Section

[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1232-3]

[Page 283-296]

TITLE 26--INTERNAL REVENUE

CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)

PART 1_INCOME TAXES--Table of Contents

Sec. 1.1232-3 Gain upon sale or exchange of obligations issued at a
discount after December 31, 1954.

(a) General rule; sale or exchange--(1) Obligations issued by a
corporation after May 27, 1969--(i) General rule. Under section
1232(a)(2)(A), in the case of gain realized upon the sale or exchange of
an obligation issued at a discount by a corporation after May 27, 1969
(other than an obligation subject to the transitional rule of
subparagraph (4) of this paragraph), and held by the taxpayer for more
than 1 year (6 months for taxable years beginning before 1977; 9 months
for taxable years beginning in 1977):
(a) If at the time of original issue there was no intention to call
the obligation before maturity, such gain shall be considered as long-
term capital gain, or
(b) If at the time of original issue there was an intention to call
the obligation before maturity, such gain shall be considered ordinary
income to the extent it does not exceed the excess of:
(1) An amount equal to the entire original issue discount, over

[[Page 284]]

(2) An amount equal to the entire original issue discount multiplied
by a fraction the numerator of which is the sum of the number of
complete months and any fractional part of a month elapsed since the
date of original issue and the denominator of which is the number of
complete months and any fractional part of a month from the date of
original issue to the stated maturity date.

The balance, if any, of the gain shall be considered as long-term
capital gain. The amount described in (2) of this subdivision (b) in
effect reduces the amount of original issue discount to be treated as
ordinary income under this subdivision (b) by the amounts previously
includible (regardless of whether included) by all holders (computed,
however, as to any holder without regard to any purchase allowance under
paragraph (a)(2)(ii) of Sec. 1.1232-3A and without regard to whether
any holder purchased at a premium as defined in paragraph (d)(2) of
Sec. 1.1232-3).
(ii) Cross references. For definition of the terms original issue
discount and intention to call before maturity, see paragraphs (b) (1)
and (4) respectively of this section. For definition of the term date of
original issue, see paragraph (b)(3) of this section. For computation of
the number of complete months and any fractional portion of a month, see
paragraph (a)(3) of Sec. 1.1232-3A.
(iii) Effect of section 582(c). Gain shall not be considered to be
long-term capital gain under subdivision (i) of this subparagraph if
section 582(c) (relating to treatment of losses and gains on bonds of
certain financial institutions) applies.
(2) Examples. The provisions of subparagraph (1) of this paragraph
may be illustrated by the following examples:

Example 1. On January 1, 1970, A, a calendar-year taxpayer,
purchases at original issue for cash of $7,600, M Corporation's 10-year,
5 percent bond which has a stated redemption price at maturity of
$10,000. On January 1, 1972, A sells the bond to B, for $9,040. A has
previously included $480 of the original issue discount in his gross
income (see example (1) of paragraph (d) of Sec. 1.1232-3A) and
increased his basis in the bond by that amount to $8,080 (see paragraph
(c) of Sec. 1.1232-3A). Thus, if at the time of original issue there
was no intention to call the bond before maturity, A's gain of $960
(amount realized, $9,040, less adjusted basis, $8,080) is considered
long-term capital gain.
Example 2. (i) Assume the same facts as in example (1), except that
at the time of original issue there was an intention to call the bond
before maturity. The amount of the entire gain includible by A as
ordinary income under subparagraph (1)(i) of this paragraph is
determined as follows:

(1) Entire original issue discount (stated redemption price $2,400
at maturity, $10,000, minus issue price, $7,600)...........
(2) Less: Line (1), $2,400, multiplied by months elapsed $480
since date of original issue, 24, divided by months from
such date to stated maturity date, 120.....................
-----------
(3) Maximum amount includible by A as ordinary income....... $1,920

Since the amount in line (3) is greater than A's gain, $960, A's entire
gain is includible as ordinary income.
(ii) On January 1, 1979, B, a calendar-year taxpayer, sells the bond
to C for $10,150. Assume that B has included $120 of original issue
discount in his gross income for each taxable year he held the bond (see
example (2) of paragraph (d) of Sec. 1.1232-3A) and therefore increased
his basis by $840 (i.e., $120 each yearx7 years) to $9,880. B's gain is
therefore $270 (amount realized, $10,150, less basis, $9,880). The
amount of such gain includible by B as ordinary income under
subparagraph (1)(i) of this paragraph is determined as follows:

(1) Entire original issue discount (as determined in part $2,400
(i) of this example).......................................
(2) Less: Line (1), $2,400, multiplied by months elapsed $2,160
since date of original issue, 108, divided by months from
such date to stated maturity date, 120.....................
-----------
(3) Maximum amount includible by B as ordinary income....... $240

Since the amount in line (3) is less than B's gain, $270, only $240 of
B's gain is includible as ordinary income. The remaining portion of B's
gain, $30, is considered long-term capital gain.

(3) Obligations issued by a corporation on or before May 27, 1969,
and government obligations. Under section 1232(a)(2)(B), if gain is
realized on the sale or exchange after December 31, 1957, of an
obligation held by the taxpayer more than 6 months, and if the
obligation either was issued at a discount after December 31, 1954, and
on or before May 27, 1969, by a corporation or was issued at a discount
after December 31, 1954, by or on behalf of the United States or a
foreign country, or a political subdivision of either, then such gain
shall be considered ordinary

[[Page 285]]

income to the extent it does not exceed:
(i) An amount equal to the entire original issue discount, or
(ii) If at the time of original issue there was no intention to call
the obligation before maturity, a portion of the original issue discount
determined in accordance with paragraph (c) of this section,

And the balance, if any, of the gain shall be considered as long-term
capital gain. For the definition of the terms original issue discount
and intention to call before maturity, see paragraphs (b) (1) and (4)
respectively of this section. See section 1037(b) and paragraph (b) of
Sec. 1.1037-1 for special rules which are applicable in applying
section 1232(a)(2)(B) and this subparagraph to gain realized on the
disposition or redemption of obligations of the United States which were
received from the United States in an exchange upon which gain or loss
is not recognized because of section 1037(a) (or so much of section 1031
(b) or (c) as relates to section 1037(a)).
(4) Transitional rule. Subparagraph (3) of this paragraph (in lieu
of subparagraph (1) of this paragraph) shall apply to an obligation
issued by a corporation pursuant to a written commitment which was
binding on May 27, 1969, and at all times thereafter.
(5) Obligations issued after December 31, 1954, and sold or
exchanged before January 1, 1958. Gain realized upon the sale or
exchange before January 1, 1958, of an obligation issued at a discount
after December 31, 1954, and held by the taxpayer for more than 6
months, shall be considered ordinary income to the extent it equals a
specified portion of the original issue discount, and the balance, if
any, of the gain shall be considered as long-term capital gain. The term
original issue discount is defined in paragraph (b)(1) of this section.
The computation of the amount of gain which constitutes ordinary income
is illustrated in paragraph (c) of this section.
(6) Obligations issued before January 1, 1955. Whether gain
representing original issue discount realized upon the sale or exchange
of obligations issued at a discount before January 1, 1955, is capital
gain or ordinary income shall be determined without reference to section
1232.
(b) Definitions--(1) Original issue discount--(i) In general. For
purposes of section 1232, the term original issue discount means the
difference between the issue price and the stated redemption price at
maturity. The stated redemption price is determined without regard to
optional call dates.
(ii) De minimis rule. If the original issue discount is less than
one-fourth of 1 percent of the stated redemption price at maturity
multiplied by the number of full years from the date of original issue
to maturity, then the discount shall be considered to be zero. For
example, a 10-year bond with a stated redemption price at maturity of
$100 issued at $98 would be regarded as having an original issue
discount of zero. Thus, any gain realized by the holder would be a long-
term capital gain if the bond was a capital asset in the hands of the
holder and held by him for more than 1 year (6 months for taxable years
beginning before 1977; 9 months for taxable years beginning in 1977).
However, if the bond were issued at $97.50 or less, the original issue
discount would not be considered zero.
(iii) Stated redemption price at maturity--(a) Definition. Except as
otherwise provided in this subdivision (iii), the term stated redemption
price at maturity means the amount fixed by the last modification of the
purchase agreement, including dividends, interest, and any other
amounts, however designated, payable at that time. If any amount based
on a fixed rate of simple or compound interest is actually payable or
will be treated as constructively received under section 451 and the
regulations thereunder either: (1) At fixed periodic intervals of one
year or less during the entire term of an obligation, or (2) except as
provided in subdivision (e) of this paragraph (b)(1)(iii), at maturity
in the case of an obligation with a term of one year or less, any such
amount payable at maturity shall not be included in determining the
stated redemption price at maturity. For purposes of subdivision (a)(2)
of this paragraph (b)(1)(iii), the term of an obligation shall include
any renewal period with respect to which, under the terms of the
obligation, the

[[Page 286]]

holder may either take action or refrain from taking action which would
prevent the actual or constructive receipt of any interest on such
obligation until the expiration of any such renewal period. To
illustrate this paragraph (b)(1)(iii), assume that a note which promises
to pay $1,000 at the end of three years provides for additional amounts
labeled as interest to be paid at the rate of $50 at the end of the
first year, $50 at the end of the second year, and $120 at the end of
the third year. The stated redemption price at maturity will be $1,070
since only $50 of the $120 payable at the end of the third year is based
on a fixed rate of simple or compound interest. If, however, the $120
were payable at the end of the second year, so that only $50 in addition
to principal would be payable at the end of the third year, then under
the rule for serial obligations contained in subparagraph (2)(iv)(c) of
this paragraph, the $1,000 note is treated as consisting of two series.
The first series is treated as maturing at the end of the second year at
a stated redemption price of $70. The second series is treated as
maturing at the end of the third year at a stated redemption price of
$1,000. For the calculation of issue price and the allocation of
original issue discount with respect to each such series, see example
(3) of subparagraph (2)(iv)(f) of this paragraph.
(b) Special rules. In the case of face -amount certificates, the
redemption price at maturity is the price as modified through changes
such as extensions of the purchase agreement and includes any dividends
which are payable at maturity. In the case of an obligation issued as
part of an investment unit consisting of such obligation and an option
(which is not excluded by (c) of this subdivision (iii)), security, or
other property, the term stated redemption price at maturity means the
amount payable on maturity in respect of the obligation, and does not
include any amount payable in respect of the option, security, or other
property under a repurchase agreement or option to buy or sell the
option, security, or other property. For application of this subdivision
to certain deposits in financial institutions, see paragraph (e) of
Sec. 1.1232-3A.
(c) Excluded option. An option is excluded by this subdivision (c)
if it is an option to which paragraph (a) of Sec. 1.61-15 applies or if
it is an option, referred to in paragraph (a) of Sec. 1.83-7, granted
in connection with performance of services to which section 421 does not
apply.
(d) Obligation issued in installments. If an obligation is issued by
a corporation under terms whereby the holder makes installment payments,
then the stated redemption price for each installment payment shall be
computed in a manner consistent with the rules contained in subparagraph
(2)(iv) of this paragraph for computing the issue price for each series
of a serial obligation. For application of this subdivision (d) to
certain open account deposit arrangements, see examples (1) and (2) of
paragraph (e)(5)(ii) of Sec. 1.1232-3A.
(e) Application of definition. Subdivision (a)(2) of this paragraph
(b)(1)(iii) shall not apply:
(1) For taxable years beginning before September 19, 1979, if for
the issuer's last taxable year beginning before September 19, 1978, the
rules of Sec. 1.163-4 were properly applied by the issuer, or
(2) In the case of an obligation with a term of six months or less
held by a nonresident alien individual or foreign corporation, but only
for purposes of the appliction of sections 871 and 881.
(iv) Carryover of original issue discount. If in pursuance of a plan
of reorganization an obligation is received in an exchange for another
obligation, and if gain or loss is not recognized in whole or in part on
such exchange of obligations by reason, for example, of section 354 or
356, then the obligation received shall be considered to have the same
original issue discount as the obligation surrendered reduced by the
amount of gain (if any) recognized as ordinary income upon such exchange
of obligations, and by the amount of original issue discount with
respect to the obligation surrendered which was included as interest
income under the ratable inclusion rules of sections 1232(a)(3) and
1.1232-3A. If inclusion as interest of the ratable monthly portion of
original issue discount is required under section 1232(a)(3) with
respect to the obligation received, see paragraph

[[Page 287]]

(a)(2)(iii) of Sec. 1.1232-3A for computation of the ratable monthly
portion of original issue discount. For special rules in connection with
certain exchanges of U.S. obligations, see section 1037.
(2) Issue price defined--(i) In general. The term issue price in the
case of obligations registered with the Securities and Exchange
Commission means the initial offering price to the public at which price
a substantial amount of such obligations were sold. For this purpose,
the term the public does not include bond houses and brokers, or similar
persons or organizations acting in the capacity of underwriters or
wholesalers. Ordinarily, the issue price will be the first price at
which the obligations were sold to the public, and the issue price will
not change if, due to market developments, part of the issue must be
sold at a different price. When obligations are privately placed, the
issue price of each obligation is the price paid by the first buyer of
the particular obligation, irrespective of the issue price of the
remainder of the issue. In the case of an obligation issued by a foreign
obligor, the issue price shall be increased by the amount, if any, of
interest equalization tax paid under section 4911 (and not credited,
refunded, or reimbursed) on the acquisition of the obligation by the
first buyer. In the case of an obligation which is convertible into
stock or another obligation, the issue price includes any amount paid in
respect of the conversion privilege. However, in the case of an
obligation issued as part of an investment unit (as defined in
subdivision (ii)(a) of this subparagraph), the issue price of the
obligation includes only that portion of the initial offering price or
price paid by the first buyer properly allocable to the obligation under
the rules prescribed in subdivision (ii) of this subparagraph. The terms
initial offering price and price paid by the first buyer include the
aggregate payments made by the purchaser under the purchase agreement,
including modifications thereof. Thus, all amounts paid by the purchaser
under the purchase agreement or a modification of it are included in the
issue price (but in the case of an obligation issued as part of an
investment unit, only to the extent allocable to such obligation under
subdivision (ii) of this subparagraph), such as amounts paid upon face-
amount certificates or installment trust certificates in which the
purchaser contracts to make a series of payments which will be
returnable to the holder with an increment at a later date.
(ii) Investment units consisting of obligations and property--(a) In
general. An investment unit, within the meaning of this subdivision (ii)
and for purposes of section 1232, consists of an obligation and an
option, security, or other property. For purposes of this subparagraph,
the initial offering price of an investment unit shall be allocated to
the individual elements of the unit on the basis of their respective
fair market values. However, if the fair market value of the option,
security, or other property is not readily ascertainable (within the
meaning of paragraph (c) of Sec. 1.421-6), then the portion of the
initial offering price or price paid by the first buyer of the unit
which is allocable to the obligation issued as part of such unit shall
be ascertained as of the time of acquisition of such unit by reference
to the assumed price at which such obligation would have been issued had
it been issued apart from such unit. The assumed price of the obligation
shall be ascertained by comparison to the yields at which obligations of
a similar character which are not issued as part of an investment unit
are sold in arm's length transactions, and by adjusting the price of the
obligation in question to this yield. The adjustment may be made by
subtracting from the face amount of the obligation the total present
value of the interest foregone by the purchaser as a result of
purchasing the obligation at a lower yield as part of an investment
unit. In most cases, assumed price may also be determined in a similar
manner through the use of standard bond tables. Any reasonable method
may be used in selecting an obligation for comparative purposes.
Obligations of the same grade and classification shall be used to the
extent possible, and proper regard shall be given, with respect to both
the obligation in question and the comparative obligation, to the
solvency of the issuer, the nature of the issuer's trade or business,
the presence and nature of

[[Page 288]]

security for the obligation, the geographic area in which the loan is
made, and all other factors relevant to the circumstances. An obligation
which is convertible into stock or another obligation must not be used
as a comparative obligation (except where the investment unit contains
an obligation convertible into stock or another obligation), since such
an obligation would not reflect the yield attributable solely to the
obligation element of the investment unit.
(b) Agreement as to assumed price. In the case of an investment unit
which is privately placed, the assumed price at which the obligation
would have been issued had it been issued apart from such unit may be
agreed to by the issuer and the original purchaser of the investment
unit in writing on or before the date of purchase. Alternatively, an
agreement between the issuer and original purchaser may specify the rate
of interest which would have been paid on the obligation if the
transaction were one not involving the issuance of options, and an
assumed issue price may be determined (in the manner described in (a) of
this subdivision) from such agreed assumed rate of interest. An assumed
price based upon such an agreement between the parties will generally be
presumed to be the issue price of the obligation with respect to the
issuer, original purchaser, and all subsequent holders: Provided, That
the agreement was made in arm's length negotiations between parties
having adverse interests: And, provided further, That such price does
not, under the rules stated in (a) of this subdivision, appear to be
clearly erroneous. An assumed issue price agreed to by the parties as
provided herein will not be considered clearly erroneous if it is not
less than the face value adjusted (in the manner described in (a) of
this subdivision) to a yield which is one percentage point greater than
the actual rate of interest payable on the obligation. Similarly, if the
agreement between the parties specifies an agreed assumed rate of
interest (in lieu of an agreed assumed issue price) and such agreed rate
is not more than 1 percentage point greater than the actual rate payable
on the obligation, an adjusted issue price based upon such agreed
assumed rate of interest will not be considered clearly erroneous.
(c) Cross references. For rules relating to the deductibility by the
issuing corporation of bond discount resulting from an allocation under
the rule stated in (a) of this subdivision, see Sec. Sec. 1.163-3 and
1.163-4. For rules relating to the basis of obligations and options,
securities, or other property acquired in investment units, see Sec.
1.1012-1(d). For rules relating to certain reporting requirements with
respect to options acquired in connection with evidences of indebtedness
and for the tax treatment of such options, see Sec. 1.61-15, and
section 1234 and the regulations thereunder. With respect to the tax
consequences to the issuing corporation upon the exercise of options
issued in connection with evidences of indebtedness to which this
section applies, see section 1032 and the regulations thereunder.
(d) Examples. The application of the principles set forth in this
subdivision (ii) may be illustrated by the following examples in each of
which it is assumed that there was no intention to call the note before
maturity:

Example 1. M Corporation is a small manufacturer of electronic
components located in the southwestern United States. On January 1,
1969, in consideration for the payment of $41,500, M issues to X its
unsecured note for $40,000 together with warrants to purchase 3,000
shares of M stock at $10 per share at any time during the term of the
note. The note is payable in 4 years and provides for interest at the
rate of 5 percent per year, payable semiannually. The fair market values
of the note and the warrants are not readily ascertainable. Assume that
companies in the same industry as M Corporation, and similarly situated
both financially and geographically, are generally able to borrow money
on their unsecured notes at an annual interest rate of 6 percent. Using
a present value table, the calculation of the issue price of a 5
percent, 4 year, $40,000 note, discounted to yield 6 percent compounded
semiannually is made as follows:

------------------------------------------------------------------------
(1) (2) (3) (2)x(3)
------------------------------------------------------------------------
Factor for
present
Amount value Present
Semiannual interest period payable at discounted value of
5 percent at 3 payment
percent
per period
------------------------------------------------------------------------
1................................... $1,000 0.9709 $970.90
2................................... 1,000 .9426 942.60
3................................... 1,000 .9151 915.10

[[Page 289]]

4................................... 1,000 .8885 888.50
5................................... 1,000 .8626 862.60
6................................... 1,000 .8375 837.50
7................................... 1,000 .8131 813.10
8................................... 1,000 .7894 789.40
8................................... 40,000 .7804 31,576.00
-------------------------------------
Total present value of note discounted at 6 percent, 38,595.70
compounded semiannually..................................
------------------------------------------------------------------------

The same result may be reached through the use of a standard bond
table or by the following present value calculation:

Present value of annuity of $1,000 payable over 8 periods at $7,019.70
3 percent per period=1000x7.0197=..........................
Add: Present value of principal (as calculated above)....... 31,576.00
-----------
Total................................................... $38,595.70

Accordingly, the assumed price at which M's note would have been issued
had it been issued without stock purchase warrants, i.e., that portion
of the $41,500 price paid by X which is allocable to M's note, is
$38,596 (rounded). Since the price payable on redemption of M's note at
maturity is $40,000, the original issue discount on M's note is $1,404
($40,000 minus $38,596). Under the rules stated in Sec. 1.163-3, M is
entitled to a deduction, to be prorated or amortized over the life of
the note, equal to this original issue discount on the note. The excess
of the price for the unit over the portion of such price allocable to
the note, $2,904 ($41,500 minus $38,596), is allocable to and is the
basis of the stock purchase warrants acquired by X in connection with
M's note. Upon the exercise of X's warrants, M will be allowed no
deduction and will have no income. Upon maturity of the note X will
receive $40,000 from M, of which $1,404, the amount of the original
issue discount, will be taxable as ordinary income. If X were to
transfer the note at its face amount to A 2 years after the issue date,
X would realize, under section 1232(a)(2)(B), ordinary income of $702
(one-half of $1,404).
Example 2. (1) On January 1, 1969, N Corporation negotiates with Y,
a small business investment company, for a loan in the amount of $51,500
in consideration of which N Corporation issues to Y its unsecured 5-year
note for $50,000, together with warrants to purchase 2,000 shares of N
stock at $5 per share at any time during the term of the note. The note
provides for interest of 6 percent, payable semiannually. The fair
market values of the note and warrants are not readily ascertainable.
The loan agreement between Y and N contains a provision, agreed to in
arms-length bargaining between the parties, that a rate of 7 percent
payable semiannually would have been applied to the loan if warrants
were not issued as part of the consideration for the loan. The issue
price of the note is $47,921 (rounded), determined with the use of a
standard bond table, or computed in the manner illustrated in Example 1
or in the following alternative manner:

----------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (4)x(5)
----------------------------------------------------------------------------------------------------------------
Factor for
Interest present value Present value
Interest period Interest rate Principal foregone for discounted at of interest
differential period (\1/ 3\1/2\ percent foregone
2\%) per period
----------------------------------------------------------------------------------------------------------------
1............................... 1%(7%-6%) $50,000 250 0.9662 $241.53
2............................... 1% 50,000 250 .9335 233.38
3............................... 1% 50,000 250 .9019 225.48
4............................... 1% 50,000 250 .8714 217.85
5............................... 1% 50,000 250 .8420 210.50
6............................... 1% 50,000 250 .8135 203.38
7............................... 1% 50,000 250 .7860 196.50
8............................... 1% 50,000 250 .7594 189.85
9............................... 1% 50,000 250 .7337 183.43
10.............................. 1% 50,000 250 .7089 177.25
---------------------------------
Total present value of interest foregone.................................................... $2,079.15
===============
Principal....................................................................................... 50,000.00
Less: Total present value of interest foregone.................................................. 2,079.15
---------------
Issue price................................................................................. 47,920.85
----------------------------------------------------------------------------------------------------------------

The calculation of present value of interest foregone may also be
made as follows:
Present value of annuity of $250 discounted for 10 periods at 3\1/2\
percent per period=$250x8.3166=$2,079.15.

[[Page 290]]

The total present value of interest foregone, $2,079, is also the
original issue discount attributable to the note ($50,000 -$47,921).
Under (b) of this subdivision, since the agreed assumed rate of interest
of 7 percent is not more than 1 percentage point greater than the actual
rate payable on the note, determination of the issue price of the note
(and original issue discount) based upon such assumed rate will be
presumed to be correct and will not be considered clearly erroneous,
provided that both N and Y adhere to such determination. Under the rules
in Sec. 1.163-3, N is entitled to a deduction, to be prorated or
amortized over the life of the note, equal to the original issue
discount on the note. The excess of the price paid for the unit over the
portion of such price allocable to the note, $3,579 ($51,500-$47,921) is
allocable to and is the basis of the stock purchase warrants acquired by
Y in connection with N's note. Upon the exercise or sale of the warrants
by Y, N will be allowed no deduction and will have no income. Upon
maturity of the note Y will receive $50,000 from N, of which $2,079, the
amount of the original issue discount, will be taxable as ordinary
income. If Y were to transfer the note at its face value to B 2\1/2\
years after the issue date, Y would realize, under section
1232(a)(2)(B), ordinary income of $1,039.50 (one-half of $2,079).
(2) Assume that instead of the parties agreeing on an assumed
interest rate at which the obligation would have been issued without the
warrants, the parties agreed that the obligation at the actual 6 percent
rate would have been issued without the warrants at a discounted price
of $48,000. In this situation the agreed assumed issue price is presumed
to be correct since it is not less than the face value adjusted (in the
manner illustrated in part (1) of this example) to a yield which is one
percentage point greater than the actual rate of interest payable on the
obligation ($47,921).
Example 3. O Corporation is a small advertising company located in
the northeastern United States. Z is a tax-exempt organization. In
consideration for the payment of $60,000, O issues to Z, in a
transaction not within the scope of section 503(b), its unsecured 5-year
note for $60,000, together with warrants to purchase 6,000 shares of O
stock at $10 per share at any time during the term of the note. The note
is subject to quarterly amortization at the rate of $3,000 per quarter,
and provides for interest on the outstanding unpaid balance at an annual
rate of 6 percent payable quarterly (1\1/2\ percent per quarter). The
fair market values of the notes and warrants are not readily
ascertainable. The loan agreement between O and Z contains a recital
that if the $60,000 note had been issued without the warrants only
$45,000 would have been paid for it. An examination of relevant facts
indicates that companies in the same industry as O Corporation, and
similarly situated both financially and geographically, are able to
borrow money on their unsecured notes at an annual interest cost of 8\1/
2\ percent payable quarterly (2\1/8\ percent per quarter). By reference
to a present value table, it is found that the present value of O's note
discounted to yield 8\1/2\ percent compounded quarterly is $56,608
(rounded). The computation is as follows:

----------------------------------------------------------------------------------------------------------------
(1) (2) (3) (4) (5) (6)
----------------------------------------------------------------------------------------------------------------
Factor for
Interest Total amount present value Present value
Quarterly interest period Principal payable (1\1/ payable discounted at of total
payable 2\ percent) (2)+(3) 2\1/8\ percent payment
per quarter (4)x(5)
----------------------------------------------------------------------------------------------------------------
1............................... $3,000 $900 $3,900 0.9792 $3,818.88
2............................... 3,000 855 3,855 .9588 3,696.17
3............................... 3,000 810 3,810 .9389 3,577.21
4............................... 3,000 765 3,765 .9193 3,461.16
5............................... 3,000 720 3,720 .9002 3,348.74
6............................... 3,000 675 3,675 .8815 3,239.51
7............................... 3,000 630 3,630 .8631 3,133.05
8............................... 3,000 585 3,585 .8452 3,030.04
9............................... 3,000 540 3,540 .8276 2,929.70
10.............................. 3,000 495 3,495 .8104 2,832.35
11.............................. 3,000 450 3,450 .7935 2,737.58
12.............................. 3,000 405 3,405 .7770 2,645.69
13.............................. 3,000 360 3,360 .7608 2,556.29
14.............................. 3,000 315 3,315 .7450 2,469.68
15.............................. 3,000 270 3,270 .7295 2,385.47
16.............................. 3,000 225 3,225 .7143 2,303.62
17.............................. 3,000 180 3,180 .6994 2,224.09
18.............................. 3,000 135 3,135 .6849 2,147.16
19.............................. 3,000 90 3,090 .6706 2,072.15
20.............................. 3,000 45 3,045 .6567 1,999.65
---------------------------------
Total....................................................................................... 56,608.19
----------------------------------------------------------------------------------------------------------------

[[Page 291]]

This amount ($56,608) is the assumed price at which the note would have
been issued had it been issued without stock purchase warrants. The
assumed price of $45,000 agreed to by the parties is not presumed to be
correct since it is less than the face value adjusted to a yield which
is one percentage point greater than the actual rate of interest payable
on the obligation. The parties did not have adverse interests in
agreeing upon an assumed price (since an excessively large amount of
original issue discount would benefit O, the borrower, without adversely
affecting Z, an exempt organization which would pay no tax on original
issue discount income), and the price agreed to appears to be clearly
erroneous when compared to the $56,608 assumed issue price determined
under the principles of (a) of this subdivision. Since the maturity
value of O's note is $60,000, the original issue discount on O's note is
$3,392 ($60,000 minus $56,608). Under the rules in Sec. 1.163-3, O is
entitled to a deduction, to be prorated or amortized over the life of
the note, equal to this original issue discount on the note. The excess
of the price paid for the unit over the portion of such price allocable
to the note, $3,392 ($60,000 minus $56,608), is allocable to and is the
basis of the stock purchase warrants acquired by Z in connection with
O's note. Upon the exercise or sale of the warrants by Z, O will be
allowed no deduction and will have no income.

(iii) Issuance for property after May 27, 1969--(a) In general.
Except as provided in (b) of this subdivision, if an obligation or an
investment unit is issued for property other than money, the issue price
of such obligation shall be the stated redemption price at maturity and,
therefore, no original issue discount is created as a result of the
exchange. However, in such case, there may be an amount treated as
interest under section 483. In the case of certain exchanges of
obligations of the United States for other such obligations, see section
1037 for the determination of the amount of original issue discount on
the obligation acquired in the exchange. For carryover of original issue
discount in the case of certain exchanges of obligations, see
subparagraph (1)(iv) of this paragraph.
(b) Exceptions for original issue discount. If an obligation or
investment unit is issued for property in an exchange which is not
pursuant to a plan of reorganization referred to in (d) of this
subdivision, and if:
(1) The obligation, investment unit, or an element of the investment
unit is part of an issue a portion of which is traded on an established
securities market, or
(2) The property for which such obligation or investment unit is
issued is stock or securities which are traded on an established
securities market,

then the issue price of the obligation or investment unit shall be the
fair market value of the property for which such obligation or
investment unit is issued, as determined under (c) of this subdivision.
Such issue price shall control for purposes of determining the amount
realized by the person exchanging the property for the obligation or
unit issued and the bases of the property acquired by the holder and
issuer.

An obligation which is not traded on an established securities market
and which is not part of an issue or investment unit a portion of which
is so traded shall not be treated as property described in (1) of this
(b) even though the obligation is convertible into property so traded.
For purposes of this (b), an obligation, investment unit, or element of
an investment unit shall be treated as traded on an established
securities market if it is so traded on or within 10 trading days after
the date it is issued. Trading days shall mean those days on which an
established securities market is open. For purposes of this subdivision
(iii), the term established securities market shall have the same
meaning as in paragraph (d)(4) of Sec. 1.453-3 (relating to limitations
on installment method for purchaser evidences of indebtedness payable on
demand or readily tradable).
(c) Determination of fair market value in cases to which (b) of this
subdivision applies. In general, for purposes of (b) of this
subdivision, the fair market value of property for which an obligation
or investment unit is issued shall be deemed to be the same as the fair
market value of such obligation or investment unit, determined by
reference to the fair market value of that portion of the issue, of
which such obligation or unit is a part, which is traded on an
established securities market. The fair market value of such obligation
or unit shall be determined as of the first date after the date of issue
(within the meaning of section 1232(b)(3)) that such

[[Page 292]]

obligation or unit is traded on an established securities market. If,
however, the obligation or investment unit is not part of an issue a
portion of which is traded on an established securities market, but the
property for which the obligation or investment unit is issued is stock
or securities which are traded on an established securities market, the
fair market value of such property shall be the fair market value of
such stock or securities on the date such obligation or unit is issued
for such property. The fair market value of property for purposes of
this (c) shall be determined as provided in Sec. 20.2031-2 of this
chapter (Estate Tax Regulations) but without applying the blockage and
other special rules contained in paragraph (e) thereof.
(d) Not in reorganization. An exchange which is not pursuant to a
reorganization referred to in this subdivision (d) is an exchange in
which the obligation or investment unit is not issued pursuant to a plan
of reorganization within the meaning of section 368(a)(1) or pursuant to
an insolvency reorganization within the meaning of section 371, 373, or
374. Thus, for example, no original issue discount is created on an
obligation issued in a recapitalization within the meaning of section
368(a)(1)(E). Similarly, no original issue discount is created on an
obligation issued in an exchange, pursuant to a plan of reorganization,
to which section 361 applies regardless of the income tax consequences
to any person who pursuant to such plan is the ultimate recipient of the
obligation. The application of section 351 shall not preclude the
creation of original issue discount. For carryover of original issue
discount in the case of an exchange of obligations pursuant to a plan of
reorganization, see subparagraph (1)(iv) of this paragraph.
(e) Effective date. Determinations with respect to obligations
issued on or before May 27, 1969, or pursuant to a written commitment
which was binding on that date and at all times thereafter, shall be
made without regard to this subdivision (iii).
(iv) Serial obligations--(a) In general. If an issue of obligations
which matures serially is issued by a corporation, and if on the basis
of the facts and circumstances in such case an independent issue price
for each particular maturity can be established, then the obligations
with each particular maturity shall be considered a separate series, and
the obligations of each such series shall be treated as a separate issue
with a separate issue price, maturity date, and stated redemption price
at maturity. The ratable monthly portion of original issue discount
attributable to each obligation within a particular series shall be
determined and ratably included as interest in gross income under the
rules of Sec. 1.1232-3A.
(b) Issue price not independently established. If a separate issue
price cannot be established with respect to each series of an issue of
obligations which matures serially, the issue price for each obligation
of each series shall be its stated redemption price at maturity minus
the amount of original issue discount allocated thereto in accordance
with (d) of this subdivision. The amount of original issue discount so
allocated shall be ratably included as interest in gross income under
rules of Sec. 1.1232-3A.
(c) Single obligation rule. If a single corporate obligation
provides for payments (other than payments which would not be included
in the stated redemption price at maturity under subparagraph (1)(iii)
of this paragraph) in two or more installments, the provisions of (b) of
this subdivision shall be applied by treating such obligation as an
issue of obligations consisting of more than one series each of which
matures on the due date of each such installment payment.
(d) Allocation of discount. For purposes of (b) and (c) of this
subdivision, the original issue discount with respect to each series of
an issue shall be the total original issue discount for the issue
multiplied by a fraction:
(1) The numerator of which is the product of (i) the stated
redemption price of such series and (ii) the number of complete years
(and any fraction thereof) constituting the period for such series from
the date of original issue (as defined in paragraph (b)(3) of this
section) to its stated maturity date, and
(2) The denominator of which is the sum of the products determined
in (1)

[[Page 293]]

of this subdivision (d) with respect to each such series.

If a series consists of more than one obligation, the original issue
discount allocated to such series shall be apportioned to such
obligations in proportion to the stated redemption price of each.
Computations under this subdivision (d) may be made using periods other
than years, such as, for example, months or periods of 3 months.
(e) Effective date. The provisions of this subdivision (iv) shall
apply with respect to corporate obligations issued after July 22, 1971.
However, no inference shall be drawn from the preceding sentence with
respect to serial obligations issued prior to such date.
(f) Examples. The provisions of this subdivision (iv) may be
illustrated by the following examples:

Example 1. On January 1, 1972, P Corporation issued a note with a
total face value of $100,000 to B for cash of $94,000. The terms of the
note provide that $50,000 is payable on December 31, 1973, and the other
$50,000 on December 31, 1975. Each payment is treated as the stated
redemption price of a series, and the total original issue discount with
respect to the note, $6,000, is allocated to each such series as
follows:

------------------------------------------------------------------------
Year of maturity 1973 1975 Total
------------------------------------------------------------------------
(1) Stated redemption price............ $50,000 $50,000
(2) Multiply by years outstanding...... 2 4
--------------------------------
(3) Product of bond years.............. $100,000 $200,000
(4) Sum of products.................... ......... ......... $300,000
(5) Fractional portion of discount..... $100,000 $200,000
--------------------------------
$300,000 $300,000
(6) Multiply line (5) by discount for $6,000 $6,000
entire issue..........................
----------------------
(7) Discount for each series........... $2,000 $4,000
======================
(8) Issue price (line (1), minus line $48,000 $46,000
(7))..................................
------------------------------------------------------------------------

Example 2. Assume the same facts as in example (1) except that a
separate note is issued for each payment. The result is the same as in
example (1).
Example 3. On January 1, 1971, Y Bank, a corporation, issues a note
to C for $1,000 cash. The terms of the note provide that $50 will be
paid at the end of the first year, $120 at the end of the second year,
and $1,050 at the end of the third year. Under (c) of this subdivision
(iv), the $1,000 note is treated as consisting of two series, the first
of which matures at the end of the second year, and the second of which
matures at the end of the third year. The issue price and the allocation
of original issue discount with respect to each series is computed as
follows:

------------------------------------------------------------------------
Year of maturity 1972 1973 Total
------------------------------------------------------------------------
(1) Stated redemption price............ $70 $1,000
(2) Multiply by years outstanding...... 2 3
----------------------
(3) Product of bond years.............. $140 $3,000
(4) Sum of products.................... ......... ......... $3,140
(5) Fractional portion of discount..... $140 $3,000
----------------------
$3,140 $3,140
(6) Multiply line (5) by discount for $70 $70
entire issue..........................
----------------------
(7) Discount for each series........... $3.12 $66.88
======================
(8) Issue price (line 1 minus line (7)) $66.88 $933.12
------------------------------------------------------------------------

(3) Date of original issue. In the case of issues of obligations
which are registered with the Securities and Exchange Commission, the
term date of original issue means the date on which the issue was first
sold to the public at the issue price. In the case of issues which are
privately placed, the term date of original issue means the date on
which each obligation was sold to the original purchaser.
(4) Intention to call before maturity--(i) Meaning of term. For
purposes of section 1232, the term intention to call the bond or other
evidence of indebtedness before maturity means an understanding between
(a) the issuing corporation (such corporation is hereinafter referred to
as the issuer), and (b) the original purchaser of such obligation (or,
in the case of obligations constituting part of an issue, any of the
original purchasers of such obligations) that the issuer will redeem the
obligation before maturity. For purposes of this subparagraph, the term
original purchaser does not include persons or organizations acting in
the capacity of underwriters or dealers, who purchased the obligation
for resale in the ordinary course of their trade or business. It is not
necessary that the issuer's intention to call the obligation before
maturity be communicated directly to

[[Page 294]]

the original purchaser by the issuer. The understanding to call before
maturity need not be unconditional; it may, for example, be dependent
upon the financial condition of the issuer on the proposed early call
date.
(ii) Proof of intent--(a) In general. Ordinarily, the existence or
non-existance of an understanding at the time of original issue that the
obligation will be redeemed before maturity shall be determined by an
examination of all of the circumstances under which the obligation was
issued and held. The fact that the obligation is issued with provisions
on its face giving the issuer the privilege of redeeming the obligation
before maturity is not determinative of an intention to call before
maturity; likewise, the absence of such provision is not determinative
of the absence of an intention to call before maturity. However, such
provision, or the absence of such provision, is one of the circumstances
to be given consideration along with other factors in determining
whether an understanding existed. If the obligation was part of an issue
registered with the Securities and Exchange Commission and was sold to
the public (whether or not sold directly to the public by the obligor)
without representation to the public that the obligor intends to call
the obligation before maturity, there shall be a presumption that no
intention to call the obligation before maturity was in existence at the
time of original issue. The existence of a provision on the face of an
obligation giving the issuer the privilege of redeeming the obligation
before maturity shall not in and of itself overcome the presumption set
forth in the preceding sentence.
(b) Circumstances indicating absence of understanding. Examples of
circumstances which would be evidence that there was no understanding at
the time of original issue to redeem the obligation before maturity are:
(1) The issue price and term of the obligation appear to be
reasonable, taking into account the interest rate, if any, on the
obligation, for a corporation in the financial condition of the issuer
at the time of issue.
(2) The original purchaser and the issuer are not related within the
meaning of section 267(b) and have not engaged in transactions with each
other (other than concerning the obligation).
(3) The original purchaser is not related within the meaning of
section 267(b) to any of the officers or directors of the issuer, and he
has not engaged in transactions with such officers or directors (other
than concerning the obligation).
(4) The officers and directors of the issuer at the time of issue of
the obligation are different from those in control at the time the
obligation is called or the taxpayer disposes of it.
(c) Gain treated as ordinary income in certain cases; computation.
The amount of gain treated as ordinary income under paragraph (a)
(3)(ii) or (5) of this section is computed by multiplying the original
issue discount by a fraction, the numerator of which is the number of
full months the obligation was held by the holder and the denominator of
which is the number of full months from the date of original issue to
the date specified as the redemption date at maturity. (See paragraph
(b)(3) of this section for definition of date of original issue.) The
period that the obligation was held by the taxpayer shall include any
period that it was held by another person if, under chapter 1 of the
Code, for the purpose of determining gain or loss from a sale or
exchange, the obligation has the same basis, in whole or in part, in the
hands of the taxpayer as it would have in the hands of such other
person. This computation is illustrated by the following examples:

Example 1. An individual purchases a 10-year, 3-percent coupon bond
for $900 on original issue on February 1, 1955, and sells it on February
20, 1960, for $940. The redemption price is $1,000. At the time of
original issue, there was no intention to call the bond before maturity.
The bond has been held by the taxpayer for 60 full months. (The
additional days amounting to less than a full month are not taken into
account.) The number of complete months from date of issue to date of
maturity is 120 (10 years). The fraction \60/120\ multiplied by the
discount of $100 is equal to $50, which represents the proportionate
part of the original issue discount attributable to the period of
ownership by the taxpayer. Accordingly, any part of the gain up to $50
will be treated as ordinary income. Therefore, in this case the entire
gain of $40 is treated as ordinary income.

[[Page 295]]

Example 2. Assume the same facts in the preceding example, except
that the selling price of the bond is $970. In this case $50 of the gain
of $70 is treated as ordinary income and the balance of $20 is treated
as long-term capital gain.
Example 3. Assume the same facts as in example (1), except that the
selling price of the bond is $800. In this case, the individual has a
long-term capital loss of $100.
Example 4. Assume the same facts as in example (1), except that the
bond is purchased by the second holder February 1, 1960, for $800. The
second holder keeps it to the maturity date (February 1, 1965) when it
is redeemed for $1,000. Since that holder has held the bond for 60 full
months, he will, upon redemption, have $50 in ordinary income and $150
in long-term capital gain.

(d) Exceptions to the general rule--(1) In general. Section
1232(a)(2)(C) provides that section 1232(a)(2) does not apply (i) to
obligations the interest on which is excluded from gross income under
section 103 (relating to certain government obligations), or (ii) to any
holder who purchases an obligation at a premium.
(2) Premium. For purposes of section 1232, this section, and Sec.
1.1232-3A, premium means a purchase price which exceeds the stated
redemption price of an obligation at its maturity. For purposes of the
preceding sentence, if an obligation is acquired as part of an
investment unit consisting of an option, security, or other property and
an obligation, the purchase price of the obligation is that portion of
the price paid or payable for the unit which is allocable to the
obligation. The price paid for the unit shall be allocated to the
individual elements of the unit on the basis of their respective fair
market values. However, if the fair market value of the option,
security, or other property is not readily ascertainable (within the
meaning of paragraph (c) of Sec. 1.421-6), then the price paid for the
unit shall be allocated in accordance with the rules under paragraph
(b)(2)(ii) of this section for allocating the initial offering price of
an investment unit to its elements. If, under chapter 1 of the Code, the
basis of an obligation in the hands of the holder is the same, in whole
or in part, for the purposes of determining gain or loss from a sale or
exchange, as the basis of the obligation in the hands of another person
who purchased the obligation at a premium, then the holder shall be
considered to have purchased the obligation at a premium. Thus, the
donee of an obligation purchased at a premium by the doner will be
considered a holder who purchased the obligation at a premium.
(e) Amounts previously includible in income. Nothing in section
1232(a)(2) shall require the inclusion of any amount previously
includible in gross income. Thus, if an amount was previously includible
in a taxpayer's income on account of obligations issued at a discount
and redeemable for fixed amounts increasing at stated intervals, or,
under section 818(b) (relating to accrual of discount on bonds and other
evidences of indebtedness held by life insurance companies), such amount
is not again includible in the taxpayer's gross income under section
1232(a)(2). For example, amounts includible in gross income by a cash
receipts and disbursements method taxpayer who has made an election
under section 454 (a) or (c) (relating to accounting rules for certain
obligations issued at a discount to which section 1232(a)(3) does not
apply) are not includible in gross income under section 1232(a)(2). In
the case of a gain which would include, under section 1232(a)(2), an
amount considered to be ordinary income and a further amount considered
long-term capital gain, any amount to which this paragraph applies is
first used to offset the amount considered ordinary income. For example,
on January 1, 1955, A purchases a 10-year bond which is redeemable for
fixed amounts increasing at stated intervals. At the time of original
issue, there was no intention to call the bond before maturity. The
purchase price of the bond is $75, which is also the issue price. The
stated redemption price at maturity of the bond is $100. A elects to
treat the annual increase in the redemption price of the bond as income
pursuant to section 454(a). On January 1, 1960, A sells the bond for
$90. The total stated increase in the redemption price of the bond which
A has reported annually as income for the taxable years 1955 through
1959 is $7. The portion of the original issue discount of $25
attributable to this period is $12.50, computed as follows:

[[Page 296]]

60 (months bond is held by A)/120 (months from date of original issue to
redemption date)x$25 (original issue discount)

However, $7, which represents the annual stated increase taken into
income, is offset against the amount of $12.50, leaving $5.50 of the
gain from the sale to be treated as ordinary income.
(f) Recordkeeping requirements. In the case of any obligation held
by a taxpayer which was issued at an original issue discount after
December 31, 1954, the taxpayer shall keep a record of the issue price
and issue date upon or with each obligation (if known to or reasonably
ascertainable by him). If the obligation held by the taxpayer is an
obligation of the United States received from the United States in an
exchange upon which gain or loss is not recognized because of section
1037 (a) (or so much of section 1031 (b) or (c) as relates to section
1037(a)), the taxpayer shall keep sufficient records to determine the
issue price of such obligation for purposes of applying section 1037(b)
and paragraphs (a) and (b) of Sec. 1.1037-1 upon the disposition or
redemption of such obligation. The issuer (or in the case of obligations
first sold to the public through an underwriter or wholesaler, the
underwriter or wholesaler) shall mark the issue price and issue date
upon every obligation which is issued at an original issue discount
after September 26, 1957, but only if the period between the date of
original issue (as defined in paragraph (b)(3) of this section) and the
stated maturity date is more than 6 months.

[T.D. 6500, 25 FR 12008, Nov. 26, 1960, as amended by T.D. 6984, 33 FR
19176, Dec. 21, 1968; T.D. 7154, 36 FR 25000, Dec. 28, 1971; 37 FR 527,
Jan. 13, 1972; T.D. 7213, 37 FR 21992, Oct. 18, 1972; 37 FR 22863, Oct.
26, 1972; T.D. 7663, 44 FR 76782, Dec. 28, 1979; T.D. 7728, 45 FR 72650,
Nov. 3, 1980]