[Federal Register: August 29, 2003 (Volume 68, Number 168)]
[Proposed Rules]
[Page 51944-51958]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr29au03-22]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-106486-98; INTL-0015-91]
RIN 1545-AW33; RIN 1545-PP78
Guidance Regarding the Treatment of Certain Contingent Payment
Debt Instruments With One or More Payments That Are Denominated in, or
Determined by Reference to, a Nonfunctional Currency
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking; notice of public hearing; and
withdrawal of previous proposed regulations section.
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SUMMARY: This document contains proposed regulations regarding the
treatment of contingent payment debt instruments for which one or more
payments are denominated in, or determined by reference to, a currency
other than the taxpayer's functional currency. These regulations are
necessary because current regulations do not provide guidance
concerning the tax treatment of such instruments. The proposed
regulations generally provide that taxpayers should apply the existing
rules under section 1275 of the Internal Revenue Code, with certain
modifications, to nonfunctional currency contingent payment debt
instruments. This document also withdraws existing proposed regulations
and provides notice of a public hearing on these proposed regulations.
DATES: Written or electronic comments and requests to speak (with
outlines of oral comments to be discussed) at the public hearing
scheduled for December 3, 2003, at 10 a.m. must be submitted by
November 12, 2003.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106486-98), room
5203, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 4 p.m. to: REG-106486-98, Courier's Desk, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or sent
electronically, via the IRS Internet site at: http://www.irs.gov/regs.
The public hearing will be held in room 6718, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Milton Cahn at (202) 622-3870; concerning submission and delivery of
comments and the public hearing, Treena Garrett, (202) 622-7180 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collections of information should be
sent 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, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP
Washington, DC 20224. Comments on the collection of Information should
be received by October 28, 2003. Comments are specifically requested
concerning:
Whether the proposed collections of information is necessary for
the proper performance of the functions of the Internal Revenue
Service, including whether the information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.
The collections of information in this proposed regulation are in
Sec. 1.988-6(a)(1) (cross reference to Sec. 1.1275-4) and Sec.
1.988-6(d)(3). This information is required to ensure consistency in
the treatment of the debt instrument between the issuer and the
holders. This information will be used for audit and examination
purposes. The disclosure of information is mandatory as regards the
issuers of nonfunctional currency contingent payment debt instruments.
The reporting of information is mandatory as regards holders of debt
instruments which determine their own projected payment schedule. The
recordkeeping requirement is mandatory for any party that determines
the comparable yield and projected payment schedule for a debt
instrument. The likely respondents are business or other for-profit
institutions.
Taxpayers provide the information on a statement attached to its
timely filed federal income tax return for the taxable year that
includes the acquisition date of the debt instrument.
Estimated total annual reporting, and/or recordkeeping burden: 100
hours.
Estimated average annual burden hours per respondent and/or
recordkeeper: 1 hour.
Estimated number of respondents and/or recordkeepers: 100.
Estimated annual frequency of responses: on occasion.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection 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
On March 17, 1992, Treasury and the IRS issued proposed regulations
(INTL-0015-91), Sec. Sec. 1.988-1(a)(3), (4) and (5), regarding
contingent payment debt instruments, dual currency debt instruments and
multi-currency debt
[[Page 51945]]
instruments. The proposed regulations followed the general approach in
the then-proposed Sec. 1.1275-4(g) contingent payment debt regulations
(LR-189-84; 51 FR 12022 (1986), amended at 56 FR 8308 (1991)) and
bifurcated such debt instruments into contingent and noncontingent
components. After an instrument was bifurcated, the proposed
regulations applied the rules in Sec. Sec. 1.988-1 through 1.988-5, as
appropriate, to the resulting components.
On December 16, 1994, Treasury and the IRS withdrew the then
proposed Sec. 1.1275-4(g) regulations and proposed a new set of Sec.
1.1275-4 regulations (FI-59-91, 59 FR-64884). These regulations were
finalized on June 14, 1996.
Section 1.1275-4 of the final regulations adopted the
``noncontingent bond method'' for certain contingent payment debt
instruments. Under the noncontingent bond method, interest accrues on a
contingent payment debt instrument at a rate equal to the instrument's
comparable yield, which is the yield at which an issuer would issue a
fixed rate debt instrument with terms and conditions similar to those
of the contingent payment debt instrument. In addition, the
noncontingent bond method treats all interest on a debt instrument as
original issue discount, which must be taken into account as it
accrues, regardless of the taxpayer's normal method of accounting.
Under the noncontingent bond method, the comparable yield is used
to construct a projected payment schedule for the debt instrument,
which includes a projected amount for each contingent payment. If the
actual amount of a contingent payment is greater than the projected
amount, the difference is treated as additional interest. If the actual
amount of a contingent payment is less than the projected amount, the
difference generally offsets current interest accruals. In some cases,
the difference may result in a loss to the holder and income to the
issuer.
On August 2, 1999, as a result of the withdrawal of the 1994
proposed Sec. 1.1275-4(g) regulations and the promulgation of the
final Sec. 1.1275-4 regulations, the IRS issued Announcement 99-76
(1999-2 C.B. 223) which provided a description of a regulatory approach
that Treasury and the IRS were considering as a replacement to the
proposed regulations in Sec. Sec. 1.988-1(a)(3), (4) and (5) for
contingent payment debt instruments with one or more payments
denominated in, or determined by reference to, a nonfunctional
currency. Announcement 99-76 stated that Treasury and the IRS were
considering issuing regulations that would apply the noncontingent bond
method in the taxpayer's nonfunctional currency and would translate
payments received on the instrument into functional currency under the
rules of Sec. Sec. 1.988-1 through 1.988-5. Announcement 99-76
requested comments on this approach. No comments were received.
Treasury and the IRS believe that proposed regulations Sec. 1.988-
1(a)(3), (4) and (5) should be withdrawn because they incorporate the
bifurcation approach rather than the noncontingent bond method
ultimately adopted under Sec. 1.1275-4. Treasury and the IRS believe,
as reflected in Announcement 99-76, that nonfunctional currency
contingent payment debt instruments should be accounted for under rules
similar to those that govern the treatment of functional currency
contingent payment debt instruments. Treasury and the IRS believe that
providing a consistent set of rules in this area is in the best
interests of sound tax administration.
Explanation of Provisions
In General
These proposed regulations provide guidance for four different
types of debt instruments: (1) Debt instruments issued for money or
publicly-traded property for which all payments of principal and
interest are denominated in, or determined by reference to, a single
nonfunctional currency and which have one or more non-currency
contingencies, (2) debt instruments issued for money or publicly-traded
property for which payments of principal or interest are denominated
in, or determined by reference to, more than one currency and which
have no non-currency contingencies, (3) debt instruments issued for
money or publicly-traded property for which payments of principal or
interest are denominated in, or determined by reference to, more than
one currency and which also have one or more non-currency
contingencies, and (4) debt instruments which otherwise would fall into
one of the three foregoing categories but for the fact that the
instruments are not issued for money or publicly-traded property. These
proposed regulations do not discuss the treatment of tax-exempt
obligations described in Sec. 1.1275-4(d) which are denominated in one
or more nonfunctional currencies. Comments are requested as to the
proper treatment of such instruments.
Consistent with the approach described in Announcement 99-76, these
proposed regulations generally apply the rules of Sec. 1.1275-4(b)
(i.e., the noncontingent bond method) to nonfunctional currency
contingent payment debt instruments issued for money or publicly traded
property. The proposed regulations generally provide that the
noncontingent bond method is applied in the currency in which the
instrument is denominated (the denomination currency).
Application of the Sec. 1.1275-4(b) rules to nonfunctional
currency contingent instruments generally requires taxpayers (i) to
accrue interest in the denomination currency at a yield at which the
issuer would issue a fixed rate debt instrument denominated in the
denomination currency with terms and conditions similar to those of the
contingent payment debt instrument, (ii) to translate the interest
accrued from the denomination currency into the functional currency
(and account for foreign currency gain or loss on payments of interest
and principal) under the principles of Sec. 1.988-2(b), and (iii) to
account for gain or loss arising from contingencies in a manner
consistent with the rules of Sec. 1.1275-4(b).
Applying the Noncontingent Bond Method in the Denomination Currency
As noted, the proposed regulations require taxpayers to apply the
noncontingent bond method in the instrument's denomination currency.
For example, in the case of an instrument whose denomination currency
is the British pound, an issuer whose functional currency is the U.S.
dollar would first determine the comparable yield of the instrument,
that is, the yield at which the issuer would issue a fixed rate
instrument in British pounds with terms and conditions similar to those
of the instrument actually being issued. Second, the issuer would
construct a projected payment schedule applying that yield. Third, the
amount of interest accrued in each taxable year would be determined in
British pounds based on the comparable yield and translated into
dollars under the principles of section 988. Fourth, the issuer and
holder would account for differences between the projected amount of
payments and the actual amount of payments (so-called positive
adjustments and negative adjustments) under rules similar to those in
Sec. 1.1275-4(b). Consistent with the rules of Sec. 1.1275-4(b), the
proposed regulations provide that net positive adjustments are treated
as additional interest on the instrument. Net negative adjustments
generally offset current interest accruals, and in some cases may
result in a loss to the holder and income to the issuer. Finally, the
issuer and holders would
[[Page 51946]]
determine foreign currency gain or loss with respect to interest and
principal payments on the instrument.
Determination of the Comparable Yield and Projected Payment Schedule
Consistent with Sec. 1.1275-4(b)(4)(iv), the holder uses the yield
and projected payment schedule determined by the issuer to determine
the holder's interest accruals and adjustments for a debt instrument.
If the issuer does not determine a comparable yield and projected
payment schedule for the debt instrument, or if the issuer's comparable
yield or projected payment schedule is unreasonable, the holder of the
debt instrument must determine the comparable yield and the projected
payment schedule for the debt instrument under the rules of the
proposed regulations. A holder that determines its own comparable yield
and projected payment schedule must explicitly disclose, in the manner
set forth in Sec. 1.1275-4(b)(4)(iv), both this fact and the reason
why the holder made its own determination.
Determination of Basis
In general, the proposed regulations provide that a holder
maintains its adjusted basis in functional currency by computing basis
adjustments in the denomination currency under the rules of Sec.
1.1275-4(b)(7)(iii) and then translating such adjustments into
functional currency. Thus, the proposed regulations provide that a
holder's basis is increased by the holder's accrued but unpaid interest
inclusions on the debt instrument, generally without regard to any
positive or negative adjustments, and decreased by the amount of any
noncontingent payment and the projected amount of any contingent
payment previously made on the debt instrument to the holder. These
amounts are translated into functional currency under the principles of
Sec. 1.988-2(b).
Determination of Amount Realized
The proposed regulations generally follow Sec. 1.1275-4(b)(7)(iv)
in determining the amount realized, but do so in the denomination
currency. Thus, for purposes of determining the amount realized by a
holder on the scheduled retirement of a debt instrument, the holder
generally is treated as receiving the projected amount of any
contingent payment due at maturity. In the case of a sale, exchange or
unscheduled retirement of a debt instrument, general recognition
principles of tax law generally apply (e.g., section 1001(b)). However,
the amount realized by a holder on either the scheduled retirement, or
the sale, exchange, or unscheduled retirement of a debt instrument, is
reduced by any negative adjustment carryforward existing in the taxable
year of the sale, exchange or retirement.
To calculate gain or loss other than foreign currency gain or loss,
the proposed regulations require the translation of the amount realized
into functional currency. Foreign currency gain or loss is computed
separately, as described below. The proposed regulations generally
translate the amount realized by reference to the rates used to
translate the components of interest and principal that make up
adjusted basis. The amount realized is translated using the adjusted
basis rates in order to separate from the foreign currency gain or loss
the amount of gain or loss on the sale, exchange or retirement of the
debt instrument which does not result from changes in foreign exchange
rates. Thus, where the amount realized in the denomination currency
equals the adjusted basis of the instrument in the denomination
currency prior to translation, the amount realized is translated in its
entirety by reference to the rates used to translate adjusted basis.
Where the amount realized differs from the adjusted basis prior to
translation, additional attribution and translation rules are required.
Where the amount realized in the denomination currency is less than
the adjusted basis in the denomination currency, that is, where the
holder realizes a loss (not taking into account foreign currency gain
or loss), the following rules apply as to which parts of adjusted basis
are not recovered. In the case of a scheduled retirement at maturity,
the loss is attributable to principal (the amount in denomination
currency which the holder paid to purchase the debt instrument). The
loss is attributable to principal because the holder will not entirely
recover the holder's original investment in the debt instrument. In the
case of a sale or exchange, the loss is first attributable to accrued
interest. Attributing the loss first to interest results in symmetrical
treatment between a loss resulting from a negative adjustment and a
loss resulting from a sale.
When the holder's amount realized in the denomination currency
exceeds the amount of its basis in the denomination currency prior to
translation, that is, where the holder realizes a gain (not taking into
account foreign currency gain or loss), the excess of amount realized
over adjusted basis is translated at the spot rate on the date of
receipt. This rule ensures symmetrical treatment between a positive
adjustment and a gain on the instrument.
Determination of Foreign Currency Gain or Loss
The proposed regulations provide that foreign currency gain or loss
is determined on an instrument with respect to principal and interest
based on the comparable yield and projected payment schedule under the
principles of Sec. 1.988-2(b). In general, no foreign currency gain or
loss is recognized until payment is made or received pursuant to the
instrument, and no foreign currency gain or loss is computed with
respect to positive or negative adjustments. However, foreign currency
gain or loss is determined with respect to positive adjustments
described in Sec. 1.1275-4(b)(9)(ii) (relating to certain fixed but
deferred contingent payments), based upon the difference between the
spot rate on the date the positive adjustment becomes fixed and the
spot rate on the date the positive adjustment is paid or received.
Source Rules
Consistent with the rules of Sec. 1.1275-4(b)(6)(ii), the proposed
regulations provide that all gain (other than foreign currency gain) on
an instrument is characterized as interest for all tax purposes,
including source and character rules. Losses of a holder from a
contingent payment debt instrument are generally sourced by reference
to the rules of Sec. 1.1275-4(b)(9)(iv). Under Sec. 1.1275-
4(b)(9)(iv), a holder's deductions or loss related to a contingent
payment debt instrument that are treated as ordinary losses are treated
as deductions that are definitely related to the class of gross income
to which income from such debt instrument belongs. Deductions or losses
that the holder treats as capital losses are allocated, consistently
with the general principles of Sec. 1.865-1(b)(2), to the class of
gross income with respect to which interest income from the instrument
would give rise.
Treatment of Subsequent Holders
The proposed regulations provide that the rules of Sec. 1.1275-
4(b)(9) generally apply to subsequent holders of an instrument who
purchase the instrument for an amount greater or less than the
instrument's adjusted issue price (determined in the denomination
currency). Accordingly, to the extent that the purchase price for an
instrument exceeds the adjusted issue price of the instrument, the
holder is required to allocate such excess to interest accrued on the
instrument or to projected payments on the instrument
[[Page 51947]]
in a reasonable manner. Each such allocation is treated as a negative
adjustment on the instrument, and the holder's basis on the instrument
is decreased as these negative adjustments are taken into account.
To the extent that the adjusted issue price of the instrument
exceeds its purchase price, the holder is required to allocate such
excess to interest accrued on the instrument or to projected payments
on the instrument in a reasonable manner. As the difference is taken
into account, the holder is treated as receiving a positive adjustment
on the instrument, and the holder's basis is increased as these
positive adjustments are taken into account.
The proposed regulations generally translate the difference between
the purchase price and adjusted issue price into functional currency at
the rate used to translate the interest or projected payment subject to
the adjustment. Thus, for example, a positive adjustment attributable
to interest is translated at the same rate used to translate interest
in the period in which it accrues (e.g., the average rate for the
accrual period). The basis adjustment corresponding to such a positive
or negative adjustment is translated at the same rate applicable to the
positive or negative adjustment itself.
Netting
The proposed regulations do not provide for the netting of market
gain or loss with currency gain or loss on nonfunctional currency
contingent payment debt instruments. On the one hand, different
character and source rules generally apply to market gain or loss and
currency gain or loss, and netting such items may produce results
inconsistent with the tax treatment of other types of instruments. On
the other hand, where market gain or loss and currency gain or loss
counteract each other with respect to a taxpayer, requiring separate
recognition of such gain and loss may not accurately reflect the
economic benefits and burdens associated with the instrument.
Accordingly, Treasury and the IRS request comments regarding the extent
to which netting should be permitted or required. Examples 2 and 4 of
the proposed regulations demonstrate cases in which netting potentially
could be permitted or required because both illustrate instances in
which market loss could be netted against currency gain.
Debt Instruments Denominated in Multiple Currencies
In the case of an instrument for which payments are denominated in,
or determined by reference to, more than one currency, the proposed
regulations provide that the issuer must first determine the
instrument's predominant currency, which will be used as the
instrument's denomination currency for purposes of applying the rules
of the proposed regulations. The predominant currency of the instrument
is determined on the issue date by comparing the present value in
functional currency of the noncontingent and projected payments
denominated in, or determined by reference to, each currency. For this
purpose, the applicable discount rate must be a nonfunctional currency
discount rate, but the rate may be determined using any method,
consistently applied, that reasonably reflects the instrument's
economic substance. If a taxpayer does not determine a discount rate
using such a method, the Commissioner may choose a method for
determining the discount rate that does reflect the instrument's
economic substance.
After the denomination currency has been determined, all payments
on the instrument that are denominated in, or determined by reference
to, a currency other than the denomination currency are treated as non-
currency related contingent payments for purposes of applying the rules
of the proposed regulations. Treasury and the IRS request comments
regarding whether all gain or loss with respect to a debt instrument
for which payments are denominated in, or determined by reference to,
more than one currency and which has no non-currency contingencies
should be treated as foreign currency gain or loss.
Debt Instruments Issued for Non-Publicly Traded Property
In the case of a nonfunctional currency contingent debt instrument
issued for non-publicly traded property, the instrument is not
accounted for using the noncontingent bond method. Rather, the debt
instrument is separated into its components based on the currency in
which the payments are denominated and whether the payments are
contingent or noncontingent. The noncontingent components in each
currency are treated as a separate debt instrument denominated in the
currency in which the payment (or payments) is denominated. A component
consisting of a contingent payment is generally treated in the manner
provided in Sec. 1.1275-4(c)(4). For purposes of the contingent
payment, the test rate (the interest rate which is used to discount the
contingent payment so as to determine the amount of the payment which
is treated as principal, and the amount which is treated as interest)
is determined by reference to the dollar unless the dollar does not
reasonably reflect the economic substance of the contingent component.
Proposed Effective Dates
Section 1.988-6 is proposed to apply to nonfunctional currency
contingent payment debt instruments issued 60 days or more after the
date Sec. 1.988-6 is published as a final regulation in the Federal
Register.
Special Analysis
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required.
It is hereby certified that these regulations will not have a
significant economic impact on a substantial number of small entities.
This certification is based upon the fact that few, if any, small
entities issue or hold foreign currency denominated contingent payment
debt instruments. Generally, it is expected that the only domestic
holders of these instruments will likely be financial institutions,
investment banking firms, investment funds, and other sophisticated
investors, due to the foreign currency risk and other contingencies
inherent in these instruments. Therefore, a Regulatory Flexibility
Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is
not required.
Pursuant to section 7805(f) of the Internal Revenue Code, this
notice of proposed rulemaking will be submitted to the Chief Counsel
for Advocacy of the Small Business Administration for comment on its
impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a
signed original and eight (8) copies) that are submitted timely to the
IRS. The IRS and Treasury Department request comments on the clarity of
the proposed regulations and how they can be made easier to understand.
All comments will be available for public inspection and copying.
A public hearing has been scheduled for December 3, 2003, at 10
a.m. in room 6718 Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC. Due to building security procedures, visitors must
enter at the Constitution Avenue entrance. In addition, all visitors
must present photo identification to enter the building.
[[Page 51948]]
Because of access restrictions, visitors will not be admitted beyond
the immediate entrance area more than 30 minutes before the hearing
starts. For information about having your name placed on the building
access list to attend the hearing, see the FOR FURTHER INFORMATION
CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit electronic or
written comments and an outline of the topics to be discussed and the
time to be devoted to each topic (signed original and eight (8) copies)
by November 12, 2003. 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 regulations is Milton Cahn of the
Office of the Associate Chief Counsel (International). 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.
Section 1.988-1(a)(3), (4) and (5) as proposed on March 17, 1992 at
57 FR 9218 income tax regulations are withdrawn, and 26 CFR Part 1 is
proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.988-2 is amended by:
1. Adding the text of paragraph (b)(2)(i)(B)(1).
2. Removing the last sentence of paragraph (b)(2)(i)(B)(2).
The addition reads as follows:
Sec. 1.988-2 Recognition and computation of exchange gain or loss.
* * * * *
(b) * * *
(2) * * *
(i) * * *
(B) * * * (1) Operative rules. See Sec. 1.988-6 for rules
applicable to contingent debt instruments for which one or more
payments are denominated in, or determined by reference to, a
nonfunctional currency.
* * * * *
Par. 3. Section 1.988-6 is added to read as follows:
Sec. 1.988-6 Nonfunctional currency contingent payment debt
instruments.
(a) In general--(1) Scope. This section determines the accrual of
interest and the amount, timing, source, and character of any gain or
loss on nonfunctional currency contingent payment debt instruments
described in this paragraph (a)(1). Except as set forth by the rules in
this section, the rules in Sec. 1.1275-4 (relating to contingent
payment debt instruments) apply to the following instruments--
(i) A debt instrument described in Sec. 1.1275-4(b)(1) for which
all payments of principal and interest are denominated in, or
determined by reference to, a single nonfunctional currency and which
has one or more non-currency related contingencies;
(ii) A debt instrument described in Sec. 1.1275-4(b)(1) for which
payments of principal or interest are denominated in, or determined by
reference to, more than one currency and which has no non-currency
related contingencies;
(iii) A debt instrument described in Sec. 1.1275-4(b)(1) for which
payments of principal or interest are denominated in, or determined by
reference to, more than one currency and which has one or more non-
currency related contingencies; and
(iv) A debt instrument otherwise described in paragraph (a)(1)(i),
(ii) or (iii) of this section, except that the debt instrument is
described in Sec. 1.1275-4(c)(1) rather than Sec. 1.1275-4(b)(1)
(e.g., the instrument is issued for non-publicly traded property).
(2) Exception for hyperinflationary currencies--(i) In general.
Except as provided in paragraph (a)(2)(ii) of this section, this
section shall not apply to an instrument described in paragraph (a)(1)
of this section if any payment made under such instrument is determined
by reference to a hyperinflationary currency, as defined in Sec.
1.985-1(b)(2)(ii)(D). In such case, the amount, timing, source and
character of interest, principal, foreign currency gain or loss, and
gain or loss relating to a non-currency contingency shall be determined
under the method that reflects the instrument's economic substance.
(ii) Discretion as to method. If a taxpayer does not account for an
instrument described in paragraph (a)(2)(i) of this section in a manner
that reflects the instrument's economic substance, the Commissioner may
apply the rules of this section to such an instrument or apply the
principles of Sec. 1.988-2(b)(15), reasonably taking into account the
contingent feature or features of the instrument.
(b) Instruments described in paragraph (a)(1)(i) of this section--
(1) In general. Paragraph (b)(2) of this section provides rules for
applying the noncontingent bond method (as set forth in Sec. 1.1275-
4(b)) in the nonfunctional currency in which a debt instrument
described in paragraph (a)(1)(i) of this section is denominated, or by
reference to which its payments are determined (the denomination
currency). Paragraph (b)(3) of this section describes how amounts
determined in paragraph (b)(2) of this section shall be translated from
the denomination currency of the instrument into the taxpayer's
functional currency. Paragraph (b)(4) of this section describes how
gain or loss (other than foreign currency gain or loss) shall be
determined and characterized with respect to the instrument. Paragraph
(b)(5) of this section describes how foreign currency gain or loss
shall be determined with respect to accrued interest and principal on
the instrument. Paragraph (b)(6) of this section provides rules for
determining the source and character of any gain or loss with respect
to the instrument. Paragraph (b)(7) of this section provides rules for
subsequent holders of an instrument who purchase the instrument for an
amount other than the adjusted issue price of the instrument. Paragraph
(c) of this section provides examples of the application of paragraph
(b) of this section. See paragraph (d) of this section for the
determination of the denomination currency of an instrument described
in paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of
this section for the treatment of an instrument described in paragraph
(a)(1)(iv) of this section.
(2) Application of noncontingent bond method--(i) Accrued interest.
Interest accruals on an instrument described in paragraph (a)(1)(i) of
this section are initially determined in the denomination currency of
the instrument by applying the noncontingent bond method, set forth in
Sec. 1.1275-4(b), to the instrument in its denomination currency.
Accordingly, the comparable yield, projected payment schedule, and
comparable fixed rate debt instrument, described in Sec. 1.1275-
4(b)(4), are determined in the denomination currency. For purposes of
applying the noncontingent bond method to instruments described in this
paragraph, the applicable Federal rate described in Sec. 1.1275-
4(b)(4)(i) shall be
[[Page 51949]]
the rate described in Sec. 1.1274-4(d) with respect to the
denomination currency.
(ii) Net positive and negative adjustments. Positive and negative
adjustments, and net positive and net negative adjustments, with
respect to an instrument described in paragraph (a)(1)(i) of this
section are determined by applying the rules of Sec. 1.1275-4(b)(6)
(and Sec. 1.1275-4(b)(9)(i) and (ii), if applicable) in the
denomination currency. Accordingly, a net positive adjustment is
treated as additional interest (in the denomination currency) on the
instrument. A net negative adjustment first reduces interest that
otherwise would be accrued by the taxpayer during the current tax year
in the denomination currency. If a net negative adjustment exceeds the
interest that would otherwise be accrued by the taxpayer during the
current tax year in the denomination currency, the excess is treated as
ordinary loss (if the taxpayer is a holder of the instrument) or
ordinary income (if the taxpayer is the issuer of the instrument). The
amount treated as ordinary loss by a holder with respect to a net
negative adjustment is limited, however, to the amount by which the
holder's total interest inclusions on the debt instrument (determined
in the denomination currency) exceed the total amount of the holder's
net negative adjustments treated as ordinary loss on the debt
instrument in prior taxable years (determined in the denomination
currency). Similarly, the amount treated as ordinary income by an
issuer with respect to a net negative adjustment is limited to the
amount by which the issuer's total interest deductions on the debt
instrument (determined in the denomination currency) exceed the total
amount of the issuer's net negative adjustments treated as ordinary
income on the debt instrument in prior taxable years (determined in the
denomination currency). To the extent a net negative adjustment exceeds
the current year's interest accrual and the amount treated as ordinary
loss to a holder (or ordinary income to the issuer), the excess is
treated as a negative adjustment carryforward, within the meaning of
Sec. 1.1275-4(b)(6)(iii)(C), in the denomination currency.
(iii) Adjusted issue price. The adjusted issue price of an
instrument described in paragraph (a)(1)(i) of this section is
determined by applying the rules of Sec. 1.1275-4(b)(7) in the
denomination currency. Accordingly, the adjusted issue price is equal
to the debt instrument's issue price in the denomination currency,
increased by the interest previously accrued on the debt instrument
(determined without regard to any net positive or net negative
adjustments on the instrument) and decreased by the amount of any
noncontingent payment and the projected amount of any contingent
payment previously made on the instrument. All adjustments to the
adjusted issue price are calculated in the denomination currency.
(iv) Adjusted basis. The adjusted basis of an instrument described
in paragraph (a)(1)(i) of this section is determined by applying the
rules of Sec. 1.1275-4(b)(7) in the taxpayer's functional currency. In
accordance with those rules, a holder's basis in the debt instrument is
increased by the interest previously accrued on the debt instrument
(translated into functional currency), without regard to any net
positive or net negative adjustments on the instrument (except as
provided in paragraph (b)(7) or (8) of this section, if applicable),
and decreased by the amount of any noncontingent payment and the
projected amount of any contingent payment previously made on the
instrument to the holder (translated into functional currency). See
paragraph (b)(3)(iii) of this section for translation rules.
(v) Amount realized. The amount realized by a holder and the
repurchase price paid by the issuer on the scheduled or unscheduled
retirement of a debt instrument described in paragraph (a)(1)(i) of
this section are determined by applying the rules of Sec. 1.1275-
4(b)(7) in the denomination currency. For example, with regard to a
scheduled retirement at maturity, the holder is treated as receiving
the projected amount of any contingent payment due at maturity, reduced
by the amount of any negative adjustment carryforward. For purposes of
translating the amount realized by the holder into functional currency,
the rules of paragraph (b)(3)(iv) of this section shall apply.
(3) Treatment and translation of amounts determined under
noncontingent bond method--(i) Accrued interest. The amount of accrued
interest, determined under paragraph (b)(2)(i) of this section, is
translated into the taxpayer's functional currency at the average
exchange rate, as described in Sec. 1.988-2(b)(2)(iii)(A), or, at the
taxpayer's election, at the appropriate spot rate, as described in
Sec. 1.988-2(b)(2)(iii)(B).
(ii) Net positive and negative adjustments--(A) Net positive
adjustments. A net positive adjustment, as referenced in paragraph
(b)(2)(ii) of this section, is translated into the taxpayer's
functional currency at the spot rate on the last day of the taxable
year in which the adjustment is taken into account under Sec. 1.1275-
4(b)(6), or, if earlier, the date the instrument is disposed of or
otherwise terminated.
(B) Net negative adjustments. A net negative adjustment is treated
and, where necessary, is translated from the denomination currency into
the taxpayer's functional currency under the following rules:
(1) The amount of a net negative adjustment determined in the
denomination currency that reduces the current year's interest in that
currency shall first reduce the current year's accrued but unpaid
interest, and then shall reduce the current year's interest which was
accrued and paid. No translation is required.
(2) The amount of a net negative adjustment treated as ordinary
income or loss under Sec. 1.1275-4(b)(6)(iii)(B) first is attributable
to accrued but unpaid interest accrued in prior taxable years. For this
purpose, the net negative adjustment shall be treated as attributable
to any unpaid interest accrued in the immediately preceding taxable
year, and thereafter to unpaid interest accrued in each preceding
taxable year. The amount of the net negative adjustment applied to
accrued but unpaid interest is translated into functional currency at
the same rate used, in each of the respective prior taxable years, to
translate the accrued interest.
(3) Any amount of the net negative adjustment remaining after the
application of paragraphs (b)(3)(ii)(B)(1) and (2) of this section is
attributable to interest accrued and paid in prior taxable years. The
amount of the net negative adjustment applied to such amounts is
translated into functional currency at the spot rate on the date the
debt instrument was issued or, if later, acquired.
(4) Any amount of the net negative adjustment remaining after
application of paragraphs (b)(3)(ii)(B)(1), (2) and (3) of this section
is a negative adjustment carryforward, within the meaning of Sec.
1.1275-4(b)(6)(iii)(C). A negative adjustment carryforward is carried
forward in the denomination currency and is applied to reduce interest
accruals in subsequent years. In the year in which the instrument is
sold, exchanged or retired, any negative adjustment carryforward not
applied to interest reduces the holder's amount realized on the
instrument (in the denomination currency). An issuer of a debt
instrument described in paragraph (a)(1)(i) of this section who takes
into income a negative adjustment carryforward (that is not applied to
interest) in the year the instrument is
[[Page 51950]]
retired, as described in Sec. 1.1275-4(b)(6)(iii)(C), translates such
income into functional currency at the spot rate on the date the
instrument was issued.
(iii) Adjusted basis--(A) In general. Except as otherwise provided
in this paragraph and paragraphs (b)(7) or (8) of this section, a
holder determines and maintains adjusted basis by translating the
denomination currency amounts determined under Sec. 1.1275-
4(b)(7)(iii) into functional currency as follows:
(1) The holder's initial basis in the instrument is determined by
translating the amount paid by the holder to acquire the instrument (in
the denomination currency) into functional currency at the spot rate on
the date the instrument was issued or, if later, acquired.
(2) An increase in basis attributable to interest accrued on the
instrument is translated at the rate applicable to such interest under
paragraph (b)(3)(i) of this section.
(3) Any noncontingent payment and the projected amount of any
contingent payments determined in the denomination currency that
decrease the holder's basis in the instrument under Sec. 1.1275-
4(b)(7)(iii) are translated as follows:
(i) The payment first is attributable to the most recently accrued
interest to which prior amounts have not already been attributed. The
payment is translated into functional currency at the rate at which the
interest was accrued.
(ii) Any amount remaining after the application of paragraph
(b)(3)(iii)(A)(3)(i) of this section is attributable to principal. Such
amounts are translated into functional currency at the spot rate on the
date the instrument was issued or, if later, acquired.
(B) Exception for interest reduced by a negative adjustment
carryforward. Solely for purposes of this Sec. 1.988-6, any amounts of
accrued interest income that are reduced as a result of a negative
adjustment carryforward shall be treated as principal and translated at
the spot rate on the date the instrument was issued or, if later,
acquired.
(iv) Amount realized--(A) Instrument held to maturity--(1) In
general. With respect to an instrument held to maturity, a holder
translates the amount realized by separating such amount in the
denomination currency into the component parts of interest and
principal that make up adjusted basis prior to translation under
paragraph (b)(3)(iii) of this section, and translating each of those
component parts of the amount realized at the same rate used to
translate the respective component parts of basis under paragraph
(b)(3)(iii) of this section. The amount realized first shall be
translated by reference to the component parts of basis consisting of
accrued interest during the taxpayer's holding period as determined
under paragraph (b)(3)(iii) of this section and ordering such amounts
on a last in first out basis. Any remaining portion of the amount
realized shall be translated by reference to the rate used to translate
the component of basis consisting of principal as determined under
paragraph (b)(3)(iii) of this section.
(2) Subsequent purchases at discount and fixed but deferred
contingent payments. For purposes of this paragraph (b)(3)(iv) of this
section, any amount which is required to be added to adjusted basis
under paragraph (b)(7) or (8) of this section shall be treated as
additional interest which was accrued on the date the amount was added
to adjusted basis. To the extent included in amount realized, such
amounts shall be translated into functional currency at the same rates
at which they were translated for purposes of determining adjusted
basis. See paragraphs (b)(7)(iv) and (b)(8) of this section for rules
governing the rates at which the amounts are translated for purposes of
determining adjusted basis.
(B) Sale, exchange, or unscheduled retirement--(1) Holder. In the
case of a sale, exchange, or unscheduled retirement, application of the
rule stated in paragraph (b)(3)(iv)(A) of this section shall be
modified as follows. The holder's amount realized first shall be
translated by reference to the principal component of basis as
determined under paragraph (b)(3)(iii) of this section, and then to the
component of basis consisting of accrued interest as determined under
paragraph (b)(3)(iii) of this section and ordering such amounts on a
first in first out basis. Any gain recognized by the holder (i.e., any
excess of the sale price over the holder's basis, both expressed in the
denomination currency) is translated into functional currency at the
spot rate on the payment date.
(2) Issuer. In the case of an unscheduled retirement of the debt
instrument, any excess of the adjusted issue price of the debt
instrument over the amount paid by the issuer (expressed in
denomination currency) shall first be attributable to accrued unpaid
interest, to the extent the accrued unpaid interest had not been
previously offset by a negative adjustment, on a last-in-first-out
basis, and then to principal. The accrued unpaid interest shall be
translated into functional currency at the rate at which the interest
was accrued. The principal shall be translated at the spot rate on the
date the debt instrument was issued.
(C) Effect of negative adjustment carryforward with respect to the
issuer. Any amount of negative adjustment carryforward treated as
ordinary income under Sec. 1.1275-4(b)(6)(iii)(C) shall be translated
at the exchange rate on the day the debt instrument was issued.
(4) Determination of gain or loss not attributable to foreign
currency. A holder of a debt instrument described in paragraph
(a)(1)(i) of this section shall recognize gain or loss upon sale,
exchange, or retirement of the instrument equal to the difference
between the amount realized with respect to the instrument, translated
into functional currency as described in paragraph (b)(3)(iv) of this
section, and the adjusted basis in the instrument, determined and
maintained in functional currency as described in paragraph (b)(3)(iii)
of this section. The amount of any gain or loss so determined is
characterized as provided in Sec. 1.1275-4(b)(8), and sourced as
provided in paragraph (b)(6) of this section.
(5) Determination of foreign currency gain or loss--(i) In general.
Other than in a taxable disposition of the debt instrument, foreign
currency gain or loss is recognized with respect to a debt instrument
described in paragraph (a)(1)(i) of this section only when payments are
made or received. No foreign currency gain or loss is recognized with
respect to a net positive or negative adjustment, as determined under
paragraph (b)(2)(ii) of this section (except with respect to a positive
adjustment described in paragraph (b)(8) of this section). As described
in this paragraph (b)(5), foreign currency gain or loss is determined
in accordance with the rules of Sec. 1.988-2(b).
(ii) Foreign currency gain or loss attributable to accrued
interest. The amount of foreign currency gain or loss recognized with
respect to payments of interest previously accrued on the instrument is
determined by translating the amount of interest paid or received into
functional currency at the spot rate on the date of payment and
subtracting from such amount the amount determined by translating the
interest paid or received into functional currency at the rate at which
such interest was accrued under the rules of paragraph (b)(3)(i) of
this section. For purposes of this paragraph, the amount of any payment
that is treated as accrued interest shall be reduced by the amount of
any net negative adjustment treated as ordinary loss (to the holder) or
ordinary income (to the issuer), as provided in paragraph (b)(2)(ii) of
this
[[Page 51951]]
section. For purposes of determining whether the payment consists of
interest or principal, see the payment ordering rules in paragraph
(b)(5)(iv) of this section.
(iii) Principal. The amount of foreign currency gain or loss
recognized with respect to payment or receipt of principal is
determined by translating the amount paid or received into functional
currency at the spot rate on the date of payment or receipt and
subtracting from such amount the amount determined by translating the
principal into functional currency at the spot rate on the date the
instrument was issued or, in case of the holder, if later, acquired.
For purposes of determining whether the payment consists of interest or
principal, see the payment ordering rules in paragraph (b)(5)(iv) of
this section.
(iv) Payment ordering rules--(A) In general. Except as provided in
paragraph (b)(5)(iv)(B) of this section, payments with respect to an
instrument described in paragraph (a)(1)(i) of this section shall be
treated as follows:
(1) A payment shall first be attributable to any net positive
adjustment on the instrument that has not previously been taken into
account.
(2) Any amount remaining after applying paragraph (b)(5)(iv)(A)(1)
of this section shall be attributable to accrued but unpaid interest,
remaining after reduction by any net negative adjustment, and shall be
attributable to the most recent accrual period to the extent prior
amounts have not already been attributed to such period.
(3) Any amount remaining after applying paragraphs (b)(5)(iv)(A)(1)
and (2) of this section shall be attributable to principal. Any
interest paid in the current year that is reduced by a net negative
adjustment shall be considered a payment of principal for purposes of
determining foreign currency gain or loss.
(B) Special rule for sale or exchange or unscheduled retirement.
Payments made or received upon a sale or exchange or unscheduled
retirement shall first be applied against the principal of the debt
instrument (or in the case of a subsequent purchaser, the purchase
price of the instrument in denomination currency) and then against
accrued unpaid interest (in the case of a holder, accrued while the
holder held the instrument).
(C) Subsequent purchaser that has a positive adjustment allocated
to a daily portion of interest. A positive adjustment that is allocated
to a daily portion of interest pursuant to paragraph (b)(7)(iv) of this
section shall be treated as interest for purposes of applying the
payment ordering rule of this paragraph (b)(5)(iv).
(6) Source of gain or loss. The source of foreign currency gain or
loss recognized with respect to an instrument described in paragraph
(a)(1)(i) of this section shall be determined pursuant to Sec. 1.988-
4. Consistent with the rules of Sec. 1.1275-4(b)(8), all gain (other
than foreign currency gain) on an instrument described in paragraph
(a)(1)(i) of this section is treated as interest income for all
purposes. The source of an ordinary loss (other than foreign currency
loss) with respect to an instrument described in paragraph (a)(1)(i) of
this section shall be determined pursuant to Sec. 1.1275-4(b)(9)(iv).
The source of a capital loss with respect to an instrument described in
paragraph (a)(1)(i) of this section shall be determined pursuant to
Sec. 1.865-1(b)(2).
(7) Basis different from adjusted issue price--(i) In general. The
rules of Sec. 1.1275-4(b)(9)(i), except as set forth in this paragraph
(b)(7), shall apply to an instrument described in paragraph (a)(1)(i)
of this section purchased by a subsequent holder for more or less than
the instrument's adjusted issue price.
(ii) Determination of basis. If an instrument described in
paragraph (a)(1)(i) of this section is purchased by a subsequent
holder, the subsequent holder's initial basis in the instrument shall
equal the amount paid by the holder to acquire the instrument,
translated into functional currency at the spot rate on the date of
acquisition.
(iii) Purchase price greater than adjusted issue price. If the
purchase price of the instrument (determined in the denomination
currency) exceeds the adjusted issue price of the instrument, the
holder shall, consistent with the rules of Sec. 1.1275-4(b)(9)(i)(B),
reasonably allocate such excess to the daily portions of interest
accrued on the instrument or to a projected payment on the instrument.
To the extent attributable to interest, the excess shall be reasonably
allocated over the remaining term of the instrument to the daily
portions of interest accrued and shall be a negative adjustment on the
dates the daily portions accrue. On the date of such adjustment, the
holder's adjusted basis in the instrument is reduced by the amount
treated as a negative adjustment under this paragraph (b)(7)(iii),
translated into functional currency at the rate used to translate the
interest which is offset by the negative adjustment. To the extent
related to a projected payment, such excess shall be treated as a
negative adjustment on the date the payment is made. On the date of
such adjustment, the holder's adjusted basis in the instrument is
reduced by the amount treated as a negative adjustment under this
paragraph (b)(7)(iii), translated into functional currency at the spot
rate on the date the instrument was acquired.
(iv) Purchase price less than adjusted issue price. If the purchase
price of the instrument (determined in the denomination currency) is
less than the adjusted issue price of the instrument, the holder shall,
consistent with the rules of Sec. 1.1275-4(b)(9)(i)(C), reasonably
allocate the difference to the daily portions of interest accrued on
the instrument or to a projected payment on the instrument. To the
extent attributable to interest, the difference shall be reasonably
allocated over the remaining term of the instrument to the daily
portions of interest accrued and shall be a positive adjustment on the
dates the daily portions accrue. On the date of such adjustment, the
holder's adjusted basis in the instrument is increased by the amount
treated as a positive adjustment under this paragraph (b)(7)(iv),
translated into functional currency at the rate used to translate the
interest to which it relates. For purposes of determining adjusted
basis under paragraph (b)(3)(iii) of this section, such increase in
adjusted basis shall be treated as an additional accrual of interest
during the period to which the positive adjustment relates. To the
extent related to a projected payment, such difference shall be treated
as a positive adjustment on the date the payment is made. On the date
of such adjustment, the holder's adjusted basis in the instrument is
increased by the amount treated as a positive adjustment under this
paragraph (b)(7)(iv), translated into functional currency at the spot
rate on the date the adjustment is taken into account. For purposes of
determining the amount realized on the instrument in functional
currency under paragraph (b)(3)(iv) of this section, amounts
attributable to the excess of the adjusted issue price of the
instrument over the purchase price of the instrument shall be
translated into functional currency at the same rate at which the
corresponding adjustments are taken into account under this paragraph
(b)(7)(iv) for purposes of determining the adjusted basis of the
instrument.
(8) Fixed but deferred contingent payments. In the case of an
instrument with a contingent payment that becomes fixed as to amount
before the payment is due, the rules of Sec. 1.1275-4(b)(9)(ii) shall
be applied in the denomination currency of the instrument. For this
purpose, foreign currency gain or loss shall be recognized on the date
payment
[[Page 51952]]
is made or received with respect to the instrument under the principles
of paragraph (b)(5) of this section. Any increase or decrease in basis
required under Sec. 1.1275-4(b)(9)(ii)(D) shall be taken into account
at the same exchange rate as the corresponding net positive or negative
adjustment is taken into account.
(c) Examples. The provisions of paragraph (b) of this section may
be illustrated by the following examples. 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. The
examples are as follows:
Example 1. Treatment of net positive adjustment--(i) Facts. On
December 31, 2004, Z, a calendar year U.S. resident taxpayer whose
functional currency is the U.S. dollar, purchases from a foreign
corporation, at original issue, a zero-coupon debt instrument with a
non-currency contingency for [pound]1000. All payments of principal
and interest with respect to the instrument are denominated in, or
determined by reference to, a single nonfunctional currency (the
British pound). The debt instrument would be subject to Sec.
1.1275-4(b) if it were denominated in dollars. The debt instrument's
comparable yield, determined in British pounds under paragraph
(b)(2)(i) of this section and Sec. 1.1275-4(b), is 10 percent,
compounded annually, and the projected payment schedule, as
constructed under the rules of Sec. 1.1275-4(b), provides for a
single payment of [pound]1210 on December 31, 2006 (consisting of a
noncontingent payment of [pound]975 and a projected payment of
[pound]235). The debt instrument is a capital asset in the hands of
Z. Z does not elect to use the spot-rate convention described in
Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on December
31, 2006, is [pound]1300. The relevant pound/dollar spot rates over
the term of the instrument are as follows:
------------------------------------------------------------------------
Date Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004.......................... []1.00=$1.00
Dec. 31, 2005.......................... []1.00=$1.10
Dec. 31, 2006.......................... []1.00=$1.20
------------------------------------------------------------------------
------------------------------------------------------------------------
Average rate (pounds to
Accrual period dollars)
------------------------------------------------------------------------
2005................................... []1.00=$1.05
2006................................... []1.00=$1.15
------------------------------------------------------------------------
(ii) Treatment in 2005--(A) Determination of accrued interest.
Under paragraph (b)(2)(i) of this section, and based on the
comparable yield, Z accrues
[]100 of interest on
the debt instrument for 2005 (issue price of
[]1000 x 10 percent).
Under paragraph (b)(3)(i) of this section, Z translates the
[pound]100 at the average exchange rate for the accrual period
($1.05 x []100 =
$105). Accordingly, Z has interest income in 2005 of $105.
(B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii)
and (iv) of this section, the adjusted issue price of the debt
instrument determined in pounds and Z's adjusted basis in dollars in
the debt instrument are increased by the interest accrued in 2005.
Thus, on January 1, 2006, the adjusted issue price of the debt
instrument is [pound]1100. For purposes of determining Z's dollar
basis in the debt instrument, the $1000 basis ($1.00 x
[]1000 original cost
basis) is increased by the [pound]100 of accrued interest,
translated at the rate at which interest was accrued for 2005. See
paragraph (b)(3)(iii) of this section. Accordingly, Z's adjusted
basis in the debt instrument as of January 1, 2006, is $1105.
(iii) Treatment in 2006--(A) Determination of accrued interest.
Under paragraph (b)(2)(i) of this section, and based on the
comparable yield, Z accrues [pound]110 of interest on the debt
instrument for 2006 (adjusted issue price of
[]1100 x 10 percent).
Under paragraph (b)(3)(i) of this section, Z translates the
[pound]110 at the average exchange rate for the accrual period
($1.15 x []110 =
$126.50). Accordingly, Z has interest income in 2006 of $126.50.
(B) Effect of net positive adjustment. The payment actually made
on December 31, 2006, is [pound]1300, rather than the projected
[pound]1210. Under paragraph (b)(2)(ii) of this section, Z has a net
positive adjustment of
[]90 on December 31,
2006, attributable to the difference between the amount of the
actual payment and the amount of the projected payment. Under
paragraph (b)(3)(ii)(A) of this section, the
[]90 net positive
adjustment is treated as additional interest income and is
translated into dollars at the spot rate on the last day of the year
($1.20 x []90 = $108).
Accordingly, Z has a net positive adjustment of $108 resulting in a
total interest inclusion for 2006 of $234.50 ($126.50 + $108 =
$234.50).
(C) Adjusted issue price and basis. Based on the projected
payment schedule, the adjusted issue price of the debt instrument
immediately before the payment at maturity is
[]1210
([]1100 plus
[]110 of accrued
interest for 2006). Z's adjusted basis in dollars, based only on the
noncontingent payment and the projected amount of the contingent
payment to be received, is $1231.50 ($1105 plus $126.50 of accrued
interest for 2006).
(D) Amount realized. Even though Z receives [pound]1300 at
maturity, for purposes of determining the amount realized, Z is
treated under paragraph (b)(2)(v) of this section as receiving the
projected amount of the contingent payment on December 31, 2006.
Therefore, Z is treated as receiving
[]1210 on December 31,
2006. Under paragraph (b)(3)(iv) of this section, Z translates its
amount realized into dollars and computes its gain or loss on the
instrument (other than foreign currency gain or loss) by breaking
the amount realized into its component parts. Accordingly,
[]100 of the
[pound]1210 (representing the interest accrued in 2005) is
translated at the rate at which it was accrued
([]1 = $1.05),
resulting in an amount realized of $105;
[]110 of the
[]1210 (representing
the interest accrued in 2006) is translated into dollars at the rate
at which it was accrued
([]1 = $1.15),
resulting in an amount realized of $126.50; and
[]1000 of the
[]1210 (representing a
return of principal) is translated into dollars at the spot rate on
the date the instrument was purchased
([]1 = $1), resulting
in an amount realized of $1000. Z's total amount realized is
$1231.50, the same as its basis, and Z recognizes no gain or loss
(before consideration of foreign currency gain or loss) on
retirement of the instrument.
(E) Foreign currency gain or loss. Under paragraph (b)(5) of
this section Z recognizes foreign currency gain under section 988 on
the instrument with respect to the consideration actually received
at maturity (except for the net positive adjustment),
[]1210. The amount of
recognized foreign currency gain is determined based on the
difference between the spot rate on the date the instrument matures
and the rates at which the principal and interest were taken into
account. With respect to the portion of the payment attributable to
interest accrued in 2005, the foreign currency gain is $15
[[]100 x ($1.20-
$1.05)]. With respect to interest accrued in 2006, the foreign
currency gain equals $5.50
[[]110 x ($1.20-
$1.15)]. With respect to principal, the foreign currency gain is
$200 [[]1000 x ($1.20-
$1.00)]. Thus, Z recognizes a total foreign currency gain on
December 31, 2006, of $220.50.
(F) Source. Z has interest income of $105 in 2005, interest
income of $234.50 in 2006 (attributable to [pound]110 of accrued
interest and the [pound]90 net positive adjustment), and a foreign
currency gain of $220.50 in 2006. Under paragraph (b)(6) of this
section and section 862(a)(1), the interest income is sourced by
reference to the residence of the payor and is therefore from
sources without the United States. Under paragraph (b)(6) of this
section and Sec. 1.988-4, Z's foreign currency gain of $220.50 is
sourced by reference to Z's residence and is therefore from sources
within the United States.
Example 2. Treatment of net negative adjustment--(i) Facts.
Assume the same facts as in Example 1, except that Z receives
[pound]975 at maturity instead of [pound]1300.
(ii) Treatment in 2005. The treatment of the debt instrument in
2005 is the same as in Example 1. Thus, Z has interest income in
2005 of $105. On January 1, 2006, the adjusted issue price of the
debt instrument is
[]1100, and Z's
adjusted basis in the instrument is $1105.
(iii) Treatment in 2006--(A) Determination of accrued interest.
Under paragraph (b)(2)(i) of this section and based on the
comparable yield, Z's accrued interest for 2006 is
[]110 (adjusted issue
price of []1100 x 10
percent). Under paragraph (b)(3)(i) of this section, the
[]110 of accrued
interest is translated at the average exchange rate for the accrual
period ($1.15 x []110
= $126.50).
(B) Effect of net negative adjustment. The payment actually made
on December 31, 2006, is
[]975, rather than the
projected []1210.
Under paragraph (b)(2)(ii) of this section, Z has a net negative
adjustment of []235 on
December 31, 2006, attributable to the difference between the amount
of the actual payment and the amount of the
[[Page 51953]]
projected payment. Z's accrued interest income of
[]110 in 2006 is
reduced to zero by the net negative adjustment. Under paragraph
(b)(3)(ii)(B)(1) of this section the net negative adjustment which
reduces the current year's interest is not translated into
functional currency. Under paragraph (b)(2)(ii) of this section, Z
treats the remaining
[]125 net negative
adjustment as an ordinary loss to the extent of the
[]100 previously
accrued interest in 2005. This
[]100 ordinary loss is
attributable to interest accrued but not paid in the preceding year.
Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z
translates the loss into dollars at the average rate for such year
([]1 = $1.05).
Accordingly, Z has an ordinary loss of $105 in 2006. The remaining
[]25 of net negative
adjustment is a negative adjustment carryforward under paragraph
(b)(2)(ii) of this section.
(C) Adjusted issue price and basis. Based on the projected
payment schedule, the adjusted issue price of the debt instrument
immediately before the payment at maturity is
[]1210
([]1100 plus
[]110 of accrued
interest for 2006). Z's adjusted basis in dollars, based only on the
noncontingent payments and the projected amount of the contingent
payments to be received, is $1231.50 ($1105 plus $126.50 of accrued
interest for 2006).
(D) Amount realized. Even though Z receives
[]975 at maturity, for
purposes of determining the amount realized, Z is treated under
paragraph (b)(2)(v) of this section as receiving the projected
amount of the contingent payment on December 31, 2006, reduced by
the amount of Z's negative adjustment carryforward of
[]25. Therefore, Z is
treated as receiving
[]1185
([