Inflation-Indexed Debt Instruments

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8838] RIN 1545-AU45

TITLE: Inflation-Indexed Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
federal income tax treatment of inflation-indexed debt instruments,
including Treasury Inflation-Indexed Securities. The regulations in
this document provide needed guidance to holders and issuers of
inflation-indexed debt instruments.

EFFECTIVE DATE: The regulations are effective September 7, 1999.

FOR FURTHER INFORMATION CONTACT: Helen Vanek-Bigelow or William E.

Blanchard, (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 6, 1997, temporary regulations (TD 8709 [1997-1 C.B.
167]) relating to the federal income tax treatment of inflation-
indexed debt instruments under sections 1275 and 1286 of the
Internal Revenue Code (Code) were published in the Federa Register
(62 FR 615). A notice of proposed rulemaking (REG-242996-96 [1997-1
C.B. 784]) cross-referencing the temporary regulations was published
in the Federa for the same day (62 FR 694). A public hearing was
held on April 30, 1997.

However, no one requested to speak at the hearing.

No written comments responding to the notice were received.
Therefore, the proposed regulations under sections 1275 and 1286 are
adopted by this Treasury decision with no changes, and the
corresponding temporary regulations are redesignated as final
regulations.

Explanation of provisions

The following is a general explanation of the provisions in the
final regulations, which are the same as the provisions in the
temporary regulations.

A. In General.

The final regulations provide rules for the treatment of certain
debt instruments that are indexed for inflation and deflation,
including Treasury Inflation-Indexed Securities. The final
regulations generally require holders and issuers of inflation-
indexed debt instruments to account for interest and original issue
discount (OID) using constant yield principles. In addition, the
final regulations generally require holders and issuers of
inflation-indexed debt instruments to account for inflation and
deflation by making current adjustments to their OID accruals.

B. Applicability.

The final regulations apply to inflation-indexed debt instruments.
In general, an inflation-indexed debt instrument is a debt
instrument that (1) is issued for cash, (2) is indexed for inflation
and deflation (as described below), and (3) is not otherwise a
contingent payment debt instrument. The final regulations do not
apply, however, to certain debt instruments, such as debt
instruments issued by qualified state tuition programs.

C. Indexing Methodology.

A debt instrument is considered indexed for inflation and deflation
if the payments on the instrument are indexed by reference to the
changes in the values of a general price or wage index over the term
of the instrument. Specifically, the amount of each payment on an
inflation-indexed debt instrument must equal the product of (1) the
amount of the payment that would be payable on the instrument
(determined as if there were no inflation or deflation over the term
of the instrument) and (2) the ratio of the value of the reference
index for the payment date to the value of the reference index for
the issue date.

The reference index for a debt instrument is the mechanism for
measuring inflation and deflation over the term of the instrument.
This mechanism associates the value of a single qualified inflation
index for a particular month with a specified day of a succeeding
month. For example, under the terms of the Treasury Inflation-
Indexed Securities, the reference index for the first day of a month
is the value of a qualified inflation index for the third preceding
month. The reference index must be reset once a month to the current
value of a qualified inflation index. Between reset dates, the value
of the reference index is determined through straight-line
interpolation.

A qualified inflation index is a general price or wage index that is
updated and published at least monthly by an agency of the United
States Government. A general price or wage index is an index that
measures price or wage changes in the economy as a whole. An index
is not general if it only measures price or wage changes in a
particular segment of the economy. For example, the non-seasonally
adjusted U.S. City Average All Items Consumer Price Index for All
Urban Consumers (CPI-U), which is published by the Bureau of Labor
Statistics of the Department of Labor, is a qualified inflation
index because it measures general price changes in the economy. By
contrast, the gasoline price component of the CPI-U is not a
qualified inflation index because it only measures price changes in
a particular segment of the economy.

D. Coupon Bond Method.

The final regulations provide a simplified method of accounting for
qualified stated interest and inflation adjustments on certain
inflation-indexed debt instruments (the coupon bond method). To
qualify for the coupon bond method, an inflation-indexed debt
instrument must satisfy two conditions. First, there must be no more
than a de minimis difference between the debt instrument's issue
price and its principal amount for the issue date. Second, all
stated interest on the debt instrument must be qualified stated
interest. Because Treasury Inflation-Indexed Securities that are not
stripped into principal and interest components satisfy both of
these conditions, the coupon bond method applies to these
securities.

If an inflation-indexed debt instrument qualifies for the coupon
bond method, the stated interest payable on the debt instrument is
taken into account under the taxpayer's regular method of
accounting. Any increase in the inflation-adjusted principal amount
is treated as OID for the period in which the increase occurs. Any
decrease in the inflation-adjusted principal amount is taken into
account under the rules for deflation adjustments described below.
For example, if a taxpayer holds a Treasury Inflation-Indexed
Security for an entire calendar year and the taxpayer uses the cash
receipts and disbursements method of accounting (cash method), the
taxpayer generally includes in income the interest payments received
on the security during the year. In addition, the taxpayer includes
in income an amount of OID measured by subtracting the inflation-
adjusted principal amount of the security at the beginning of the
year from the inflation-adjusted principal amount of the security at
the end of the year. If the taxpayer uses an accrual method of
accounting rather than the cash method, the taxpayer includes in
income the qualified stated interest that accrued on the debt
instrument during the year and an amount of OID measured by
subtracting the inflation-adjusted principal amount of the security
at the beginning of the year from the inflation-adjusted principal
amount of the security at the end of the year.

E. Discount Bond Method.

If an inflation-indexed debt instrument does not qualify for the
coupon bond method (for example, because it is issued at a
discount), the instrument is subject to the discount bond method. In
general, the discount bond method requires holders and issuers to
make current adjustments to their OID accruals to account for
inflation and deflation.

Under the discount bond method, a taxpayer determines the amount of
OID allocable to an accrual period by using steps similar to those
provided in §1.1272-1(b)(1). First, the taxpayer determines the
yield to maturity of the debt instrument as if there were no
inflation or deflation over the term of the instrument.

Second, the taxpayer determines the length of the accrual periods to
be used to allocate OID over the term of the debt instrument,
provided no accrual period is longer than one month. Third, the
taxpayer determines the percentage change in the value of the
reference index during the accrual period by comparing the value at
the beginning of the period to the value at the end of the period.
Fourth, the taxpayer determines the OID allocable to the accrual
period by using a formula that takes into account both the yield of
the debt instrument and the percentage change in the value of the
reference index during the period. Fifth, the taxpayer allocates to
each day in the accrual period a ratable portion of the OID for the
accrual period (the daily portions). If the daily portions for an
accrual period are positive amounts, these amounts are taken into
account under section 163(e) by an issuer and under section 1272 by
a holder. If the daily portions for an accrual period are negative
amounts, these amounts are taken into account under the rules for
deflation adjustments described below.

F. Deflation Adjustments.

The final regulations treat deflation adjustments in a manner
consistent with the treatment of net negative adjustments on
contingent payment debt instruments under §1.1275-4(b)(6)(iii). If a
holder has a deflation adjustment for a taxable year, the deflation
adjustment first reduces the amount of interest otherwise includible
in income with respect to the debt instrument for the taxable year.
If the amount of the deflation adjustment exceeds the interest
otherwise includible in income for the taxable year, the holder
treats the excess as an ordinary loss in the taxable year. However,
the amount treated as an ordinary loss is limited to the amount by
which the holder's total interest inclusions on the debt instrument
in prior taxable years exceed the total amount treated by the holder
as an ordinary loss on the debt instrument in prior taxable years.
If the deflation adjustment exceeds the interest otherwise
includible in income by the holder with respect to the debt
instrument for the taxable year and the amount treated as an
ordinary loss for the taxable year, the excess is carried forward to
offset interest income on the debt instrument in subsequent taxable
years. Similar rules apply to determine an issuer's interest
deductions and income for the debt instrument.

G. Miscellaneous Rules.

The final regulations provide special rules for reopenings, strips,
subsequent holders, and minimum guarantees.

H. Effective Date.

The final regulations apply to an inflation-indexed debt instrument
issued on or after January 6, 1997.

Special Analyses It has been determined that this Treasury decision
is not a significant regulatory action as defined in Executive Order
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) does not apply to these
regulations and, because the regulations do not impose a collection
of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Code, the notice of proposed rulemaking preceding these regulations
was submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business.
....Information The principal author of the regulations is Helen
Vanek-Bigelow, Office of Assistant Chief Counsel (Financial
Institutions and Products). However, other personnel from the IRS
and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regu ations Accordingly, 26 CFR part 1
is amended as follows:

Part 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
removing the entries for §§1.1275-7T and 1.1286-2T and adding two
entries in numerical order to read in part as follows:

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

Section 1.1275-7 also issued under 26 U.S.C. 1275(d). * * *

Section 1.1286-2 also issued under 26 U.S.C. 1286(f). * * *

§1.148-4 [Amended ] Par. 2. Section 1.148-4 is amended by:

1. Removing the "T" from the reference "§1.1275-7T" in paragraph (h)
(2)(v)(A).

2. Removing the "T" from the reference "§1.1275-7T" in paragraph (h)
(2)(v)(B).

§1.163-13 [Amended ] Par. 3. Section 1.163-13 is amended by:

1. Removing the "T" from the reference "§1.1275-7T(f)(1)(ii)" in the
next to the last sentence in paragraph (e)(2). 2.

Removing the "T" from the reference "§1.1275-7T" in the last
sentence in paragraph (e)(2).

§1.171-3 [Amended ] Par. 4. Section 1.171-3 is amended by :

1. Removing the "T" from the reference "§1.1275-7T(f)(1)(i)" in the
next to last sentence in paragraph (b).

2. Removing the "T" from the reference "§1.1275-7T" in the last
sentence in paragraph (b).

Par. 5. In §1.1271-0, paragraph (b) is amended by revising the entry
for §1.1275-7T to read as follows:

§1.1271-0 Original issue discount; effective date; table of
contents.

* * * * *

(b) * * *

* * * * *

§1.1275-7 Inflation-indexed debt instruments.

* * * * *

§1.1275-4 [Amended ] Par. 6. Section 1.1275-4 is amended by removing
the "T" from the reference "§1.1275-7T" in paragraph (a)(2)(vii).

§1.1275-7T [Redesignated as §1.1275-7 ] Par. 7. Section 1.1275-7T is
redesignated as §1.1275-7 and the language "(temporary)" is removed
from the section heading. .......1.1286-2T [Redesignated as
§1.1286-2 ] Par. 8. Section 1.1286-2T is redesignated as §1.1286-2
and the language "(temporary)" is removed from the section heading.

Par. 9. Newly designated §1.1286-2 is amended by removing the "T"
from the reference "§1.1275-7T(e)".

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: August 25, 1999
Jonathan Talisman
Deputy Assistant Secretary of the Treasury

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