[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1272-1]
[Page 507-514]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
GAIN OR LOSS ON DISPOSITION OF PROPERTY--Table of Contents
Sec. 1.1272-1 Current inclusion of OID in income.
(a) Overview--(1) In general. Under section 1272(a)(1), a holder of
a debt instrument includes accrued OID in gross income (as interest),
regardless of the holder's regular method of accounting. A holder
includes qualified stated interest (as defined in Sec. 1.1273-1(c)) in
income under the holder's regular method of accounting. See Secs. 1.446-
2 and 1.451-1.
(2) Debt instruments not subject to OID inclusion rules. Sections
1272(a)(2) and 1272(c) list exceptions to the general inclusion rule of
section 1272(a)(1). For purposes of section 1272(a)(2)(E) (relating to
certain loans between natural persons), a loan does not include a
stripped bond or stripped coupon within the meaning of section 1286(e),
and the rule in section 1272(a)(2)(E)(iii), which treats a husband and
wife as 1 person, does not apply to loans made between a husband and
wife.
(b) Accrual of OID--(1) Constant yield method. Except as provided in
paragraphs (b)(2) and (b)(3) of this section, the amount of OID
includible in the income of a holder of a debt instrument for any
taxable year is determined using the constant yield method as described
under this paragraph (b)(1).
(i) Step one: Determine the debt instrument's yield to maturity. The
yield to maturity or yield of a debt instrument is the discount rate
that, when used in computing the present value of all principal and
interest payments to be made under the debt instrument, produces an
amount equal to the issue price of the debt instrument. The yield must
be constant over the term of the debt instrument and, when expressed as
a percentage, must be calculated to at least two decimal places. See
paragraph (c) of this section for rules relating to the yield of certain
debt instruments subject to contingencies.
(ii) Step two: Determine the accrual periods. An accrual period is
an interval of time over which the accrual of OID is measured. Accrual
periods may be of any length and may vary in length over the term of the
debt instrument, provided that each accrual period is no longer than 1
year and each scheduled payment of principal or interest occurs either
on the final day of an accrual period or on the first day of an accrual
period. In general, the computation of OID is simplest if accrual
periods correspond to the intervals between payment dates provided by
the terms of the debt instrument. In computing the length of accrual
periods, any reasonable counting convention may be used (e.g., 30 days
per month/360 days per year).
(iii) Step three: Determine the OID allocable to each accrual
period. Except as
[[Page 508]]
provided in paragraph (b)(4) of this section, the OID allocable to an
accrual period equals the product of the adjusted issue price of the
debt instrument (as defined in Sec. 1.1275-1(b)) at the beginning of the
accrual period and the yield of the debt instrument, less the amount of
any qualified stated interest allocable to the accrual period. In
performing this calculation, the yield must be stated appropriately
taking into account the length of the particular accrual period. Example
1 in paragraph (j) of this section provides a formula for converting a
yield based upon an accrual period of one length to an equivalent yield
based upon an accrual period of a different length.
(iv) Step four: Determine the daily portions of OID. The daily
portions of OID are determined by allocating to each day in an accrual
period the ratable portion of the OID allocable to the accrual period.
The holder of the debt instrument includes in income the daily portions
of OID for each day during the taxable year on which the holder held the
debt instrument.
(2) Exceptions. Paragraph (b)(1) of this section does not apply to--
(i) A debt instrument to which section 1272(a)(6) applies (certain
interests in or mortgages held by a REMIC, and certain other debt
instruments with payments subject to acceleration);
(ii) A debt instrument that provides for contingent payments, other
than a debt instrument described in paragraph (c) or (d) of this section
or except as provided in Sec. 1.1275-4; or
(iii) A variable rate debt instrument to which Sec. 1.1275-5
applies, except as provided in Sec. 1.1275-5.
(3) Modifications. The amount of OID includible in income by a
holder under paragraph (b)(1) of this section is adjusted if--
(i) The holder purchased the debt instrument at a premium or an
acquisition premium (within the meaning of Sec. 1.1272-2); or
(ii) The holder made an election for the debt instrument under
Sec. 1.1272-3 to treat all interest as OID.
(4) Special rules for determining the OID allocable to an accrual
period. The following rules apply to determine the OID allocable to an
accrual period under paragraph (b)(1)(iii) of this section.
(i) Unpaid qualified stated interest allocable to an accrual period.
In determining the OID allocable to an accrual period, if an interval
between payments of qualified stated interest contains more than 1
accrual period--
(A) The amount of qualified stated interest payable at the end of
the interval (including any qualified stated interest that is payable on
the first day of the accrual period immediately following the interval)
is allocated on a pro rata basis to each accrual period in the interval;
and
(B) The adjusted issue price at the beginning of each accrual period
in the interval must be increased by the amount of any qualified stated
interest that has accrued prior to the first day of the accrual period
but that is not payable until the end of the interval. See Example 2 of
paragraph (j) of this section for an example illustrating the rules in
this paragraph (b)(4)(i).
(ii) Final accrual period. The OID allocable to the final accrual
period is the difference between the amount payable at maturity (other
than a payment of qualified stated interest) and the adjusted issue
price at the beginning of the final accrual period.
(iii) Initial short accrual period. If all accrual periods are of
equal length, except for either an initial shorter accrual period or an
initial and a final shorter accrual period, the amount of OID allocable
to the initial accrual period may be computed using any reasonable
method. See Example 3 in paragraph (j) of this section.
(iv) Payment on first day of an accrual period. The adjusted issue
price at the beginning of an accrual period is reduced by the amount of
any payment (other than a payment of qualified stated interest) that is
made on the first day of the accrual period.
(c) Yield and maturity of certain debt instruments subject to
contingencies--(1) Applicability. This paragraph (c) provides rules to
determine the yield and maturity of certain debt instruments that
provide for an alternative payment schedule (or schedules) applicable
upon the occurrence of a contingency (or contingencies). This paragraph
(c) applies, however, only if the timing
[[Page 509]]
and amounts of the payments 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 Sec. 1.1275-4 for the treatment
of a debt instrument that provides for a contingency that is not
described in this paragraph (c). See Sec. 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 significantly more likely than not to
occur. If, based on all the facts and circumstances as of the issue
date, a single payment schedule for a debt instrument, 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 provision. 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
purchased by the issuer either in the open market or pursuant to an
offer made to all holders (with any proration determined 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, exercisable on one or
more dates during the term of the debt instrument, that, if exercised,
require payments to be made on the debt instrument under an alternative
payment schedule or schedules (e.g., an option to extend or an option to
call a debt instrument at a fixed premium). Under this paragraph (c)(5),
an issuer 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
Sec. 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
[[Page 510]]
yield, the yield of the debt instrument is the fixed yield. For example,
the yield of a debt instrument with principal payments that are fixed in
total amount but that are uncertain as to time (such as a demand loan)
is the stated interest rate if the issue price of the instrument is
equal to the stated principal amount and interest is paid or compounded
at a fixed rate over the entire term of the instrument. This paragraph
(d) applies to debt instruments issued on or after August 13, 1996.
(e) Convertible debt instruments. For purposes of section 1272, an
option is ignored if it is an option to convert a debt instrument into
the stock of the issuer, into the stock or debt of a related party
(within the meaning of section 267(b) or 707(b)(1)), or into cash or
other property in an amount equal to the approximate value of such stock
or debt.
(f) Special rules to determine whether a debt instrument is a short-
term obligation--(1) Counting of either the issue date or maturity date.
For purposes of determining whether a debt instrument is a short-term
obligation (i.e., a debt instrument with a fixed maturity date that is
not more than 1 year from the date of issue), the term of the debt
instrument includes either the issue date or the maturity date, but not
both dates.
(2) Coordination with paragraph (c) of this section for certain
sections of the Internal Revenue Code. Notwithstanding paragraph (c) of
this section, solely for purposes of determining whether a debt
instrument is a short-term obligation under sections 871(g)(1)(B)(i),
881, 1271(a)(3), 1271(a)(4), 1272(a)(2)(C), and 1283(a)(1), the maturity
date of a debt instrument is the last possible date that the instrument
could be outstanding under the terms of the instrument. For purposes of
the preceding sentence, the last possible date that the debt instrument
could be outstanding is determined without regard to Sec. 1.1275-2(h)
(relating to payments subject to remote or incidental contingencies).
(g) Basis adjustment. The basis of a debt instrument in the hands of
the holder is increased by the amount of OID included in the holder's
gross income and decreased by the amount of any payment from the issuer
to the holder under the debt instrument other than a payment of
qualified stated interest. See, however, Sec. 1.1275-2(f) for rules
regarding basis adjustments on a pro rata prepayment.
(h) Debt instruments denominated in a currency other than the U.S.
dollar. Section 1272 and this section apply to a debt instrument that
provides for all payments denominated in, or determined by reference to,
the functional currency of the taxpayer or qualified business unit of
the taxpayer (even if that currency is other than the U.S. dollar). See
Sec. 1.988-2(b) to determine interest income or expense for debt
instruments that provide for payments denominated in, or determined by
reference to, a nonfunctional currency.
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section. Each example assumes that all taxpayers use the calendar year
as the taxable year. In addition, each example assumes a 30-day month,
360-day year, and that the initial accrual period begins on the issue
date and the final accrual period ends on the day before the stated
maturity date. Although, for purposes of simplicity, the yield as stated
is rounded to two decimal places, the computations do not reflect any
such rounding convention.
Example 1. Accrual of OID on zero coupon debt instrument; choice of
accrual periods--(i) Facts. On July 1, 1994, A purchases at original
issue, for $675,564.17, a debt instrument that matures on July 1, 1999,
and provides for a single payment of $1,000,000 at maturity.
(ii) Determination of yield. Under paragraph (b)(1)(i) of this
section, the yield of the debt instrument is 8 percent, compounded
semiannually.
(iii) Determination of accrual period. Under paragraph (b)(1)(ii) of
this section, accrual periods may be of any length, provided that each
accrual period is no longer than 1 year and each scheduled payment of
principal or interest occurs either on the first or final day of an
accrual period. The yield to maturity to be used in computing OID
accruals in any accrual period, however, must reflect the length of the
accrual period chosen. A yield based on compounding b times per year is
equivalent to a yield based on compounding c times per year as indicated
by the following formula:
[[Page 511]]
r = c{(1 + i / b)\b/c\ - 1}
In which:
i = The yield based on compounding b times per year expressed as a
decimal
r = The equivalent yield based on compounding c times per year expressed
as a decimal
b = The number of compounding periods in a year on which i is based (for
example, 12, if i is based on monthly compounding)
c = The number of compounding periods in a year on which r is based
(iv) Determination of OID allocable to each accrual period. Assume
that A decides to compute OID on the debt instrument using semiannual
accrual periods. Under paragraph (b)(1)(iii) of this section, the OID
allocable to the first semiannual accrual period is $27,022.56: the
product of the issue price ($675,564.17) and the yield properly adjusted
for the length of the accrual period (8 percent/2), less qualified
stated interest allocable to the accrual period ($0). The daily portion
of OID for the first semiannual accrual period is $150.13 ($27,022.56/
180).
(v) Determination of OID if monthly accrual periods are used.
Alternatively, assume that A decides to compute OID on the debt
instrument using monthly accrual periods. Using the above formula, the
yield on the debt instrument reflecting monthly compounding is 7.87
percent, compounded monthly (12{(1 + .08 / 2)\2/12\ - 1}). Under
paragraph (b)(1)(iii) of this section, the OID allocable to the first
monthly accrual period is $4,430.48: the product of the issue price
($675,564.17) and the yield properly adjusted for the length of the
accrual period (7.87 percent/12), less qualified stated interest
allocable to the accrual period ($0). The daily portion of OID for the
first monthly accrual period is $147.68 ($4,430.48/30).
Example 2. Accrual of OID on debt instrument with qualified stated
interest--(i) Facts. On September 1, 1994, A purchases at original
issue, for $90,000, B corporation's debt instrument that matures on
September 1, 2004, and has a stated principal amount of $100,000,
payable on that date. The debt instrument provides for semiannual
payments of interest of $3,000, payable on September 1 and March 1 of
each year, beginning on March 1, 1995.
(ii) Determination of yield. The debt instrument is a 10-year debt
instrument with an issue price of $90,000 and a stated redemption price
at maturity of $100,000. The semiannual payments of $3,000 are qualified
stated interest payments. Under paragraph (b)(1)(i) of this section, the
yield is 7.44 percent, compounded semiannually.
(iii) Accrual of OID if semiannual accrual periods are used. Assume
that A decides to compute OID on the debt instrument using semiannual
accrual periods. Under paragraph (b)(1)(iii) of this section, the OID
allocable to the first semiannual accrual period equals the product of
the issue price ($90,000) and the yield properly adjusted for the length
of the accrual period (7.44 percent/2), less qualified stated interest
allocable to the accrual period ($3,000). Therefore, the amount of OID
for the first semiannual accrual period is $345.78 ($3,345.78-$3,000).
(iv) Adjustment for accrued but unpaid qualified stated interest if
monthly accrual periods are used. Assume, alternatively, that A decides
to compute OID on the debt instrument using monthly accrual periods. The
yield, compounded monthly, is 7.32 percent. Under paragraph (b)(1)(iii)
of this section, the OID allocable to the first monthly accrual period
is the product of the issue price ($90,000) and the yield properly
adjusted for the length of the accrual period (7.32 percent/12), less
qualified stated interest allocable to the accrual period. Under
paragraph (b)(4)(i)(A) of this section, the qualified stated interest
allocable to the first monthly accrual period is the pro rata amount of
qualified stated interest allocable to the interval between payment
dates ($3,000x\1/6\, or $500). Therefore, the amount of OID for the
first monthly accrual period is $49.18 ($549.18-$500). Under paragraph
(b)(4)(i)(B) of this section, the adjusted issue price of the debt
instrument for purposes of determining the amount of OID for the second
monthly accrual period is $90,549.18 ($90,000 + $49.18 + $500). Although
the adjusted issue price of the debt instrument for this purpose
includes the amount of qualified stated interest allocable to the first
monthly accrual period, A includes the qualified stated interest in
income based on A's regular method of accounting (e.g., an accrual
method or the cash receipts and disbursements method).
Example 3. Accrual of OID for debt instrument with initial short
accrual period--(i) Facts. On May 1, 1994, G purchases at original
issue, for $80,000, H corporation's debt instrument maturing on July 1,
2004. The debt instrument provides for a single payment at maturity of
$250,000. G computes its OID using 6-month accrual periods ending on
January 1 and July 1 of each year and an initial short 2-month accrual
period from May 1, 1994, through June 30, 1994.
(ii) Determination of yield. The yield on the debt instrument is
11.53 percent, compounded semiannually.
(iii) Determination of OID allocable to initial short accrual
period. Under paragraph (b)(4)(iii) of this section, G may use any
reasonable method to compute OID for the initial short accrual period.
One reasonable method is to calculate the amount of OID pursuant to the
following formula:
OIDshort=IPx(i/k)xf
In which:
[[Page 512]]
OIDshort=The amount of OID allocable to the initial short
accrual period
IP=The issue price of the debt instrument
i=The yield to maturity expressed as a decimal
k=The number of accrual periods in a year
f=A fraction whose numerator is the number of days in the initial short
accrual period, and whose denominator is the number of days in a full
accrual period
(iv) Amount of OID for the initial short accrual period. Under this
method, the amount of OID for the initial short accrual period is $1,537
($80,000x(11.53 percent/2) x (60/180)).
(v) Alternative method. Another reasonable method is to calculate
the amount of OID for the initial short accrual period using the yield
based on bi-monthly compounding, computed pursuant to the formula set
forth in Example 1 of paragraph (j) of this section. Under this method,
the amount of OID for the initial short accrual period is $1,508.38
($80,000x(11.31 percent/6)).
Example 4. Impermissible accrual of OID using a method other than
constant yield method--(i) Facts. On July 1, 1994, B purchases at
original issue, for $100,000, C corporation's debt instrument that
matures on July 1, 1999, and has a stated principal amount of $100,000.
The debt instrument provides for a single payment at maturity of
$148,024.43. The yield of the debt instrument is 8 percent, compounded
semiannually.
(ii) Determination of yield. Assume that C uses 6 monthly accrual
periods to compute its OID for 1994. The yield must reflect monthly
compounding (as determined using the formula described in Example 1 of
paragraph (j) of this section). As a result, the monthly yield of the
debt instrument is 7.87 percent, divided by 12. C may not compute its
monthly yield for the last 6 months in 1994 by dividing 8 percent by 12.
Example 5. Debt instrument subject to put option--(i) Facts. On
January 1, 1995, G purchases at original issue, for $70,000, H
corporation's debt instrument maturing on January 1, 2010, with a stated
principal amount of $100,000, payable at maturity. The debt instrument
provides for semiannual payments of interest of $4,000, payable on
January 1 and July 1 of each year, beginning on July 1, 1995. The debt
instrument gives G an unconditional right to put the bond back to H,
exercisable on January 1, 2005, in return for $85,000 (exclusive of the
$4,000 of stated interest payable on that date).
(ii) Determination of yield and maturity. Yield determined without
regard to the put option is 12.47 percent, compounded semiannually.
Yield determined by assuming that the put option is exercised (i.e., by
using January 1, 2005, as the maturity date and $85,000 as the stated
principal amount payable on that date) is 12.56 percent, compounded
semiannually. Thus, under paragraph (c)(5) of this section, it is
assumed that G will exercise the put option, because exercise of the
option would increase the yield of the debt instrument. Thus, for
purposes of calculating OID, the debt instrument is assumed to be a 10-
year debt instrument with an issue price of $70,000, a stated redemption
price at maturity of $85,000, and a yield of 12.56 percent, compounded
semiannually.
(iii) Consequences if put option is, in fact, not exercised. If the
put option is, in fact, not exercised, then, under paragraph (c)(6) of
this section, the debt instrument is treated, solely for purposes of
sections 1272 and 1273, as if it were reissued on January 1, 2005, for
an amount equal to its adjusted issue price on that date, $85,000. The
new debt instrument matures on January 1, 2010, with a stated principal
amount of $100,000 payable on that date and provides for semiannual
payments of interest of $4,000. The yield of the new debt instrument is
12.08 percent, compounded semiannually.
Example 6. Debt instrument subject to partial call option--(i)
Facts. On January 1, 1995, H purchases at original issue, for $95,000, J
corporation's debt instrument that matures on January 1, 2000, and has a
stated principal amount of $100,000, payable on that date. The debt
instrument provides for semiannual payments of interest of $4,000,
payable on January 1 and July 1 of each year, beginning on July 1, 1995.
On January 1, 1998, J has an unconditional right to call 50 percent of
the principal amount of the debt instrument for $55,000 (exclusive of
the $4,000 of stated interest payable on that date). If the call is
exercised, the semiannual payments of interest made after the call date
will be reduced to $2,000.
(ii) Determination of yield and maturity. Yield determined without
regard to the call option is 9.27 percent, compounded semiannually.
Yield determined by assuming J exercises its call option is 10.75
percent, compounded semiannually. Thus, under paragraph (c)(5) of this
section, it is assumed that J will not exercise the call option because
exercise of the option would increase the yield of the debt instrument.
Thus, for purposes of calculating OID, the debt instrument is assumed to
be a 5-year debt instrument with a single principal payment at maturity
of $100,000, and a yield of 9.27 percent, compounded semiannually.
(iii) Consequences if the call option is, in fact, exercised. If the
call option is, in fact, exercised, then under paragraph (c)(6) of this
section, the debt instrument is treated as if the issuer made a pro rata
prepayment of $55,000 that is subject to Sec. 1.1275-2(f). Consequently,
under Sec. 1.1275-2(f)(1), the instrument is treated as consisting of
two debt instruments, one that is retired on the call date and one that
remains outstanding after the call date. The adjusted issue price,
adjusted basis in the
[[Page 513]]
hands of the holder, and accrued OID of the original debt instrument is
allocated between the two instruments based on the portion of the
original instrument treated as retired. Since each payment remaining to
be made after the call date is reduced by one-half, one-half of the
adjusted issue price, adjusted basis, and accrued OID is allocated to
the debt instrument that is treated as retired. The adjusted issue price
of the original debt instrument immediately prior to the call date is
$97,725.12, which equals the issue price of the original debt instrument
($95,000) increased by the OID previously includible in gross income
($2,725.12). One-half of this adjusted issue price is allocated to the
debt instrument treated as retired, and the other half is allocated to
the debt instrument that is treated as remaining outstanding. Thus, the
debt instrument treated as remaining outstanding has an adjusted issue
price immediately after the call date of $97,725.12/2, or $48,862.56.
The yield of this debt instrument continues to be 9.27 percent,
compounded semiannually. In addition, the portion of H's adjusted basis
allocated to the debt instrument treated as retired is $97,725.12/2 or
$48,862.56. Accordingly, under section 1271, H realizes a gain on the
deemed retirement equal to $6,137.44 ($55,000 - $48,862.56).
Example 7. Debt instrument issued at par that provides for payment
of interest in kind--(i) Facts. On January 1, 1995, A purchases at
original issue, for $100,000, X corporation's debt instrument maturing
on January 1, 2000, at a stated principal amount of $100,000, payable on
that date. The debt instrument provides for annual payments of interest
of $6,000 on January 1 of each year, beginning on January 1, 1996. The
debt instrument gives X the unconditional right to issue, in lieu of the
first interest payment, a second debt instrument (PIK instrument)
maturing on January 1, 2000, with a stated principal amount of $6,000.
The PIK instrument, if issued, would provide for annual payments of
interest of $360 on January 1 of each year, beginning on January 1,
1997.
(ii) Aggregation of PIK instrument with original debt instrument.
Under Sec. 1.1275-2(c)(3), the issuance of the PIK instrument is not
considered a payment made on the original debt instrument, and the PIK
instrument is aggregated with the original debt instrument. The issue
date of the PIK instrument is the same as the original debt instrument.
(iii) Determination of yield and maturity. The right to issue the
PIK instrument is treated as an option to defer the initial interest
payment until maturity. Yield determined without regard to the option is
6 percent, compounded annually, Yield determined by assuming X exercises
the option is 6 percent, compounded annually. Thus, under paragraph
(c)(5) of this section, it is assumed that X will not exercise the
option by issuing the PIK instrument because exercise of the option
would not decrease the yield of the debt instrument. For purposes of
calculating OID, the debt instrument is assumed to be a 5-year debt
instrument with a single principal payment at maturity of $100,000 and
ten semiannual interest payments of $6,000, beginning on January 1,
1996. As a result, the debt instrument's yield is 6 percent, compounded
annually.
(iv) Determination of OID. Under the payment schedule that would
result if the option was exercised, none of the interest on the debt
instrument would be qualified stated interest. Accordingly, under
Sec. 1.1273-1(c)(2), no payments on the debt instrument are qualified
stated interest payments. Thus, $6,000 of OID accrues during the first
annual accrual period. If the PIK instrument is not issued, $6,000 of
OID accrues during each annual accrual period.
(v) Consequences if the PIK instrument is issued. Under paragraph
(c)(6) of this section, if X issues the PIK instrument on January 1,
1996, the issuance of the PIK instrument is not a payment on the debt
instrument. Solely for purposes of sections 1272 and 1273, the debt
instrument is deemed reissued on January 1, 1996, for an issue price of
$106,000. The recomputed yield is 6 percent, compounded annually. The
OID for the first annual accrual period after the deemed reissuance is
$6,360. The adjusted issue price of the debt instrument at the beginning
of the next annual accrual period is $106,000 ($106,000 + $6,360 -
$6,360). The OID for each of the four remaining annual accrual periods
is $6,360.
Example 8. Debt instrument issued at a discount that provides for
payment of interest in kind--(i) Facts. On January 1, 1995, T purchases
at original issue, for $75,500, U corporation's debt instrument maturing
on January 1, 2000, at a stated principal amount of $100,000, payable on
that date. The debt instrument provides for annual payments of interest
of $4,000 on January 1 of each year, beginning on January 1, 1996. The
debt instrument gives U the unconditional right to issue, in lieu of the
first interest payment, a second debt instrument (PIK instrument)
maturing on January 1, 2000, with a stated principal amount of $4,000.
The PIK instrument, if issued, would provide for annual payments of
interest of $160 on January 1 of each year, beginning on January 1,
1997.
(ii) Aggregation of PIK instrument with original debt instrument.
Under Sec. 1.1275-2(c)(3), the issuance of the PIK instrument is not
considered a payment made on the original debt instrument, and the PIK
instrument is aggregated with the original debt instrument. The issue
date of the PIK instrument is the same as the original debt instrument.
(iii) Determination of yield and maturity. The right to issue the
PIK instrument is treated
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as an option to defer the initial interest payment until maturity. Yield
determined without regard to the option is 10.55 percent, compounded
annually. Yield determined by assuming U exercises the option is 10.32
percent, compounded annually. Thus, under paragraph (c)(5) of this
section, it is assumed that U will exercise the option by issuing the
PIK instrument because exercise of the option would decrease the yield
of the debt instrument. For purposes of calculating OID, the debt
instrument is assumed to be a 5-year debt instrument with a single
principal payment at maturity of $104,000 and four annual interest
payments of $4,160, beginning on January 1, 1997. As a result, the yield
is 10.32 percent, compounded annually.
(iv) Consequences if the PIK instrument is not issued. Assume that T
chooses to compute OID accruals on the basis of an annual accrual
period. On January 1, 1996, the adjusted issue price of the debt
instrument, and T's adjusted basis in the instrument, is $83,295.15.
Under paragraph (c)(6) of this section, if U actually makes the $4,000
interest payment on January 1, 1996, the debt instrument is treated as
if U made a pro rata prepayment (within the meaning of Sec. 1.1275-
2(f)(2)) of $4,000, which reduces the amount of each payment remaining
on the instrument by a factor of 4/104, or 1/26. Thus, under
Sec. 1.1275-2(f)(1) and section 1271, T realizes a gain of $796.34
($4,000 -($83,295.15/26)). The adjusted issue price of the debt
instrument and T's adjusted basis immediately after the payment is
$80,091.49 ($83,295.15 x 25/26) and the yield continues to be 10.32
percent, compounded annually.
Example 9. Debt instrument with stepped interest rate--(i) Facts. On
July 1, 1994, G purchases at original issue, for $85,000, H
corporation's debt instrument maturing on July 1, 2004. The debt
instrument has a stated principal amount of $100,000, payable on the
maturity date and provides for semiannual interest payments on January 1
and July 1 of each year, beginning on January 1, 1995. The amount of
each payment is $2,000 for the first 5 years and $5,000 for the final 5
years.
(ii) Determination of OID. Assume that G computes its OID using 6-
month accrual periods ending on January 1 and July 1 of each year. The
yield of the debt instrument, determined under paragraph (b)(1)(i) of
this section, is 8.65 percent, compounded semiannually. Interest is
unconditionally payable at a fixed rate of at least 4 percent,
compounded semiannually, for the entire term of the debt instrument.
Consequently, under Sec. 1.1273-1(c)(1), the semiannual payments are
qualified stated interest payments to the extent of $2,000. The amount
of OID for the first 6-month accrual period is $1,674.34 (the issue
price of the debt instrument ($85,000) times the yield of the debt
instrument for that accrual period (.0865/2) less the amount of any
qualified stated interest allocable to that accrual period ($2,000)).
Example 10. Debt instrument payable on demand that provides for
interest at a constant rate--(i) Facts. On January 1, 1995, V purchases
at original issue, for $100,000, W corporation's debt instrument. The
debt instrument calls for interest to accrue at a rate of 9 percent,
compounded annually. The debt instrument is redeemable at any time at
the option of V for an amount equal to $100,000, plus accrued interest.
V uses annual accrual periods to accrue OID on the debt instrument.
(ii) Amount of OID. Pursuant to paragraph (d) of this section, the
yield of the debt instrument is 9 percent, compounded annually. If the
debt instrument is not redeemed during 1995, the amount of OID allocable
to the year is $9,000.
[T.D. 8517, 59 FR 4810, Feb. 2, 1994, as amended by T.D. 8674, 61 FR
30140, June 14, 1996]