest date
that the payment could be made pur-
suant to the contingency. If the pay-
ment is not made on this date, a
taxpayer makes appropriate adjustments
to take into account the delay in
payment. However, see paragraph
(h)(6)(i)(C) of this section for the
treatment of the debt instrument if the
delay is not insignificant.
(4)Aggregation rule. For purposes
of paragraph (h)(2) of this section, if a
debt instrument provides for multiple
contingencies each of which has a
remote likelihood of occurring but,
when all of the contingencies are con-
sidered together, there is a greater than
remote likelihood that at least one of
the contingencies will occur, none of
the contingencies is treated as a remote
contingency. For purposes of paragraph
(h)(3)(i) of this section, if a debt
instrument provides for multiple con-
tingencies each of which is incidental
but the potential total amount of all of
the payments subject to the contingen-
cies is not, under reasonably expected
market conditions, insignificant relative
to the total expected amount of the
remaining payments on the debt instru-
ment, none of the contingencies is
treated as incidental.
(5)Consistency rule. For purposes
of paragraphs (h)(2) and (3) of this sec-
tion, the issuer’s determination that a
contingency is either remote or inci-
dental is binding on all holders. How-
ever, the issuer’s determination is not
binding on a holder that explicitly
discloses that its determination is dif-
ferent 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 instru-
ment. See §1.1275–2(e) for rules relat-
ing to the issuer’s obligation to disclose
certain information to holders.
(6)Subsequent adjustments—(i) Ap-
plicability. This paragraph (h)(6) ap-
plies to a debt instrument when there is
a change in circumstances. For pur-
poses of the preceding sentence, there
is a change in circumstances if—
(A)A remote contingency actually
occurs or does not occur, contrary to
the assumption made in paragraph
(h)(2) of this section;
(B)A payment subject to an inci-
dental contingency described in para-
graph (h)(3)(i) of this section becomes
fixed in an amount that is not insignifi-
cant relative to the total expected
amount of the remaining payments on
the debt instrument; or
(C)A payment subject to an inci-
dental contingency described in para-
graph (h)(3)(ii) of this section becomes
fixed such that the difference between
the assumed payment date and the due
date of the payment is not insignificant.
(ii)In general. If a change in
circumstances occurs, solely for pur-
poses of sections 1272 and 1273, the
debt instrument is treated as retired and
then reissued on the date of the change
in circumstances for an amount equal
to the instrument’s adjusted issue price
on that date.
(iii)Contingent payment debt instru-
ments. Notwithstanding paragraph

SEQ 0019 JOB IRS28-004-005 PAGE-0018 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
18
(h)(6)(ii) of this section, in the case of
a contingent payment debt instrument
subject to §1.1275–4, if a change in
circumstances occurs, no retirement or
reissuance is treated as occurring, but
any payment that is fixed as a result of
the change in circumstances is gov-
erned by the rules in §1.1275–4 that
apply when the amount of a contingent
payment becomes fixed.
(7)Effective date. This paragraph (h)
applies to debt instruments issued on or
after August 13, 1996.
(i)[Reserved]
(j)Treatment of certain modifica-
tions. If the terms of a debt instrument
are modified to defer one or more
payments, and the modification does
not cause an exchange under section
1001, then, solely for purposes of
sections 1272 and 1273, the debt in-
strument is treated as retired and then
reissued on the date of the modification
for an amount equal to the instrument’s
adjusted issue price on that date. This
paragraph (j) applies to debt instru-
ments issued on or after August 13,
1996.
§1.1275–2T [Removed]
Par. 13. Section 1.1275–2T is re-
moved effective August 13, 1996.
Par. 14. In §1.1275–3, paragraph
(b)(1)(i) is revised to read as follows:
§1.1275–3 OID information reporting
requirements.
******
(b)* * * (1)* * *
(i)Set forth on the face of the debt
instrument the issue price, the amount
of OID, the issue date, the yield to
maturity, and, in the case of a debt
instrument subject to the rules of
§1.1275–4(b), the comparable yield and
projected payment schedule; or
******
Par. 15. Section 1.1275–4 is added to
read as follows:
§1.1275–4 Contingent payment debt
instruments.
(a)Applicability—(1) In general.
Except as provided in paragraph (a)(2)
of this section, this section applies to
any debt instrument that provides for
one or more contingent payments. In
general, paragraph (b) of this section
applies to a contingent payment debt
instrument that is issued for money or
publicly traded property and paragraph
(c) of this section applies to a con-
tingent payment debt instrument that is
issued for nonpublicly traded property.
Paragraph (d) of this section provides
special rules for tax-exempt obliga-
tions. See §1.1275–6 for a taxpayer’s
treatment of a contingent payment debt
instrument and a hedge.
(2)Exceptions. This section does not
apply to—
(i)A debt instrument that has an
issue price determined under section
1273(b)(4) (e.g., a debt instrument
subject to section 483);
(ii)A variable rate debt instrument
(as defined in §1.1275–5);
(iii)A debt instrument subject to
§1.1272–1(c) (a debt instrument that
provides for certain contingencies) or
§1.1272–1(d) (a debt instrument that
provides for a fixed yield);
(iv)A debt instrument subject to
section 988 (except as provided in
section 988 and the regulations
thereunder);
(v)A debt instrument to which
section 1272(a)(6) applies (certain in-
terests in or mortgages held by a
REMIC, and certain other debt instru-
ments with payments subject to
acceleration);
(vi)A debt instrument (other than a
tax-exempt obligation) described in
section 1272(a)(2) (e.g., U.S. savings
bonds, certain loans between natural
persons, and short-term taxable obliga-
tions); or
(vii)A debt instrument issued pur-
suant to a plan or arrangement if—
(A)The plan or arrangement is
created by a state statute;
(B)A primary objective of the plan
or arrangement is to enable the partici-
pants to pay for the costs of post-
secondary education for themselves or
their designated beneficiaries; and
(C)Contingent payments on the debt
i n s t r u m e n t a r e r e l a t e d t o s u c h
objective.
(3)Insolvency and default. A pay-
ment is not contingent merely because
of the possibility of impairment by
insolvency, default, or similar cir-
cumstances.
(4)Convertible debt instruments. A
debt instrument does not provide for
contingent payments merely because it
provides for an option to convert the
debt instrument into the stock of the
issuer, into the stock or debt of a
related party (within the meaning of
section 267(b) or 707(b)(1)), or into
cash or other property in an amount
equal to the approximate value of such
stock or debt.
(5)Remote and incidental contingen-
cies. A payment is not a contingent
payment merely because of a con-
tingency that, as of the issue date, is
either remote or incidental. See
§1.1275–2(h) for the treatment of re-
mote and incidental contingencies.
(b)Noncontingent bond method—(1)
Applicability. The noncontingent bond
method described in this paragraph (b)
applies to a contingent payment debt
instrument that has an issue price
determined under §1.1273–2 (e.g., a
contingent payment debt instrument
that is issued for money or publicly
traded property).
(2)In general. Under the noncon-
tingent bond method, interest on a debt
instrument must be taken into account
whether or not the amount of any pay-
ment is fixed or determinable in the
taxable year. The amount of interest
that is taken into account for each
accrual period is determined by con-
structing a projected payment schedule
for the debt instrument and applying
rules similar to those for accruing OID
on a noncontingent debt instrument. If
the actual amount of a contingent pay-
ment is not equal to the projected
amount, appropriate adjustments are
made to reflect the difference.
(3)Description of method. The fol-
lowing steps describe how to compute
the amount of income, deductions,
gain, and loss under the noncontingent
bond method:
(i)Step one: Determine the compar-
able yield. Determine the comparable
yield for the debt instrument under the
rules of paragraph (b)(4) of this sec-
tion. The comparable yield is deter-
mined as of the debt instrument’s issue
date.
(ii)Step two: Determine the pro-
jected payment schedule. Determine the
projected payment schedule for the
debt instrument under the rules of
paragraph (b)(4) of this section. The
projected payment schedule is deter-
mined as of the issue date and remains
fixed throughout the term of the debt
instrument (except under paragraph
(b)(9)(ii) of this section, which applies
to a payment that is fixed more than 6
months before it is due).
(iii)Step three: Determine the daily
portions of interest. Determine the

SEQ 0020 JOB IRS28-004-005 PAGE-0019 PT 1 PGS 10-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-004
19
daily portions of interest on the debt
instrument for a taxable year as fol-
lows. The amount of interest that
accrues in each accrual period is the
product of the comparable yield of the
debt instrument (properly adjusted for
the length of the accrual period) and
the debt instrument’s adjusted issue
price at the beginning of the accrual
period. See paragraph (b)(7)(ii) of this
section to determine the adjusted issue
price of the debt instrument. The daily
portions of interest are determined by
allocating to each day in the accrual
period the ratable portion of the interest
that accrues in the accrual period.
Except as modified by paragraph
(b)(3)(iv) of this section, the daily
portions of interest are includible in
income by a holder for each day in the
holder’s taxable year on which the
holder held the debt instrument and are
deductible by the issuer for each day
during the issuer’s taxable year on
which the issuer was primarily liable
on the debt instrument.
(iv)Step four: Adjust the amount of
income or deductions for differences
between projected and actual con-
tingent payments. Make appropriate
adjustments to the amount of income or
deductions attributable to the debt
instrument in a taxable year for any
differences between projected and ac-
tual contingent payments. See para-
graph (b)(6) of this section to deter-
mine the amount of an adjustment and
the treatment of the adjustment.
(4)Comparable yield and projected
payment schedule. This paragraph (b)-
(4) provides rules for determining the
comparable yield and projected pay-
ment schedule for a debt instrument.
The comparable yield and projected
payment schedule must be supported by
contemporaneous documentation show-
ing that both are reasonable, are based
on reliable, complete, and accurate
data, and are made in good faith.
(i)Comparable yield—(A) In gen-
eral. Except as provided in paragraph
(b)(4)(i)(B) of this section, the compar-
able yield for a debt instrument is the
yield at which the issuer would issue a
fixed rate debt instrument with terms
and conditions similar to those of the
contingent payment debt instrument
(the comparable fixed rate debt instru-
ment), including the level of subordina-
tion, term, timing of payments, and
general market conditions. For exam-
ple, if a §1.1275–6 hedge (or the
substantial equivalent) is available, the
comparable yield is the yield on the
synthetic fixed rate debt instrument that
would result if the issuer entered into
the §1.1275–6 hedge. If a §1.1275–6
hedge (or the substantial equivalent) is
not available, but similar fixed rate
debt instruments of the issuer trade at a
price that reflects a spread above a
benchmark rate, the comparable yield is
the sum of the value of the benchmark
rate on the issue date and the spread. In
determining the comparable yield, no
adjustments are made for the riskiness
of the contingencies or the liquidity of
the debt instrument. The comparable
yield must be a reasonable yield for the
issuer and must not be less than the
applicable Federal rate (based on the
overall maturity of the debt in-
strument).
(B)Presumption for certain debt
instruments. This paragraph (b)(4)(i)(B)
applies to a debt instrument if the
instrument provides for one or more
contingent payments not based on
market information and the instrument
is part of an issue that is marketed or
sold in substantial part to persons for
whom the inclusion of interest under
this paragraph (b) is not expected to
have a substantial effect on their U.S.
t a x l i a b i l i t y . I f t h i s p a r a g r a p h
(b)(4)(i)(B) applies to a debt instru-
ment, the instrument’s comparable
yield is presumed to be the applicable
Federal rate (based on the overall
maturity of the debt instrument). A
taxpayer may overcome this presump-
tion only with clear and convincing
evidence that the comparable yield for
the debt instrument should be a specific
yield (determined using the principles
in paragraph (b)(4)(i)(A) of this sec-
tion) that is higher than the applicable
Federal rate. The presumption may not
be overcome with appraisals or other
valuations of nonpublicly traded prop-
erty. Evidence used to overcome the
presumption must be specific to the
issuer and must not be based on
comparable issuers or general market
conditions.
(ii)Projected payment schedule. The
projected payment schedule for a debt
instrument includes each noncontingent
payment and an amount for each
contingent payment determined as
follows:
(A)Market-based payments. If a
contingent payment is based on market
information (a market-based payment),
the amount of the projected payment is
the forward price of the contingent
payment. The forward price of a
contingent payment is the amount one
party would agree, as of the issue date,
to pay an unrelated party for the right
to the contingent payment on the
settlement date (e.g., the date the
contingent payment is made). For ex-
ample, if the right to a contingent
payment is substantially similar to an
exchange-traded option, the forward
price is the spot price of the option (the
option premium) compounded at the
applicable Federal rate from the issue
date to the date the contingent payment
is due.
(B)Other payments. If a contingent
payment is not based on market infor-
mation (a non-market-based payment),
the amount of the projected payment is
the expected value of the contingent
payment as of the issue date.
(C)Adjustments to the projected
payment schedule. The projected pay-
ment schedule must produce the com-
parable yield. If the projected payment
schedule does not produce the compar-
able yield, the schedule must be ad-
justed consistent with the principles of
this paragraph (b)(4) to produce the
comparable yield. For example, the
adjusted amounts of non-market-based
payments must reasonably reflect the
relative expected values of the pay-
ments and must not be set to accelerate
or defer income or deductions. If the
debt instrument contains both market-
based and non-market-based payments,
adjustments are generally made first to
the non-market-based payments be-
cause more objective information is
a v a i l a b l e f o r t h e m a r k e t - b a s e d
payments.
(iii)Market information. For pur-
poses of this paragraph (b), market
information is any information on
which an objective rate can be based
under §1.1275–5(c)(1) or (2).
(iv)Issuer/holder consistency. The
issuer’s projected payment schedule is
used to determine the holder’s interest
accruals and adjustments. The issuer
must provide the projected payment
schedule to the holder in a manner
consistent with the issuer disclosure
rules of §1.1275–2(e). If the issuer
does not create a projected payment
schedule for a debt instrument or the
issuer’s projected payment schedule is
unreasonable, the holder of the debt
instrument must determine the compar-
able yield and projected payment
schedule for the debt instrument under
the rules of this paragraph (b)(4). A
holder that determines its own pro-
jected payment schedule must explicitly

SEQ 0022 JOB IRS28-005-007 PAGE-0020 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
20
disclose this fact and the reason why
the holder set its own schedule (e.g.,
why the issuer’s projected payment
schedule is unreasonable). Unless oth-
erwise prescribed by the Commissioner,
the disclosure must be made on a
statement attached to the holder’s
timely filed federal income tax return
for the taxable year that includes the
acquisition date of the debt instrument.
( v )I s s u e r ’ s d e t e r m i n a t i o n r e -
spected—(A) In general. If the issuer
maintains the contemporaneous docu-
mentation required by this paragraph
(b)(4), the issuer’s determination of the
comparable yield and projected pay-
ment schedule will be respected unless
either is unreasonable.
(B)Unreasonable determination. For
purposes of paragraph (b)(4)(v)(A) of
this section, a comparable yield or
projected payment schedule generally
will be considered unreasonable if it is
set with a purpose to overstate, unders-
tate, accelerate, or defer interest ac-
cruals on the debt instrument. In a
determination of whether a comparable
yield or projected payment schedule is
unreasonable, consideration will be
given to whether the treatment of the
debt instrument under this section is
expected to have a substantial effect on
the issuer’s or holder’s U.S. tax lia-
bility. For example, if a taxable issuer
markets a debt instrument to a holder
not subject to U.S. taxation, the com-
parable yield will be given close
scrutiny and will not be respected
unless contemporaneous documentation
shows that the yield is not too high.
(C)Exception. Paragraph (b)(4)(v)-
(A) of this section does not apply to a
debt instrument subject to paragraph
(b)(4)(i)(B) of this section (concerning
a yield presumption for certain debt
instruments that provide for non-
market-based payments).
(vi)Examples. The following exam-
ples illustrate the provisions of this
paragraph (b)(4). In each example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Market-based payment—(i) Facts.
On December 31, 1996, X corporation issues for
$1,000,000 a debt instrument that matures on
December 31, 2006. The debt instrument pro-
vides for annual payments of interest, beginning
in 1997, at the rate of 6 percent and for a
payment at maturity equal to $1,000,000 plus the
excess, if any, of the price of 10,000 shares of
publicly traded stock in an unrelated corporation
on the maturity date over $350,000, or less the
excess, if any, of $350,000 over the price of
10,000 shares of the stock on the maturity date.
On the issue date, the forward price to purchase
10,000 shares of the stock on December 31,
2006, is $350,000.
(ii)Comparable yield. Under paragraph
(b)(4)(i) of this section, the debt instrument’s
comparable yield is the yield on the synthetic
debt instrument that would result if X corpora-
tion entered into a §1.1275–6 hedge. A §1.1275–
6 hedge in this case is a forward contract to
purchase 10,000 shares of the stock on December
31, 2006. If X corporation entered into this
hedge, the resulting synthetic debt instrument
would yield 6 percent, compounded annually.
Thus, the comparable yield on the debt instru-
ment is 6 percent, compounded annually.
(iii)Projected payment schedule. Under para-
graph (b)(4)(ii) of this section, the projected
payment schedule for the debt instrument con-
sists of 10 annual payments of $60,000 and a
projected amount for the contingent payment at
maturity. Because the right to the contingent
payment is based on market information, the
projected amount of the contingent payment is
the forward price of the payment. The right to
the contingent payment is substantially similar to
a right to a payment of $1,000,000 combined
with a cash-settled forward contract for the
purchase of 10,000 shares of the stock for
$350,000 on December 31, 2006. Because the
forward price to purchase 10,000 shares of the
stock on December 31, 2006, is $350,000, the
amount to be received or paid under the forward
contract is projected to be zero. As a result, the
projected amount of the contingent payment at
maturity is $1,000,000, consisting of the
$1,000,000 base amount and no additional
amount to be received or paid under the forward
contract.
(A)Assume, alternatively, that on the issue
date the forward price to purchase 10,000 shares
of the stock on December 31, 2006, is $370,000.
If X corporation entered into a §1.1275–6 hedge
(a forward contract to purchase the shares for
$370,000), the resulting synthetic debt instrument
would yield 6.15 percent, compounded annually.
Thus, the comparable yield on the debt instru-
ment is 6.15 percent, compounded annually. The
projected payment schedule for the debt instru-
ment consists of 10 annual payments of $60,000
and a projected amount for the contingent
payment at maturity. The projected amount of
the contingent payment is $1,020,000, consisting
of the $1,000,000 base amount plus the excess
$20,000 of the forward price of the stock over
the purchase price of the stock under the forward
contract.
(B)Assume, alternatively, that on the issue
date the forward price to purchase 10,000 shares
of the stock on December 31, 2006, is $330,000.
If X corporation entered into a §1.1275–6 hedge,
the resulting synthetic debt instrument would
yield 5.85 percent, compounded annually. Thus,
the comparable yield on the debt instrument is
5.85 percent, compounded annually. The pro-
jected payment schedule for the debt instrument
consists of 10 annual payments of $60,000 and a
projected amount for the contingent payment at
maturity. The projected amount of the contingent
payment is $980,000, consisting of the
$1,000,000 base amount minus the excess
$20,000 of the purchase price of the stock under
the forward contract over the forward price of
the stock.
Example 2. Non-market-based payments—(i)
Facts. On December 31, 1996, Y issues to Z for
$1,000,000 a debt instrument that matures on
December 31, 2000. The debt instrument has a
stated principal amount of $1,000,000, payable at
maturity, and provides for payments on Decem-
ber 31 of each year, beginning in 1997, of
$20,000 plus 1 percent of Y’s gross receipts, if
any, for the year. On the issue date, Y has
outstanding fixed rate debt instruments with
maturities of 2 to 10 years that trade at a price
that reflects an average of 100 basis points over
Treasury bonds. These debt instruments have
terms and conditions similar to those of the debt
instrument. Assume that on December 31, 1996,
4-year Treasury bonds have a yield of 6.5
percent, compounded annually, and that no
§1.1275–6 hedge is available for the debt
instrument. In addition, assume that the interest
inclusions attributable to the debt instrument are
expected to have a substantial effect on Z’s U.S.
tax liability.
(ii)Comparable yield. The comparable yield
for the debt instrument is equal to the value of
the benchmark rate (i.e., the yield on 4-year
Treasury bonds) on the issue date plus the
spread. Thus, the debt instrument’s comparable
yield is 7.5 percent, compounded annually.
(iii)Projected payment schedule. Y anticipates
that it will have no gross receipts in 1997, but
that it will have gross receipts in later years, and
those gross receipts will grow each year for the
next three years. Based on its business projec-
tions, Y believes that it is not unreasonable to
expect that its gross receipts in 1999 and each
year thereafter will grow by between 6 percent
and 13 percent over the prior year. Thus, Y must
take these expectations into account in establish-
ing a projected payment schedule for the debt
instrument that results in a yield of 7.5 percent,
compounded annually. Accordingly, Y could
reasonably set the following projected payment
schedule for the debt instrument:
DateNoncontingent
payment
Contingent
payment
12/31/1997$ 20,000$ 0
12/31/199820,00070,000
12/31/199920,00075,600
12/31/20001,020,00083,850
(5)Qualified stated interest. No
amounts payable on a debt instrument
to which this paragraph (b) applies are
qualified stated interest within the
meaning of §1.1273–1(c).
(6)Adjustments. This paragraph
(b)(6) provides rules for the treatment
of positive and negative adjustments
under the noncontingent bond method.
A taxpayer takes into account only
those adjustments that occur during a
taxable year while the debt instrument
is held by the taxpayer or while the
taxpayer is primarily liable on the debt
instrument.
(i)Determination of positive and
negative adjustments. If the amount of
a contingent payment is more than the
projected amount of the contingent
payment, the difference is a positive
adjustment on the date of the payment.

SEQ 0023 JOB IRS28-005-007 PAGE-0021 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
21
If the amount of a contingent payment
is less than the projected amount of the
contingent payment, the difference is a
negative adjustment on the date of the
payment (or on the scheduled date of
the payment if the amount of the
payment is zero).
(ii)Treatment of net positive adjust-
ments. The amount, if any, by which
total positive adjustments on a debt
instrument in a taxable year exceed the
total negative adjustments on the debt
instrument in the taxable year is a net
positive adjustment. A net positive
adjustment is treated as additional
interest for the taxable year.
(iii)Treatment of net negative ad-
justments. The amount, if any, by
which total negative adjustments on a
debt instrument in a taxable year
exceed the total positive adjustments on
the debt instrument in the taxable year
is a net negative adjustment. A tax-
payer’s net negative adjustment on a
debt instrument for a taxable year is
treated as follows:
(A)Reduction of interest accruals.
A net negative adjustment first reduces
interest for the taxable year that the
taxpayer would otherwise account for
on the debt instrument under paragraph
(b)(3)(iii) of this section.
(B)Ordinary income or loss. If the
net negative adjustment exceeds the
interest for the taxable year that the
taxpayer would otherwise account for
on the debt instrument under paragraph
(b)(3)(iii) of this section, the excess is
treated as ordinary loss by a holder and
ordinary income by an issuer. How-
ever, the amount treated as ordinary
loss by a holder is limited to the
amount by which the holder’s total
interest inclusions on the debt instru-
ment exceed the total amount of the
holder’s net negative adjustments
treated as ordinary loss on the debt
instrument in prior taxable years. The
amount treated as ordinary income by
an issuer is limited to the amount by
which the issuer’s total interest deduc-
tions on the debt instrument exceed the
total amount of the issuer’s net nega-
tive adjustments treated as ordinary
income on the debt instrument in prior
taxable years.
(C)Carryforward. If the net nega-
tive adjustment exceeds the sum of the
amounts treated by the taxpayer as a
reduction of interest and as ordinary
income or loss (as the case may be) on
the debt instrument for the taxable
year, the excess is a negative adjust-
ment carryforward for the taxable year.
In general, a taxpayer treats a negative
adjustment carryforward for a taxable
year as a negative adjustment on the
debt instrument on the first day of the
succeeding taxable year. However, if a
holder of a debt instrument has a
negative adjustment carryforward on
the debt instrument in a taxable year in
which the debt instrument is sold,
exchanged, or retired, the negative
adjustment carryforward reduces the
holder’s amount realized on the sale,
exchange, or retirement. If an issuer of
a debt instrument has a negative
adjustment carryforward on the debt
instrument for a taxable year in which
the debt instrument is retired, the issuer
takes the negative adjustment carryfor-
ward into account as ordinary income.
(D)Treatment under section 67. A
net negative adjustment is not subject
to section 67 (the 2-percent floor on
miscellaneous itemized deductions).
(iv)Cross-references. If a holder has
a basis in a debt instrument that is
different from the debt instrument’s
adjusted issue price, the holder may
have additional positive or negative
adjustments under paragraph (b)(9)(i)
of this section. If the amount of a
contingent payment is fixed more than
6 months before the date it is due, the
amount and timing of the adjustment
are determined under paragraph
(b)(9)(ii) of this section.
(7)Adjusted issue price, adjusted
basis, and retirement—(i) In general. If
a debt instrument is subject to the
noncontingent bond method, this para-
graph (b)(7) provides rules to deter-
mine the adjusted issue price of the
debt instrument, the holder’s basis in
the debt instrument, and the treatment
of any scheduled or unscheduled retire-
ments. In general, because any dif-
ference between the actual amount of a
contingent payment and the projected
amount of the payment is taken into
account as an adjustment to income or
deduction, the projected payments are
treated as the actual payments for
purposes of making adjustments to
issue price and basis and determining
the amount of any contingent payment
made on a scheduled retirement.
(ii)Definition of adjusted issue
price. The adjusted issue price of a
debt instrument is equal to the debt
instrument’s issue price, increased by
the interest previously accrued on the
debt instrument under paragraph
(b)(3)(iii) of this section (determined
without regard to any adjustments
taken into account under paragraph
(b)(3)(iv) of this section), and de-
creased by the amount of any noncon-
tingent payment and the projected
amount of any contingent payment
previously made on the debt instru-
ment. See paragraph (b)(9)(ii) of this
section for special rules that apply
when a contingent payment is fixed
more than 6 months before it is due.
(iii)Adjustments to basis. A holder’s
basis in a debt instrument is increased
by the interest previously accrued by
the holder on the debt instrument under
paragraph (b)(3)(iii) of this section
(determined without regard to any
adjustments taken into account under
paragraph (b)(3)(iv) of this section),
and decreased by the amount of any
noncontingent payment and the pro-
jected amount of any contingent pay-
ment previously made on the debt
instrument to the holder. See paragraph
(b)(9)(i) of this section for special rules
that apply when basis is different from
adjusted issue price and paragraph
(b)(9)(ii) of this section for special
rules that apply when a contingent
payment is fixed more than 6 months
before it is due.
(iv)Scheduled retirements. For pur-
poses of determining the amount real-
ized by a holder and the repurchase
price paid by the issuer on the sched-
uled retirement of a debt instrument, a
holder is treated as receiving, and the
issuer is treated as paying, the pro-
jected amount of any contingent pay-
ment due at maturity. If the amount
paid or received is different from the
projected amount, see paragraph (b)(6)
of this section for the treatment of the
difference by the taxpayer. Under para-
graph (b)(6)(iii)(C) of this section, the
amount realized by a holder on the
retirement of a debt instrument is
reduced by any negative adjustment
carryforward determined in the taxable
year of the retirement.
(v)Unscheduled retirements. An un-
scheduled retirement of a debt instru-
ment (or the receipt of a pro-rata
prepayment that is treated as a retire-
ment of a portion of a debt instrument
under §1.1275-2(f)) is treated as a
repurchase of the debt instrument (or a
pro-rata portion of the debt instrument)
by the issuer from the holder for the
amount paid by the issuer to the holder.
(vi)Examples. The following exam-
ples illustrate the provisions of para-
graphs (b)(6) and (7) of this section. In

SEQ 0024 JOB IRS28-005-007 PAGE-0022 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
22
each example, assume that the instru-
ment described is a debt instrument for
federal income tax purposes. No in-
ference is intended, however, as to
whether the instrument is a debt
instrument for federal income tax
purposes.
Example 1. Treatment of positive and negative
adjustments—(i) Facts. On December 31, 1996,
Z, a calendar year taxpayer, purchases a debt
instrument subject to this paragraph (b) at
original issue for $1,000. The debt instrument’s
comparable yield is 10 percent, compounded
annually, and the projected payment schedule
provides for payments of $500 on December 31,
1997 (consisting of a noncontingent payment of
$375 and a projected amount of $125) and $660
on December 31, 1998 (consisting of a noncon-
tingent payment of $600 and a projected amount
of $60). The debt instrument is a capital asset in
the hands of Z.
(ii)Adjustment in 1997. Based on the pro-
jected payment schedule, Z’s total daily portions
of interest on the debt instrument are $100 for
1997 (issue price of $1,000 x 10 percent).
Assume that the payment actually made on
December 31, 1997, is $375, rather than the
projected $500. Under paragraph (b)(6)(i) of this
section, Z has a negative adjustment of $125 on
December 31, 1997, attributable to the difference
between the amount of the actual payment and
the amount of the projected payment. Because Z
has no positive adjustments for 1997, Z has a net
negative adjustment of $125 on the debt
instrument for 1997. This net negative adjust-
ment reduces to zero the $100 total daily
portions of interest Z would otherwise include in
income in 1997. Accordingly, Z has no interest
income on the debt instrument for 1997. Because
Z had no interest inclusions on the debt
instrument for prior taxable years, the remaining
$25 of the net negative adjustment is a negative
adjustment carryforward for 1997 that results in
a negative adjustment of $25 on January 1, 1998.
(iii)Adjustment to issue price and basis. Z’s
total daily portions of interest on the debt
instrument are $100 for 1997. The adjusted issue
price of the debt instrument and Z’s adjusted
basis in the debt instrument are increased by this
amount, despite the fact that Z does not include
this amount in income because of the net
negative adjustment for 1997. In addition, the
adjusted issue price of the debt instrument and
Z’s adjusted basis in the debt instrument are
decreased on December 31, 1997, by the
projected amount of the payment on that date
($500). Thus, on January 1, 1998, Z’s adjusted
basis in the debt instrument and the adjusted
issue price of the debt instrument are $600.
(iv)Adjustments in 1998. Based on the pro-
jected payment schedule, Z’s total daily portions
of interest are $60 for 1998 (adjusted issue price
of $600 3 10 percent). Assume that the payment
actually made on December 31, 1998, is $700,
rather than the projected $660. Under paragraph
(b)(6)(i) of this section, Z has a positive
adjustment of $40 on December 31, 1998,
attributable to the difference between the amount
of the actual payment and the amount of the
projected payment. Because Z also has a
negative adjustment of $25 on January 1, 1998,
Z has a net positive adjustment of $15 on the
debt instrument for 1998 (the excess of the $40
positive adjustment over the $25 negative adjust-
ment). As a result, Z has $75 of interest income
on the debt instrument for 1998 (the $15 net
positive adjustment plus the $60 total daily
portions of interest that are taken into account by
Z in that year).
(v)Retirement. Based on the projected pay-
ment schedule, Z’s adjusted basis in the debt
instrument immediately before the payment at
maturity is $660 ($600 plus $60 total daily
portions of interest for 1998). Even though Z
receives $700 at maturity, for purposes of
determining the amount realized by Z on
retirement of the debt instrument, Z is treated as
receiving the projected amount of the contingent
payment on December 31, 1998. Therefore, Z is
treated as receiving $660 on December 31, 1998.
Because Z’s adjusted basis in the debt instrument
immediately before its retirement is $660, Z
recognizes no gain or loss on the retirement.
Example 2. Negative adjustment carryforward
for year of sale—(i) Facts. Assume the same
facts as in Example 1 of this paragraph
(b)(7)(vi), except that Z sells the debt instrument
on January 1, 1998, for $630.
(ii)Gain on sale. On the date the debt
instrument is sold, Z’s adjusted basis in the debt
instrument is $600. Because Z has a negative
adjustment of $25 on the debt instrument on
January 1, 1998, and has no positive adjustments
on the debt instrument in 1998, Z has a net
negative adjustment for 1998 of $25. Because Z
has not included in income any interest on the
debt instrument, the entire $25 net negative
adjustment is a negative adjustment carryforward
for the taxable year of the sale. Under paragraph
(b)(6)(iii)(C) of this section, the $25 negative
adjustment carryforward reduces the amount
realized by Z on the sale of the debt instrument
from $630 to $605. Thus, Z has a gain on the
sale of $5 ($605 – $600). Under paragraph
(b)(8)(i) of this section, the gain is treated as
interest income.
Example 3. Negative adjustment carryforward
for year of retirement—(i) Facts. Assume the
same facts as in Example 1 of this paragraph
(b)(7)(vi), except that the payment actually made
on December 31, 1998, is $615, rather than the
projected $660.
(ii)Adjustments in 1998. Under paragraph
(b)(6)(i) of this section, Z has a negative
adjustment of $45 on December 31, 1998,
attributable to the difference between the amount
of the actual payment and the amount of the
projected payment. In addition, Z has a negative
adjustment of $25 on January 1, 1998. See
Example 1 (ii) of this paragraph (b)(7)(vi).
Because Z has no positive adjustments in 1998,
Z has a net negative adjustment of $70 for 1998.
This net negative adjustment reduces to zero the
$60 total daily portions of interest Z would
otherwise include in income for 1998. Therefore,
Z has no interest income on the debt instrument
for 1998. Because Z had no interest inclusions
on the debt instrument for 1997, the remaining
$10 of the net negative adjustment is a negative
adjustment carryforward for 1998 that reduces
the amount realized by Z on retirement of the
debt instrument.
(iii)Loss on retirement. Immediately before
the payment at maturity, Z’s adjusted basis in the
debt instrument is $660. Under paragraph
(b)(7)(iv) of this section, Z is treated as receiving
the projected amount of the contingent payment,
or $660, as the payment at maturity. Under
paragraph (b)(6)(iii)(C) of this section, however,
this amount is reduced by any negative adjust-
ment carryforward determined for the taxable
year of retirement to calculate the amount Z
realizes on retirement of the debt instrument.
Thus, Z has a loss of $10 on the retirement of
the debt instrument, equal to the amount by
which Z’s adjusted basis in the debt instrument
($660) exceeds the amount Z realizes on the
retirement of the debt instrument ($660 minus
the $10 negative adjustment carryforward). Un-
der paragraph (b)(8)(ii) of this section, the loss is
a capital loss.
(8)Character on sale, exchange, or
retirement—(i) Gain. Any gain recog-
nized by a holder on the sale, ex-
change, or retirement of a debt
instrument subject to this paragraph (b)
is interest income.
(ii)Loss. Any loss recognized by a
holder on the sale, exchange, or retire-
ment of a debt instrument subject to
this paragraph (b) is ordinary loss to
the extent that the holder’s total interest
inclusions on the debt instrument ex-
ceed the total net negative adjustments
on the debt instrument the holder took
into account as ordinary loss. Any
additional loss is treated as loss from
the sale, exchange, or retirement of the
debt instrument. However, any loss that
would otherwise be ordinary under this
paragraph (b)(8)(ii) and that is attribu-
table to the holder’s basis that could
not be amortized under section
171(b)(4) is loss from the sale, ex-
change, or retirement of the debt
instrument.
(iii)Special rule if there are no
remaining contingent payments on the
debt instrument—(A) In general. Not-
withstanding paragraphs (b)(8)(i) and
(ii) of this section, if, at the time of the
sale, exchange, or retirement of the
debt instrument, there are no remaining
contingent payments due on the debt
instrument under the projected payment
schedule, any gain or loss recognized
by the holder is gain or loss from the
sale, exchange, or retirement of the
debt instrument. See paragraph (b)-
(9)(ii) of this section to determine
whether there are no remaining con-
tingent payments on a debt instrument
that provides for fixed but deferred
contingent payments.
(B)Exception for certain positive
adjustments. Notwithstanding paragraph
(b)(8)(iii)(A) of this section, if a
positive adjustment on a debt instru-
ment is spread under paragraph (b)(9)-
(ii)(F) or (G) of this section, any gain
recognized by the holder on the sale,
exchange, or retirement of the instru-
ment is treated as interest income to
the extent of the positive adjustment
that has not yet been accrued and
included in income by the holder.

SEQ 0025 JOB IRS28-005-007 PAGE-0023 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
23
(iv)Examples. The following exam-
ples illustrate the provisions of this
paragraph (b)(8). In each example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example 1. Gain on sale—(i) Facts. On
January 1, 1998, D, a calendar year taxpayer,
sells a debt instrument that is subject to
paragraph (b) of this section for $1,350. The
projected payment schedule for the debt instru-
ment provides for contingent payments after
January 1, 1998. On January 1, 1998, D has an
adjusted basis in the debt instrument of $1,200.
In addition, D has a negative adjustment carry-
forward of $50 for 1997 that, under paragraph
(b)(6)(iii)(C) of this section, results in a negative
adjustment of $50 on January 1, 1998. D has no
positive adjustments on the debt instrument on
January 1, 1998.
(ii)Character of gain. Under paragraph (b)(6)
of this section, the $50 negative adjustment on
January 1, 1998, results in a negative adjustment
carryforward for 1998, the taxable year of the
sale of the debt instrument. Under paragraph
(b)(6)(iii)(C) of this section, the negative adjust-
ment carryforward reduces the amount realized
by D on the sale of the debt instrument from
$1,350 to $1,300. As a result, D realizes a $100
gain on the sale of the debt instrument, equal to
the $1,300 amount realized minus D’s $1,200
adjusted basis in the debt instrument. Under
paragraph (b)(8)(i) of this section, the gain is
interest income to D.
Example 2. Loss on sale—(i) Facts. On
December 31, 1996, E, a calendar year taxpayer,
purchases a debt instrument at original issue for
$1,000. The debt instrument is a capital asset in
the hands of E. The debt instrument provides for
a single payment on December 31, 1998 (the
maturity date of the instrument), of $1,000 plus
an amount based on the increase, if any, in the
price of a specified commodity over the term of
the instrument. The comparable yield for the debt
instrument is 9.54 percent, compounded an-
nually, and the projected payment schedule
provides for a payment of $1,200 on December
31, 1998. Based on the projected payment
schedule, the total daily portions of interest are
$95 for 1997 and $105 for 1998.
(ii)Ordinary loss. Assume that E sells the
debt instrument for $1,050 on December 31,
1997. On that date, E has an adjusted basis in the
debt instrument of $1,095 ($1,000 original basis,
plus total daily portions of $95 for 1997).
Therefore, E realizes a $45 loss on the sale of
the debt instrument ($1,050 – $1,095). The loss
is ordinary to the extent E’s total interest
inclusions on the debt instrument ($95) exceed
the total net negative adjustments on the
instrument that E took into account as an
ordinary loss. Because E has not had any net
negative adjustments on the debt instrument, the
$45 loss is an ordinary loss.
(iii)Capital loss. Alternatively, assume that E
sells the debt instrument for $990 on December
31, 1997. E realizes a $105 loss on the sale of
the debt instrument ($990 – $1,095). The loss is
ordinary to the extent E’s total interest inclusions
on the debt instrument ($95) exceed the total net
negative adjustments on the instrument that E
took into account as an ordinary loss. Because E
has not had any net negative adjustments on the
debt instrument, $95 of the $105 loss is an
ordinary loss. The remaining $10 of the $105
loss is a capital loss.
(9)Operating rules. The rules of
this paragraph (b)(9) apply to a debt
instrument subject to the noncontingent
bond method notwithstanding any other
rule of this paragraph (b).
(i)Basis different from adjusted is-
sue price. This paragraph (b)(9)(i)
provides rules for a holder whose basis
in a debt instrument is different from
the adjusted issue price of the debt
instrument (e.g., a subsequent holder
that purchases the debt instrument for
more or less than the instrument’s
adjusted issue price).
(A)General rule. The holder ac-
crues interest under paragraph (b)-
(3)(iii) of this section and makes
adjustments under paragraph (b)(3)(iv)
of this section based on the projected
payment schedule determined as of the
issue date of the debt instrument.
However, upon acquiring the debt
instrument, the holder must reasonably
allocate any difference between the
adjusted issue price and the basis to
daily portions of interest or projected
payments over the remaining term of
the debt instrument. Allocations are
taken into account under paragraphs
(b)(9)(i)(B) and (C) of this section.
(B)Basis greater than adjusted issue
price. If the holder’s basis in the debt
instrument exceeds the debt instru-
ment’s adjusted issue price, the amount
of the difference allocated to a daily
portion of interest or to a projected
payment is treated as a negative
adjustment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s
adjusted basis in the debt instrument is
reduced by the amount the holder treats
as a negative adjustment under this
paragraph (b)(9)(i)(B). See paragraph
(b)(9)(ii)(E) of this section for a special
rule that applies when a contingent
payment is fixed more than 6 months
before it is due.
(C)Basis less than adjusted issue
price. If the holder’s basis in the debt
instrument is less than the debt instru-
ment’s adjusted issue price, the amount
of the difference allocated to a daily
portion of interest or to a projected
payment is treated as a positive adjust-
ment on the date the daily portion
accrues or the payment is made. On the
date of the adjustment, the holder’s
adjusted basis in the debt instrument is
increased by the amount the holder
treats as a positive adjustment under
this paragraph (b)(9)(i)(C). See para-
graph (b)(9)(ii)(E) of this section for a
special rule that applies when a con-
tingent payment is fixed more than 6
months before it is due.
(D)Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1272(a)(7), 1276, and 1281 do not
apply. Other rules of those sections,
such as section 171(b)(4), continue to
apply to the extent relevant.
(E)Safe harbor for exchange listed
debt instruments. If the debt instrument
is exchange listed property (within the
meaning of §1.1273–2(f)(2)), it is
reasonable for the holder to allocate
any difference between the holder’s
basis and the adjusted issue price of the
debt instrument pro-rata to daily por-
tions of interest (as determined under
paragraph (b)(3)(iii) of this section)
over the remaining term of the debt
instrument. A pro-rata allocation is not
reasonable, however, to the extent the
holder’s yield on the debt instrument,
determined after taking into account the
amounts allocated under this paragraph
(b)(9)(i)(E), is less than the applicable
Federal rate for the instrument. For
purposes of the preceding sentence, the
applicable Federal rate for the debt
instrument is determined as if the
purchase date were the issue date and
the remaining term of the instrument
were the term of the instrument.
(F)Examples. The following exam-
ples illustrate the provisions of this
paragraph (b)(9)(i). In each example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes. In addition, assume that
each instrument is not exchange listed
property.
Example 1. Basis greater than adjusted issue
price—(i) Facts. On July 1, 1998, Z purchases
for $1,405 a debt instrument that matures on
December 31, 1999, and promises to pay on the
maturity date $1,000 plus the increase, if any, in
the price of a specified amount of a commodity
from the issue date to the maturity date. The debt
instrument was originally issued on December
31, 1996, for an issue price of $1,000. The
comparable yield for the debt instrument is 10.25
percent, compounded semiannually, and the
projected payment schedule for the debt instru-
ment (determined as of the issue date) provides
for a single payment at maturity of $1,350. At
the time of the purchase, the debt instrument has

SEQ 0026 JOB IRS28-005-007 PAGE-0024 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
24
an adjusted issue price of $1,162, assuming
semiannual accrual periods ending on December
31 and June 30 of each year. The increase in the
value of the debt instrument over its adjusted
issue price is due to an increase in the expected
amount of the contingent payment and not to a
decrease in market interest rates. The debt
instrument is a capital asset in the hands of Z. Z
is a calendar year taxpayer.
(ii)Allocation of the difference between basis
and adjusted issue price. Z’s basis in the debt
instrument on July 1, 1998, is $1,405. Under
paragraph (b)(9)(i)(A) of this section, Z allocates
the $243 difference between basis ($1,405) and
adjusted issue price ($1,162) to the contingent
payment at maturity. Z’s allocation of the
difference between basis and adjusted issue price
is reasonable because the increase in the value of
the debt instrument over its adjusted issue price
is due to an increase in the expected amount of
the contingent payment.
(iii)Treatment of debt instrument for 1998.
Based on the projected payment schedule, $60 of
interest accrues on the debt instrument from July
1, 1998 to December 31, 1998 (the product of
the debt instrument’s adjusted issue price on July
1, 1998 ($1,162) and the comparable yield
properly adjusted for the length of the accrual
period (10.25 percent/2)). Z has no net negative
or positive adjustments for 1998. Thus, Z
includes in income $60 of total daily portions of
interest for 1998. On December 31, 1998, Z’s
adjusted basis in the debt instrument is $1,465
($1,405 original basis, plus total daily portions of
$60 for 1998).
(iv)Effect of allocation to contingent payment
at maturity. Assume that the payment actually
made on December 31, 1999, is $1,400, rather
than the projected $1,350. Thus, under paragraph
(b)(6)(i) of this section, Z has a positive
adjustment of $50 on December 31, 1999. In
addition, under paragraph (b)(9)(i)(B) of this
section, Z has a negative adjustment of $243 on
December 31, 1999, which is attributable to the
difference between Z’s basis in the debt instru-
ment on July 1, 1998, and the instrument’s
adjusted issue price on that date. As a result, Z
has a net negative adjustment of $193 for 1999.
This net negative adjustment reduces to zero the
$128 total daily portions of interest Z would
otherwise include in income in 1999. Accord-
ingly, Z has no interest income on the debt
instrument for 1999. Because Z had $60 of
interest inclusions for 1998, $60 of the remaining
$65 net negative adjustment is treated by Z as an
ordinary loss for 1999. The remaining $5 of the
net negative adjustment is a negative adjustment
carryforward for 1999 that reduces the amount
realized by Z on the retirement of the debt
instrument from $1,350 to $1,345.
(v)Loss at maturity. On December 31, 1999,
Z’s basis in the debt instrument is $1,350
($1,405 original basis, plus total daily portions of
$60 for 1998 and $128 for 1999, minus the
negative adjustment of $243). As a result, Z
realizes a loss of $5 on the retirement of the debt
instrument (the difference between the amount
realized on the retirement ($1,345) and Z’s
adjusted basis in the debt instrument ($1,350)).
Under paragraph (b)(8)(ii) of this section, the $5
loss is treated as loss from the retirement of the
debt instrument. Consequently, Z realizes a total
loss of $65 on the debt instrument for 1999 (a
$60 ordinary loss and a $5 capital loss).
Example 2. Basis less than adjusted issue
price—(i) Facts. On January 1, 1999, Y pur-
chases for $910 a debt instrument that pays 7
percent interest semiannually on June 30 and
December 31 of each year, and that promises to
pay on December 31, 2001, $1,000 plus or minus
$10 times the positive or negative difference, if
any, between a specified amount and the value of
an index on December 31, 2001. However, the
payment on December 31, 2001, may not be less
than $650. The debt instrument was originally
issued on December 31, 1996, for an issue price
of $1,000. The comparable yield for the debt
instrument is 9.80 percent, compounded semian-
nually, and the projected payment schedule for
the debt instrument (determined as of the issue
date) provides for semiannual payments of $35
and a contingent payment at maturity of $1,175.
On January 1, 1999, the debt instrument has an
adjusted issue price of $1,060, assuming semian-
nual accrual periods ending on December 31 and
June 30 of each year. Y is a calendar year
taxpayer.
(ii)Allocation of the difference between basis
and adjusted issue price. Y’s basis in the debt
instrument on January 1, 1999, is $910. Under
paragraph (b)(9)(i)(A) of this section, Y must
allocate the $150 difference between basis ($910)
and adjusted issue price ($1,060) to daily
portions of interest or to projected payments.
These amounts will be positive adjustments taken
into account at the time the daily portions accrue
or the payments are made.
(A)Assume that, because of a decrease in the
relevant index, the expected value of the
payment at maturity has declined by about 9
percent. Based on forward prices on January 1,
1999, Y determines that approximately $105 of
the difference between basis and adjusted issue
price is allocable to the contingent payment. Y
allocates the remaining $45 to daily portions of
interest on a pro-rata basis (i.e., the amount
allocated to an accrual period equals the product
of $45 and a fraction, the numerator of which is
the total daily portions for the accrual period and
the denominator of which is the total daily
portions remaining on the debt instrument on
January 1, 1999). This allocation is reasonable.
(B)Assume alternatively that, based on yields
of comparable debt instruments and its purchase
price for the debt instrument, Y determines that
an appropriate yield for the debt instrument is 13
percent, compounded semiannually. Based on
this determination, Y allocates $55.75 of the
difference between basis and adjusted issue price
to daily portions of interest as follows: $15.19 to
the daily portions of interest for the taxable year
ending December 31, 1999; $18.40 to the daily
portions of interest for the taxable year ending
December 31, 2000; and $22.16 to the daily
portions of interest for the taxable year ending
December 31, 2001. Y allocates the remaining
$94.25 to the contingent payment at maturity.
This allocation is reasonable.
(ii)Fixed but deferred contingent
payments. This paragraph (b)(9)(ii)
provides rules that apply when the
amount of a contingent payment be-
comes fixed before the payment is due.
For purposes of paragraph (b) of this
section, if a contingent payment be-
comes fixed within the 6-month period
ending on the due date of the payment,
the payment is treated as a contingent
payment even after the payment is
fixed. If a contingent payment becomes
fixed more than 6 months before the
payment is due, the following rules
apply to the debt instrument.
(A)Determining adjustments. The
amount of the adjustment attributable
to the contingent payment is equal to
the difference between the present
value of the amount that is fixed and
the present value of the projected
amount of the contingent payment. The
present value of each amount is deter-
mined by discounting the amount from
the date the payment is due to the date
the payment becomes fixed, using a
discount rate equal to the comparable
yield on the debt instrument. The
adjustment is treated as a positive or
negative adjustment, as appropriate, on
the date the contingent payment be-
comes fixed. See paragraph (b)(9)-
(ii)(G) of this section to determine the
timing of the adjustment if all remain-
ing contingent payments on the debt
instrument become fixed substantially
contemporaneously.
(B)Payment schedule. The con-
tingent payment is no longer treated as
a contingent payment after the date the
amount of the payment becomes fixed.
On the date the contingent payment
becomes fixed, the projected payment
schedule for the debt instrument is
modified prospectively to reflect the
fixed amount of the payment. There-
fore, no adjustment is made under
paragraph (b)(3)(iv) of this section
when the contingent payment is actu-
ally made.
(C)Accrual period. Notwithstanding
the determination under §1.1272–1(b)-
(1)(ii) of accrual periods for the debt
instrument, an accrual period ends on
the day the contingent payment be-
comes fixed, and a new accrual period
begins on the day after the day the
contingent payment becomes fixed.
(D)Adjustments to basis and ad-
justed issue price. The amount of any
positive adjustment on a debt instru-
ment determined under paragraph (b)-
(9)(ii)(A) of this section increases the
adjusted issue price of the instrument
and the holder’s adjusted basis in the
instrument. Similarly, the amount of
any negative adjustment on a debt
instrument determined under paragraph
(b)(9)(ii)(A) of this section decreases
the adjusted issue price of the instru-
ment and the holder’s adjusted basis in
the instrument.
(E)Basis different from adjusted
issue price. If a holder’s basis in a debt
instrument exceeds the debt instru-
ment’s adjusted issue price, the amount

SEQ 0027 JOB IRS28-005-007 PAGE-0025 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
25
allocated to a projected payment under
paragraph (b)(9)(i) of this section is
treated as a negative adjustment on the
date the payment becomes fixed. If a
holder’s basis in a debt instrument is
less than the debt instrument’s adjusted
issue price, the amount allocated to a
projected payment under paragraph
(b)(9)(i) of this section is treated as a
positive adjustment on the date the
payment becomes fixed.
(F)Special rule for certain con-
tingent interest payments. Notwith-
standing paragraph (b)(9)(ii)(A) of this
section, this paragraph (b)(9)(ii)(F) ap-
plies to contingent stated interest pay-
ments that are adjusted to compensate
for contingencies regarding the reason-
ableness of the debt instrument’s stated
rate of interest. For example, this
paragraph (b)(9)(ii)(F) applies to a debt
instrument that provides for an increase
in the stated rate of interest if the credit
quality of the issuer or liquidity of the
debt instrument deteriorates. Contingent
stated interest payments of this type are
recognized over the period to which
they relate in a reasonable manner.
(G)Special rule when all contingent
payments become fixed. Notwithstand-
ing paragraph (b)(9)(ii)(A) of this
section, if all the remaining contingent
payments on a debt instrument become
fixed substantially contemporaneously,
any positive or negative adjustments on
the instrument are taken into account in
a reasonable manner over the period to
which they relate. For purposes of the
preceding sentence, a payment is
treated as a fixed payment if all
remaining contingencies with respect to
the payment are remote or incidental
(within the meaning of §1.1275–2(h)).
(H)Example. The following exam-
ple illustrates the provisions of this
paragraph (b)(9)(ii). In this example,
assume that the instrument described is
a debt instrument for federal income
tax purposes. No inference is intended,
however, as to whether the instrument
is a debt instrument for federal income
tax purposes.
Example. Fixed but deferred payments—(i)
Facts. On December 31, 1996, B, a calendar year
taxpayer, purchases a debt instrument at original
issue for $1,000. The debt instrument matures on
December 31, 2002, and provides for a payment
of $1,000 at maturity. In addition, on December
31, 1999, and December 31, 2002, the debt
instrument provides for payments equal to the
excess of the average daily value of an index for
the 6-month period ending on September 30 of
the preceding year over a specified amount. The
debt instrument’s comparable yield is 10 percent,
compounded annually, and the instrument’s
projected payment schedule consists of a pay-
ment of $250 on December 31, 1999, and a
payment of $1,439 on December 31, 2002. B
uses annual accrual periods.
(ii)Interest accrual for 1997. Based on the
projected payment schedule, B includes a total of
$100 of daily portions of interest in income in
1997. B’s adjusted basis in the debt instrument
and the debt instrument’s adjusted issue price on
December 31, 1997, is $1,100.
(iii)Interest accrual for 1998—(A) Adjust-
ment. Based on the projected payment schedule,
B would include $110 of total daily portions of
interest in income in 1998. However, assume that
on September 30, 1998, the payment due on
December 31, 1999, fixes at $300, rather than
the projected $250. Thus, on September 30,
1998, B has an adjustment equal to the
difference between the present value of the $300
fixed amount and the present value of the $250
projected amount of the contingent payment. The
present values of the two payments are deter-
mined by discounting each payment from the
date the payment is due (December 31, 1999) to
the date the payment becomes fixed (September
30, 1998), using a discount rate equal to 10
percent, compounded annually. The present value
of the fixed payment is $266.30 and the present
value of the projected amount of the contingent
payment is $221.91. Thus, on September 30,
1998, B has a positive adjustment of $44.39
($266.30 – $221.91).
(B)Effect of adjustment. Under paragraph
(b)(9)(ii)(C) of this section, B’s accrual period
ends on September 30, 1998. The daily portions
of interest on the debt instrument for the period
from January 1, 1998 to September 30, 1998
total $81.51. The adjusted issue price of the debt
instrument and B’s adjusted basis in the debt
instrument are thus increased over this period by
$125.90 (the sum of the daily portions of interest
of $81.51 and the positive adjustment of $44.39
made at the end of the period) to $1,225.90. For
purposes of all future accrual periods, including
the new accrual period from October 1, 1998, to
December 31, 1998, the debt instrument’s
projected payment schedule is modified to reflect
a fixed payment of $300 on December 31, 1999.
Based on the new adjusted issue price of the debt
instrument and the new projected payment
schedule, the yield on the debt instrument does
not change.
(C)Interest accrual for 1998. Based on the
modified projected payment schedule, $29.56 of
interest accrues during the accrual period that
ends on December 31, 1998. Because B has no
other adjustments during 1998, the $44.39
positive adjustment on September 30, 1998,
results in a net positive adjustment for 1998,
which is additional interest for that year. Thus, B
includes $155.46 ($81.51 + $29.56 + $44.39) of
interest in income in 1998. B’s adjusted basis in
the debt instrument and the debt instrument’s
adjusted issue price on December 31, 1998, is
$1,255.46 ($1,225.90 from the end of the prior
accrual period plus $29.56 total daily portions
for the current accrual period).
(iii)Timing contingencies. This para-
graph (b)(9)(iii) provides rules for debt
instruments that have payments that are
contingent as to time.
(A)Treatment of certain options. If
a taxpayer has an unconditional option
to put or call the debt instrument, to
exchange the debt instrument for other
property, or to extend the maturity date
of the debt instrument, the projected
payment schedule is determined by
using the principles of §1.1272–1(c)(5).
(B)Other timing contingencies.
[Reserved]
(iv)Cross-border transactions—(A)
Allocation of deductions. For purposes
of §1.861–8, the holder of a debt
instrument shall treat any deduction or
loss treated as an ordinary loss under
paragraph (b)(6)(iii)(B) or (b)(8)(ii) of
this section as a deduction that is
definitely related to the class of gross
income to which income from such
debt instrument belongs. Accordingly,
if a U.S. person holds a debt instru-
ment issued by a related controlled
foreign corporation and, pursuant to
section 904(d)(3) and the regulations
thereunder, any interest accrued by
such U.S. person with respect to such
debt instrument would be treated as
foreign source general limitation in-
come, any deductions relating to a net
negative adjustment will reduce the
U.S. person’s foreign source general
limitation income. The holder shall
apply the general rules relating to
allocation and apportionment of deduc-
tions to any other deduction or loss
realized by the holder with respect to
the debt instrument.
(B)Investments in United States real
property. Notwithstanding paragraph
(b)(8)(i) of this section, gain on the
sale, exchange, or retirement of a debt
instrument that is a United States real
property interest is treated as gain for
purposes of sections 897, 1445, and
6039C.
(v)Coordination with subchapter M
and related provisions. For purposes of
sections 852(c)(2) and 4982 and
§1.852–11, any positive adjustment,
negative adjustment, income, or loss on
a debt instrument that occurs after
October 31 of a taxable year is treated
in the same manner as foreign currency
gain or loss that is attributable to a
section 988 transaction.
(vi)Coordination with section 1092.
A holder treats a negative adjustment
and an issuer treats a positive adjust-
ment as a loss with respect to a
position in a straddle if the debt
instrument is a position in a straddle
and the contingency (or any portion of
the contingency) to which the adjust-
ment relates would be part of the
straddle if entered into as a separate
position.

SEQ 0028 JOB IRS28-005-007 PAGE-0026 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
26
(c)Method for debt instruments not
subject to the noncontingent bond
method—(1) Applicability. This para-
graph (c) applies to a contingent
payment debt instrument (other than a
tax-exempt obligation) that has an issue
price determined under §1.1274–2. For
example, this paragraph (c) generally
applies to a contingent payment debt
instrument that is issued for non-
publicly traded property.
(2)Separation into components. If
paragraph (c) of this section applies to
a debt instrument (the overall debt
instrument), the noncontingent pay-
ments are subject to the rules in
paragraph (c)(3) of this section, and the
contingent payments are accounted for
separately under the rules in paragraph
(c)(4) of this section.
(3)Treatment of noncontingent pay-
ments. The noncontingent payments are
treated as a separate debt instrument.
The issue price of the separate debt
instrument is the issue price of the
overall debt instrument, determined
under §1.1274–2(g). No interest pay-
ments on the separate debt instrument
are qualified stated interest payments
(within the meaning of §1.1273–1(c))
and the de minimis rules of section
1273(a)(3) and §1.1273–1(d) do not
apply to the separate debt instrument.
(4)Treatment of contingent pay-
ments—(i) In general. Except as
provided in paragraph (c)(4)(iii) of this
section, the portion of a contingent
payment treated as interest under para-
graph (c)(4)(ii) of this section is
includible in gross income by the
holder and deductible from gross in-
come by the issuer in their respective
taxable years in which the payment is
made.
(ii)Characterization of contingent
payments as principal and interest—
(A) General rule. A contingent pay-
ment is treated as a payment of
principal in an amount equal to the
present value of the payment, deter-
mined by discounting the payment at
the test rate from the date the payment
is made to the issue date. The amount
of the payment in excess of the amount
treated as principal under the preceding
sentence is treated as a payment of
interest.
(B)Test rate. The test rate used for
purposes of paragraph (c)(4)(ii)(A) of
this section is the rate that would be
the test rate for the overall debt
instrument under §1.1274–4 if the term
of the overall debt instrument began on
the issue date of the overall debt
instrument and ended on the date the
contingent payment is made. However,
in the case of a contingent payment
that consists of a payment of stated
principal accompanied by a payment of
stated interest at a rate that exceeds the
test rate determined under the preced-
ing sentence, the test rate is the stated
interest rate.
(iii)Certain delayed contingent
payments—(A) General rule. Notwith-
standing paragraph (c)(4)(ii) of this
section, if a contingent payment be-
comes fixed more than 6 months before
the payment is due, the issuer and
holder are treated as if the issuer had
issued a separate debt instrument on
the date the payment becomes fixed,
maturing on the date the payment is
due. This separate debt instrument is
treated as a debt instrument to which
section 1274 applies. The stated princi-
pal amount of this separate debt
instrument is the amount of the pay-
ment that becomes fixed. An amount
equal to the issue price of this debt
instrument is characterized as interest
or principal under the rules of para-
graph (c)(4)(ii) of this section and
accounted for as if this amount had
been paid by the issuer to the holder on
the date that the amount of the payment
becomes fixed. To determine the issue
price of the separate debt instrument,
the payment is discounted at the test
rate from the maturity date of the
separate debt instrument to the date
that the amount of the payment be-
comes fixed.
(B)Test rate. The test rate used for
purposes of paragraph (c)(4)(iii)(A) of
this section is determined in the same
manner as the test rate under paragraph
(c)(4)(ii)(B) of this section is deter-
mined except that the date the con-
tingent payment is due is used rather
than the date the contingent payment is
made.
(5)Basis different from adjusted
issue price. This paragraph (c)(5)
provides rules for a holder whose basis
in a debt instrument is different from
the instrument’s adjusted issue price
(e.g., a subsequent holder). This para-
graph (c)(5), however, does not apply
if the holder is reporting income under
the installment method of section 453.
(i)Allocation of basis. The holder
must allocate basis to the noncon-
tingent component (i.e., the right to the
noncontingent payments) and to any
separate debt instruments described in
paragraph (c)(4)(iii) of this section in
an amount up to the total of the
adjusted issue price of the noncon-
tingent component and the adjusted
issue prices of the separate debt instru-
ments. The holder must allocate the
remaining basis, if any, to the con-
tingent component (i.e., the right to the
contingent payments).
(ii)Noncontingent component. Any
difference between the holder’s basis in
the noncontingent component and the
adjusted issue price of the noncon-
tingent component, and any difference
between the holder’s basis in a separate
debt instrument and the adjusted issue
price of the separate debt instrument, is
taken into account under the rules for
market discount, premium, and acquisi-
tion premium that apply to a noncon-
tingent debt instrument.
(iii)Contingent component. Amounts
received by the holder that are treated
as principal payments under paragraph
(c)(4)(ii) of this section reduce the
holder’s basis in the contingent compo-
nent. If the holder’s basis in the
contingent component is reduced to
zero, any additional principal payments
on the contingent component are
treated as gain from the sale or
exchange of the debt instrument. Any
basis remaining on the contingent
component on the date the final con-
tingent payment is made increases the
holder’s adjusted basis in the noncon-
tingent component (or, if there are no
remaining noncontingent payments, is
treated as loss from the sale or
exchange of the debt instrument).
(6)Treatment of a holder on sale,
exchange, or retirement. This para-
graph (c)(6) provides rules for the
treatment of a holder on the sale,
exchange, or retirement of a debt
instrument subject to paragraph (c) of
this section. Under this paragraph
(c)(6), the holder must allocate the
amount received from the sale, ex-
change, or retirement of a debt instru-
ment first to the noncontingent
component and to any separate debt
instruments described in paragraph
(c)(4)(iii) of this section in an amount
up to the total of the adjusted issue
price of the noncontingent component
and the adjusted issue prices of the
separate debt instruments. The holder
must allocate the remaining amount
received, if any, to the contingent
component.
(i)Amount allocated to the noncon-
tingent component. The amount allo-

SEQ 0029 JOB IRS28-005-007 PAGE-0027 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
27
cated to the noncontingent component
and any separate debt instruments is
treated as an amount realized from the
sale, exchange, or retirement of the
noncontingent component or separate
debt instrument.
(ii)Amount allocated to the con-
tingent component. The amount allo-
cated to the contingent component is
treated as a contingent payment that is
made on the date of the sale, exchange,
or retirement and is characterized as
interest and principal under the rules of
paragraph (c)(4)(ii) of this section.
(7)Examples. The following exam-
ples illustrate the provisions of this
paragraph (c). In each example, assume
that the instrument described is a debt
instrument for federal income tax pur-
poses. No inference is intended, how-
ever, as to whether the instrument is a
debt instrument for federal income tax
purposes.
Example 1. Contingent interest payments—(i)
Facts. A owns Blackacre, unencumbered depre-
ciable real estate. On January 1, 1997, A sells
Blackacre to B. As consideration for the sale, B
makes a downpayment of $1,000,000 and issues
to A a debt instrument that matures on December
31, 2001. The debt instrument provides for a
payment of principal at maturity of $5,000,000
and a contingent payment of interest on Decem-
ber 31 of each year equal to a fixed percentage
of the gross rents B receives from Blackacre in
that year. Assume that the debt instrument is not
issued in a potentially abusive situation. Assume
also that on January 1, 1997, the short-term
applicable Federal rate is 5 percent, compounded
annually, and the mid-term applicable Federal
rate is 6 percent, compounded annually.
(ii)Determination of issue price. Under
§1.1274–2(g), the issue price of the debt
instrument is $3,736,291, which is the present
value, as of the issue date, of the $5,000,000
noncontingent payment due at maturity, calcu-
lated using a discount rate equal to the mid-term
applicable Federal rate. Under §1.1012–1(g)(1),
B’s basis in Blackacre on January 1, 1997, is
$4,736,291 ($1,000,000 down payment plus the
$3,736,291 issue price of the debt instrument).
(iii)Noncontingent payment treated as sepa-
rate debt instrument. Under paragraph (c)(3) of
this section, the right to the noncontingent
payment of principal at maturity is treated as a
separate debt instrument. The issue price of this
separate debt instrument is $3,736,291 (the issue
price of the overall debt instrument). The
separate debt instrument has a stated redemption
price at maturity of $5,000,000 and, therefore,
OID of $1,263,709.
(iv)Treatment of contingent payments. As-
sume that the amount of contingent interest that
is fixed and paid on December 31, 1997, is
$200,000. Under paragraph (c)(4)(ii) of this
section, this payment is treated as consisting of a
payment of principal of $190,476, which is the
present value of the payment, determined by
discounting the payment at the test rate of 5
percent, compounded annually, from the date the
payment is made to the issue date. The
remainder of the $200,000 payment ($9,524) is
treated as interest. The additional amount treated
as principal gives B additional basis in Blackacre
on December 31, 1997. The portion of the pay-
ment treated as interest is includible in gross
income by A and deductible by B in their
respective taxable years in which December 31,
1997 occurs. The remaining contingent payments
on the debt instrument are accounted for
similarly, using a test rate of 5 percent,
compounded annually, for the contingent pay-
ments due on December 31, 1998, and December
31, 1999, and a test rate of 6 percent,
compounded annually, for the contingent pay-
ments due on December 31, 2000, and December
31, 2001.
Example 2. Fixed but deferred payment—(i)
Facts. The facts are the same as in paragraph
(c)(7) Example 1 of this section, except that the
contingent payment of interest that is fixed on
December 31, 1997, is not payable until Decem-
ber 31, 2001, the maturity date.
(ii)Treatment of deferred contingent payment.
Assume that the amount of the payment that
becomes fixed on December 31, 1997, is
$200,000. Because this amount is not payable
until December 31, 2001, under paragraph
(c)(4)(iii) of this section, a separate debt
instrument to which section 1274 applies is
treated as issued by B on December 31, 1997
(the date the payment is fixed). The maturity
date of this separate debt instrument is December
31, 2001 (the date on which the payment is due).
The stated principal amount of this separate debt
instrument is $200,000, the amount of the
payment that becomes fixed. The imputed
principal amount of the separate debt instrument
is $158,419, which is the present value, as of
December 31, 1997, of the $200,000 payment,
computed using a discount rate equal to the test
rate of the overall debt instrument (6 percent,
compounded annually). An amount equal to the
issue price of the separate debt instrument is
treated as an amount paid on December 31,
1997, and characterized as interest and principal
under the rules of paragraph (c)(4)(ii) of this
section. The amount of the deemed payment
characterized as principal is equal to $150,875,
which is the present value, as of January 1, 1997
(the issue date of the overall debt instrument), of
the deemed payment, computed using a discount
rate of 5 percent, compounded annually. The
amount of the deemed payment characterized as
interest is $7,544 ($158,419 – $150,875), which
is includible in gross income by A and
deductible by B in their respective taxable years
in which December 31, 1997 occurs.
( d )R u l e s f o r t a x - e x e m p t
obligations—(1) In general. Except as
modified by this paragraph (d), the
noncontingent bond method described
in paragraph (b) of this section applies
to a tax-exempt obligation (as defined
in section 1275(a)(3)) to which this
section applies. Paragraph (d)(2) of this
section applies to certain tax-exempt
obligations that provide for interest-
based payments or revenue-based pay-
ments and paragraph (d)(3) of this
section applies to all other obligations.
Paragraph (d)(4) of this section pro-
vides rules for a holder whose basis in
a tax-exempt obligation is different
from the adjusted issue price of the
obligation.
(2)Certain tax-exempt obligations
with interest-based or revenue-based
payments—(i) Applicability. This para-
graph (d)(2) applies to a tax-exempt
obligation that provides for interest-
based payments or revenue-based
payments.
(ii)Interest-based payments. A tax-
exempt obligation provides for interest-
based payments if the obligation would
otherwise qualify as a variable rate
debt instrument under §1.1275–5 ex-
cept that—
(A) The obligation provides for
more than one fixed rate;
(B)The obligation provides for one
or more caps, floors, or governors (or
similar restrictions) that are fixed as of
the issue date;
(C)The interest on the obligation is
not compounded or paid at least
annually; or
(D)The obligation provides for in-
terest at one or more rates equal to the
product of a qualified floating rate and
a fixed multiple greater than zero and
less than .65, or at one or more rates
equal to the product of a qualified
floating rate and a fixed multiple
greater than zero and less than .65,
increased or decreased by a fixed rate.
(iii)Revenue-based payments. A tax-
e x e m p t o b l i g a t i o n p r o v i d e s f o r
r e v e n u e - b a s e d p a y m e n t s i f t h e
obligation—
(A)Is issued to refinance (including
a series of refinancings) an obligation
(in a series of refinancings, the original
obligation), the proceeds of which were
used to finance a project or enterprise;
and
(B)Would otherwise qualify as a
variable rate debt instrument under
§1.1275–5 except that it provides for
stated interest payments at least an-
nually based on a single fixed percent-
age of the revenue, value, change in
value, or other similar measure of the
performance of the refinanced project
or enterprise.
(iv)Modifications to the noncon-
tingent bond method. If a tax-exempt
obligation is subject to this paragraph
(d)(2), the following modifications to
the noncontingent bond method de-
scribed in paragraph (b) of this section
apply to the obligation.
(A)Daily portions and net positive
adjustments. The daily portions of
interest determined under paragraph
(b)(3)(iii) of this section and any net
positive adjustment on the obligation
are interest for purposes of section 103.

SEQ 0030 JOB IRS28-005-007 PAGE-0028 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
28
(B)Net negative adjustments. A net
negative adjustment for a taxable year
reduces the amount of tax-exempt
interest the holder would otherwise
account for on the obligation for the
taxable year under paragraph (b)(3)(iii)
of this section. If the net negative
adjustment exceeds this amount, the
excess is a nondeductible, noncapitaliz-
able loss. If a regulated investment
company (RIC) within the meaning of
section 851 has a net negative adjust-
ment in a taxable year that would be a
nondeductible, noncapitalizable loss un-
der the prior sentence, the RIC must
use this loss to reduce its tax-exempt
interest income on other tax-exempt
obligations held during the taxable
year.
(C)Gains. Any gain recognized on
the sale, exchange, or retirement of the
obligation is gain from the sale or
exchange of the obligation.
(D)Losses. Any loss recognized on
the sale, exchange, or retirement of the
obligation is treated the same as a net
negative adjustment under paragraph
(d)(2)(iv)(B) of this section.
(E)Special rule for losses and net
negative adjustments. Notwithstanding
paragraphs (d)(2)(iv)(B) and (D) of this
section, on the sale, exchange, or
retirement of the obligation, the holder
may claim a loss from the sale or
exchange of the obligation to the extent
the holder has not received in cash or
property the sum of its original invest-
ment in the obligation and any amounts
included in income under paragraph
(d)(4)(ii) of this section.
( 3 )A l l o t h e r t a x - e x e m p t
obligations—(i) Applicability. This
paragraph (d)(3) applies to a tax-
exempt obligation that is not subject to
paragraph (d)(2) of this section.
(ii)Modifications to the noncon-
tingent bond method. If a tax-exempt
obligation is subject to this paragraph
(d)(3), the following modifications to
the noncontingent bond method de-
scribed in paragraph (b) of this section
apply to the obligation.
(A)Modification to projected pay-
ment schedule. The comparable yield
for the obligation is the greater of the
obligation’s yield, determined without
regard to the contingent payments, and
the tax-exempt applicable Federal rate
that applies to the obligation. The
Internal Revenue Service publishes the
tax-exempt applicable Federal rate for
each month in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii) of this
chapter).
(B)Daily portions. The daily por-
tions of interest determined under
paragraph (b)(3)(iii) of this section are
interest for purposes of section 103.
(C)Adjustments. A net positive ad-
justment on the obligation is treated as
gain to the holder from the sale or
exchange of the obligation in the
taxable year of the adjustment. A net
negative adjustment on the obligation is
treated as a loss to the holder from the
sale or exchange of the obligation in
the taxable year of the adjustment.
(D)Gains and losses. Any gain or
loss recognized on the sale, exchange,
or retirement of the obligation is gain
or loss from the sale or exchange of the
obligation.
(4)Basis different from adjusted
issue price. This paragraph (d)(4)
provides rules for a holder whose basis
in a tax-exempt obligation is different
from the adjusted issue price of the
obligation. The rules of paragraph
(b)(9)(i) of this section do not apply to
tax-exempt obligations.
(i)Basis greater than adjusted issue
price. If the holder’s basis in the
obligation exceeds the obligation’s ad-
justed issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis
over the remaining term of the obliga-
tion. The amount allocated to a daily
portion of interest is not deductible by
the holder. However, the holder’s basis
in the obligation is reduced by the
amount allocated to a daily portion of
interest on the date the daily portion
accrues.
(ii)Basis less than adjusted issue
price. If the holder’s basis in the
obligation is less than the obligation’s
adjusted issue price, the holder, upon
acquiring the obligation, must allocate
this difference to daily portions of
interest on a yield to maturity basis
over the remaining term of the obliga-
tion. The amount allocated to a daily
portion of interest is includible in
income by the holder as ordinary
income on the date the daily portion
accrues. The holder’s adjusted basis in
the obligation is increased by the
amount includible in income by the
holder under this paragraph (d)(4)(ii)
on the date the daily portion accrues.
(iii)Premium and discount rules do
not apply. The rules for accruing
premium and discount in sections 171,
1276, and 1288 do not apply. Other
rules of those sections continue to
apply to the extent relevant.
(e)Amounts treated as interest un-
der this section. Amounts treated as
interest under this section are treated as
OID for all purposes of the Internal
Revenue Code.
(f)Effective date. This section ap-
plies to debt instruments issued on or
after August 13, 1996.
Par. 16. Section 1.1275–5 is
amended by:
1.Revising paragraph (a)(1).
2. Removing the language ‘‘The
debt instrument must provide for stated
interest’’ from the introductory lan-
guage of paragraph (a)(3)(i) and adding
the language ‘‘The debt instrument
must not provide for any stated interest
other than stated interest’’ in its place.
3. Removing the language ‘‘less
than 1 year’’ from the first sentence of
paragraph (a)(3)(ii) and adding the
language ‘‘1 year or less’’ in its place.
4. Adding paragraphs (a)(5) and
(a)(6).
5.Revising paragraph (b)(2).
6.Revising paragraphs (c)(1) and
(c)(5).
7.Removing the language ‘‘cost of
newly borrowed funds’’ from para-
graph (c)(3)(ii) and adding the lan-
guage ‘‘qualified floating rate’’ in its
place.
8.Revising paragraph (d) introduc-
tory text; revising Examples 4 through
9; and adding Example 10.
9.Revising paragraph (e)(2).
10.Revising paragraph (e)(3)(v) in-
troductory text; revising Example 3 (ii);
and removing Example 3 (iii).
The revisions and additions read as
follows:
§1.1275–5 Variable rate debt
instruments.
(a)Applicability—(1) In general.
This section provides rules for variable
rate debt instruments. Except as
provided in paragraph (a)(6) of this
section, a variable rate debt instrument
is a debt instrument that meets the
conditions described in paragraphs
(a)(2), (3), (4), and (5) of this section.
If a debt instrument that provides for a
variable rate of interest does not
qualify as a variable rate debt instru-
ment, the debt instrument is a con-
tingent payment debt instrument. See
§1.1275–4 for the treatment of a
contingent payment debt instrument.
See §1.1275–6 for a taxpayer’s treat-

SEQ 0031 JOB IRS28-005-007 PAGE-0029 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
29
ment of a variable rate debt instrument
and a hedge.
******
(5)No contingent principal pay-
ments. Except as provided in paragraph
(a)(2) of this section, the debt instru-
ment must not provide for any princi-
pal payments that are contingent
(within the meaning of §1.1275–4(a)).
(6)Special rule for debt instruments
issued for nonpublicly traded property.
A debt instrument (other than a tax-
exempt obligation) that would other-
wise qualify as a variable rate debt
instrument under this section is not a
variable rate debt instrument if section
1274 applies to the instrument and any
stated interest payments on the instru-
ment are treated as contingent pay-
ments under §1.1274–2. This paragraph
(a)(6) applies to debt instruments
issued on or after August 13, 1996.
(b)* * *
(2)Certain rates based on a
qualified floating rate. For a debt
instrument issued on or after August
13, 1996, a variable rate is a qualified
floating rate if it is equal to either—
(i)The product of a qualified float-
ing rate described in paragraph (b)(1)
of this section and a fixed multiple that
is greater than .65 but not more than
1.35; or
(ii)The product of a qualified float-
ing rate described in paragraph (b)(1)
of this section and a fixed multiple that
is greater than .65 but not more than
1.35, increased or decreased by a fixed
rate.
******
(c)Objective rate—(1) Definition—
(i) In general. For debt instruments
issued on or after August 13, 1996, an
objective rate is a rate (other than a
qualified floating rate) that is deter-
mined using a single fixed formula and
that is based on objective financial or
economic information. For example, an
objective rate generally includes a rate
that is based on one or more qualified
floating rates or on the yield of actively
traded personal property (within the
meaning of section 1092(d)(1)).
(ii)Exception. For purposes of para-
graph (c)(1)(i) of this section, an
objective rate does not include a rate
based on information that is within the
control of the issuer (or a related party
within the meaning of section 267(b) or
707(b)(1)) or that is unique to the
circumstances of the issuer (or a related
party within the meaning of section
267(b) or 707(b)(1)), such as dividends,
profits, or the value of the issuer’s
stock. However, a rate does not fail to
be an objective rate merely because it
is based on the credit quality of the
issuer.
******
(5)Tax-exempt obligations. Notwith-
standing paragraph (c)(1) of this sec-
tion, in the case of a tax-exempt
obligation (within the meaning of sec-
tion 1275(a)(3)), a variable rate is an
objective rate only if it is a qualified
inverse floating rate or a qualified
inflation rate. A rate is a qualified
inflation rate if the rate measures
contemporaneous changes in inflation
based on a general inflation index.
(d)Examples. The following exam-
ples illustrate the rules of paragraphs
(b) and (c) of this section. For purposes
of these examples, assume that the debt
instrument is not a tax-exempt obliga-
tion. In addition, unless otherwise
provided, assume that the rate is not
reasonably expected to result in a
significant front-loading or back-
loading of interest and that the rate is
not based on objective financial or
economic information that is within the
control of the issuer (or a related party)
or that is unique to the circumstances
of the issuer (or a related party).
******
Example 4. Rate based on changes in the
value of a commodity index. On January 1, 1997,
X issues a debt instrument that provides for
annual interest payments at the end of each year
at a rate equal to the percentage increase, if any,
in the value of an index for the year immediately
preceding the payment. The index is based on
the prices of several actively traded commodities.
Variations in the value of this interest rate cannot
reasonably be expected to measure contempo-
raneous variations in the cost of newly borrowed
funds. Accordingly, the rate is not a qualified
floating rate. However, because the rate is based
on objective financial information using a single
fixed formula, the rate is an objective rate.
Example 5. Rate based on a percentage of
S&P 500 Index. On January 1, 1997, X issues a
debt instrument that provides for annual interest
payments at the end of each year based on a
fixed percentage of the value of the S&P 500
Index. Variations in the value of this interest rate
cannot reasonably be expected to measure
contemporaneous variations in the cost of newly
borrowed funds and, therefore, the rate is not a
qualified floating rate. Although the rate is
described in paragraph (c)(1)(i) of this section,
the rate is not an objective rate because, based
on historical data, it is reasonably expected that
the average value of the rate during the first half
of the instrument’s term will be significantly less
than the average value of the rate during the
final half of the instrument’s term.
Example 6. Rate based on issuer’s profits. On
January 1, 1997, Z issues a debt instrument that
provides for annual interest payments equal to 1
percent of Z’s gross profits earned during the
year immediately preceding the payment. Varia-
tions in the value of this interest rate cannot
reasonably be expected to measure contempo-
raneous variations in the cost of newly borrowed
funds. Accordingly, the rate is not a qualified
floating rate. In addition, because the rate is
based on information that is unique to the
issuer’s circumstances, the rate is not an
objective rate.
Example 7. Rate based on a multiple of an
interest index. On January 1, 1997, Z issues a
debt instrument with annual interest payments at
a rate equal to two times the value of 1-year
LIBOR as of the payment date. Because the rate
is a multiple greater than 1.35 times a qualified
floating rate, the rate is not a qualified floating
rate. However, because the rate is based on
objective financial information using a single
fixed formula, the rate is an objective rate.
Example 8. Variable rate based on the cost of
borrowed funds in a foreign currency. On
January 1, 1997, Y issues a 5-year dollar
denominated debt instrument that provides for
annual interest payments at a rate equal to the
value of 1-year French franc LIBOR as of the
payment date. Variations in the value of French
franc LIBOR do not measure contemporaneous
changes in the cost of newly borrowed funds in
dollars. As a result, the rate is not a qualified
floating rate for an instrument denominated in
dollars. However, because the rate is based on
objective financial information using a single
fixed formula, the rate is an objective rate.
Example 9. Qualified inverse floating rate. On
January 1, 1997, X issues a debt instrument that
provides for annual interest payments at the end
of each year at a rate equal to 12 percent minus
the value of 1-year LIBOR as of the payment
date. On the issue date, the value of 1-year
LIBOR is 6 percent. Because the rate can
reasonably be expected to inversely reflect
contemporaneous variations in 1-year LIBOR, it
is a qualified inverse floating rate. However, if
the value of 1-year LIBOR on the issue date
were 11 percent rather than 6 percent, the rate
would not be a qualified inverse floating rate
because the rate could not reasonably be
expected to inversely reflect contemporaneous
variations in 1-year LIBOR.
Example 10. Rate based on an inflation index.
On January 1, 1997, X issues a debt instrument
that provides for annual interest payments at the
end of each year at a rate equal to 400 basis
points (4 percent) plus the annual percentage
change in a general inflation index (e.g., the
Consumer Price Index, U.S. City Average, All
Items, for all Urban Consumers, seasonally
unadjusted). The rate, however, may not be less
than zero. Variations in the value of this interest
rate cannot reasonably be expected to measure
contemporaneous variations in the cost of newly
borrowed funds. Accordingly, the rate is not a
qualified floating rate. However, because the rate
is based on objective economic information using
a single fixed formula, the rate is an objective
rate.
(e)* * *
(2)Variable rate debt instrument
that provides for annual payments of
interest at a single variable rate. If a
variable rate debt instrument provides

SEQ 0032 JOB IRS28-005-007 PAGE-0030 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
30
for stated interest at a single qualified
floating rate or objective rate and the
interest is unconditionally payable in
cash or in property (other than debt
instruments of the issuer), or will be
constructively received under section
451, at least annually, the following
rules apply to the instrument:
(i)All stated interest with respect to
the debt instrument is qualified stated
interest.
(ii)The amount of qualified stated
interest and the amount of OID, if any,
that accrues during an accrual period is
determined under the rules applicable
to fixed rate debt instruments by
assuming that the variable rate is a
fixed rate equal to—
(A)In the case of a qualified float-
ing rate or qualified inverse floating
rate, the value, as of the issue date, of
the qualified floating rate or qualified
inverse floating rate; or
(B)In the case of an objective rate
(other than a qualified inverse floating
rate), a fixed rate that reflects the yield
that is reasonably expected for the debt
instrument.
(iii)The qualified stated interest al-
locable to an accrual period is in-
creased (or decreased) if the interest
actually paid during an accrual period
exceeds (or is less than) the interest
assumed to be paid during the accrual
period under paragraph (e)(2)(ii) of this
section.
(3)* * *
(v)Examples. The following exam-
ples illustrate the rules in paragraphs
(e)(2) and (3) of this section.
******
Example 3. * * *
(ii)Accrual of OID and qualified stated
interest. Under paragraph (e)(2) of this section,
the variable rate debt instrument is treated as a
2-year debt instrument that has an issue price of
$90,000, a stated principal amount of $100,000,
and interest payments of $5,000 at the end of
each year. The debt instrument has $10,000 of
OID and the annual interest payments of $5,000
are qualified stated interest payments. Under
§1.1272–1, the debt instrument has a yield of
10.82 percent, compounded annually. The
amount of OID allocable to the first annual
accrual period (assuming Z uses annual accrual
periods) is $4,743.25 (($90,000 3 .1082) –
$5,000), and the amount of OID allocable to the
second annual accrual period is $5,256.75
($100,000 – $94,743.25). Under paragraph
(e)(2)(iii) of this section, the $2,000 difference
between the $7,000 interest payment actually
made at maturity and the $5,000 interest payment
assumed to be made at maturity under the
equivalent fixed rate debt instrument is treated as
additional qualified stated interest for the period.
******
Par. 17. Section 1.1275–6 is added to
read as follows:
§1.1275–6 Integration of qualifying
debt instruments.
(a)In general. This section generally
provides for the integration of a
qualifying debt instrument with a hedge
or combination of hedges if the com-
bined cash flows of the components are
substantially equivalent to the cash
flows on a fixed or variable rate debt
instrument. The integrated transaction
is generally subject to the rules of this
section rather than the rules to which
each component of the transaction
would be subject on a separate basis.
The purpose of this section is to permit
a more appropriate determination of the
character and timing of income, deduc-
tions, gains, or losses than would be
permitted by separate treatment of the
components. The rules of this section
affect only the taxpayer who holds (or
issues) the qualifying debt instrument
and enters into the hedge.
(b)Definitions—(1) Qualifying debt
instrument. A qualifying debt instru-
ment is any debt instrument (including
an integrated transaction as defined in
paragraph (c) of this section) other
than—
(i)A tax-exempt obligation as de-
fined in section 1275(a)(3);
(ii)A debt instrument to which
section 1272(a)(6) applies (certain in-
terests in or mortgages held by a
REMIC, and certain other debt instru-
ments with payments subject to accel-
eration); or
(iii)A debt instrument that is subject
to §1.483–4 or §1.1275–4(c) (certain
contingent payment debt instruments
issued for nonpublicly traded property).
(2)Section 1.1275–6 hedge—(i) In
general. A §1.1275–6 hedge is any
financial instrument (as defined in
paragraph (b)(3) of this section) if the
combined cash flows of the financial
instrument and the qualifying debt
instrument permit the calculation of a
yield to maturity (under the principles
of section 1272), or the right to the
combined cash flows would qualify
under §1.1275–5 as a variable rate debt
instrument that pays interest at a
qualified floating rate or rates (except
for the requirement that the interest
payments be stated as interest). A
financial instrument is not a §1.1275–6
hedge, however, if the resulting syn-
thetic debt instrument does not have
the same term as the remaining term of
the qualifying debt instrument. A finan-
cial instrument that hedges currency
risk is not a §1.1275–6 hedge.
(ii)Limitations—(A) A debt instru-
ment issued by a taxpayer and a debt
instrument held by the taxpayer cannot
be part of the same integrated
transaction.
(B)A debt instrument can be a
§1.1275–6 hedge only if it is issued
substantially contemporaneously with,
and has the same maturity (including
rights to accelerate or delay payments)
as, the qualifying debt instrument.
(3)Financial instrument. For pur-
poses of this section, a financial
instrument is a spot, forward, or futures
contract, an option, a notional principal
contract, a debt instrument, or a similar
instrument, or combination or series of
financial instruments. Stock is not a
financial instrument for purposes of
this section.
(4)Synthetic debt instrument. The
synthetic debt instrument is the hypo-
thetical debt instrument with the same
cash flows as the combined cash flows
of the qualifying debt instrument and
the §1.1275–6 hedge.
(c)Integrated transaction—(1) Inte-
gration by taxpayer. Except as other-
wise provided in this section, a qualify-
ing debt instrument and a §1.1275–6
hedge are an integrated transaction if
all of the following requirements are
satisfied:
(i)The taxpayer satisfies the identi-
fication requirements of paragraph (e)
of this section on or before the date the
taxpayer enters into the §1.1275–6
hedge.
(ii)None of the parties to the
§1.1275–6 hedge are related within the
meaning of section 267(b) or 707(b)(1),
or, if the parties are related, the party
providing the hedge uses, for federal
income tax purposes, a mark-to-market
method of accounting for the hedge and
all similar or related transactions.
(iii)Both the qualifying debt instru-
ment and the §1.1275–6 hedge are
entered into by the same individual,
partnership, trust, estate, or corporation
(regardless of whether the corporation
is a member of an affiliated group of
corporations that files a consolidated
return).
(iv)If the taxpayer is a foreign
person engaged in a U.S. trade or

SEQ 0033 JOB IRS28-005-007 PAGE-0031 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
31
business and the taxpayer issues or
acquires a qualifying debt instrument,
or enters into a §1.1275–6 hedge,
through the trade or business, all items
of income and expense associated with
the qualifying debt instrument and the
§1.1275–6 hedge (other than interest
expense that is subject to §1.882–5)
would have been effectively connected
with the U.S. trade or business
throughout the term of the qualifying
debt instrument had this section not
applied.
(v) Neither the qualifying debt in-
strument, nor any other debt instrument
that is part of the same issue as the
qualifying debt instrument, nor the
§1.1275–6 hedge was, with respect to
the taxpayer, part of an integrated
transaction that was terminated or
otherwise legged out of within the 30
days immediately preceding the date
that would be the issue date of the
synthetic debt instrument.
(vi)The qualifying debt instrument
is issued or acquired by the taxpayer
on or before the date of the first
payment on the §1.1275–6 hedge,
whether made or received by the
taxpayer (including a payment made to
purchase the hedge). If the qualifying
debt instrument is issued or acquired
by the taxpayer after, but substantially
contemporaneously with, the date of
the first payment on the §1.1275–6
hedge, the qualifying debt instrument is
treated, solely for purposes of this
paragraph (c)(1)(vi), as meeting the
requirements of the preceding sentence.
(vii)Neither the §1.1275–6 hedge
nor the qualifying debt instrument was,
with respect to the taxpayer, part of a
straddle (as defined in section 1092(c))
prior to the issue date of the synthetic
debt instrument.
(2)Integration by Commissioner.
The Commissioner may treat a qualify-
ing debt instrument and a financial
instrument (whether entered into by the
taxpayer or by a related party) as an
integrated transaction if the combined
cash flows on the qualifying debt
instrument and financial instrument are
substantially the same as the combined
cash flows required for the financial
instrument to be a §1.1275–6 hedge.
The Commissioner, however, may not
integrate a transaction unless the
qualifying debt instrument either is
subject to §1.1275–4 or is subject to
§1.1275–5 and pays interest at an
objective rate. The circumstances under
which the Commissioner may require
integration include, but are not limited
to, the following:
(i)A taxpayer fails to identify a
qualifying debt instrument and the
§1.1275–6 hedge under paragraph (e)
of this section.
(ii)A taxpayer issues or acquires a
qualifying debt instrument and a related
party (within the meaning of section
267(b) or 707(b)(1)) enters into the
§1.1275–6 hedge.
(iii)A taxpayer issues or acquires a
qualifying debt instrument and enters
into the §1.1275–6 hedge with a related
party (within the meaning of section
267(b) or 707(b)(1)).
(iv)The taxpayer legs out of an
integrated transaction and within 30
days enters into a new §1.1275–6
hedge with respect to the same qualify-
ing debt instrument or another debt
instrument that is part of the same
issue.
(d)Special rules for legging into
and legging out of an integrated
transaction—(1) Legging into—(i) Def-
inition. Legging into an integrated
transaction under this section means
that a §1.1275–6 hedge is entered into
after the date the qualifying debt
instrument is issued or acquired by the
taxpayer, and the requirements of para-
graph (c)(1) of this section are satisfied
on the date the §1.1275–6 hedge is
entered into (the leg-in date).
(ii)Treatment. If a taxpayer legs
into an integrated transaction, the tax-
payer treats the qualifying debt instru-
ment under the applicable rules for
taking interest and OID into account up
to the leg-in date, except that the day
before the leg-in date is treated as the
end of an accrual period. As of the leg-
in date, the qualifying debt instrument
is subject to the rules of paragraph (f)
of this section.
(iii)Anti-abuse rule. If a taxpayer
legs into an integrated transaction with
a principal purpose of deferring or
accelerating income or deductions on
the qualifying debt instrument, the
Commissioner may—
(A)Treat the qualifying debt instru-
ment as sold for its fair market value
on the leg-in date; or
(B)Refuse to allow the taxpayer to
integrate the qualifying debt instrument
and the §1.1275–6 hedge.
(2)Legging out—(i) Definition—(A)
Legging out if the taxpayer has inte-
grated. If a taxpayer has integrated a
qualifying debt instrument and a
§1.1275–6 hedge under paragraph
(c)(1) of this section, legging out
means that, prior to the maturity of the
synthetic debt instrument, the §1.1275–
6 hedge ceases to meet the require-
ments for a §1.1275–6 hedge, the
taxpayer fails to meet any requirement
of paragraph (c)(1) of this section, or
the taxpayer disposes of or otherwise
terminates all or a part of the qualify-
ing debt instrument or §1.1275–6
hedge. If the taxpayer fails to meet the
requirements of paragraph (c)(1) of this
section but meets the requirements of
paragraph (c)(2) of this section, the
Commissioner may treat the taxpayer
as not legging out.
(B)Legging out if the Commissioner
has integrated. If the Commissioner
has integrated a qualifying debt instru-
ment and a financial instrument under
paragraph (c)(2) of this section, legging
out means that, prior to the maturity of
the synthetic debt instrument, the re-
quirements for Commissioner integra-
tion under paragraph (c)(2) of this
section are not met or the taxpayer fails
to meet the requirements for taxpayer
integration under paragraph (c)(1) of
this section and the Commissioner
agrees to allow the taxpayer to be
treated as legging out.
(C)Exception for certain nonrecog-
nition transactions. If, in a single
nonrecognition transaction, a taxpayer
disposes of, or ceases to be primarily
liable on, the qualifying debt instru-
ment and the §1.1275–6 hedge, the
taxpayer is not treated as legging out.
Instead, the integrated transaction is
treated under the rules governing the
nonrecognition transaction. For exam-
ple, if a holder of an integrated
transaction is acquired in a reorganiza-
tion under section 368(a)(1)(A), the
holder is treated as disposing of the
synthetic debt instrument in the reorga-
nization rather than legging out. If the
successor holder is not eligible for
integrated treatment, the successor is
treated as legging out.
(ii)Operating rules. If a taxpayer
legs out (or is treated as legging out) of
an integrated transaction, the following
rules apply:
(A)The transaction is treated as an
integrated transaction during the time
the requirements of paragraph (c)(1) or
(2) of this section, as appropriate, are
satisfied.
(B)Immediately before the taxpayer
legs out, the taxpayer is treated as
selling or otherwise terminating the

SEQ 0034 JOB IRS28-005-007 PAGE-0032 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
32
synthetic debt instrument for its fair
market value and, except as provided in
paragraph (d)(2)(ii)(D) of this section,
any income, deduction, gain, or loss is
realized and recognized at that time.
(C)If, immediately after the tax-
payer legs out, the taxpayer holds or
remains primarily liable on the qualify-
ing debt instrument, adjustments are
made to reflect any difference between
the fair market value of the qualifying
debt instrument and the adjusted issue
price of the qualifying debt instrument.
If, immediately after the taxpayer legs
out, the taxpayer is a party to a
§1.1275–6 hedge, the §1.1275–6 hedge
is treated as entered into at its fair
market value.
(D)If a taxpayer legs out of an
integrated transaction by disposing of
or otherwise terminating a §1.1275–6
hedge within 30 days of legging into
the integrated transaction, then any loss
or deduction determined under para-
graph (d)(2)(ii)(B) of this section is not
allowed. Appropriate adjustments are
made to the qualifying debt instrument
for any disallowed loss. The adjust-
ments are taken into account on a yield
to maturity basis over the remaining
term of the qualifying debt instrument.
(E)If a holder of a debt instrument
subject to §1.1275–4 legs into an
integrated transaction with respect to
the instrument and subsequently legs
out of the integrated transaction, any
gain recognized under paragraph (d)(2)-
(ii)(B) or (C) of this section is treated
as interest income to the extent deter-
mined under the principles of §1.1275–
4(b)(8)(iii)(B) (rules for determining
the character of gain on the sale of a
debt instrument all of the payments on
which have been fixed). If the synthetic
debt instrument would qualify as a
variable rate debt instrument, the
equivalent fixed rate debt instrument
determined under §1.1275–5(e) is used
for this purpose.
(e)Identification requirements. For
each integrated transaction, a taxpayer
must enter and retain as part of its
books and records the following
information—
(1)The date the qualifying debt
instrument was issued or acquired (or
is expected to be issued or acquired) by
the taxpayer and the date the §1.1275–
6 hedge was entered into by the
taxpayer;
(2)A description of the qualifying
debt instrument and the §1.1275–6
hedge; and
(3)A summary of the cash flows
and accruals resulting from treating the
qualifying debt instrument and the
§1.1275–6 hedge as an integrated trans-
action (i.e., the cash flows and accruals
on the synthetic debt instrument).
(f)Taxation of integrated trans-
actions—(1) General rule. An inte-
grated transaction is generally treated
as a single transaction by the taxpayer
during the period that the transaction
qualifies as an integrated transaction.
Except as provided in paragraph (f)(12)
of this section, while a qualifying debt
instrument and a §1.1275–6 hedge are
part of an integrated transaction, nei-
ther the qualifying debt instrument nor
the §1.1275–6 hedge is subject to the
rules that would apply on a separate
basis to the debt instrument and the
§1.1275–6 hedge, including section
1092 or §1.446–4. The rules that would
govern the treatment of the synthetic
debt instrument generally govern the
treatment of the integrated transaction.
For example, the integrated transaction
may be subject to section 263(g) or, if
the synthetic debt instrument would be
part of a straddle, section 1092. Gener-
ally, the synthetic debt instrument is
subject to sections 163(e) and 1271
through 1275, with terms as set forth in
paragraphs (f)(2) through (13) of this
section.
(2)Issue date. The issue date of the
synthetic debt instrument is the first
date on which the taxpayer entered into
all of the components of the synthetic
debt instrument.
(3)Term. The term of the synthetic
debt instrument is the period beginning
on the issue date of the synthetic debt
instrument and ending on the maturity
date of the qualifying debt instrument.
(4)Issue price. The issue price of
the synthetic debt instrument is the
adjusted issue price of the qualifying
debt instrument on the issue date of the
synthetic debt instrument. If, as a result
of entering into the §1.1275–6 hedge,
the taxpayer pays or receives one or
more payments that are substantially
contemporaneous with the issue date of
the synthetic debt instrument, the pay-
ments reduce or increase the issue price
as appropriate.
(5)Adjusted issue price. In general,
the adjusted issue price of the synthetic
debt instrument is determined under the
principles of §1.1275–1(b).
(6)Qualified stated interest. No
amounts payable on the synthetic debt
instrument are qualified stated interest
within the meaning of §1.1273–1(c).
(7)Stated redemption price at
maturity—(i) Synthetic debt instruments
that are borrowings. In general, if the
synthetic debt instrument is a borrow-
ing, the instrument’s stated redemption
price at maturity is the sum of all
amounts paid or to be paid on the
qualifying debt instrument and the
§1.1275–6 hedge, reduced by any
amounts received or to be received on
the §1.1275–6 hedge.
(ii)Synthetic debt instruments that
are held by the taxpayer. In general, if
the synthetic debt instrument is held by
the taxpayer, the instrument’s stated
redemption price at maturity is the sum
of all amounts received or to be
received by the taxpayer on the
qualifying debt instrument and the
§1.1275–6 hedge, reduced by any
amounts paid or to be paid by the
taxpayer on the §1.1275–6 hedge.
(iii)Certain amounts ignored. For
purposes of this paragraph (f)(7), if an
amount paid or received on the
§1.1275–6 hedge is taken into account
under paragraph (f)(4) of this section to
determine the issue price of the syn-
thetic debt instrument, the amount is
not taken into account to determine the
synthetic debt instrument’s stated re-
demption price at maturity.
(8)Source of interest income and
allocation of expense. The source of
interest income from the synthetic debt
instrument is determined by reference
to the source of income of the qualify-
ing debt instrument under sections
861(a)(1) and 862(a)(1). For purposes
of section 904, the character of interest
from the synthetic debt instrument is
determined by reference to the charac-
ter of the interest income from the
qualifying debt instrument. Interest ex-
pense is allocated and apportioned
under regulations under section 861 or
under §1.882–5.
(9)Effectively connected income. If
the requirements of paragraph (c)(1)(iv)
of this section are satisfied, any interest
income resulting from the synthetic
debt instrument entered into by the
foreign person is treated as effectively
connected with a U.S. trade or busi-
ness, and any interest expense resulting
from the synthetic debt instrument
entered into by the foreign person is
allocated and apportioned under
§1.882–5.
(10)Not a short-term obligation. For
purposes of section 1272(a)(2)(C), a
synthetic debt instrument is not treated
as a short-term obligation.

SEQ 0035 JOB IRS28-005-007 PAGE-0033 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
33
(11)Special rules in the event of
integration by the Commissioner. If the
Commissioner requires integration, ap-
propriate adjustments are made to the
treatment of the synthetic debt instru-
ment, and, if necessary, the qualifying
debt instrument and financial instru-
ment. For example, the Commissioner
may treat a financial instrument that is
not a §1.1275–6 hedge as a §1.1275–6
hedge when applying the rules of this
section. The issue date of the synthetic
debt instrument is the date determined
appropriate by the Commissioner to
require integration.
(12)Retention of separate transac-
tion rules for certain purposes. This
paragraph (f)(12) provides for the
retention of separate transaction rules
for certain purposes. In addition, by
publication in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii) of this
chapter), the Commissioner may re-
quire use of separate transaction rules
for any aspect of an integrated
transaction.
(i)Foreign persons that enter into
integrated transactions giving rise to
U.S. source income not effectively
connected with a U.S. trade or busi-
ness. If a foreign person enters into an
integrated transaction that gives rise to
U.S. source interest income (deter-
mined under the source rules for the
synthetic debt instrument) not effec-
tively connected with a U.S. trade or
business of the foreign person, para-
graph (f) of this section does not apply
for purposes of sections 871(a), 881,
1441, 1442, and 6049. These sections
of the Internal Revenue Code are
applied to the qualifying debt instru-
ment and the §1.1275–6 hedge on a
separate basis.
(ii)Relationship between taxpayer
and other persons. Because the rules of
this section affect only the taxpayer
that enters into an integrated transac-
tion (i.e., either the issuer or a particu-
lar holder of a qualifying debt instru-
ment), any provisions of the Internal
Revenue Code or regulations that
govern the relationship between the
taxpayer and any other person are
applied on a separate basis. For exam-
ple, taxpayers must comply with any
reporting or disclosure requirements on
any qualifying debt instrument as if it
were not part of an integrated transac-
tion. Thus, if required under §1.1275–
4(b)(4), an issuer of a contingent
payment debt instrument subject to
integrated treatment must provide the
projected payment schedule to holders.
Similarly, if a U.S. corporation enters
into an integrated transaction that in-
cludes a notional principal contract, the
source of any payment received by the
counterparty on the notional principal
contract is determined under §1.863–7
as if the contract were not part of an
integrated transaction, and, if received
by a foreign person who is not engaged
in a U.S. trade or business, the
payment is non-U.S. source income
that is not subject to U.S. withholding
tax.
(13)Coordination with consolidated
return rules. If a taxpayer enters into a
§1.1275–6 hedge with a member of the
same consolidated group (the counter-
party) and the §1.1275–6 hedge is part
of an integrated transaction for the
taxpayer, the §1.1275–6 hedge is not
treated as an intercompany transaction
for purposes of §1.1502–13. If the
taxpayer legs out of integrated treat-
ment, the taxpayer and the counterparty
are each treated as disposing of its
position in the §1.1275–6 hedge under
the principles of paragraph (d)(2) of
this section. If the §1.1275–6 hedge
remains in existence after the leg-out
date, the §1.1275–6 hedge is treated
under the rules that would otherwise
apply to the transaction (including
§1.1502–13 if the transaction is be-
tween members).
(g)Predecessors and successors. For
purposes of this section, any reference
to a taxpayer, holder, issuer, or person
includes, where appropriate, a reference
to a predecessor or successor. For
purposes of the preceding sentence, a
predecessor is a transferor of an asset
or liability (including an integrated
transaction) to a transferee (the suc-
cessor) in a nonrecognition transaction.
Appropriate adjustments, if necessary,
are made in the application of this
section to predecessors and successors.
(h)Examples. The following exam-
ples illustrate the provisions of this
section. In each example, assume that
the qualifying debt instrument is a debt
instrument for federal income tax pur-
poses. No inference is intended, how-
ever, as to whether the debt instrument
is a debt instrument for federal income
tax purposes.
Example 1. Issuer hedge—(i) Facts. On
January 1, 1997, V, a domestic corporation,
issues a 5-year debt instrument for $1,000. The
debt instrument provides for annual payments of
interest at a rate equal to the value of 1-year
LIBOR and a principal payment of $1,000 at
maturity. On the same day, V enters into a
5-year interest rate swap agreement with an
unrelated party. Under the swap, V pays 6
percent and receives 1-year LIBOR on a notional
principal amount of $1,000. The payments on the
swap are fixed and made on the same days as the
payments on the debt instrument. On January 1,
1997, V identifies the debt instrument and the
swap as an integrated transaction in accordance
with the requirements of paragraph (e) of this
section.
(ii)Eligibility for integration. The debt instru-
ment is a qualifying debt instrument. The swap is
a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the swap and the debt
instrument can be calculated. V has met the
identification requirements, and the other require-
ments of paragraph (c)(1) of this section are
satisfied. Therefore, the transaction is an inte-
grated transaction under this section.
(iii)Treatment of the synthetic debt instru-
ment. The synthetic debt instrument is a 5-year
debt instrument that has an issue price of $1,000
and provides for annual interest payments of $60
and a principal payment of $1,000 at maturity.
Under paragraph (f)(6) of this section, no
amounts payable on the synthetic debt instrument
are qualified stated interest. Thus, under para-
graph (f)(7)(i) of this section, the synthetic debt
instrument has a stated redemption price at
maturity of $1,300 (the sum of all amounts to be
paid on the qualifying debt instrument and the
swap, reduced by amounts to be received on the
swap). The synthetic debt instrument, therefore,
has $300 of OID.
Example 2. Issuer hedge with an option—(i)
Facts. On December 31, 1996, W, a domestic
corporation, issues for $1,000 a debt instrument
that matures on December 31, 1999. The debt
instrument has a stated principal amount of
$1,000 payable at maturity. The debt instrument
also provides for a payment at maturity equal to
$10 times the increase, if any, in the value of a
nationally known composite index of stocks from
December 31, 1996, to the maturity date. On
December 31, 1996, W purchases from an
unrelated party an option that pays $10 times the
increase, if any, in the stock index from
December 31, 1996, to December 31, 1999. W
pays $250 for the option. On December 31,
1996, W identifies the debt instrument and
option as an integrated transaction in accordance
with the requirements of paragraph (e) of this
section.
(ii)Eligibility for integration. The debt instru-
ment is a qualifying debt instrument. The option
is a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the option and the debt
instrument can be calculated. W has met the
identification requirements, and the other require-
ments of paragraph (c)(1) of this section are
satisfied. Therefore, the transaction is an inte-
grated transaction under this section.
(iii)Treatment of the synthetic debt instru-
ment. Under paragraph (f)(4) of this section, the
issue price of the synthetic debt instrument is
equal to the issue price of the debt instrument
($1,000) reduced by the payment for the option
($250). As a result, the synthetic debt instrument
is a 3-year debt instrument with an issue price of
$750. Under paragraph (f)(7) of this section, the
synthetic debt instrument has a stated redemption
price at maturity of $1,000 (the $250 payment
for the option is not taken into account). The
synthetic debt instrument, therefore, has $250 of
OID.
Example 3. Hedge with prepaid swap—(i)
Facts. On January 1, 1997, H purchases for

SEQ 0036 JOB IRS28-005-007 PAGE-0034 PT 1 PGS 20-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-005
34
£1,000 a 5-year debt instrument that provides for
semiannual payments based on 6-month pound
LIBOR and a payment of the £1,000 principal at
maturity. On the same day, H enters into a swap
with an unrelated third party under which H
receives semiannual payments, in pounds, of 10
percent, compounded semiannually, and makes
semiannual payments, in pounds, of 6-month
pound LIBOR on a notional principal amount of
£1,000. Payments on the swap are fixed and
made on the same dates as the payments on the
debt instrument. H also makes a £162 prepay-
ment on the swap. On January 1, 1997, H
identifies the swap and the debt instrument as an
integrated transaction in accordance with the
requirements of paragraph (e) of this section.
(ii)Eligibility for integration. The debt instru-
ment is a qualifying debt instrument. The swap is
a §1.1275–6 hedge because it is a financial
instrument and a yield to maturity on the
combined cash flows of the swap and the debt
instrument can be calculated. Although the debt
instrument is denominated in pounds, the swap
hedges only interest rate risk, not currency risk.
Therefore, the transaction is an integrated trans-
action under this section. See §1.988–5(a) for the
treatment of a debt instrument and a swap if the
swap hedges currency risk.
(iii)Treatment of the synthetic debt instru-
ment. Under paragraph (f)(4) of this section, the
issue price of the synthetic debt instrument is
equal to the issue price of the debt instrument
(£1,000) increased by the prepayment on the
swap (£162). As a result, the synthetic debt
instrument is a 5-year debt instrument that has an
issue price of £1,162 and provides for semian-
nual interest payments of £50 and a principal
payment of £1,000 at maturity. Under paragraph
(f)(6) of this section, no amounts payable on the
synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(ii) of this
section, the synthetic debt instrument’s stated
redemption price at maturity is £1,500 (the sum
of all amounts to be received on the qualifying
debt instrument and the §1.1275–6 hedge,
reduced by all amounts to be paid on the
§1.1275–6 hedge other than the £162 prepayment
for the swap). The synthetic debt instrument,
therefore, has £338 of OID.
Example 4. Legging into an integrated trans-
action by a holder—(i) Facts. On December 31,
1996, X corporation purchases for $1,000,000 a
debt instrument that matures on December 31,
2006. The debt instrument provides for annual
payments of interest at the rate of 6 percent and
for a payment at maturity equal to $1,000,000,
increased by the excess, if any, of the price of
1,000 units of a commodity on December 31,
2006, over $350,000, and decreased by the
excess, if any, of $350,000 over the price of
1,000 units of the commodity on that date. The
projected amount of the payment at maturity
determined under §1.1275–4(b)(4) is $1,020,000.
On December 31, 1999, X enters into a cash-
settled forward contract with an unrelated party
to sell 1,000 units of the commodity on
December 31, 2006, for $450,000. On December
31, 1999, X also identifies the debt instrument
and the forward contract as an integrated
transaction in accordance with the requirements
of paragraph (e) of this section.
(ii)Eligibility for integration. X meets the
requirements for integration as of December 31,
1999. Therefore, X legged into an integrated
transaction on that date. Prior to that date, X
treats the debt instrument under the applicable
rules of §1.1275–4.
(iii)Treatment of the synthetic debt instru-
ment. As of December 31, 1999, the debt
instrument and the forward contract are treated
as an integrated transaction. The issue price of
the synthetic debt instrument is equal to the
adjusted issue price of the qualifying debt
instrument on the leg-in date, $1,004,804 (as-
suming one year accrual periods). The term of
the synthetic debt instrument is from December
31, 1999, to December 31, 2006. The synthetic
debt instrument provides for annual interest
payments of $60,000 and a principal payment at
maturity of $1,100,000 ($1,000,000 + $450,000 –
$350,000). Under paragraph (f)(6) of this section,
no amounts payable on the synthetic debt
instrument are qualified stated interest. Thus,
under paragraph (f)(7)(ii) of this section, the
synthetic debt instrument’s stated redemption
price at maturity is $1,520,000 (the sum of all
amounts to be received by X on the qualifying
debt instrument and the §1.1275–6 hedge,
reduced by all amounts to be paid by X on the
§1.1275–6 hedge). The synthetic debt instrument,
therefore, has $515,196 of OID.
Example 5. Abusive leg-in—(i) Facts. On
January 1, 1997, Y corporation purchases for
$1,000,000 a debt instrument that matures on
December 31, 2001. The debt instrument
provides for annual payments of interest at the
rate of 6 percent, a payment on December 31,
1999, of the increase, if any, in the price of a
commodity from January 1, 1997, to December
31, 1999, and a payment at maturity of
$1,000,000 and the increase, if any, in the price
of the commodity from December 31, 1999 to
maturity. Because the debt instrument is a
contingent payment debt instrument subject to
§1.1275–4, Y accrues interest based on the
projected payment schedule.
(ii)Leg-in. By late 1999, the price of the
commodity has substantially increased, and Y
expects a positive adjustment on December 31,
1999. In late 1999, Y enters into an agreement to
exchange the two commodity based payments on
the debt instrument for two payments on the
same dates of $100,000 each. Y identifies the
transaction as an integrated transaction in accord-
ance with the requirements of paragraph (e) of
this section. Y disposes of the hedge in early
2000.
(iii)Treatment. The legging into an integrated
transaction has the effect of deferring the
positive adjustment from 1999 to 2000. Because
Y legged into the integrated transaction with a
principal purpose to defer the positive adjust-
ment, the Commissioner may treat the debt
instrument as sold for its fair market value on
the leg-in date or refuse to allow integration.
Example 6. Integration of offsetting debt
instruments—(i) Facts. On January 1, 1997, Z
issues two 10-year debt instruments. The first,
Issue 1, has an issue price of $1,000, pays
interest annually at 6 percent, and, at maturity,
pays $1,000, increased by $1 times the increase,
if any, in the value of the S&P 100 Index over
the term of the instrument and reduced by $1
times the decrease, if any, in the value of the
S&P 100 Index over the term of the instrument.
However, the amount paid at maturity may not
be less than $500 or more than $1,500. The
second, Issue 2, has an issue price of $1,000,
pays interest annually at 8 percent, and, at
maturity, pays $1,000, reduced by $1 times the
increase, if any, in the value of the S&P 100
Index over the term of the instrument and
increased by $1 times the decrease, if any, in the
value of the S&P 100 Index over the term of the
instrument. The amount paid at maturity may not
be less than $500 or more than $1,500. On
January 1, 1997, Z identifies Issue 1 as the
qualifying debt instrument, Issue 2 as a §1.1275–
6 hedge, and otherwise meets the identification
requirements of paragraph (e) of this section.
(ii)Eligibility for integration. Both Issue 1
and Issue 2 are qualifying debt instruments. Z
has met the identification requirements by
identifying Issue 1 as the qualifying debt
instrument and Issue 2 as the §1.1275–6 hedge.
The other requirements of paragraph (c)(1) of
this section are satisfied. Therefore, the transac-
tion is an integrated transaction under this
section.
(iii)Treatment of the synthetic debt instru-
ment. The synthetic debt instrument has an issue
price of $2,000, provides for a payment at
maturity of $2,000, and, in addition, provides for
annual payments of $140. Under paragraph (f)(6)
of this section, no amounts payable on the
synthetic debt instrument are qualified stated
interest. Thus, under paragraph (f)(7)(i) of this
section, the synthetic debt instrument’s stated
redemption price at maturity is $3,400 (the sum
of all amounts to be paid on the qualifying debt
instrument and the §1.1275–6 hedge, reduced by
amounts to be received on the §1.1275–6 hedge
other than the $1,000 payment received on the
issue date). The synthetic debt instrument,
therefore, has $1,400 of OID.
Example 7. Integrated transaction entered into
by a foreign person—(i) Facts. X, a foreign
person, enters into an integrated transaction by
purchasing a qualifying debt instrument that pays
U.S. source interest and entering into a notional
principal contract with a U.S. corporation.
Neither the income from the qualifying debt
instrument nor the income from the notional
principal contract is effectively connected with a
U.S. trade or business. The notional principal
contract is a §1.1275–6 hedge.
(ii)Treatment of integrated transaction. Under
paragraph (f)(8) of this section, X will receive
U.S. source income from the integrated transac-
tion. However, under paragraph (f)(12)(i) of this
section, the qualifying debt instrument and the
notional principal contract are treated as if they
are not part of an integrated transaction for
purposes of determining whether tax is due and
must be withheld on income. Accordingly,
because the §1.1275–6 hedge would produce
foreign source income under §1.863–7 to X if it
were not part of an integrated transaction, any
income on the §1.1275–6 hedge generally will
not be subject to tax under sections 871(a) and
881, and the U.S. corporation that is the
counterparty will not be required to withhold tax
on payments under the §1.1275–6 hedge under
sections 1441 and 1442.
(i)[Reserved]
(j)Effective date. This section ap-
plies to a qualifying debt instrument
issued on or after August 13, 1996.
This section also applies to a qualifying
debt instrument acquired by the tax-
payer on or after August 13, 1996, if—
(1)The qualifying debt instrument is
a fixed rate debt instrument or a
variable rate debt instrument; or
(2)The qualifying debt instrument
and the §1.1275–6 hedge are acquired

SEQ 0037 JOB IRS28-006-004 PAGE-0035 PT 1 PG 35
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-006
35
by the taxpayer substantially con-
temporaneously.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 18. The authority citation for
part 602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 19. Section 602.101, paragraph
(c) is amended by:
1.Removing the following entries
from the table:
§602.101 OMB Control numbers.
******
(c)* * *
CFR part or sectionCurrent OMB
where identifiedcontrol number
and described
******
1.1272–1(c)(4)........... 1545–1353
******
1.1275–3(b)............. 1545–1353
1.1275–3(c)............. 1545–0887
******
2.Adding entries in numerical order
to the table to read as follows:
§602.101 OMB Control numbers.
******
(c)* * *
CFR part or sectionCurrent OMB
where identifiedcontrol number
and described
******
1.1275–2(h)............. 1545–1450
1.1275–3............... 1545–0887
1545–1353
1545–1450
1.1275–4(b)............. 1545–1450
1.1275–6(e)............. 1545–1450
******
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved March 22, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
June 11, 1996, 8:45 a.m., and published in the
issue of the Federal Register for June 14,
1996, 61 F.R. 30133)
Section 1288.—Treatment of Original
Issue Discount on Tax-Exempt
Obligations.
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.
Section 7520.—Valuation Tables
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.
Section 7872.—Treatment of Loans
with Below-Market Interest Rates
The adjusted applicable federal short-term,
mid-term, and long-term rates are set forth for
the month of July 1996. See Rev. Rul. 96–34,
page 4.

SEQ 0038 JOB IRS28-007-005 PAGE-0036 PT 2 PGS 36-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-007
36
Part II.Treaties and Tax Legislation
Subpart A.—Tax Conventions
LUXEMBOURG
EMBASSY OF THE UNITED
STATES OF AMERICA
LUXEMBOURG
APRIL 11, 1989
The Embassy of the United States of
America presents its compliments to
the Ministry of Foreign Affairs of the
Grand Duchy of Luxembourg and has
the honor to propose that the two
Governments conclude an agreement to
exempt from income and capital tax, on
a reciprocal basis, income derived and
capital owned by residents of the other
country in respect of the international
operations of ships and aircraft. The
terms of the agreement are as follows:
The Government of the United States
of America, in accordance with sec-
tions 872(b) and 883(a) of the Internal
Revenue Code, agrees to exempt from
tax, gross income derived from the
international operation of ships or
aircraft by individuals who are re-
sidents of Luxembourg (other than U.S.
citizens) and corporations organized in
Luxembourg. This exemption is granted
on the basis of equivalent exemptions
granted by the Grand Duchy of Lux-
embourg to individual residents of the
United States and to corporations
organized in the United States (which
are not subject to tax by Luxembourg
on the basis of residence).
In the case of a Luxembourg corpo-
ration, the exemption shall apply only
if the corporation meets either of the
following conditions:
(i)The corporation’s stock is pri-
marily and regularly traded on an
established securities market in Lux-
embourg, another country which grants
an equivalent exemption to U.S. corpo-
rations, or the United States; or
(ii)More than 50 percent of the
value of the corporation’s stock is
owned, directly or indirectly, by indi-
viduals who are residents of Lux-
embourg or of another country which
grants an equivalent exemption to U.S.
corporations or by a corporation
organized in a country which grants a
reciprocal exemption to U.S. corpora-
tions and whose stock is primarily and
regularly traded on an established
securities market in that country, an-
o t h e r c o u n t r y w h i c h g r a n t s a n
equivalent exemption to U.S. corpora-
tions, or the United States.
For purposes of subparagraph (ii),
the Government of the Grand Duchy of
Luxembourg will be treated as an
individual resident of Luxembourg. For
purposes of the exemption from U.S.
tax, subparagraph (ii) will be consid-
ered to be satisfied if the corporation is
a ‘‘controlled foreign corporation’’ un-
der the Internal Revenue Code.
Gross income includes all income
derived from the international operation
of ships or aircraft, including income
from the rental of ships or aircraft on a
full (time or voyage) basis and income
from the rental of containers and
related equipment which is incidental
to the international operation of ships
or aircraft. It also includes income
from the rental on a bareboat basis of
ships and aircraft used for international
transport.
The Grand Duchy of Luxembourg
agrees to exempt from income taxes on
individuals and corporations and from
communal tax on commercial profits
income derived from the international
operation of ships or aircraft by U.S.
residents and corporations organized in
the United States (other than corpora-
tions which are subject to tax by
Luxembourg on the basis of residence).
The Grand Duchy of Luxembourg
agrees to exempt from wealth tax and
communal tax on invested capital,
capital represented by ships or aircraft
operated in international traffic and by
movable property pertaining to the
operation of such ships or aircraft.
In the case of a U.S. corporation, the
exemption shall apply only if the
corporation meets either of the follow-
ing conditions:
(i)the corporation’s stock is pri-
marily and regularly traded on an
established securities market in the
United States, another country which
grants a reciprocal exemption to Lux-
embourg corporations, or the United
States; or
(ii)more than 50 percent of the
value of the corporation’s stock is
owned, directly or indirectly, by indi-
viduals who are residents of the United
States or of another country which
grants a reciprocal exemption to Lux-
embourg corporations or by a corpora-
tion organized in a country which
grants a reciprocal exemption to Lux-
embourg corporations and whose stock
is primarily and regularly traded on an
established securities exchange in that
country, another country which grants a
reciprocal exemption to Luxembourg
corporations or the United States.
Income includes all income derived
from the international operation of
ships or aircraft, including income from
the rental of ships or aircraft on a full
(time or voyage) basis and income
from the rental of containers and
related equipment which is incidental
to the international operation of ships
or aircraft. It also includes income
from the rental on a bareboat basis of
ships and aircraft used for international
transport.
This agreement will not affect the
provisions of Article V of the Conven-
tion of December 18, 1962, between
the United States of America and the
Grand Duchy of Luxembourg with
respect to taxes on income and prop-
erty which will remain in effect.
This agreement shall enter into force
upon the confirmation by the Embassy
of the United States of America of the
notification by the Government of the
Grand Duchy of Luxembourg indicat-
ing that all necessary internal proce-
dures have been completed and the
exemption from taxes as provided for
in paragraphs 1 and 2 shall have effect
with respect to taxable years beginning
on or after January 1, 1987.
Either government may terminate
this agreement by giving written notice
of termination through diplomatic
channels.
The Embassy of the United States of
America takes this opportunity to re-
new to the Ministry of Foreign Affairs
the assurances of its highest con-
sideration.
GRAND DUCHY OF LUXEMBOURG
MINISTRY OF FOREIGN AFFAIRS
LUXEMBOURG
JUNE 22, 1989
The Ministry of Foreign Affairs of
the Grand Duchy of Luxembourg pres-
ents its compliments to the Embassy of
the United States of America and has
the honor to acknowledge receipt of its
note of 11 April 1989, proposing the

SEQ 0039 JOB IRS28-007-005 PAGE-0037 PT 2 PGS 36-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-007
37
terms of an agreement for a reciprocal
exemption from income and capital tax
of income derived and capital owned in
respect of the international operation of
ships and aircraft. The terms of the
agreement are as follow:
1. The Goverment of the United
States of America, in accordance with
sections 872(b) and 883(a) of the
Internal Revenue Code, agrees to ex-
empt from tax gross income derived
from the international operation of
ships or aircraft by individuals who are
residents of Luxembourg (other than
U . S . c i t i z e n s ) a n d c o r p o r a t i o n s
organized in Luxembourg. This exemp-
tion is granted on the basis of
equivalent exemptions granted by the
Grand Duchy of Luxembourg to indi-
vidual residents of the United States
and to corporations organized in the
United States (which are not subject to
tax by Luxembourg on the basis of
residence).
In the case of a Luxembourg corpo-
ration, the exemption shall apply only
if the corporation meets either of the
following conditions:
(i)The corporation’s stock is pri-
marily and regularly traded on an
established securities market in Lux-
embourg, another country which grants
an equivalent exemption to U.S. corpo-
rations, or the United States; or
(ii)More than 50 percent of the
value of the corporation’s stock is
owned, directly or indirectly, by indi-
viduals who are residents of Lux-
embourg or of another country which
grants an equivalent exemption to U.S.
corporations or by a corporation
organized in a country which grants a
reciprocal exemption to U.S. corpora-
tions and whose stock is primarily and
regularly traded on an established
securites market in that country, an-
o t h e r c o u n t r y w h i c h g r a n t s a n
equivalent exemption to U.S. corpora-
tions, or the United States.
For purposes of subparagraph (ii),
the Government of the Grand Duchy of
Luxembourg will be treated as an
individual resident of Luxembourg. For
purposes of the exemption from U.S.
tax, subparagraph (ii) will be consid-
ered to be satisfied if the corporation is
a ‘‘controlled foreign corporation’’ un-
der the Internal Revenue Code.
Gross income includes all income
derived from the international operation
of ships or aircraft, including income
from the rental of ships or aircraft on a
full (time or voyage) basis and income
from the rental of containers and
related equipment which is incidental
to the international operation of ships
or aircraft. It also includes income
from the rental on a bareboat basis of
ships and aircraft used for international
transport.
2.The Grand Duchy of Luxembourg
agrees to exempt from income taxes on
individuals and corporations and from
communal tax on commercial profits
income derived from the international
operations of ships or aircraft by U.S.
residents and corporations organized in
the United States (other than corpora-
tions which are subject to tax by
Luxembourg on the basis of residence).
The Grand Duchy of Luxembourg
agrees to exempt from wealth tax and
communal tax on invested capital,
capital represented by ships or aircraft
operated in international traffic and by
movable property pertaining to the
operation of such ships or aircraft.
In the case of a U.S. corporation, the
exemption shall apply only if the
corporation meets either of the follow-
ing conditions:
(i)The corporation’s stock is pri-
marily and regularly traded on an
established securities market in the
United States, another country which
grants a reciprocal exemption to Lux-
embourg corporations, or Luxembourg;
or
(ii)More than 50 percent of the
value of the corporation’s stock is
owned, directly or indirectly, by indi-
viduals who are residents of the United
States or of another country which
grants a reciprocal exemption to Lux-
embourg corporations or by a corpora-
tion organized in a country which
grants a reciprocal exemption to Lux-
embourg corporations and whose stock
is primarily and regularly traded on an
established securities exchange in that
country, another country which grants a
reciprocal exemption to Luxembourg
corporations or Luxembourg.
Income includes all income derived
from the international operation of
ships or aircraft, including income from
the rental of ships or aircraft on a full
(time or voyage) basis and income
from the rental of containers and
related equipment which is incidental
to the international operation of ships
or aircraft. It also includes income
from the rental on a bareboat basis of
ships and aircraft used for international
transport.
3.This agreement will not affect the
provisions of Article V of the Conven-
tion of December 18, 1962, between
the United States of America and the
Grand Duchy of Luxembourg with
respect to taxes on income and prop-
erty which will remain in effect.
4.This agreement shall enter into
force upon the confirmation by the
Embassy of the United States of
America of the notification by the
Government of the Grand Duchy of
Luxembourg indicating that all neces-
sary internal procedures have been
completed and the exemption from
taxes as provided for in paragraphs 1
and 2 shall have effect with respect to
taxable years beginning on or after
January 1, 1987.
5.Either Government may terminate
this agremeent by giving written notice
of termination through diplomatic
channels.
The Ministry of Foreign Affairs of the
Grand Duchy of Luxembourg takes this
opportunity to renew to the Embassy of
the United States of America the as-
surances of his highest consideration.

SEQ 0040 JOB IRS28-008-003 PAGE-0038 PT 4 PGS 38-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-008
381996–28 I.R.B.
Part IV. Items of General Interest
Notice of Proposed Rulemaking and
Notice of Public Hearing
Section 467 Rental Agreements
IA–292–84
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains
proposed regulations relating to the
treatment of rent and interest under
certain agreements for the lease of
tangible property. The proposed regula-
tions apply to certain rental agreements
that provide increasing or decreasing
rents, or deferred or prepaid rent. This
document also provides notice of a
public hearing on these regulations.
DATES: Written comments, requests to
appear and outlines of topics to be
discussed at the public hearing sched-
uled for September 25, 1996, must be
received by September 3, 1996.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (IA–292–84), Room
5228, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044. In the alternative, submis-
sions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to
CC:DOM:CORP:R (IA–292–84), Cou-
rier’s Desk, Internal Revenue Service,
1111 Constitution Avenue NW., Wash-
ington, DC. The public hearing will be
held in the Commissioner’s Conference
Room, 3rd Floor, 1111 Constitution
Avenue NW., Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Forest Boone of the Office
of Assistant Chief Counsel (Income
T a x a n d A c c o u n t i n g ) a t ( 2 0 2 )
622-4960; concerning submissions and
the public hearing, Mike Slaughter at
(202) 622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains proposed
amendments to the Income Tax Regula-
tions (26 CFR part 1) relating to
section 467 of the Internal Revenue
Code (Code). This section was added
by the Tax Reform Act of 1984. In
general, section 467 requires parties to
certain rental agreements to accrue rent
and interest in accordance with the
rules specified in section 467. These
proposed regulations provide guidance
regarding the applicability of section
467, and the amount of rent and
interest required to be accrued under
section 467. No inference should be
drawn from any provision in the
p r o p o s e d r e g u l a t i o n s c o n c e r n i n g
whether an arrangement constitutes a
lease for Federal income tax purposes.
Explanation of Provisions
1.Section 467 rental agreements
Section 467(a) provides that, if a
rental agreement is a section 467 rental
agreement, the lessor and lessee must
take into account for a taxable year the
section 467 rent and the section 467
interest for that year. A section 467
rental agreement is a rental agreement
that has increasing or decreasing rents,
or prepaid or deferred rents. A rental
agreement has increasing or decreasing
rents if the annualized fixed rent
allocated to any rental period exceeds
the annualized fixed rent allocated to
any other rental period in the lease
term. The proposed regulations provide
that a rent holiday at the beginning of
the lease term is disregarded in deter-
mining whether the rental agreement
has increasing or decreasing rent if the
rent holiday period is three months or
less.
In addition, the proposed regulations
provide that a rental agreement has
increasing or decreasing rent if it
requires (or may require) the payment
of contingent rent, other than con-
tingent rent that is contingent due to (a)
a provision computing rent based on a
percentage of the lessee’s gross or net
receipts (but only if the percentage
does not vary throughout the term of
the lease); (b) adjustments based on a
reasonable price index; or (c) a provi-
sion requiring the lessee to pay real
estate taxes, insurance premiums, main-
tenance costs, or any other cost (other
than a debt service cost) that relates to
the leased property and is not within
the control of the lessor or lessee or a
person related to the lessor or lessee.
Section 467(d)(1)(A) provides that a
rental agreement has deferred rent if
rent allocated to a calendar year is
payable after the close of the succeed-
ing calendar year. The proposed regula-
tions provide that there is prepaid rent
if rent allocated to a calendar year is
payable prior to the beginning of the
prior calendar year.
Section 467(d)(2) provides that sec-
tion 467 does not apply to a rental
agreement if the aggregate rental pay-
ments and other consideration to be
received for the use of the property do
not exceed $250,000.
2.Section 467 rent
Under the proposed regulations, the
section 467 rent for a taxable year is
the sum of the fixed rent for any rental
periods that begin and end in the
taxable year, a ratable portion of the
fixed rent for other rental periods
beginning or ending in the taxable year,
and any contingent rent that accrues in
the taxable year. In general, the pro-
posed regulations provide that rental
periods may be of any length as long
as (a) the rental periods are one year or
less, cover the entire lease term, and do
not overlap, and (b) each scheduled
payment under the rental agreement
occurs within 30 days of the beginning
or end of a rental period. The amount
of fixed rent for a rental period
depends on the terms of the rental
agreement.
A.Disqualified leaseback or long-
term agreement
Section 467 provides that if the
section 467 rental agreement is a
leaseback or long-term agreement and
has increasing or decreasing rents a
principal purpose of which is tax
avoidance (a disqualified leaseback or
long-term agreement), the fixed rent for
each rental period is the constant rental
amount. The proposed regulations pro-
vide that (a) the Commissioner, rather
than the parties to the rental agreement,
will determine whether a rental agree-
ment is a disqualified leaseback or
long-term agreement and (b) a rental
agreement will not be disqualified
unless it requires more than $2,000,000

SEQ 0041 JOB IRS28-008-003 PAGE-0039 PT 4 PGS 38-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-008
391996–28 I.R.B.
in rental payments and other considera-
tion. The proposed regulations also
provide that, if either the lessor or the
lessee is not subject to Federal income
tax on its income or is a tax-exempt
entity (within the meaning of section
168(h)(2)), the rental agreement will be
closely scrutinized, and clear and con-
vincing evidence will be required to
establish that tax avoidance is not a
principal purpose for providing increas-
ing or decreasing rent.
Section 467(b)(5) provides that reg-
ulations should set forth circumstances
under which section 467 rental agree-
ments will not be treated as dis-
qualified leasebacks or long-term
agreements, including circumstances re-
lating to the use of price indices,
percentage rents, reasonable rent holi-
days, or changes in amounts paid to
third parties. In addition to these safe
harbors, which have been included in
the proposed regulations, the Con-
ference Committee Report stated that
the Committee anticipated that regula-
tions under section 467 would adopt
standards under which leases providing
for fluctuations in rents by no more
than a reasonable percentage above or
below the average rent over the term of
the lease will be deemed not motivated
by tax avoidance. The report cited the
standards for advance rulings on lever-
aged lease transactions set forth in Rev.
Proc. 75–21 (1975–1 C.B. 715), and
stated that such standards may not be
appropriate for real estate leases. H.R.
Rep. No. 861, 98th Cong., 2d Sess. 893
(1984).
The proposed regulations contain a
safe harbor providing that tax avoid-
ance will not be considered to be a
principal purpose for providing increas-
ing or decreasing rents if the rents
allocable to each calendar year of the
lease do not vary from the average
annual rents over the entire lease term
by more than 10 percent. This safe
harbor is based on, but is not identical
to, the safe harbor contained in Rev.
Proc. 75–21. The proposed regulations
do not provide a safe harbor specifi-
cally applicable to real estate leases.
The IRS and the Treasury Department
invite comments regarding the nature
and extent of a safe harbor for such
leases, as well as comments on whether
additional safe harbors are appropriate
either generally or for particular
industries.
Section 467(e)(1) provides that the
constant rental amount is the amount
that, if paid at the end of each rental
period, would result in a present value
equal to the present value of all
amounts payable under the disqualified
leaseback or long-term agreement. If
constant rental accrual is required, all
rental periods must be equal in length
except for an initial or final short rental
period.
B.Agreements without adequate
interest
If the section 467 rental agreement is
not a disqualified leaseback or long-
term agreement and does not provide
adequate interest for prepaid or de-
ferred rent, the proposed regulations
provide that the fixed rent for each
rental period is the proportional rental
amount. The proportional rental amount
is the fixed rent allocated to the rental
period under the rental agreement
multiplied by a fraction, the numerator
of which is the present value of the
amounts payable as fixed rent and
interest on fixed rent under the rental
agreement and the denominator of
which is the present value of the fixed
rent allocated to each rental period
under the rental agreement. Under the
proposed regulations, a rental agree-
ment provides adequate interest if (a)
no deferred or prepaid rent is required
under the agreement, (b) there is
deferred or prepaid rent but the agree-
ment requires the payment of interest at
an adequate single fixed rate, or (c)
there is deferred or prepaid rent but the
present values of rent payments and
rent accruals meet certain tests set forth
in the proposed regulations.
C. Rental agreement accrual
The proposed regulations provide
that if neither the constant rental
amount nor the proportional rental
amount is required to be accrued, the
fixed rent for a rental period is the
fixed rent allocated to that rental period
in accordance with the section 467
rental agreement. The amount of fixed
rent allocated to a rental period by the
rental agreement depends on whether
the agreement provides a specific al-
location of fixed rent. The proposed
regulations provide that if a rental
agreement provides a specific alloca-
tion of fixed rent, the amount of fixed
rent allocated to each rental period
during the lease term is the amount of
rent allocated to that period by the
agreement. For this purpose, a rental
agreement that allocates rent to a
period is treated as allocating rent
ratably within that period. Thus, if a
r e n t a l a g r e e m e n t p r o v i d e s t h a t
$120,000 is allocated to each calendar
year in the lease term, $10,000 of rent
is allocated to each calendar month. In
general, under the proposed regulations,
a rental agreement specifically allocates
fixed rent if the agreement unam-
biguously specifies, for periods of no
longer than a year, a fixed amount of
rent for which the lessee becomes
liable on account of the use of the
property during that period.
If a section 467 rental agreement
does not provide a specific allocation
of fixed rent, the amount of fixed rent
allocated to a rental period is the
amount of fixed rent payable during
that rental period.
3.Section 467 interest
The section 467 interest for a taxable
year is the sum of the interest on fixed
rent for any rental period that begins
and ends in the taxable year, a ratable
portion of the interest on fixed rent for
any other rental period beginning or
ending in the taxable year, and any
interest that accrues on contingent rent
during the taxable year. If a section
467 rental agreement provides an ade-
quate stated rate of interest, the interest
on fixed rent for a rental period is the
interest provided in the agreement for
that period. If no adequate stated rate
of interest is provided, the interest on
fixed rent for a rental period is
determined under the section 467 loan
rules.
Under the proposed regulations, there
is a deemed loan (a section 467 loan)
in a rental period if, at the beginning of
that period, there is a difference be-
tween the amount of fixed rent payable
under the section 467 rental agreement
and the amount of fixed rent required
to be accrued under the proposed
regulations. For rental periods in which
there is a section 467 loan, the interest
for the rental period is equal to the
product of the principal balance of the
section 467 loan at the beginning of the
rental period and the yield of the
section 467 loan.
In general, the principal balance of a
section 467 loan as of the beginning of
any rental period is the difference
between the cumulative amount of
accrued fixed rent and interest and the

SEQ 0042 JOB IRS28-008-003 PAGE-0040 PT 4 PGS 38-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-008
401996–28 I.R.B.
cumulative amount of fixed rent and
interest payable under the section 467
rental agreement. The yield of a section
467 loan is the discount rate at which
the sum of the present values of all
amounts payable by the lessee as fixed
rent and interest on fixed rent, plus the
sum of the negative present values of
all amounts payable by the lessor as
interest on prepaid fixed rent, equals
the sum of the present values of the
fixed rent allocated to the rental
periods.
The amount constituting a section
467 loan may be either positive or
negative. For purposes of applying any
aspect of the proposed regulations
relating to a section 467 loan, the
principal balance of the loan should be
clearly identified as either positive or
negative. For example, if the principal
balance of a loan at the beginning of a
rental period is a negative number, the
interest on the loan for that period will
also be a negative number.
4.Rental agreements with variable
rates of interest
The proposed regulations provide
rules for section 467 rental agreements
that provide for certain types of vari-
able rates of interest. The rules in the
proposed regulations are similar to the
rules provided in §1.1275–5 for the
computation of original issue discount
(OID) for variable rate debt instruments
providing for interest at qualified float-
ing rates. Under the proposed regula-
tions, a rental agreement provides
variable interest if the rental agreement
provides for stated interest that is paid
or compounded at least annually at a
rate or rates that meet the requirements
of §1.1275–5(a)(3)(i)(A) or (B) and
§1.1275–5(a)(4). If a rental agreement
provides for fluctuations in interest
other than pursuant to one or more
qualified floating rates the interest will
be subject to the rules for contingent
payments.
Under the proposed regulations, if a
section 467 rental agreement provides
variable interest, the fixed rate sub-
stitutes (determined in the same manner
as under §1.1275–5(e) treating the
agreement date as the issue date) for
the variable rates of interest called for
by the agreement must be used in
computing the proportional rental
amount, the constant rental amount, the
principal balance of a section 467 loan,
and the yield of a section 467 loan.
Further, in determining the interest on
fixed rent for any rental period, the
variable interest adjustment amount
must be taken into account. The
variable interest adjustment amount for
a rental period is the difference be-
tween (a) the amount of interest that
would have accrued during the rental
period under the terms of the rental
agreement, and (b) the amount of
interest that would have accrued during
the rental period under the terms of the
agreement using the fixed rate
substitutes.
5.Rental agreements with contingent
payments
The proposed regulations reserve on
the issue of the section 467 treatment
of contingent rent. The IRS and the
Treasury Department anticipate that
regulations addressing this issue will
provide rules for contingent rent similar
to those provided for computing OID
for contingent payment debt instru-
ments in §1.1275–4. The IRS and the
Treasury Department invite comments
regarding the application of the
§1.1275–4 rules to section 467 rental
agreements.
6.Recapture
Section 467(c) provides that if a
section 467 rental agreement is a
leaseback or long-term agreement
providing for increasing rent but is not
subject to constant rental accrual, and
the property subject to the agreement is
disposed of, a portion of the gain
realized on the disposition is required
to be recaptured by the lessor as
ordinary income. Accordingly, a lease-
back or long-term agreement could be
subject to section 467(c) even though it
does not require more than $2,000,000
in rental payments and other considera-
tion and is thus not subject to constant
rental accrual.
The recapture amount is equal to the
lesser of the prior understated inclu-
sions or the section 467 gain. The prior
understated inclusions are the excess of
(a) the aggregate amount of section 467
rent and section 467 interest for the
period during which the lessor held the
property, determined as if the section
467 rental agreement were a dis-
qualified leaseback or long-term agree-
ment, over (b) the aggregate amount of
section 467 rent and section 467
interest accrued by the lessor during
that period. The section 467 gain is the
excess of (a) the amount realized from
the disposition, over (b) the sum of the
adjusted basis of the property and the
amount of any gain from the disposi-
tion that is treated as ordinary income
under any provision of subtitle A of the
Code other than section 467(c) (e.g.,
section 1245 or 1250).
In the case of a disposition that is
not a sale, exchange, or involuntary
conversion, the section 467 gain is the
excess of (a) the fair market value of
the property on the date of disposition,
over (b) the sum of the adjusted basis
of the property and the amount of any
gain from the disposition that is treated
as ordinary income under Code provi-
sions other than section 467(c). The
regulations provide exceptions to this
recapture rule for dispositions by gift,
transfers at death, and certain tax-free
transactions.
7.Other disposition rules
Under the proposed regulations, if
property subject to a section 467 rental
agreement is sold, exchanged, or other-
wise disposed of, the section 467 rent
for a period is taken into account by
the owner of the property during the
period. The lessee, however, must
continue to take section 467 rent and
section 467 interest into account with-
out regard to the change of ownership.
Further, if there is a sale, exchange
or other disposition of property subject
to a section 467 rental agreement, the
beginning balance of the transferor’s
section 467 loan after the transfer
equals the net present value at the time
of the transfer of all amounts subse-
quently payable as fixed rent and
interest on fixed rent to the transferor
and all amounts subsequently payable
as interest on prepaid fixed rent by the
transferor. The transferor must continue
to take into account interest on the
transferor’s section 467 loan balance
after the transfer. The beginning bal-
ance of the transferee’s section 467
loan is equal to the principal balance of
the section 467 loan immediately be-
fore the transfer reduced by the begin-
ning balance of the transferor’s section
467 loan after the transfer. Amounts
payable to the transferor after the
transfer are not taken into account in
adjusting the transferee’s section 467
loan balance.
Finally, under the proposed regula-
tions, if there is a disposition of

SEQ 0043 JOB IRS28-008-003 PAGE-0041 PT 4 PGS 38-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-008
411996–28 I.R.B.
property subject to a section 467 rental
agreement, the transferor and transferee
must treat the beginning balance of the
transferee’s section 467 loan as a
liability that is either assumed in
connection with the transfer of the
property or secured by the property
acquired subject to the liability (if
negative) and as a reduction in the
consideration for the transfer of the
property (if positive). In the case of a
positive section 467 loan balance, a
reduction in the consideration for the
transfer of the property is appropriate
because the transferee will also be
deemed to have acquired an asset other
than the property itself, i.e., the loan,
and a portion of the total consideration
should be allocated to the loan balance.
Similar rules apply to transfers of
leasehold interests under section 467
rental agreements.
In order to account for any timing
differences that may exist between a
schedule of payments under a section
467 rental agreement and a separate
schedule providing an allocation of
rent, it will be necessary, in appropriate
cases, to determine the amount of a
section 467 loan balance even if the
rental agreement does not have either
deferred or prepaid rent or if the rental
agreement has deferred or prepaid rent
but provides adequate stated interest.
The proposed regulations provide that
the section 467 loan rules apply to
rental agreements described in the
preceding sentence, but only for pur-
poses of the rules relating to disposi-
tions of property subject to a section
467 rental agreement and the rules
relating to transfers of leasehold inter-
ests under a section 467 rental
agreement.
Although the proposed regulations
contain rules applicable to all disposi-
tions of property subject to a section
467 rental agreement and all transfers
of leasehold interests under a section
467 rental agreement, the regulations
reserve guidance on the question of
whether special rules should be
provided for transfers of property and
leasehold interests in transactions in
which gain or loss is not recognized in
whole or in part. Examples of these
transactions would include transfers
between a partnership and one or more
of its partners, transfers to a controlled
corporation under section 351, transfers
pursuant to a reorganization described
in section 368(a), like-kind exchanges
subject to section 1031, and transfers
by gift or upon the death of the owner
of the property or the holder of the
leasehold interest. The IRS and Treas-
ury Department invite comments on
whether special rules should be pro-
vided for any of these transactions.
8.Proposed effective date
The regulations are proposed to be
effective for (1) rental agreements
entered into after the date that final
regulations under section 467 are pub-
lished and (2) disqualified leasebacks
and long-term agreements entered into
after June 3, 1996. No inference should
be drawn from the proposed effective
date concerning the treatment of rental
agreements entered into before the
regulations are applicable. Moreover,
the IRS will, in appropriate circum-
stances, apply the provisions of section
467 requiring constant rental accrual to
rental agreements entered into on or
before June 3, 1996.
9.Issues not addressed
The proposed regulations do not
address the application of section 467
to payments for services. The IRS and
the Treasury Department invite com-
ments on the appropriate scope of rules
under section 467 for transactions
involving deferred payments for serv-
ices in light of the scope of section
404. In addition, the IRS and the
Treasury Department invite comments
on whether rules should be provided
for transactions involving prepayments
for services.
The proposed regulations do not
address the application of section 467
to transactions sometimes referred to as
‘‘lease strips’’ or ‘‘stripping transac-
tions’’, as described in Notice 95–53
(1995–44 I.R.B. 21). Notice 95–53
provides that regulations will be issued
pursuant to section 7701(l) (and, as
appropriate, other sections of the Code)
recharacterizing stripping transactions.
The IRS and the Treasury Department
invite comments on whether rules
should be provided that would apply
section 467 to such transactions.
The proposed regulations do not
provide for an adjustment to section
467 rent and interest where a section
467 rental agreement is modified. The
IRS and the Treasury Department
invite comments on the appropriate
treatment of the lessor and lessee in
these cases.
The proposed regulations do not
provide rules addressing the treatment
of payments by the lessor to induce a
lessee to enter into a rental agreement.
Special Analyses
It has been determined that this
notice of proposed rulemaking is not a
significant regulatory action as defined
in EO 12866. Therefore, a regulatory
assessment is not required. It also has
been determined that section 553(b) of
the Administrative Procedure Act (5
U.S.C. chapter 5) and the Regulatory
Flexibility Act (5 U.S.C. chapter 6) do
not apply to these proposed regulations,
and, therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to
section 7805(f) of the Internal Revenue
Code, this notice of proposed rulemak-
ing will be submitted to the Chief
Counsel for Advocacy of the Small
Business Administration for comment
on its impact on small businesses.
Comments and Public Hearing
Before these proposed regulations
are adopted as final regulations, consid-
eration will be given to any written
comments (a signed original and eight
(8) copies) that are submitted timely to
the IRS. All comments will be avail-
able for public inspection and copying.
A public hearing has been scheduled
for September 25, 1996 at 10 a.m. in
the Commissioner’s Conference Room,
1111 Constitution Avenue NW., Wash-
ington, DC. Because of access restric-
tions, visitors will not be admitted
beyond the Internal Revenue Building
lobby more than 15 minutes before the
hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral
comments at the hearing must submit
written comments and submit an out-
line of the topics to be discussed and
the time to be devoted to each topic by
September 3, 1996. A period of 10
minutes will be allotted to each person
for making comments.
An agenda showing the scheduling
of the speakers will be prepared after
the deadline for receiving outlines has
passed. Copies of the agenda will be
available free of charge at the hearing.
Drafting Information
The principal author of these pro-
posed regulations is Forest Boone of

SEQ 0045 JOB IRS28-009-003 PAGE-0042 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
421996–28 I.R.B.
the Office of Assistant Chief Counsel
(Income Tax and Accounting). How-
ever, other personnel from the IRS and
Treasury Department participated in
their development.
******
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is
proposed to be 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 1.467–1 is also issued under
26 U.S.C. 467.
Section 1.467–2 is also issued under
26 U.S.C. 467.
Section 1.467–3 is also issued under
26 U.S.C. 467.
Section 1.467–4 is also issued under
26 U.S.C. 467.
Section 1.467–5 is also issued under
26 U.S.C. 467.
Section 1.467–6 is also issued under
26 U.S.C. 467.
Section 1.467–7 is also issued under
26 U.S.C. 467.
Section 1.467–8 is also issued under
26 U.S.C. 467.
* * *
Par. 2. In §1.61–8, the first sentence
of paragraph (b) is revised to read as
follows:
§1.61–8 Rents and royalties.
******
(b)* * * Except as provided in
section 467 and the regulations there-
under, gross income includes advance
rentals, which must be included in
income for the year of receipt regard-
less of the period covered or the
method of accounting employed by the
taxpayer. * * *
******
Par. 3. In §1.451–1, paragraph (g) is
added to read as follows:
§1.451–1 General rule for taxable
year of inclusion.
******
(g)Timing of income from section
467 rental agreements. For the timing
of income with respect to section 467
rental agreements, see section 467 and
the regulations thereunder.
Par. 4. Section 1.461–1 is amended
by:
1.Adding a sentence at the end of
paragraph (a)(1).
2.Adding paragraph (a)(2)(iii)(E).
The additions read as follows:
§1.461–1. General rule for taxable
year of deduction.
(a)* * * (1) * * * See section 467
and the regulations thereunder for rules
under which a liability arising out of
the use of property pursuant to a
section 467 rental agreement is taken
into account.
(2)* * *
(iii)* * *
(E)Except as otherwise provided by
regulations or other published guidance
issued by the Commissioner, in the
case of a liability arising out of the use
of property pursuant to a section 467
rental agreement, the all events test
(including economic performance) is
considered met in the taxable year in
which the liability is to be taken into
account under section 467 and the
regulations thereunder.
******
Par. 5. Section 1.461–4 is amended
by:
1.Revising the heading of paragraph
(d)(3)(ii).
2.Redesignating the text of para-
graph (d)(3)(ii) following the heading
as paragraph (d)(3)(ii)(A) and adding a
heading for newly designated paragraph
(d)(3)(ii)(A).
2.Adding paragraph (d)(3)(ii)(B).
3.Adding sentence at the end of the
introductory text of paragraph (d)(7).
The revisions and additions read as
follows:
§1.461–4 Economic performance.
******
(d)* * *
(3)* * *
(ii)Exceptions—(A) Volume, fre-
quency of use, or income. * * *
(B)Section 467 rental agreements.
In the case of a liability arising out of
the use of property pursuant to a
section 467 rental agreement, economic
performance occurs as provided in
§1.461–1(a)(2)(iii)(E).
******
(7)* * * Assume further that the
examples do not involve section 467
rental agreements and, therefore, sec-
tion 467 is not applicable.
******
Par. 6. Sections 1.467–0 through
1.467–8 are added to read as follows:
§1.467–0 Table of contents.
This section lists the major captions
that appear in §§1.467–1 through
1.467–8.
§1.467–1 Treatment of lessors and
lessees generally.
(a)Overview.
(1)In general.
(2)Cases in which rules are
inapplicable.
(3)Limited effect for rental
agreements with total rents
between $250,000 and
$2,000,000.
(4)Summary of rules.
(i)Basic rules.
(ii)Special rules.
(b)Method of accounting for section
467 rental agreements.
(c)Section 467 rental agreements.
(1)In general.
(2)Increasing or decreasing rent.
(i)Fixed rent.
(A)In general.
(B)Certain rent holidays
disregarded.
(ii)Fixed rent allocated to a
rental period.
(A)Specific allocation.
(1) In general.
(2) R e n t a l a g r e e -
ments specifically
allocating fixed
rent.
(B)No specific
allocation.
(iii)Contingent rent.
(A)In general.
(B)Certain contingent
rent disregarded.
(3)Deferred or prepaid rent.
(i)Deferred rent.
(ii)Prepaid rent.
(iii)Rent allocated to a cal-
endar year.

SEQ 0046 JOB IRS28-009-003 PAGE-0043 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
431996–28 I.R.B.
(iv)Examples.
(4)Rental agreements involving
total payments of $250,000
or less.
(i)In general.
(ii)Special rules in comput-
ing amount described in
paragraph (c)(4)(i).
(d)Section 467 rent.
(1)In general.
(2)Fixed rent for a rental
period.
(i)Constant rental accrual.
(ii)Proportional rental
accrual.
(iii)Section 467 rental agree-
ment accrual.
(e)Section 467 interest.
(1)In general.
(2)Interest on fixed rent for a
rental period.
(i)In general.
(ii)Section 467 rental agree-
ments with adequate
interest.
(3)Treatment of interest.
(f)Modification of a rental
agreement.
(g)Treatment of amounts payable by
essor to lessee.
(1)Interest.
(2)Other amounts. [Reserved]
(h)Meaning of terms.
(i)[Reserved]
(j)Computational rules.
(1)Counting conventions.
(2)Conventions regarding timing
of rent and payments.
(i)In general.
(ii)Time amount is payable.
(3)Annualized fixed rent.
(4)Allocation of fixed rent
within a period.
(5)Rental period length.
§1.467–2 Rent accrual for section
467 rental agreements without
adequate interest.
(a)Section 467 rental agreement for
which proportional rental accrual
is required.
(b)Adequate interest on fixed rent.
(1)In general.
(2)Section 467 rental agree-
ments that provide for a
variable rate of interest.
(c)Computation of proportional
rental amount.
(1)In general.
(2)Section 467 rental agree-
ments that provide for a
variable rate of interest.
(d)Present value.
(e)Applicable Federal rate.
(1)In general.
(2)Source of applicable Federal
rates.
(3)110 percent of applicable
Federal rate.
(4)Term of the section 467
rental agreement.
(i)In general.
(ii)Section 467 rental agree-
ments with variable
interest.
(f)Examples.
§1.467–3 Disqualified leasebacks and
long-term agreements.
(a)General rule.
(b)Disqualified leaseback or long-
term agreement.
(1)In general.
(2)Leaseback.
(3)Long-term agreement.
(i)In general.
(ii)Statutory recovery
period.
(A)In general.
(B)Special rule for
leases of properties
having different stat-
utory recovery
periods.
(c)Tax avoidance as principal pur-
pose for increasing or decreasing
rent.
(1)In general.
(2)Safe harbors.
(d)Calculating constant rental
amount.
(1)In general.
(2)Initial or final short periods.
(3)Method to determine constant
rental amount; no short
periods.
(i)Step 1.
(ii)Step 2.
(iii)Step 3.
(e)Example.
§1.467–4 Section 467 loan.
(a)In general.
(1)
Overview.
(2)No section 467 loan in the
case of certain section 467
rental agreements.
(3)Rental agreements subject to
constant rental accrual.
(4)Special rule in applying the
provisions of §1.467–7(e) or
§1.467–7(f).
(b)Principal balance.
(1)In general.
(2)Section 467 rental
agreements that provide for
prepaid fixed rent and
adequate stated interest.
(3)Timing of payments.
(c)Yield.
(1)In general.
(i)Method of determining
yield.
(ii)Method of stating yield.
(iii)Rounding adjustments.
(2)Yield of section 467 rental
agreements for which con-
stant rental amount or
proportional rental amount is
computed.
(3)Determination of present
values.
(d)Contingent payments.
(e)Section 467 rental agreements
that call for payments before or
after the lease term.
(f)Examples.
§1.467–5 Section 467 rental
agreements with variable interest.
(a)Variable interest on deferred or
prepaid rent.
(1)In general.
(2)Exceptions.
(b)Variable rate treated as fixed.
(1)In general.
(2)Variable interest adjustment
amount.
(i)In general.
(ii)Sign of adjustment.
(3)Section 467 loan balance.
(c)Examples.
§1.467–6 Section 467 rental
agreements with contingent payments.
[Reserved]
§1.467–7 Section 467 recapture and
other rules relating to dispositions.
(a)Section 467 recapture.
(b)Recapture amount.
(1)In general.
(2)Prior understated inclusions.
(i)In general.
(ii)Partial rental periods.
(3)Section 467 gain.
(i)In general.
(ii)Certain dispositions.
(c)Special rules.
(1)Gifts.
(2)Dispositions at death.
(3)Certain tax-free exchanges.
(i)In general.
(ii)Dispositions covered.

SEQ 0047 JOB IRS28-009-003 PAGE-0044 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
441996–28 I.R.B.
(4)Dispositions by transferee.
(5)Like-kind exchanges and
involuntary conversions.
(6)Installment sales.
(7)Dispositions covered by
sections 170(e), 341(e)(12),
or 751(c).
(d)Examples.
(e)Other rules relating to dis-
positions.
(1)In general.
(2)Treatment of section 467
loan.
(3)Special rules for transfers in
certain nonrecognition trans-
actions. [Reserved]
(f)Treatment of assignments by
lessee and lessee-financed
renewals.
(1)Substitute lessee use.
(2)Lessor use.
(3)Special rules for transfers in
certain nonrecognition trans-
actions. [Reserved]
§1.467–8 Effective date.
§1.467–1 Treatment of lessors and
lessees generally.
(a)Overview—(1) In general. When
applicable, section 467 requires a lessor
and lessee of tangible property to treat
rents consistently and to use the accrual
method of accounting regardless of
their overall method of accounting. In
addition, in certain cases involving tax
avoidance, the lessor and lessee must
take rent and stated or imputed interest
into account under a constant rental
method, pursuant to which time value
of money principles are applied to treat
the rent as having accrued ratably over
the entire lease term.
(2)Cases in which rules are inappli-
cable. Section 467 applies only to
leases (or other similar arrangements)
that constitute section 467 rental agree-
ments as defined in paragraph (c) of
this section. For example, a rental
agreement is not a section 467 rental
agreement, and, therefore, is not sub-
ject to the provisions of this section
and §§1.467–2 through 1.467–8 (the
section 467 regulations), if it specifies
equal amounts of rent for each month
(or other similar period) throughout the
lease term and all payments of rent are
due in the year to which the rent
relates (or in the preceding or succeed-
ing year). In addition, the section 467
regulations do not apply to a rental
agreement that requires total rents of
$250,000 or less determined, for this
purpose, by disregarding any adjust-
ments based on a reasonable price
index and the amount of any rent
resulting from the lessee’s obligation to
pay certain third-party expenses of the
lessor.
(3)Limited effect for rental agree-
ments with total rents between
$250,000 and $2,000,000. A rental
agreement is a section 467 rental
agreement, and, therefore, the section
467 regulations generally apply, if the
agreement requires total rents of more
than $250,000 and does not specify
equal amounts of rent for each month
(or other similar period) throughout the
lease term. If, however, the rental
agreement requires total rents of
$2,000,000 or less (determined by
disregarding adjustments and excluding
the same types of rent that are dis-
regarded or excluded for purposes of
the $250,000 threshold requirement)
and all payments of rent are due in the
year to which the rent relates (or in the
preceding or succeeding year), the only
effect of the section 467 regulations is
to require the lessor and lessee to take
rent into account in the year to which
the rent relates.
(4)Summary of rules—(i) Basic
rules. Paragraph (c) of this section
provides rules for determining whether
a rental agreement is a section 467
rental agreement. Paragraphs (d) and
(e) of this section provide rules for
determining the amount of rent and
interest, respectively, required to be
taken into account by a lessor and
lessee under a section 467 rental
agreement. Paragraphs (f) through (h)
and (j) of this section provide various
definitions and special rules relating to
the application of the section 467
regulations.
(ii)Special rules. Section 1.467–2
provides rules for section 467 rental
agreements that have deferred or pre-
paid rents without providing for ade-
quate interest. Section 1.467–3 provides
rules for application of the constant
rental accrual requirement, including
criteria for determining whether an
agreement is subject to this require-
ment. Section 1.467–4 provides rules
for establishing and adjusting a section
467 loan, , the amount that a lessor is
deemed to have loaned to the lessee, or
vice versa, pursuant to the application
of the section 467 regulations. Sections
1.467–5 and 1.467–6 provide rules for
applying the section 467 regulations
where a rental agreement requires
variable interest or certain contingent
payments. Section 1.467–7 provides
rules for the treatment of dispositions
by a lessor of property subject to a
section 467 rental agreement and the
treatment of assignments by lessees and
certain lessee-financed renewals of a
section 467 rental agreement. Finally,
§1.467–8 provides the effective date
rules for the section 467 regulations.
(b)Method of accounting for section
467 rental agreements. If a rental
agreement is a section 467 rental
agreement, as described in paragraph
(c) of this section, the lessor and lessee
must each take into account for any
taxable year—
(1)The section 467 rent for the
taxable year (as defined in paragraph
(d) of this section); and
(2)The section 467 interest for the
taxable year (as defined in paragraph
(e) of this section).
(c)Section 467 rental agreements—
(1) In general. Except as otherwise
provided in paragraph (c)(4) of this
section, the term section 467 rental
agreement means a rental agreement, as
defined in paragraph (h) of this section,
that has increasing or decreasing rents
(as described in paragraph (c)(2) of this
section), or prepaid or deferred rents
(as described in paragraph (c)(3) of this
section).
(2)Increasing or decreasing rent—
(i) Fixed rent—(A) In general. A rental
agreement has increasing or decreasing
rent if the annualized fixed rent, as
described in paragraph (j)(3) of this
section, allocated to any rental period
exceeds the annualized fixed rent allo-
cated to any other rental period in the
lease term.
(B)Certain rent holidays dis-
regarded. Notwithstanding the provi-
sions of paragraph (c)(2)(i)(A) of this
section, a rental agreement does not
have increasing or decreasing rent if
the increasing or decreasing rent is
solely attributable to a rent holiday
provision allowing reduced rent (in-
cluding no rent) for a period at the
beginning of the lease term, but only if
the duration of the rent holiday does
not exceed three months.
(ii)Fixed rent allocated to a rental
period—(A) Specific allocation—(1) In
general. If a rental agreement provides
a specific allocation of fixed rent, as
described in paragraph (c)(2)(ii)(A)(2)
of this section, the amount of fixed rent

SEQ 0048 JOB IRS28-009-003 PAGE-0045 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
451996–28 I.R.B.
allocated to each rental period during
the lease term is the amount of fixed
rent allocated to that period by the
rental agreement.
(2)Rental agreements specifically
allocating fixed rent. A rental agree-
ment specifically allocates fixed rent if
the rental agreement unambiguously
specifies, for periods no longer than a
year, a fixed amount of rent for which
the lessee becomes liable on account of
the use of the property during that
period, and the total amount of fixed
rent specified is equal to the total
amount of fixed rent payable under the
lease. For example, a rental agreement
providing that rent is $100,000 per
calendar year, and that provides for
total payments of fixed rent equal to
the total amount specified, specifically
allocates rent. Similarly, a rental agree-
ment that states the amount of rent
accruing each month or the amount of
rent allocated to each year contains a
specific allocation if the total payments
of fixed rent equal the total amount
specified. A rental agreement stating
only when rent is payable does not
specifically allocate rent.
(B)No specific allocation. If a rental
agreement does not provide a specific
allocation of fixed rent (for example,
because the total amount of fixed rent
specified is not equal to the total
amount of fixed rent payable under the
lease), the amount of fixed rent allo-
cated to a rental period is the amount
of fixed rent payable during that rental
period. If an amount of fixed rent is
payable before the beginning of the
lease term, it is allocated to the first
rental period in the lease term. If an
amount of fixed rent is payable after
the end of the lease term, it is allocated
to the last rental period in the lease
term.
(iii)Contingent rent—(A) In gen-
eral. A rental agreement has increasing
or decreasing rent if it requires (or may
require) the payment of contingent rent
(as defined in paragraph (h) of this
section), other than contingent rent
described in paragraph (c)(2)(iii)(B) of
this section.
(B)Certain contingent rent dis-
regarded. Contingent rent is dis-
regarded for purposes of this paragraph
(c)(2)(iii) to the extent—
(1) The rent is contingent solely as
the result of a provision pursuant to
which the rent is equal to a percentage
of the lessee’s receipts (gross or net),
but only if the percentage does not
vary throughout the term of the lease;
(2) The rent is contingent solely as
the result of an adjustment based on a
reasonable price index, as defined in
paragraph (h) of this section; or
(3) The rent is contingent solely as
the result of a provision requiring the
lessee to pay third-party costs, as
defined in paragraph (h) of this section.
(3)Deferred or prepaid rent—(i)
Deferred rent. A rental agreement has
deferred rent under this paragraph
(c)(3) if the amount of rent allocated to
a calendar year (determined under
paragraph (c)(3)(iii) of this section),
when added to the rent allocated to all
preceding calendar years, exceeds the
cumulative amount of rent payable as
of the close of the succeeding calendar
year.
(ii)Prepaid rent. A rental agreement
has prepaid rent under this paragraph
(c)(3) if the amount of rent allocated to
a calendar year (determined under
paragraph (c)(3)(iii) of this section),
when added to the rent allocated to all
preceding calendar years, is less than
the cumulative amount of rent payable
before the beginning of the preceding
calendar year.
(iii)Rent allocated to a calendar
year. For purposes of this paragraph
(c)(3), the rent allocated to a calendar
year is the sum of—
(A)The fixed rent allocated to any
rental period (determined under para-
graph (c)(2)(ii) of this section) that
begins and ends in the calendar year;
(B)A ratable portion of the fixed
rent allocated to any other rental period
that begins or ends in the calendar
year; and (C) Any contingent rent that
accrues during the calendar year as
provided in §1.467–6.
(iv)Examples. The following exam-
ples illustrate the application of this
paragraph (c)(3):
Example 1. (i) A and B enter into a rental
agreement that provides for the lease of property
to begin on January 1, 1997, and end on
December 31, 2000. The rental agreement
provides that rent of $100,000 accrues during
each year of the lease term. Under the rental
agreement, no rent is payable during calendar
year 1997, a payment of $100,000 is to be made
on December 31, 1998, and December 31, 1999,
and a payment of $200,000 is to be made on
December 31, 2000. A and B both select the
calendar year as their rental period. Thus, under
paragraph (c)(3)(iii) of this section, the amount
of rent allocated to each rental period under
paragraph (c)(2)(ii) of this section is $100,000.
Therefore, the rental agreement does not have
increasing or decreasing rent as described in
paragraph (c)(2)(i) of this section.
(ii)Under paragraph (c)(3)(i) of this section, a
rental agreement has deferred rent if, at the close
of a calendar year, the cumulative amount of rent
allocated under paragraph (c)(3)(iii) of this
section exceeds the cumulative amount of rent
payable as of the close of the succeeding year. In
this example, there is no deferred rent: the rent
allocated to 1997 ($100,000) does not exceed the
cumulative rent payable as of December 31,
1998 ($100,000); the rent allocated to 1998 and
preceding years ($200,000) does not exceed the
cumulative rent payable as of December 31,
1999 ($200,000); the rent allocated to 1999 and
preceding years ($300,000) does not exceed the
cumulative rent payable as of December 31,
2000 ($400,000); and the rent allocated to 2000
and preceding years ($400,000) does not exceed
the cumulative rent payable as of December 31,
2001 ($400,000). Therefore, because the rental
agreement does not have increasing or decreasing
rent and does not have prepaid or deferred rent,
the rental agreement is not a section 467 rental
agreement.
Example 2. (i) A and B enter into a rental
agreement that provides for the lease of personal
property for ten years, beginning on January 1,
1997, and ending on December 31, 2006. The
rental agreement provides for accruals of rent of
$10,000 during each month of the lease term.
Under paragraph (c)(3)(iii) of this section,
$120,000 is allocated to each calendar year. The
rental agreement provides for a $1,200,000
payment on December 31, 1997.
(ii)The rental agreement does not have
increasing or decreasing rent as described in
paragraph (c)(2)(i) of this section. The rental
agreement provides prepaid rent under paragraph
(c)(3)(ii) of this section because an amount of
rent allocated to a calendar year, when added to
the rent allocated to all preceding calendar years,
is less than the cumulative amount of rent
payable before the beginning of the preceding
calendar year. For example, the rent allocated to
1999 and preceding calendar years ($360,000) is
less than the cumulative amount of rent payable
before the beginning of the preceding calendar
year ($1,200,000 is payable on December 31,
1997). Accordingly, the rental agreement is a
section 467 rental agreement.
(4)Rental agreements involving to-
tal payments of $250,000 or less—(i)
In general. A rental agreement is not a
section 467 rental agreement if, taking
into account any payments of con-
tingent rent, and any other contingent
consideration, the sum of the aggregate
amount of rental payments under the
rental agreement and the aggregate
value of other consideration to be
received for the use of property is not
reasonably expected, as of the agree-
ment date (as defined in paragraph (h)
of this section), to exceed $250,000.
(ii)Special rules in computing
amount described in paragraph (c)(4)-
(i). The following rules apply in
determining the amount described in
paragraph (c)(4)(i) of this section—
(A)Stated interest on deferred rent
is not taken into account. However, the
Commissioner may recharacterize a

SEQ 0049 JOB IRS28-009-003 PAGE-0046 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
461996–28 I.R.B.
portion of stated interest as additional
rent if a rental agreement provides for
interest on deferred rent at a rate that,
in light of all of the facts and
circumstances, is clearly greater than
the arm’s-length rate of interest that
would have been charged in a lending
transaction between the lessor and
lessee.
(B)Consideration that does not in-
volve a cash payment is taken into
account at its fair market value. A
liability that is either assumed or
secured by property acquired subject to
the liability is taken into account at its
remaining principal amount or, in the
case of an obligation originally issued
at a discount, at its adjusted issue price.
(C)All leases that are part of the
same transaction or a series of related
transactions are treated as a single
lease. Whether two or more leases are
part of the same transaction or a series
of related transactions depends on all
the facts and circumstances.
(D)Any increase or decrease in rent
payable solely as a result of an
adjustment based on a reasonable price
index is not taken into account.
(E) Contingent rent described in
paragraph (c)(2)(iii)(B)(3) of this sec-
tion is not taken into account.
(d)Section 467 rent—(1) In general.
The section 467 rent for a taxable year
is the sum of—
(i)The fixed rent for any rental
period (determined under paragraph
(d)(2) of this section) that begins and
ends in the taxable year;
(ii)A ratable portion of the fixed
rent for any other rental period begin-
ning or ending in the taxable year; and
(iii)In the case of a section 467
rental agreement that provides for
contingent rent, the contingent rent that
accrues during the taxable year as
provided in §1.467–6.
(2)Fixed rent for a rental period—
(i) Constant rental accrual. In the case
of a section 467 rental agreement that
is a disqualified leaseback or long-term
agreement (as described in §1.467–
3(b)), the fixed rent for a rental period
is the constant rental amount (as
determined under §1.467–3(d)).
(ii)Proportional rental accrual. In
the case of a section 467 rental
agreement that is not described in
paragraph (d)(2)(i) of this section, and
does not provide adequate interest on
fixed rent (as determined under
§1.467–2(b)), the fixed rent for a rental
period is the proportional rental amount
(as determined under §1.467–2(c)).
(iii)Section 467 rental agreement
accrual. In the case of a section 467
rental agreement that is not described
in paragraph (d)(2)(i) or (ii) of this
section, the fixed rent for a rental
period is the amount of fixed rent
allocated to the rental period under the
rental agreement, as determined under
paragraph (c)(2)(ii) of this section.
(e)Section 467 interest—(1) In gen-
eral. The section 467 interest for a
taxable year is the sum of—
(i)The interest on fixed rent for any
rental period that begins and ends in
the taxable year;
(ii)A ratable portion of the interest
on fixed rent for any other rental
period beginning or ending in the
taxable year; and
(iii)In the case of a section 467
rental agreement that provides for
contingent rent, any interest that ac-
crues on the contingent rent during the
taxable year as provided in §1.467–6.
(2)Interest on fixed rent for a rental
period—(i) In general. Except as
provided in paragraph (e)(2)(ii) of this
section and §1.467–5(b)(1)(ii), the in-
terest on fixed rent for a rental period
is equal to the product of—
(A)The principal balance of the
section 467 loan (as described in
§1.467–4(b)) at the beginning of the
rental period; and
(B)The yield of the section 467
loan (as described in §1.467–4(c)).
(ii)Section 467 rental agreements
with adequate interest. Except in the
case of a section 467 rental agreement
that is a disqualified leaseback or long-
term agreement, if a section 467 rental
agreement provides adequate interest
under §1.467–2(b)(1)(i) (agreements
with no deferred or prepaid rent) or
§1.467–2(b)(1)(ii) (agreements with ad-
equate stated interest at a single fixed
rate), the interest on fixed rent for a
rental period is the amount of interest
provided in the rental agreement for the
period.
(3)Treatment of interest. If the
section 467 interest for a rental period
is a positive amount, the lessor has
interest income and the lessee has an
interest expense. If the section 467
interest for a rental period is a negative
amount, the lessee has interest income
and the lessor has an interest expense.
(f)Modification of a rental agree-
ment. If, after the lease date, the lessor
and lessee agree to a substantial
modification of the terms of a lease,
the modified lease is treated, except as
provided in this paragraph (f), as a new
rental agreement for purposes of this
section and §§1.467–2 through 1.467–
8. If a principal purpose of such a
modification is to avoid the purpose or
intent of section 467, the Commissioner
may treat the original and modified
lease as a single rental agreement for
purposes of this section and §§1.467–2
through 1.467–8.
(g)Treatment of amounts payable by
lessor to lessee—(1) Interest. For pur-
poses of determining present value, any
amounts payable by the lessor to the
lessee as interest on prepaid rent are
treated as negative amounts.
(2)Other amounts. [Reserved]
(h)Meaning of terms. The following
meanings apply for purposes of this
section and §§1.467–2 through 1.467–
8—
(1)Agreement date means the earlier
of the lease date or the first date on
which there is a binding written con-
tract that substantially sets forth the
terms under which the property will be
leased.
(2)Contingent rent means any rent
that is not fixed rent, including any
amount reflecting an adjustment based
on a reasonable price index.
(3)Fixed rent means any rent to the
extent its amount and the time at which
it will be paid are fixed and determin-
able under the terms of the section 467
rental agreement as of the lease date, as
defined in paragraph (h)(4) of this
section. For this purpose, the possibility
of a breach or other early termination
of the rental agreement and any provi-
sion that makes adjustments based on a
reasonable price index are disregarded
in determining whether amounts spec-
ified in the agreement are fixed rent.
(4)Lease date means the date on
which the lessee first has the right to
use property that is the subject of the
section 467 rental agreement.
(5)Lease term means the period
during which the lessee has the use of
property subject to the section 467
rental agreement. An option period is
included in the lease term only if it is
expected, as of the agreement date, that
the option will be exercised by either
the lessor or the lessee. For this
purpose, a lessor is generally expected
to exercise an option if, for example, as
of the agreement date, the rent in effect

SEQ 0050 JOB IRS28-009-003 PAGE-0047 PT 4 PGS 42-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-009
471996–28 I.R.B.
for the option period exceeds the ex-
pected market rental for the property
during such period. Similarly, a lessee
is generally expected to exercise an
option if, for example, as of the
agreement date, the rent for the option
period is less than the expected market
rental for such period. The lessor’s or
lessee’s determination that an option
period is either included in or excluded
from the lease term is not binding on
the Commissioner. If the lessee (or a
related person) agrees that one or both
of them will or could be obligated to
make payments in the nature of rent
(within the meaning of §1.168(i)–2(b)-
(2)) for a period when another lessee
(the substitute lessee) or the lessor will
have use of the property subject to the
rental agreement, the Commissioner
may, in appropriate cases, treat the
period when the substitute lessee or
lessor will have use of the property as
part of the lease term. See paragraph
§1.467–7(f) for special rules applicable
to the lessee, substitute lessee, and
lessor.
(6)An adjustment is based on a
reasonable price index if the adjust-
ment reflects inflation or deflation
occurring over a period during the
lease term and is determined consist-
ently under any generally recognized
index for measuring inflation or
deflation.
(7)Except as otherwise provided in
this paragraph (h)(7), two persons are
related persons if they either have a
relationship to each other that is
specified in section 267(b) or section
707(b)(1) or are related entities within
the meaning of sections 168(h)(4)(A),
(B), or (C). For purposes of determin-
ing whether a section 467 rental
agreement is a leaseback within the
meaning of §1.467–3(b)(2), two per-
sons are related persons if they are
related persons within the meaning of
section 465(b)(3)(C).
(8)Rental agreement includes any
agreement, whether written or oral, that
provides for the use of tangible prop-
erty and is treated as a lease for
Federal income tax purposes.
(9)Third-party costs include any
real estate taxes, insurance premiums,
maintenance costs, or any other cost
(other than a debt service cost) that
relates to the leased property and is not
within the control of the lessor or
lessee or any related person.
(i)[Reserved].
(j)Computational rules. For pur-
poses of this section and §§1.467–2
through 1.467–8, the following rules
apply—
(1)Counting conventions. Any rea-
sonable counting convention may be
used (e.g., 30 days per month/360 days
per year) to determine the length of a
rental period or to perform any com-
putation. Rental periods of the same
descriptive length, for example annual,
semiannual, quarterly, or monthly, may
be treated as being of equal length.
(2)Conventions regarding timing of
rent and payments—(i) In general. For
purposes of determining present values
and yield—
(A)Except as otherwise provided in
this section and §§1.467–2 through
1.467–7, the rent allocated to a rental
period is taken into account on the last
day of the rental period;
(B)Any amount payable during the
first half of the first rental period is
treated as payable on the first day of
that rental period;
(C)Any amount payable during the
first half of any other rental period is
treated as payable on the last day of
the preceding rental period; and
(D)Any amount payable during the
second half of a rental period is treated
as payable on the last day of the rental
period.
(ii)Time amount is payable. For
purposes of this paragraph (j)(2), an
amount is payable on the last day for
timely payment (that is, the last day
such amount may be paid without
incurring interest, computed at an
arm’s-length rate, or a substantial
penalty charge) and an amount payable
at the midpoint of a rental period is
treated as payable during the first half
of the rental period.
(3)Annualized fixed rent. An-
nualized fixed rent is determined by
multiplying the fixed rent allocated to
the rental period under paragraph
(c)(2)(ii) of this section by a number
that represents the ratio of one year to
the length of the rental period. Thus, if
the fixed rent allocated to a rental
period is $100,000 and the rental
period is one month, the annualized
fixed rent allocated to the rental period
is $1,200,000.
(4)Allocation of fixed rent within a
period. A rental agreement that allo-
cates fixed rent to any period is treated
as allocating fixed rent ratably within
that period. Thus, if a rental agreement
provides that $120,000 is allocated to
each calendar year in the lease term,
$10,000 of rent is allocated to each
calendar month.
(5)Rental period length. Except as
provided in §1.467–3(d)(1) (relating to
agreements for which constant rental
accrual is required), rental periods may
be of any length and may vary in
length as long as—
(i)The rental periods are one year or
less, cover the entire lease term, and do
not overlap;
(ii)Each scheduled payment under
the rental agreement (other than a
payment scheduled to occur before or
after the lease term) occurs within 30
days of the beginning or end of a rental
period; and
(iii)In the case of a rental agree-
ment that does not provide a specific
allocation of fixed rent, the rental
periods selected do not cause the
agreement to be treated as a section
467 rental agreement unless all alterna-
tive rental period schedules would
result in such treatment.
§1.467–2 Rent accrual for section
467 rental agreements without
adequate interest.
(a)Section 467 rental agreement for
which proportional rental accrual is
required. Under §1.467–1(d)(2)(ii), the
fixed rent for each rental period is the
proportional rental amount, defined
under paragraph (c) of this section, if—
(1)The section 467 rental agreement
is not a disqualified leaseback or long-
term agreement under §1.467–3(b); and
(2)The section 467 rental agreement
does not provide adequate interest on
fixed rent under paragraph (b) of this
section.
(b)Adequate interest on fixed rent—
(1) In general. A section 467 rental
agreement provides adequate interest
on fixed rent if, disregarding any
contingent rent—
(i) The rental agreement has no
prepaid or deferred rent as described in
§1.467-1(c)(3);
(ii) The rental agreement has prepaid
or deferred rent, and—
(A) The rental agreement provides
interest (the stated rate of interest) on
deferred or prepaid fixed rent at a
single fixed rate (as defined in
§1.1273-1(c)(1)(iii));
(B) The stated rate of interest on
fixed rent is no lower than 110 percent
of the applicable Federal rate (as

SEQ 0052 JOB IRS28-010-005 PAGE-0048 PT 4 PGS 48-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-010
481996–28 I.R.B.
defined in paragraph (e)(3) of this
section);
(C)The amount of deferred or pre-
paid fixed rent on which interest is
charged is adjusted at least annually to
reflect the amount of deferred or
prepaid fixed rent as of a date no
earlier than the date of the preceding
adjustment and no later than the date of
the succeeding adjustment; and
(D)The rental agreement requires
interest to be paid or compounded at
least annually;
(iii)The rental agreement provides
for deferred rent but no prepaid rent,
and the sum of the present values of all
amounts payable by the lessee as fixed
rent (and interest, if any, thereon) is
equal to or greater than the sum of the
present values of the fixed rent allo-
cated to each rental period; or
(iv)The rental agreement provides
for prepaid rent but no deferred rent,
and the sum of the present values of all
amounts payable by the lessee as fixed
rent, plus the sum of the negative
present values of all amounts payable
by the lessor as interest, if any, on
prepaid fixed rent, is equal to or less
than the sum of the present values of
the fixed rent allocated to each rental
period.
(2)Section 467 rental agreements
that provide for a variable rate of
interest. For purposes of the adequate
interest test under paragraph (b)(1) of
this section, if a section 467 rental
agreement provides for variable inter-
est, the rental agreement is treated as
providing for fixed rates of interest on
deferred or prepaid fixed rent equal to
the fixed rate substitutes (determined in
the same manner as under §1.1275–5(e)
treating the agreement date as the issue
date) for the variable rates called for by
the rental agreement. For purposes of
this section, a rental agreement pro-
vides for variable interest if the rental
agreement provides for stated interest
that is paid or compounded at least
annually at a rate or rates that meet the
requirements of §1.1275–5(a)(3)(i)(A)
or (B) and §1.1275–5(a)(4).
(c)Computation of proportional
rental amount—(1) In general. The
proportional rental amount for a rental
period is the amount of fixed rent
allocated to the rental period under
§1.467–1(c)(2)(ii), multiplied by a frac-
tion. The numerator of the fraction is
the sum of the present values of the
amounts payable under the terms of the
section 467 rental agreement as fixed
rent and interest thereon. The de-
nominator of the fraction is the sum of
the present values of the fixed rent
allocated to each rental period under
the rental agreement.
(2)Section 467 rental agreements
that provide for a variable rate of
interest. To calculate the proportional
rental amount for a section 467 rental
agreement that provides for a variable
rate of interest, see §1.467–5.
(d)Present value. For purposes of
determining adequate interest under
paragraph (b) of this section or the
proportional rental amount under para-
graph (c) of this section, present values
are determined as of the first day a
fixed rent payment is called for by the
section 467 rental agreement if the
rental agreement calls for payments of
fixed rent prior to the lease term.
Otherwise, present values are deter-
mined as of the first day of the first
rental period in the lease term. The
present value of any amount is deter-
mined using a discount rate equal to
110 percent of the applicable Federal
rate. For purposes of the present value
determination under paragraph (b)(1)-
(iv) of this section, the fixed rent
allocated to a rental period must be
discounted from the first day of the
rental period. For other conventions
and rules relating to the determination
of present value, see §1.467–1(g) and
(j).
(e)Applicable Federal rate—(1) In
general. The applicable Federal rate for
a section 467 rental agreement is the
applicable Federal rate in effect on the
agreement date. Except as otherwise
provided in this section, the applicable
Federal rate for a rental agreement
means—
(i)The Federal short-term rate if the
term of the rental agreement is not over
3 years;
(ii)The Federal mid-term rate if the
term of the rental agreement is over 3
years but not over 9 years; and
(iii)The Federal long-term rate if
the term of the rental agreement is over
9 years.
(2)Source of applicable Federal
rates. The Internal Revenue Service
publishes the applicable Federal rates,
based on annual, semiannual, quarterly,
and monthly compounding, each month
in the Internal Revenue Bulletin (see
§601.601(d) of this chapter. However,
the applicable Federal rates may be
based on any compounding assumption.
To convert a rate based on one
c o m p o u n d i n g a s s u m p t i o n t o a n
equivalent rate based on a different
compounding assumption, see §1.1272–
1(j), Example 1.
(3)110 percent of applicable Fed-
eral rate. For purposes of §1.467–1,
this section and §§1.467–3 through
1.467–8, 110 percent of the applicable
Federal rate means 110 percent of the
applicable Federal rate based on semi-
annual compounding, or any rate based
on a different compounding assumption
that is equivalent to 110 percent of the
applicable Federal rate based on semi-
annual compounding.
(4)Term of the section 467 rental
agreement—(i) In general. For pur-
poses of determining 110 percent of the
applicable Federal rate under this para-
graph (e), the term of the section 467
rental agreement includes the lease
term, any period before the lease term
beginning with the first day an amount
of fixed rent is payable under the terms
of the rental agreement, and any period
after the lease term ending with the last
day an amount of fixed rent or interest
thereon is payable under the rental
agreement.
(ii)Section 467 rental agreements
with variable interest. If a section 467
rental agreement provides variable in-
terest on prepaid or deferred fixed rent,
the term of the rental agreement for
purposes of calculating 110 percent of
the applicable Federal rate is deter-
mined in accordance with paragraph
(e)(4)(i) of this section by substituting
for the term of the rental agreement,
the longest period between interest rate
adjustment dates, or, if the rental
agreement provides an initial fixed rate
of interest on prepaid or deferred fixed
rent, the period between the agreement
date and the last day the fixed rate
applies, if this period is longer. If, as
described in §1.1274–4(c)(2)(ii), the
rental agreement provides for a
qualified floating rate (as defined in
§1.1275–5(b)) that in substance resem-
bles a fixed rate, 110 percent of the
applicable Federal rate is determined
by reference to the lease term.
(f)Examples. The following exam-
ples illustrate the application of this
section. In each of these examples it is
assumed that constant rental accrual
does not apply:
Example 1. (i) C agrees to lease property from
D for five years beginning on January 1, 1998,
and ending on December 31, 2002. The section

SEQ 0053 JOB IRS28-010-005 PAGE-0049 PT 4 PGS 48-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-010
491996–28 I.R.B.
467 rental agreement provides that rent of
$100,000 accrues in each calendar year in the
lease term and that rent of $500,000 plus
$120,000 of interest is payable on December 31,
2002. Assume that the parties select the calendar
year as the rental period and that 110 percent of
the applicable Federal rate based on annual
compounding is 10 percent.
(ii)The rental agreement has deferred rent
under §1.467–1(c)(3)(i) because the fixed rent
allocated to calendar years 1998, 1999, and 2000
is not paid until 2002. In addition, because the
rental agreement does not state an interest rate,
the rental agreement does not satisfy the
requirements of paragraph (b)(1)(ii) of this
section. Thus, the adequacy of interest must be
determined under paragraph (b)(1)(iii) of this
section.
(iii)(A) Because the rental agreement has
deferred fixed rent and no prepaid rent, the
agreement has adequate interest only if the
present value rules provided in paragraph
(b)(1)(iii) are met. The present value of all fixed
rent and interest payable under the rental
agreement is $384,971.22, determined as follows:
$384,971.22 = $620,000/(1.10)
5
. The present
value of all fixed rent allocated under the rental
agreement (discounting the amount of fixed rent
allocated to a rental period from the last day of
the rental period) is $379,078.68, determined as
follows:
$379,078.78=$1000,0003
1–(1.10)
5
.10
(B)Accordingly, the sum of the present
values of amounts payable exceeds the sum of
the present values of fixed rent allocated. The
rental agreement provides adequate interest on
fixed rent.
(iv)For an example illustrating the computa-
tion of the yield on the rental agreement and the
allocation of the interest and rent provided for
under the rental agreement, see §1.467–4(f),
Example 2.
Example 2. (i) E and F enter into a section 467
rental agreement for the lease of equipment
beginning on January 1, 1998, and ending on
December 31, 2002. The rental agreement
provides that rent of $100,000 accrues for each
calendar month during the lease term. All rent is
payable on December 31, 2002, together with
interest on accrued rent at a qualified floating
rate set at a current value (as defined in
§1.1275–5(a)(4)) that is compounded at the end
of each calendar month and adjusted at the
beginning of each calendar month throughout the
lease term. Therefore, the rental agreement
provides for variable interest within the meaning
of paragraph (b)(2) of this section.
(ii)On the agreement date the qualified
floating rate is 7.5 percent, and 110 percent of
the applicable Federal rate, as defined in
paragraph (e)(3) of this section, based on
monthly compounding, is 7 percent. Under
paragraph (b)(2) of this section, the fixed rate
substitute for the qualified floating rate is 7.5
percent and the agreement is treated as providing
for interest at this fixed rate for purposes of
determining whether adequate interest is
provided under paragraph (b) of this section.
Accordingly, the requirements of paragraph
(b)(1)(ii) of this section are satisfied, and the
rental agreement has adequate interest.
Example 3. (i) X and Y enter into a section
467 rental agreement for the lease of real
property beginning on January 1, 1998, and
ending on December 31, 2000. The rental
agreement provides that rent of $80,000 is
allocable to 1998, $100,000 is allocable to 1999,
and $120,000 is allocable to 2000. Under the
rental agreement, Y must make a $300,000
payment on December 31, 2000. Assume that
both X and Y choose the calendar year as the
rental period, X and Y are calendar year
taxpayers, and 110 percent of the applicable
Federal rate is 8.5 percent compounded annually.
Assume further that the rental agreement fails to
provide adequate interest under paragraph (b)(1)
of this section. Therefore, under §1.467–1(d)-
(2)(ii), the fixed rent for each rental period is the
proportional rental amount.
(ii)(A) The proportional rental amount is
computed under paragraph (c) of this section.
Because the rental agreement does not call for
any fixed rent payments prior to the lease term,
under paragraph (d) of this section, present value
is determined as of the first day of the first rental
period in the lease term. The sum of the present
values of the amounts payable by the lessee
under the rental agreement is computed as
follows:
$234,872.43=
$300,000
(1 + .085)
3
(B)The sum of the present values of the fixed
rent allocated to each rental period (discounting
the fixed rent allocated to a rental period from
the last day of such rental period) is computed as
follows:
$252,627.22=
$80,000
+
$100,000
+
$120,000
(1 +.085)
(1 +.085)
2
(1 +.085)
3
(C)Thus, the fraction for determining the
proportional rental amount is .9297194
($234,872.43/$252,627.22). The section 467
fixed rents for the taxable years within the lease
term are:
Taxable
year
Section 467 rent
1998$ 74,377.55 ($ 80,000 3 .9297194)
199992,971.94 ($100,000 3 .9297194)
2000111,566.33 ($120,000 3 .9297194)
§1.467–3 Disqualified leasebacks and
long-term agreements.
(a)General rule. Under §1.467–
1(d)(2)(i), constant rental accrual (as
described under paragraph (d) of this
section) must be used to determine the
fixed rent for each rental period in the
lease term if the section 467 rental
agreement is a disqualified leaseback or
long-term agreement within the mean-
ing of paragraph (b) of this section.
(b)Disqualified leaseback or long-
term agreement—(1) In general. A
leaseback (as defined in paragraph
(b)(2) of this section) or a long-term
agreement (as defined in paragraph
(b)(3) of this section) is disqualified
only if—
(i)The amount determined with re-
spect to the section 467 rental agree-
ment under §1.467–1(c)(4) (relating to
the exception for rental agreements
involving total payments of $250,000
or less) exceeds $2,000,000;
(ii)A principal purpose for provid-
ing increasing or decreasing rent is the
avoidance of Federal income tax (as
described in paragraph (c) of this
section); and
(iii)The Commissioner determines
that it is appropriate to treat the section
467 rental agreement as a disqualified
leaseback or long-term agreement.
(2)Leaseback. A section 467 rental
agreement is a leaseback if the lessee
(or a related person) had any interest
(other than a de minimis interest) in the
property at any time during the two-
year period ending on the agreement
date. For this purpose, interests in
property include options and agree-
ments to purchase the property
(whether or not the lessee or related
person was considered the owner of the
property for Federal income tax pur-
poses) and, in the case of subleased
property, any interest as a sublessor.
(3)Long-term agreement—(i) In
general. A section 467 rental agree-
ment is a long-term agreement if the
lease term exceeds 75 percent of the
statutory recovery period for the
property.
(ii)Statutory recovery period—(A)
In general. The term statutory recovery
period means—
(1) In the case of property deprecia-
ble under section 168, the applicable
period determined under section
467(e)(3)(A);
(2) In the case of land, 19 years; and
(3) In the case of any other tangible
property, the period that would apply
under section 467(e)(3)(A) if the prop-
erty were property to which section
168 applied.
(B)Special rule for leases of prop-
erties having different statutory recov-
ery periods. In the case of a lease of
two or more related properties that
have different statutory recovery peri-
ods, the statutory recovery period for
purposes of paragraph (b)(3)(ii)(A) of
this section is the weighted average,
based on the fair market values of the
properties on the lease date, of the
statutory recovery periods of each of
the properties.
(c)Tax avoidance as principal pur-
pose for increasing or decreasing

SEQ 0054 JOB IRS28-010-005 PAGE-0050 PT 4 PGS 48-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-010
501996–28 I.R.B.
rent—(1) In general. Whether tax
avoidance is a principal purpose for
providing increasing or decreasing rent
in a leaseback or long-term agreement
is based on all of the facts and cir-
cumstances. However, if either the
lessee or the lessor is not subject to
Federal income tax on its income or is
a tax-exempt entity (within the mean-
ing of section 168(h)(2)), the agree-
ment will be closely scrutinized and
clear and convincing evidence will be
required to establish that tax avoidance
is not a principal purpose for providing
increasing or decreasing rent.
(2)Safe harbors. Tax avoidance is
not considered to be a principal pur-
pose for providing increasing or de-
creasing rent if—
(i)The rent allocated to each calen-
dar year (determined without regard to
any increase or decrease attributable to
a provision described in paragraph
(c)(2)(ii)(C) of this section) does not
vary from the average rent allocated to
all calendar years by more than 10
percent (for this purpose, the rent
allocated to a partial calendar year is
adjusted by multiplying the rent by the
number of partial years in a full
calendar year); or
(ii)All of the increases and de-
creases in rent are attributable to one or
more of the following provisions—
(A)A provision requiring an in-
crease in rent equal to a percentage of
the lessee’s receipts (gross or net) if
the percentage does not vary through-
out the term of the lease;
(B)A provision requiring an adjust-
ment based on a reasonable price index
as described in §1.467–1(h);
(C)A provision requiring the lessee
to pay third-party costs as described in
§1.467–1(h); or
(D)A rent holiday provision allow-
ing reduced rent (including no rent) for
an interim period at the beginning of
the lease term, but only if the duration
of the rent holiday does not exceed the
lesser of 24 months or 10 percent of
the lease term and there is a substantial
business purpose for the rent holiday
provision.
(d)Calculating constant rental
amount—(1) In general. Except as
provided in paragraph (d)(2) of this
section, the constant rental amount is
the amount that, if paid at the end of
each rental period, would result in a
present value equal to the present value
of all amounts payable under the dis-
qualified leaseback or long-term agree-
ment as rent and interest. In computing
the constant rental amount, the rules
for determining present value are the
same as those provided in §1.467–2(d)
for computing the proportional rental
amount. If constant rental accrual is
required, all rental periods (other than
an initial or final short period of not
more than one month) must be equal in
length and satisfy the requirements of
§1.467–1(j)(5).
(2)Initial or final short periods. If a
disqualified leaseback or long-term
agreement has an initial or final short
rental period, the constant rental
amount for the initial or final short
period may be determined under any
reasonable method. However, the sum
of the present values of all the constant
rental amounts must equal the present
values of all amounts payable under the
disqualified leaseback or long-term
agreement as rent and interest. Any
adjustment necessary to eliminate the
section 467 loan balance because of the
method used to determine the constant
rental amount for short periods must be
taken into account as section 467 rent
for the final rental period.
(3)Method to determine constant
rental amount; no short periods—(i)
Step 1. Determine the present value of
amounts payable under the disqualified
leaseback or long-term agreement as
rent or interest.
(ii)Step 2. Determine the present
value of $1 to be received at the end of
each rental period during the lease term
as of the first day of the first rental
period during the lease term (or, if
earlier, the first day a rent payment is
required under the rental agreement).
(iii)Step 3. Divide the amount deter-
mined in paragraph (d)(3)(i) of this
section (Step 1) by the number of
dollars determined in paragraph
(d)(3)(ii) of this section (Step 2).
(e) Example. The following example
illustrates the application of paragraph
(d) of this section:
Example. (i) X and Y enter into a disqualified
leaseback for a 5-year lease of personal property
beginning on January 1, 1998, and ending on
December 31, 2002. The rental agreement pro-
vides that $0 of rent is allocated to years 1998,
1999, and 2000, and that rent of $17,500,000 is
allocated to years 2001 and 2002. The rental
agreement provides that the rent allocated to
each year is payable on December 31 of that
year. Assume all rental periods are the calendar
year. Assume also that 110 percent of the
applicable Federal rate based on annual com-
pounding is 12 percent.
(ii)Step 1 in calculating the constant rental
amount is to determine the present value of the
two payments due under the rental agreement as
follows:
$21,051,536=
$17,500,000
+
$17,500,000
(1.12)
4
(1.12)
5
(iii)Because no amounts of rent are payable
before the lease term, Step 2 in calculating the
constant rental amount is to determine the
present value as of the first day of the lease term
of $1 to be received at the end of each rental
period during the lease term. This results in a
present value of $3.6047762. In Step 3 the
amount determined in Step 1 is divided by the
number of dollars determined in Step 2. Thus,
the constant rental amount is $5,839,901 for each
calendar year during the lease term computed as
follows:
$5,839,901=
$21,051,536
3.6047762
§1.467–4 Section 467 loan.
(a)In general—(1) Overview. Ex-
cept as provided in paragraph (a)(2) of
this section, the section 467 loan rules
of this section apply to a section 467
rental agreement if, as of the first day
of that period, there is a difference
between the amount of fixed rent
payable under the rental agreement on
or before the first day and the amount
of fixed rent required to be accrued in
accordance with §1.467–1(d)(2) before
the first day. Paragraph (b) of this
section provides rules for computing
the principal balance of a section 467
loan at the beginning of any rental
period. The principal balance of a
section 467 loan may be positive or
negative. For purposes of the Code, if
the principal balance is positive, the
amount represents a loan from the
lessor to the lessee and, if the principal
balance is negative, the amount repre-
sents a loan from the lessee to the
lessor.
(2)No section 467 loan in the case
of certain section 467 rental agree-
ments. Except as provided in paragraph
(a)(3) and (4) of this section, this
section does not apply to section 467
rental agreements that provide adequate
interest under §1.467–2(b)(1)(i) (agree-
ments with no deferred or prepaid rent)
or §1.467–2(b)(1)(ii) (agreements with
deferred or prepaid rent that provide
adequate stated interest at a single
fixed rate).
(3)Rental agreements subject to
constant rental accrual. Notwithstand-
ing the provisions of paragraph (a)(2)
of this section, this section applies to

SEQ 0055 JOB IRS28-010-005 PAGE-0051 PT 4 PGS 48-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-010
511996–28 I.R.B.
rental agreements subject to constant
rental accrual under §1.467–3.
(4)Special rule in applying the
provisions of §1.467–7(e) or (f). Not-
withstanding the provisions of para-
graph (a)(2) of this section, this section
applies to rental agreements that
provide adequate interest under
§1.467–2(b)(1)(i) or (ii), but only for
purposes of applying the provisions of
§1.467–7(e) (relating to dispositions of
property subject to a section 467 rental
agreement) or §1.467–7(f) (relating to
assignments by lessees and lessee-
financed renewals) to a transaction
described therein. Further, for section
467 rental agreements that provide
adequate interest under §1.467–2(b)-
(1)(i) or (ii), the section 467 interest
that accrues on the section 467 loan
balance after the sale, exchange, or
other disposition under §1.467–7(e) or
the assignment or renewal under
§1.467–7(f) is the section 467 interest
that accrues under the terms of the
rental agreement (if any).
(b) Principal balance—(1) In gen-
eral. Except as provided in paragraph
(b)(2) of this section or in §1.467–7(e)
or (f), the principal balance of the
section 467 loan at the beginning of a
rental period equals the fixed rent
accrued in preceding rental periods—
(i) Increased by the interest on fixed
rent includible in the gross income of
the lessor for preceding rental periods
and any amount payable by the lessor
on or before the first day of the rental
period as interest on prepaid fixed rent;
and
(ii) Decreased by the interest on
prepaid fixed rent includible in the
gross income of the lessee for preced-
ing rental periods and any amount
payable by the lessee on or before the
first day of the rental period as fixed
rent or interest thereon.
(2)Section 467 rental agreements
that provide for prepaid fixed rent and
adequate stated interest. If a section
467 rental agreement calls for prepaid
fixed rent and provides adequate inter-
est under §1.467–2(b)(1)(iv), the princi-
pal balance of the section 467 loan at
the beginning of a rental period equals
the principal balance determined under
paragraph (b)(1) of this section, plus
the fixed rent accrued for that rental
period.
(3)Timing of payments. For pur-
poses of this paragraph (b), the day on
which an amount is payable is deter-
mined under the rules of §1.467–
1(j)(2).
( c )Y i e l d— ( 1 ) I n g e n e r a l— ( i )
Method of determining yield. Except as
provided in paragraph (c)(2) of this
section, the yield of a section 467 loan
is the discount rate at which the sum of
the present values of all amounts
payable by the lessee as fixed rent and
interest on fixed rent, plus the sum of
the present values of all amounts
payable by the lessor as interest on
prepaid fixed rent, equals the sum of
the present values of the fixed rent that
accrues in accordance with §1.467–
1(d)(2). The yield must be constant
over the term of the section 467 rental
agreement, and, when expressed as a
percentage, must be calculated to at
least two decimal places.
(ii)Method of stating yield. In deter-
mining the section 467 interest for a
rental period, the yield of the section
467 loan must be stated appropriately
by taking into account the length of the
rental period. Section 1.1272–1(j) Ex-
ample 1 provides a formula for con-
verting a yield based on a period of
one length to an equivalent yield based
on a period of a different length.
(iii)Rounding adjustments. Any ad-
justment necessary to eliminate the
section 467 loan because of rounding
the yield to two or more decimal places
must be taken into account as section
467 interest for the final rental period
determined as provided in paragraph
(e) of this section.
(2)Yield of section 467 rental
agreements for which constant rental
amount or proportional rental amount
is computed. In the case of a section
467 rental agreement to which §1.467–
1(d)(2)(i) or (ii) applies, the yield of
the section 467 loan equals 110 percent
of the applicable Federal rate (based on
a compounding period equal to the
rental period).
(3)Determination of present values.
The rules for determining present value
in computing the yield of a section 467
loan are the same as those provided in
§1.467–2(d) for computing the propor-
tional rental amount.
(d)Contingent payments. Except as
otherwise required under §1.467–6,
contingent payments are not taken into
account in calculating either the yield
or the principal balance of a section
467 loan.
(e)Section 467 rental agreements
that call for payments before or after
the lease term. If a section 467 rental
agreement calls for the payment of
fixed rent or interest thereon before the
beginning of the lease term, this
section must be applied by treating the
period beginning on the first day an
amount is payable and ending on the
day before the beginning of the first
rental period of the lease term as one
or more rental periods. If a rental
agreement calls for the payment of
fixed rent or interest thereon after the
end of the lease term, this section must
be applied by treating the period
beginning on the day after the end of
the last rental period of the lease term
and ending on the last day an amount
of fixed rent or interest thereon is
payable as one or more rental periods.
Rental period length for the period
before the lease term or after the lease
term is determined in accordance with
the rules of §1.467–1(j)(5).
(f)Examples. The following exam-
ples illustrate the application of this
section:
Example. (i)(A) A leases property to B for a
three-year period beginning on January 1, 1998,
and ending on December 31, 2000. The section
467 rental agreement has the following rent
allocation schedule and payment schedule:
Rent
AllocationPayment
1998$400,000
1999600,000
2000800,000$1,800,000
(B)The rental agreement requires a $1.8
million payment to be made on December 31,
2000, but does not provide for interest on
deferred rent. Assume A and B choose the
calendar year as the rental period length. Assume
further that 110 percent of the applicable Federal
rate based on annual compounding is 10 percent.
(ii) The rental agreement is not a disqualified
leaseback or long-term agreement because it does
not provide for the payment of more than
$2,000,000 in rent (determined pursuant to
§1.467–3(b)(1)(i)). Because the section 467
rental agreement does not provide adequate
interest under §1.467–2(b) and is not subject to
constant rental accrual, the fixed rent that
accrues during each rental period is the propor-
tional rental amount as described in §1.467–2(c).
The proportional rental amounts for each rental
period are as follows:
1998$370,370.37
1999555,555.56
2000740,740.74
(iii)A section 467 loan arises at the beginning
of the second rental period because the rent
payable on or before that day (zero) is less than
the fixed rent accrued under §1.467–1(d)(2) in
all preceding rental periods ($370,370.37). Under
paragraph (c)(2) of this section, the yield of the
loan is equal to 110 percent of the applicable
Federal rate (10 percent compounded annually).
Because no payments are treated as made on or
before the first day of the second rental period,

SEQ 0056 JOB IRS28-011-011 PAGE-0052 PT 4 PGS 52-
REVISED 29JUL96 AT 23:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/29JUL96/IRS28-011
521996–28 I.R.B.
the principal balance of the loan at the beginning
of the second rental period is $370,370.37. The
interest for the second rental period on fixed rent
is $37,037.04 (.10 3 $370,370.37) and, under
§1.467–1(e)(3), is treated as interest income of
the lessor and as an interest expense of the
lessee.
(iv) Because no payments are made on or
before the first day of the third rental period, the
principal balance of the loan at the beginning of
the third rental period is equal to the fixed rent
accrued during the first and second rental periods
plus the lessor’s interest income on fixed rent for
the second rental period ($962,962.97 =
$370,370.37 + $555,555.56 + $37,037.04). The
interest for the third rental period on fixed rent is
$96,296.30 (.10 3 $962,962.97). Thus, the sum
of the fixed rent and interest on fixed rent for the
three rental periods is equal to the total amount
paid over the lease term (first year fixed rent
accrual, $370,370.37, plus second year fixed rent
and interest accrual, $555,555.56 + $37,037.04,
plus third year fixed rent and interest accrual,
$740,740.74 + $96,296.30, equals $1,800,000). B
takes the amounts of interest and rent into
account as expense and A takes such amounts
into account as income for the calendar years
identified above, regardless of their respective
methods of accounting.
Example 2. (i) The facts are the same as in
Example 1, §1.467–2(f).
(ii)(A) Pursuant to paragraph (c)(1) of this
section, the yield of the section 467 loan is
10.775078%, compounded annually. The follow-
ing is a schedule of the rent allocable to each
rental period during the lease term, the balance
of the section 467 loan as of the end of each
rental period (determined, in the case of the
calendar year 2002, without regard to the single
payment of rent and interest in the amount of
$620,000 payable on the last day of the lease
term), and the interest on the section 467 loan
allocable to each rental period:
Calendar
Year
Section
467
Interest
Section 467
Rent
Section 467
Loan
Balance
1988$0$100,000.00$100,000.00
199910,775.08100,000.00210,775.08
200022,711.18100,000.00333,486.26
200135,933.41100,000.00469,419.67
200250,580.33100,000.00620,000.00
(B)C takes the amounts of interest and rent
into account as expense and D takes such
amounts into account as income for the calendar
years identified above, regardless of their respec-
tive methods of accounting.
§1.467–5 Section 467 rental
agreements with variable interest.
(a) Variable interest on deferred or
prepaid rent—(1) In general. This
section provides rules for computing
section 467 rent and interest in the case
of section 467 rental agreements
providing variable interest. For pur-
poses of this section, a rental agree-
ment provides for variable interest if
the rental agreement provides for stated
interest that is paid or compounded at
least annually at a rate or rates that
meet the requirements of §1.1275–5(a)-
(3)(i)(A) or (B) and §1.1275–5(a)(4). If
a section 467 rental agreement provides
for interest that is neither variable
interest nor determined by reference to
a fixed rate, the amount of any interest
will be treated as a contingent payment
subject to §1.467–6.
(2)Exceptions. This section is not
applicable to section 467 rental agree-
ments that provide adequate interest
under §1.467–2(b)(1)(i) (agreements
with no deferred or prepaid rent) or
§1.467–2(b)(1)(ii) (rental agreements
with stated interest at a single fixed
rate). The exceptions in this paragraph
(a)(2) do not apply to rental agreements
subject to constant rental accrual under
§1.467–3.
(b)Variable rate treated as fixed—
(1) In general. If a section 467 rental
agreement provides variable interest—
(i)The fixed rate substitutes (deter-
mined in the same manner as under
§1.1275–5(e) treating the agreement
date as the issue date) for the variable
rates of interest on prepaid or deferred
fixed rent provided by the rental
agreement must be used in computing
the proportional rental amount under
§1.467–2(c), the constant rental amount
under §1.467–3(d), the principal bal-
ance of a section 467 loan under
§1.467–4(b), and the yield of a section
467 loan under §1.467–4(c); and
(ii)The interest on fixed rent for any
rental period is equal to the amount
that would be determined under
§1.467–1(e)(2) if the section 467 rental
agreement did not provide variable
interest, using the fixed rate substitutes
determined under paragraph (b)(1)(i) of
this section in place of the variable
rates called for by the rental agreement,
plus the variable interest adjustment
amount provided in paragraph (b)(2) of
this section.
(2)Variable interest adjustment
amount—(i) In general. The variable
interest adjustment amount for a rental
period equals the difference between—
(A) The amount of interest that,
without regard to section 467, would
have accrued during the rental period
under the terms of the section 467
rental agreement; and
(B) The amount of interest that,
without regard to section 467, would
have accrued during the rental period
under the terms of the section 467
rental agreement using the fixed rate
substitutes determined under paragraph
(b)(1)(i) of this section in place of the
variable interest rates called for by the
rental agreement.
(ii) Sign of adjustment. If the amount
determined under paragraph (b)(2)(i)-
(A) of this section is greater than the
amount determined under paragraph
(b)(2)(i)(B) of this section, the variable
interest adjustment amount is positive.
If the amount determined under para-
graph (b)(2)(i)(A) of this section is less
than the amount determined under
paragraph (b)(2)(i)(B) of this section,
the variable interest adjustment amount
is negative.
(3)Section 467 loan balance. The
variable interest adjustment amount is
not taken into account in determining
the principal balance of a section 467
loan under §1.467–4(b). Instead, the
section 467 loan balance is computed
as if all amounts payable under the
section 467 rental agreement were
based on the fixed rate substitutes
determined under paragraph (b)(1)(i) of
this section.
(c) Examples. The following exam-
ples illustrate the application of this
section:
Example 1. (i) X and Y enter into a section
467 rental agreement for the lease of personal
property beginning on January 1, 1998, and
ending on December 31, 2000. It allocates
$100,000 of rent to 1998, $200,000 to 1999, and
$100,000 to 2000, and requires the lessee to pay
all $400,000 of rent on December 31, 2000. The
rental agreement requires the accrual of interest
on unpaid accrued rent at two different qualified
floating rates (as defined in §1.1275–5(b)), one
for 1999 and the other for 2000, such interest to
be paid on December 31 of the year it accrues.
The rental agreement provides that the qualified
floating rate is set at a current value within the
meaning of §1.1275–5(a)(4). Assume that on the
agreement date, 110 percent of the applicable
Federal rate is 10 percent, compounded annually.
(ii) The rental agreement is not a disqualified
leaseback or long-term agreement because it does
not provide for the payment of more than
$2,000,000 in rent (determined pursuant to
§1.467–3(b)(1)(i)). To determine if the section
467 rental agreement provides for adequate
interest under §1.467–2(b), §1.467–2(b)(2) re-
quires the use of fixed rate substitutes (in this
example determined in the same manner as under
§1.1275–5(e)(3)(i) treating the agreement date as
the issue date) in place of the variable rates
called for by the rental agreement. Assume that
on the agreement date the qualified floating
rates, and therefore the fixed rate substitutes,
relating to 1999 and 2000 are 10 and 15 percent
compounded annually. Taking into account the
fixed rate substitutes, the sum of the present
values of all amounts payable by the lessee as
fixed rent and interest thereon is greater than the
sum of the present values of the fixed rent
allocated to each rental period. Accordingly, the
rental agreement provides adequate interest under
§1.467–2(b)(1)(iii) and the fixed rent accruing in

SEQ 0002 JOB IRS28-011-011 PAGE-0053 PT 4 PGS 52-
REVISED 02AUG96 AT 05:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/2AUG96/IRS28-011
531996–28 I.R.B.
each calendar year during the rental agreement is
the fixed rent allocated under the rental
agreement.
(iii) Because the section 467 rental agreement
provides for variable interest on unpaid accrued
fixed rent at qualified floating rates and the
qualified floating rates are set at a current value,
the requirements of §1.1275–5(a)(3)(i)(A) and
(4) are met and the rental agreement provides for
variable interest within the meaning of paragraph
(a)(1) of this section. Therefore, under paragraph
(b)(1)(i) of this section, the yield of the section
467 loan is computed based on the fixed rate
substitutes. Under §1.467–4(c), the constant yield
(rounded to two decimal places) equals 13.63
percent compounded annually. Based on the
fixed rate substitutes, the fixed rent, interest on
fixed rent, and the principal balance of the
section 467 loan, for each calendar year during
the lease term, are as follows:
AccruedAccruedProjectedCumulative
RentInterestPaymentLoan
1998$100,000$0 $0$100,000
1999200,00013,630(10,000)303,630
2000100,00041,370(445,000)0
(iv) To compute the actual reported interest on
fixed rent for each calendar year, the variable
interest adjustment amount, as described in
paragraph (b)(2) of this section, must be added to
the accrued interest determined in paragraph (iii)
of this Example 1. Assume that the variable rates
for 1999 and 2000 are actually 11 and 14
percent, respectively. Without regard to section
467, the interest that would have accrued during
each calendar year under the terms of the section
467 rental agreement, and the interest that would
have accrued under the terms of the rental
agreement using the fixed rate substitutes deter-
mined under paragraph (b)(1)(i) are as follows:
Accrued Interest
Under Rental
Agreement
Accrued Interest
Using Fixed Rate
Substitutes
1998$0$0
199911,00010,000
200042,00045,000
(v) Under paragraph (b)(2) of this section, the
variable interest adjustment amount is $1,000
($11,000 – $10,000) for 1999 and is –$3,000
($42,000 – $45,000) for 2000. Thus, under
paragraph (b)(1)(ii) of this section, the actual
interest on fixed rent for 1999 is $14,630
($13,630 + $1,000) and for 2000 is $38,370
($41,370 – $3,000).
Example 2. (i) The facts are the same as in
Example 1 except that 110 percent of the
applicable Federal rate is 15 percent compounded
annually and the section 467 rental agreement
does not provide adequate interest under §1.467–
2(b). Consequently, the fixed rent for each
calendar year during the lease is the proportional
rental amount.
(ii) The sum of the present values of the fixed
rent provided for each calendar year during the
lease term, discounted at 15 percent compounded
annually, equals $303,936.87.
(iii)(A) Paragraph (b)(1)(i) of this section
requires the proportional rental amount to be
computed based on the assumption that interest
will accrue and be paid based on the fixed rate
substitutes. Thus, the sum of the present values
of the projected payments under the section 467
rental agreement equals $300,156.16, computed
as follows:
$ 10,000/(1.15)
2
=$ 7,561.44
445,000/(1.15)
3
=$300,156.16
(B) The fraction for computing the proportional
r e n t a l a m o u n t e q u a l s . 9 8 7 5 6 0 9
($300,156.16/$303,936.87).
(iv) Based on the fixed rate substitutes, the
fixed rent, interest on fixed rent, and the balance
of the section 467 loan for each calendar year
during the lease term are as follows:
Propor-
tional Rent
Accrued
Interest
Projected
Payment
Cumulative
Loan
1998$ 98,756.09$ 0.00$ 0$ 98,756.09
1999197,512.1814,813.41(10,000)301,081.68
200098,756.0945,162.23(445,000)0.00
(v) The variable interest adjustment amount in
this example is the same as in Example 1. Under
paragraph (b)(1)(ii) of this section, the actual
interest on fixed rent for 1999 is $15,813.41
($14,813.41 + $1,000) and for 2000 is
$42,162.23 ($45,162.23 – $3,000).
§1.467–6 Section 467 rental
agreements with contingent payments.
[Reserved]
§1.467–7 Section 467 recapture and
other rules relating to dispositions.
(a) Section 467 recapture. Notwith-
standing any other provision of the
Code, except as provided in paragraph
(c) of this section, a lessor disposing of
property in a transaction to which this
section applies must recognize the
recapture amount (determined under
paragraph (b) of this section) and treat
that amount as ordinary income. This
section applies to any disposition of
property subject to a section 467 rental
agreement that—
(1) Is a leaseback (as defined in
§1.467–3(b)(2)) or a long-term agree-
ment (as defined in §1.467–3(b)(3));
(2) Is not disqualified under §1.467–
3(b)(1); and
(3) Allocates to any rental period
fixed rent that, when annualized, ex-
ceeds the annualized fixed rent allo-
cated to any preceding rental period.
(b) Recapture Recapture amount—
(1) In general. The recapture amount
for a disposition is the lesser of—
(i) The prior understated inclusions
(determined under paragraph (b)(2) of
this section); or
(ii) The section 467 gain (determined
under paragraph (b)(3) of this section).
(2) Prior understated inclusions—(i)
In general. The prior understated inclu-
sions are the excess (if any) of—
(A) The aggregate amount of section
467 rent and section 467 interest for
the period during which the lessor held
the property, determined as if the
section 467 rental agreement were a
disqualified leaseback or long-term
agreement; over
(B) The aggregate amount of section
467 rent and section 467 interest
accrued by the lessor during that
period.
(ii) Partial rental periods. For pur-
poses of this paragraph (b)(2), the
aggregate amounts described in para-
graph (b)(2)(i)(A) and (B) of this
section include a ratable portion of the
section 467 rent and section 467
interest for any partial rental period
during which the lessor held the
property.
(3) Section 467 gain—(i) In general.
Except as otherwise provided in para-
graph (b)(3)(ii) of this section, the
section 467 gain is the excess (if any)
of—
(A) The amount realized from the
disposition; over
(B) The sum of the adjusted basis of
the property and the amount of any
gain from the disposition that is treated
as ordinary income under any provision
of subtitle A of the Code other than
section 467(c) (e.g., section 1245 or
1250).
(ii) Certain dispositions. In the case
of a disposition that is not a sale,
exchange, or involuntary conversion,
the section 467 gain is the excess (if
any) of the fair market value of the
property on the date of disposition over
the amount determined under paragraph
(b)(3)(i)(B) of this section.
(c) Special rules—(1) Gifts. Para-
graph (a) of this section does not apply
to a disposition by gift. However, see
paragraph (c)(4) of this section for
dispositions by transferees.
(2) Dispositions at death. Paragraph
(a) of this section does not apply to a
disposition if the basis of the property
in the hands of the transferee is
determined under section 1014(a). In
the case of items constituting income in
respect of a decedent, see section 691.
(3) Certain tax-free exchanges—(i)
In general. The recapture amount in the
case of a disposition to which this
paragraph (c)(3) applies is limited to
the amount of gain recognized to the
transferor (determined without regard
to paragraph (a) of this section),
reduced by the amount of any gain
from the disposition that is treated as
ordinary income under any provision of

SEQ 0003 JOB IRS28-011-011 PAGE-0054 PT 4 PGS 52-
REVISED 02AUG96 AT 05:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/2AUG96/IRS28-011
541996–28 I.R.B.
subtitle A of the Code other than
section 467(c).
(ii) Dispositions covered. This para-
graph (c)(3) applies to a disposition of
property if the basis of the property in
the hands of the transferee is deter-
mined by reference to its basis in the
hands of the transferor by reason of the
application of section 332, 351, 361,
721, or 731.
(4) Dispositions by transferee. If the
recapture amount with respect to a
disposition of property (the first dis-
position) is limited under paragraph
(c)(1) or (3) of this section and the
transferee subsequently disposes of the
property in a transaction to which this
section applies, the amount described
in paragraph (b)(2)(i)(A) of this section
must be increased for purposes of
determining the recapture amount for
such subsequent disposition by the
excess (if any) of—
(i) The recapture amount on the first
disposition, determined without regard
to the limitations of paragraphs (c)(1)
and (3) of this section; over
(ii) The recapture amount on the first
disposition determined after application
of such limitations.
(5) Like-kind exchanges and involun-
tary conversions. If property is dis-
posed of or converted and, before the
application of paragraph (a) of this
section, gain is not recognized in whole
or in part under section 1031 or 1033,
then the amount of section 467 gain
taken into account by the lessor is
limited to the sum of—
(i) The amount of gain recognized on
the disposition or conversion of the
property (determined without regard to
paragraph (a) of this section); plus
(ii) The fair market value of property
acquired that is not subject to a section
467 rental agreement and that is not
taken into account under paragraph
(c)(5)(i) of this section.
(6) Installment sales. In the case of
an installment sale of property to which
paragraph (a) of this section applies—
(i) The recapture amount is recog-
nized and treated as ordinary income in
the year of the disposition; and
(ii) Any gain in excess of the
recapture amount shall be reported
under the installment method of ac-
counting if and to the extent that
method is otherwise available under
section 453.
(7) Dispositions covered by sections
170(e), 341(e)(12), or 751(c). For
purposes of sections 170(e), 341(e)(12),
and 751(c), amounts treated as ordinary
income under paragraph (a) of this
section must be treated in the same
manner as amounts treated as ordinary
income under section 1245 or 1250.
(d) Examples. The following exam-
ples illustrate the application of this
section:
Example 1. (i) X and Y enter into a section 467
rental agreement for a 5-year lease of personal
property beginning on January 1, 1997, and ending
on December 31, 2001. The rental agreement
provides that $0 of rent is allocated to 1997, 1998,
and 1999, and $175,000 is allocated to each of the
years 2000 and 2001. The rental agreement
provides that the calendar year will be the rental
period and that the rent allocated to each calendar
year is payable on the last day of that calendar
year. Assume that both X and Y are calendar year
taxpayers and that 110 percent of the applicable
Federal rate is 11 percent, compounded annually.
Assume further that the rental agreement is a long-
term agreement (as defined in §1.467–3(b)(3)).
The rental agreement is not a disqualified
leaseback or long-term agreement because it does
not provide for the payment of more than
$2,000,000 in rent (determined pursuant to
§1.467–3(b)(1)(i)). Therefore, the fixed rent allo-
cated under §1.467–1(c)(2)(ii) is zero for the first
three rental periods and $175,000 for the fourth
and fifth rental periods.
(ii) On December 31, 1999, X sells the
property subject to the section 467 rental
agreement to an unrelated person for $990,000.
At the time of the sale, X’s adjusted basis in the
property is $550,000. Thus, X’s gain on the sale
of the property is $440,000. Assume that none of
this gain would be treated as ordinary income
under any provision of the Internal Revenue
Code other than section 467(c). Under paragraph
(a) of this section, X is required to take the
recapture amount into account as ordinary
income. Under paragraph (b) of this section, the
recapture amount is the lesser of the prior
understated inclusions or the section 467 gain.
(iii)(A) In computing the prior understated in-
clusions under paragraph (b)(2), assume that the
section 467 rent and section 467 interest (based on
constant rental accrual) would be taken into account
as follows if the section 467 rental agreement were
a disqualified long-term agreement:
Section
467 Rent
Section 467
Interest
1997$59,290.59$0
199859,290.596,521.96
199959,290.5913,761.35
200059,290.5921,797.06
200159,290.5911,466.68
(B) The aggregate amount of the section 467
rent and section 467 interest (based on constant
rental accrual) for 1997, 1998, and 1999 is
$198,155.08 ((3 3 $59,290.59) + $6,521.96 +
$13,761.35). Since X did not take any section
467 rent or section 467 interest into account in
1997, 1998, and 1999, the prior understated
inclusions are also $198,155.08. Since none of
the gain is treated as ordinary income under any
provision of the Code other than section 467(c),
the entire amount of gain ($440,000) is section
467 gain. Accordingly, the recapture amount (,
the lesser of the prior understated inclusions or
the section 467 gain) treated as ordinary income
is $198,155.08.
Example 2. (i) The facts are the same as in
Example 1 except that the section 467 rental
agreement specifies that rents accrue and are
paid in the following pattern:
AllocationPayment
1997$60,000$0
199865,0000
199970,0000
200075,000175,000
200180,000175,000
(ii)(A) Assume the section 467 rental agree-
ment does not provide for adequate interest
under §1.467–2(b), and, therefore, the fixed rent
for a rental period is the proportional rental
amount. See §1.467–1(d)(2)(ii). Assume that,
under §1.467–2(c), the following amounts would
be required to be taken into account:
Section 467
Rent
Section 467
Interest
1997$51,585.97$0
199855,884.805,674.46
199960,183.6312,445.98
200064,482.4620,435.23
200168,781.2810,526.19
(B) The amount of section 467 rent and
section 467 interest taken into account by A for
1997, 1998, and 1999 is $185,774.84. Thus, the
prior understated inclusions are $12,380.24 (the
excess of the aggregate amount of section 467
rent and section 467 interest, based on constant
rental accrual, for these three years, $198,155.08,
over the aggregate amount of section 467 rent
and section 467 interest actually taken into
account, $185,774.84). Since this amount is less
than the section 467 gain, the recapture amount
treated as ordinary income is also $12,380.24.
(e) Other rules relating to disposi-
tions—(1) In general. If property sub-
ject to a section 467 rental agreement
is sold, exchanged, or otherwise dis-
posed of, the section 467 rent for a
period is taken into account by the
owner of the property during the
period. The lessee, however, must
continue to take section 467 rent and
section 467 interest into account with-
out regard to the change of ownership.
(2) Treatment of section 467 loan. If
there is a sale, exchange, or other
disposition of property subject to a
section 467 rental agreement (the trans-
fer), the following rules apply in
determining the amount of the section
467 loan for the period after the
transfer, the amount realized by the
transferor, and the transferee’s basis in
the property:
(i) The beginning balance of the
transferor’s section 467 loan is equal to
the net present value at the time of the
transfer of all subsequent amounts
payable as fixed rent and interest on
fixed rent to the transferor and all
subsequent amounts payable as interest
on prepaid fixed rent by the transferor.

SEQ 0004 JOB IRS28-011-011 PAGE-0055 PT 4 PGS 52-
REVISED 02AUG96 AT 05:02 BY LR DEPTH: 66.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/2AUG96/IRS28-011
551996–28 I.R.B.
The transferor must continue to take
into account interest on the transferor’s
section 467 loan balance after the date
of the transfer.
(ii) The beginning balance of the
transferee’s section 467 loan is equal to
the principal balance of the section 467
loan immediately before the transfer
reduced (below zero, if appropriate) by
the beginning balance of the trans-
feror’s section 467 loan. Amounts
payable to the transferor are not taken
into account in adjusting the trans-
feree’s section 467 loan balance.
(iii) If the beginning balance of the
transferee’s section 467 loan is nega-
tive, the transferor and transferee must
treat the balance as a liability that is
either assumed in connection with the
transfer of the property or secured by
the property acquired subject to the
liability. If the beginning balance of the
transferee’s section 467 loan is posi-
tive, the transferor and transferee must
treat the balance as an additional asset
acquired in connection with the transfer
of the property. In the case of a
positive beginning balance of the trans-
feree’s section 467 loan, the transferee
will have an initial cost basis in the
section 467 loan equal to the lesser of
the beginning balance of the loan or
the aggregate consideration for the
transfer of the property subject to the
section 467 rental agreement and the
transfer of the transferor’s interest in
the section 467 loan.
(3) Special rules for transfers in
certain nonrecognition transactions.
[Reserved]
(f) Treatment of assignments by
lessee and lessee-financed renewals—
(1) Substitute lessee use. If a lessee
assigns its interest in a section 467
rental agreement to a substitute lessee
or a period when a substitute lessee has
the use of property subject to a rental
agreement is otherwise included in the
lease term under §1.467–1(h), the sec-
tion 467 rent for a period is taken into
account by the person having the use of
the property during the period. In
addition, the following rules apply in
determining the amount of the section
467 loan for the period when the
substitute lessee has use of the property
and in computing the taxable income of
the lessee and substitute lessee—
(i) The beginning balance of the
lessee’s section 467 loan is equal to the
net present value, as of the date on
which the substitute lessee first has use
of the property, of all amounts subse-
quently payable by the lessee as fixed
rent and interest on fixed rent and all
amounts subsequently payable as inter-
est on prepaid fixed rent to the lessee.
For purposes of this paragraph (f), any
amount otherwise payable by the lessee
shall not be treated as an amount
subsequently payable by the lessee to
the extent that such payment, if made
by the lessee, would give rise to a right
of contribution or other similar claim
against the substitute lessee or any
other person. The lessee must continue
to take into account interest on the
lessee’s section 467 loan balance after
the substitute lessee first has use of the
property.
(ii) The beginning balance of the
substitute lessee’s section 467 loan is
equal to the principal balance of the
section 467 loan immediately before the
substitute lessee first has use of the
property reduced (below zero, if appro-
priate) by the beginning balance of the
lessee’s section 467 loan. Amounts pay-
able by the lessee to any person other
than the substitute lessee (or a related
person) or payable to the lessee by any
person other than the substitute lessee (or
a related person) are not taken into
account in adjusting the substitute
lessee’s section 467 loan balance.
(iii) If the beginning balance of the
substitute lessee’s section 467 loan is
positive, the beginning balance is
treated as— (A) Gross income of the
lessee for the taxable year in which the
substitute lessee first has use of the
property; and
(B) A liability that is either assumed
in connection with the transfer of the
leasehold interest to the substitute
lessee or secured by property acquired
subject to the liability.
(iv) If the beginning balance of the
substitute lessee’s section 467 loan is
negative—
(A) The beginning balance is treated
as an amount incurred by the lessee for
the taxable year in which the substitute
lessee first has use of the property; and
(B) Repayments of the beginning
balance are items of gross income of
the substitute lessee in the taxable year
in which the repayment occurs (deter-
mined by applying any repayment first
to the beginning balance of the sub-
stitute lessee’s section 467 loan).
(v) For purposes of paragraph
(f)(1)(iv)(B) of this section, repayments
occur as the negative balance is amor-
tized through the net accrual of rent
and negative interest.
(2) Lessor use. If a period when the
lessor has the use of property subject to
a section 467 rental agreement is
included in the lease term under
§1.467–1(h), the section 467 rent for
the period is not taken into account and
the lessor is treated as a substitute
lessee for purposes of paragraph (f)(1)
of this section.
(3) Special rules for transfers in
certain nonrecognition transactions.
[Reserved]
§1.467–8 Effective date.
Sections 1.467–1 through 1.467–7
are effective for—
(a) Rental agreements entered into
after the date these regulations are
published as final regulations in the
Federal Register; and
(b) Disqualified leasebacks and long-
term agreements entered into after June
3, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
May 31, 1996, 8:45 a.m., and published in the
issue of the Federal Register for June 3, 1996,
61 F.R. 27834)
Continued Use of Certain Estate and
Gift Tax Forms
Announcement 96–62
The following U.S. estate and gift
tax forms and their related instructions
are being revised. The new revisions
should be available by October 1996.
Form 706, United States Estate (and
Generation-Skipping Transfer) Tax Re-
turn (Rev. August 1993)
Form 706–A, United States Additional
Estate Tax Return (Rev. May 1993)
Form 706–NA, United States Estate
(and Generation-Skipping Transfer)
Tax Return, estate of nonresident not a
citizen of the United States (Rev.
September 1993)
Form 709, United States Gift (and
Generation-Skipping Transfer) Tax Re-
turn (Rev. November 1993)
Form 709–A, United States Short
Form Gift Tax Return (Rev. July 1993).
The IRS has received approval from
the Office of Management and Budget
to continue to use these forms even
though their expiration dates have
elapsed. Therefore, until the new revi-
sions are available, filers can still use
the current forms and instructions.
Forms can be ordered by calling 1-800-
TAX-FORM (1-800-829-3676).

SEQ 0001 JOB IRS28-050-003 PAGE-0056 ANN DISBARMENT
REVISED 05AUG96 AT 23:46 BY AT DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/5AUG96/IRS28-050
56
Announcement of the Disbarment, Suspension, and Consent to Voluntary
Suspension of Attorneys, Certified Public Accountants, Enrolled Agents and
Enrolled Actuaries From Practice Before the Internal Revenue Service
Under 31 Code of Federal Regula-
tions, Part 10, an attorney, certified
public accountant, enrolled agent or en-
rolled actuary, in order to avoid the in-
stitution or conclusion of a proceeding
for his disbarment or suspension from
practice before the Internal Revenue
Service, may offer his consent to
suspension from such practice. The
Director of Practice, in his discretion,
may suspend an attorney, certified
public accountant, enrolled agent or
enrolled actuary in accordance with the
consent offered.
Attorneys, certified public account-
ants, enrolled agents and enrolled actu-
aries are prohibited in any Internal
Revenue Service matter from directly
or indirectly employing, accepting
assistance from, being employed by,
or sharing fees with, any practi-
tioner disbarred or suspended from
practice before the Internal Revenue
Service.
To enable attorneys, certified public
accountants, enrolled agents and en-
rolled actuaries to identify practitioners
under consent suspension from practice
before the Internal Revenue Service,
the Director of Practice will announce
in the Internal Revenue Bulletin the
names and addresses of practitioners
who have been suspended from such
practice, their designation as attor-
ney, certified public accountant, en-
rolled agent or enrolled actuary and
date or period of suspension. This an-
nouncement will appear in the weekly
Bulletin at the earliest practicable date
after such action and will continue to
appear in the weekly Bulletins for five
successive weeks or for as many weeks
as is practicable for each attorney,
certified public accountant, enrolled
agent or enrolled actuary so suspended
and will be consolidated and published
in the Cumulative Bulletin.
The following individuals have been
placed under consent suspension from
practice before the Internal Revenue
Service:
NameAddressDesignationDate of Suspension
Bruender, LawrenceLesueur, MNAttorneyIndefinite from April 18, 1996
Pallman, James J.New Haven, CTCPAApril 19, 1996 to October 18, 1996
Pribble Jr., William C.Minneapolis, MNAttorneyIndefinite from May 1, 1996
Pyburn, Richard E.Downers Grove, ILCPAMay 1, 1996 to October 31, 1997
Scalise, James J.New Britain, CTAttorneyMay 1, 1996 to July 31, 1996
Kieldaisch, Dale W.Manteno, ILCPAMay 1, 1996 to October 31, 1996
Ogorek, Charolotte F.Park Ridge, ILCPAMay 3, 1996 to July 2, 1996
Korman, Steven B.Mulford, CTCPAMay 3, 1996 to February 2, 1997
Myers, Donald L.Olney, MDCPAMay 7, 1996 to May 6, 1998
Sharrett, William R.Paradise, CAEnrolled AgentMay 8, 1996 to November 7, 1996
Cornwell, Douglas S.Norwalk, CTCPAMay 10, 1996 to November 9, 1996
Chang, Sun KunMcLean, VAEnrolled AgentMay 13, 1996 to July 12, 1996
Cariveau, StewartMinneapolis, MNCPAMay 30, 1996 to August 29, 1996
Carter, Gary E.Ashdown, ARCPAJune 1, 1996 to August 31, 1996
Underwood, Wendell L.Sedalia, MOCPAJune 1, 1996 to July 31, 1996
Candiloro, James A.Glastonbury, CTCPAJune 1, 1996 to November 30, 1996
Schwartz, Leonard J.Danbury, CTEnrolled AgentJune 1, 1996 to February 28 1997
Forrester, Donald F.Fairfield, OHCPAIndefinite from June 4, 1996
Shade, Stephen E.Clearwater, FLEnrolled AgentJune 8, 1996 to May 7, 1997
Woods, James G.Huntington, CTCPAJuly 1, 1996 to June 30, 1997
Grove, Michael J.Alliance, OHCPAJuly 1, 1996 to June 30, 1997
Jenkins, FrankMontgomery, ALCPAJuly 1, 1996 to December 31, 1996
Brewton III, George W.Greenville, MSCPAJuly 1, 1996 to September 30, 1996
Fischer, Randall E.Lombard, ILCPAJuly 1, 1996 to September 30, 1996
Rhoney, BrianWheaton, ILCPAJuly 1, 1996 to December 31, 1996
Devereux, Michael J.Florissant, MOCPAJuly 1, 1996 to March 31, 1997
Cranston, Robert S.Saugerties, NYCPAJuly 1, 1996 to December 31, 1996
Miller, Dwight W.Overland Pk, KSCPAJuly 1, 1996 to June 30, 1997
Beck, Clyde E.Salina, KSCPAJuly 1, 1996 to October 31, 1996
Seal, Ernest E.Cleveland, MSCPAAugust 1, 1996 to July 31, 1998
Dicker, Joseph W.Minneapolis, MNAttorneyAugust 1, 1996 to October 31, 1996

SEQ 0002 JOB IRS28-050-003 PAGE-0057 ANN DISBARMENT
REVISED 05AUG96 AT 23:46 BY AT DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/5AUG96/IRS28-050
57
Under Section 330, Title 31 of the
United States Code, the Secretary of
the Treasury, after due notice and
opportunity for hearing, is authorized
to suspend or disbar from practice
before the Internal Revenue Service
any person who has violated the rules
and regulations governing the recogni-
tion of attorneys, certified public ac-
countants, enrolled agents or enrolled
actuaries to practice before the Internal
Revenue Service.
Attorneys, certified public account-
ants, enrolled agents, and enrolled
actuaries are prohibited in any Internal
Revenue Service matter from directly
or indirectly employing, accepting as-
sistance from, being employed by or
sharing fees with, any practitioner
disbarred or under suspension from
practice before the Internal Revenue
Service.
To enable attorneys, certified public
accountants, enrolled agents and
enrolled actuaries to identify such
disbarred or suspended practitioners,
the Director of Practice will announce
in the Internal Revenue Bulletin the
names and addresses of practitioners
who have been suspended from such
practice, their designation as attorney,
certified public accountant, enrolled
agent or enrolled actuary, and the date
of disbarment or period of suspension.
This announcement will appear in the
weekly Bulletin for five successive
weeks or as long as it is practicable for
each attorney, certified public account-
ant, enrolled agent or enrolled actuary
so suspended or disbarred and will be
consolidated and published in the
Cumulative Bulletin.
After due notice and opportunity
for hearing before an administrative
law judge, the following individuals
have been disbarred from further prac-
tice before the Internal Revenue
Service:
NameAddressDesignationEffective Date
Bushta, Patrick C.Sacramento, CACPAApril 18, 1996
Hart, Joel S.Beaumont, TXCPAApril 19, 1996
Riggs, Patricia A.Stockton, CAEnrolled AgentApril 19, 1996
Hammontree, Richard F.Ogunquit, MECPAApril 27, 1996
Otto, Judith M.Tucson, AZEnrolled AgentMay 18, 1996

SEQ 0003 JOB IRS28-051-002 PAGE-0058 TERMS
REVISED 05AUG96 AT 23:49 BY AT DEPTH: 65.01 PICAS WIDTH 46 PICAS
COMPOSITE COLOR
778/20054/5AUG96/IRS28-051
58
Definition of Terms
Revenue rulings and revenue proce-
dures (hereinafter referred to as ‘‘rul-
ings’’) that have an effect on previous
rulings use the following defined terms
to describe the effect:
Amplified describes a situation where
no change is being made in a prior
published position, but the prior posi-
tion is being extended to apply to a
variation of the fact situation set forth
therein. Thus, if an earlier ruling held
that a principle applied to A, and the
new ruling holds that the same princi-
ple also applies to B, the earlier ruling
is amplified. (Compare with modified,
below).
Clarified is used in those instances
where the language in a prior ruling is
being made clear because the language
has caused, or may cause, some confu-
sion. It is not used where a position in
a prior ruling is being changed.
Distinguished describes a situation
where a ruling mentions a previously
published ruling and points out an
essential difference between them.
Modified is used where the substance
of a previously published position is
being changed. Thus, if a prior ruling
held that a principle applied to A but
not to B, and the new ruling holds that
it applies to both A and B, the prior
ruling is modified because it corrects a
published position. (Compare with am-
plified and clarified, above).
Obsoleted describes a previously
published ruling that is not considered
determinative with respect to future
transactions. This term is most com-
monly used in a ruling that lists
previously published rulings that are
obsoleted because of changes in law or
regulations. A ruling may also be
obsoleted because the substance has
been included in regulations subse-
quently adopted.
Revoked describes situations where
the position in the previously published
ruling is not correct and the correct
position is being stated in the new
ruling.
Superseded describes a situation
where the new ruling does nothing
more than restate the substance and
situation of a previously published
ruling (or rulings). Thus, the term is
used to republish under the 1986 Code
and regulations the same position pub-
lished under the 1939 Code and regula-
tions. The term is also used when it is
desired to republish in a single ruling a
series of situations, names, etc., that
were previously published over a
period of time in separate rulings.
If the new ruling does more than
restate the substance of a prior ruling, a
combination of terms is used. For
example, modified and superseded de-
scribes a situation where the substance
of a previously published ruling is
being changed in part and is continued
without change in part and it is desired
to restate the valid portion of the
previously published ruling in a new
ruling that is self contained. In this
case the previously published ruling is
first modified and then, as modified, is
superseded.
Supplemented is used in situations in
which a list, such as a list of the names
of countries, is published in a ruling
and that list is expanded by adding
further names in subsequent rulings.
After the original ruling has been
supplemented several times, a new
ruling may be published that includes
the list in the original ruling and the
additions, and supersedes all prior
rulings in the series.
Suspended is used in rare situations
to show that the previous published
rulings will not be applied pending
some future action such as the issuance
of new or amended regulations, the
outcome of cases in litigation, or the
outcome of a Service study.
Abbreviations
The following abbreviations in current use and
formerly used will appear in material published
in the Bulletin.
A—Individual.
Acq.—Acquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank.
B.T.A.—Board of Tax Appeals.
C.—Individual.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Cooperative.
Ct.D.—Court Decision.
CY—County.
D—Decedent.
DC—Dummy Corporation.
DE—Donee.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Employer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduciary.
FC—Foreign Country.
FICA—Federal Insurance Contribution Act.
FISC—Foreign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Federal Unemployment Tax Act.
FX—Foreign Corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grantee.
GP—General Partner.
GR—Grantor
IC—Insurance Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited Partner.
LR—Lessor.
M—Minor.
Nonacq.—Nonacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Personal Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Partnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Real Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsidiary.
S.P.R.—Statements of Procedural Rules.
Stat.—Statutes at Large.
T—Target Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Transferee.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpayer.
TR—Trust.
TT—Trustee.
U.S.C.—United States Code.
X—Corporation.
Y—Corporation.
Z—Corporation.

SEQ 0063 JOB IRS28-052-008 PAGE-0059 FINDING LIST
REVISED 29JUL96 AT 23:03 BY LR DEPTH: 65.01 PICAS WIDTH 32.08 PICAS
COMPOSITE COLOR
778/20052/29JUL96/IRS28-052
59
Numerical Finding List
1
Bulletin 1996–27
Announcements:
96–61, 1996–27 I.R.B. 72
Notices:
96–36, 1996–27 I.R.B. 11
Revenue Procedures:
96–36, 1996–27 I.R.B. 11
96–1, 1996–1 I.R.B. 8
96–2, 1996–1 I.R.B. 60
96–3, 1996–1 I.R.B. 82
96–4, 1996–1 I.R.B. 94
96–5, 1996–1 I.R.B. 129
96–6, 1996–1 I.R.B. 151
96–7, 1996–1 I.R.B. 185
96–8, 1996–1 I.R.B. 187
96–8A, 1996–9 I.R.B. 10
96–9, 1996–2 I.R.B. 15
96–10, 1996–2 I.R.B. 17
96–11, 1996–2 I.R.B. 18
96–12, 1996–3 I.R.B. 30
96–13, 1996–3 I.R.B. 31
96–14, 1996–3 I.R.B. 41
96–15, 1996–3 I.R.B. 41
96–16, 1996–3 I.R.B. 45
96–17, 1996–4 I.R.B. 69
96–18, 1996–4 I.R.B. 73
96–19, 1996–4 I.R.B. 80
96–20, 1996–4 I.R.B. 88
96–21, 1996–4 I.R.B. 96
96–22, 1996–5 I.R.B. 27
96–23, 1996–5 I.R.B. 27
96–24, 1996–5 I.R.B. 28
96–24A, 1996–15 I.R.B. 12
96–25, 1996–8 I.R.B. 19
96–26, 1996–8 I.R.B. 22
96–27, 1996–11 I.R.B. 27
96–28, 1996–14 I.R.B. 31
96–29, 1996–16 I.R.B. 24
96–30, 1996–19 I.R.B. 8
96–31, 1996–20 I.R.B. 11
96–32, 1996–20 I.R.B. 14
96–33, 1996–22 I.R.B. 8
96–34, 1996–26 I.R.B. 14
96–35, 1996–25 I.R.B. 8
See footnote at the end of list.
Revenue Rulings:
96–33, 1996–27 I.R.B. 4
96–1, 1996–1 I.R.B. 7
96–2, 1996–2 I.R.B. 5
96–3, 1996–2 I.R.B. 14
96–6, 1996–2 I.R.B. 8
96–4, 1996–3 I.R.B. 16
96–5, 1996–3 I.R.B. 29
96–7, 1996–3 I.R.B. 12
96–8, 1996–4 I.R.B. 62
96–9, 1996–4 I.R.B. 5
96–10, 1996–4 I.R.B. 27
96–11, 1996–4 I.R.B. 28
96–12, 1996–9 I.R.B. 4
96–13, 1996–10 I.R.B. 19
96–14, 1996–6 I.R.B. 20
96–15, 1996–11 I.R.B. 9
96–16, 1996–11 I.R.B. 4
96–17, 1996–13 I.R.B. 5
96–18, 1996–13 I.R.B. 4
96–19, 1996–14 I.R.B. 24
96–20, 1996–15 I.R.B. 5
96–21, 1996–15 I.R.B. 7
96–22, 1996–15 I.R.B. 9
96–23, 1996–15 I.R.B. 11
96–24, 1996–19 I.R.B. 5
96–25, 1996–19 I.R.B. 4
96–26, 1996–21 I.R.B. 9
96–27, 1996–24 I.R.B. 9
96–28, 1996–24 I.R.B. 11
96–29, 1996–24 I.R.B. 5
96–30, 1996–24 I.R.B. 4
96–31, 1996–25 I.R.B. 4
96–32, 1996–25 I.R.B. 5
Treasury Decisions:
8673, 1996–27 I.R.B. 4

SEQ 0064 JOB IRS28-052-008 PAGE-0060 FINDING LIST
REVISED 29JUL96 AT 23:03 BY LR DEPTH: 65.01 PICAS WIDTH 32.08 PICAS
COMPOSITE COLOR
778/20052/29JUL96/IRS28-052
60
Finding List of Current Action on
Previously Published Items
1
Bulletin 1996–27
*Denotes entry since last publication
Revenue Procedures:
95–29
Superseded by
96–36, 1996–27 I.R.B. 11
95–29A
Superseded by
96–36, 1996–27 I.R.B. 11
1
A cumulative finding list for previously
published items mentioned in Internal Revenue
Bulletins 1996–1 through 1996–26, will be found
in Internal Revenue Bulletin 1996–27, dated July
1, 1996.

SEQ 0065 JOB IRS28-052-008 PAGE-0061 FINDING LIST
REVISED 29JUL96 AT 23:03 BY LR DEPTH: 65.01 PICAS WIDTH 32.08 PICAS
COMPOSITE COLOR
778/20052/29JUL96/IRS28-052
61
1
A cumulative finding list for previously
published items mentioned in Internal Revenue
Bulletins 1996–1 through 1996–26 will be found
in Internal Revenue Bulletin 1996–27, dated July
1, 1996.

Setzen Sie Ihre Recherche in ChatGPT oder Claude fort

Verbinden Sie Omnilex, um den Rechtskorpus über Ihren KI-Assistenten zu durchsuchen.