[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: 26CFR1.1275-6] [Page 577-584] TITLE 26--INTERNAL REVENUE CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY (CONTINUED) PART 1_INCOME TAXES--Table of Contents Sec. 1.1275-6 Integration of qualifying debt instruments. (a) In general. This section generally provides for the integration of a qualifying debt instrument with a hedge or combination of hedges if the combined cash flows of the components are substantially equivalent to the cash flows on a fixed or variable rate debt instrument. The integrated transaction is generally subject to the rules of this section rather than the rules to which each component of the transaction would be subject on a separate basis. The purpose of this section is to permit a more appropriate determination of the character and timing of income, deductions, gains, or losses than would be permitted by separate treatment of the components. The rules of this section affect only the taxpayer who holds (or issues) the qualifying debt instrument and enters into the hedge. (b) Definitions--(1) Qualifying debt instrument. A qualifying debt instrument is any debt instrument (including an integrated transaction as defined in paragraph (c) of this section) other than-- (i) A tax-exempt obligation as defined in section 1275(a)(3); (ii) A debt instrument to which section 1272(a)(6) applies (certain interests in or mortgages held by a REMIC, and certain other debt instruments with payments subject to acceleration); or (iii) A debt instrument that is subject to Sec. 1.483-4 or Sec. 1.1275-4(c) (certain contingent payment debt instruments issued for nonpublicly traded property). (2) Section 1.1275-6 hedge--(i) In general. A Sec. 1.1275-6 hedge is any financial instrument (as defined in paragraph (b)(3) of this section) if the combined cash flows of the financial instrument and the qualifying debt instrument permit the calculation of a yield to maturity (under the principles of section 1272), or the right to the combined cash flows would qualify under Sec. 1.1275-5 as a variable rate debt instrument that pays interest at a qualified floating rate or rates (except for the requirement that the interest payments be stated as interest). A financial instrument is not a Sec. 1.1275-6 hedge, however, if the resulting synthetic debt instrument does not have the same term as the remaining term of the qualifying debt instrument. A financial instrument that hedges currency risk is not a Sec. 1.1275-6 hedge. (ii) Limitations--(A) A debt instrument issued by a taxpayer and a debt instrument held by the taxpayer cannot be part of the same integrated transaction. (B) A debt instrument can be a Sec. 1.1275-6 hedge only if it is issued substantially contemporaneously with, and has the same maturity (including rights to accelerate or delay payments) as, the qualifying debt instrument. (3) Financial instrument. For purposes of this section, a financial instrument is a spot, forward, or futures contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments. Stock is not a financial instrument for purposes of this section. (4) Synthetic debt instrument. The synthetic debt instrument is the hypothetical debt instrument with the same cash flows as the combined cash flows of the qualifying debt instrument and the Sec. 1.1275-6 hedge. (c) Integrated transaction--(1) Integration by taxpayer. Except as otherwise provided in this section, a qualifying debt instrument and a Sec. 1.1275-6 hedge are an integrated transaction if all of the following requirements are satisfied: (i) The taxpayer satisfies the identification requirements of paragraph (e) of this section on or before the date the taxpayer enters into the Sec. 1.1275-6 hedge. (ii) None of the parties to the Sec. 1.1275-6 hedge are related within the meaning of section 267(b) or 707(b)(1), or, if the parties are related, the party providing [[Page 578]] the hedge uses, for Federal income tax purposes, a mark-to-market method of accounting for the hedge and all similar or related transactions. (iii) Both the qualifying debt instrument and the Sec. 1.1275-6 hedge are entered into by the same individual, partnership, trust, estate, or corporation (regardless of whether the corporation is a member of an affiliated group of corporations that files a consolidated return). (iv) If the taxpayer is a foreign person engaged in a U.S. trade or business and the taxpayer issues or acquires a qualifying debt instrument, or enters into a Sec. 1.1275-6 hedge, through the trade or business, all items of income and expense associated with the qualifying debt instrument and the Sec. 1.1275-6 hedge (other than interest expense that is subject to Sec. 1.882-5) would have been effectively connected with the U.S. trade or business throughout the term of the qualifying debt instrument had this section not applied. (v) Neither the qualifying debt instrument, nor any other debt instrument that is part of the same issue as the qualifying debt instrument, nor the Sec. 1.1275-6 hedge was, with respect to the taxpayer, part of an integrated transaction that was terminated or otherwise legged out of within the 30 days immediately preceding the date that would be the issue date of the synthetic debt instrument. (vi) The qualifying debt instrument is issued or acquired by the taxpayer on or before the date of the first payment on the Sec. 1.1275- 6 hedge, whether made or received by the taxpayer (including a payment made to purchase the hedge). If the qualifying debt instrument is issued or acquired by the taxpayer after, but substantially contemporaneously with, the date of the first payment on the Sec. 1.1275-6 hedge, the qualifying debt instrument is treated, solely for purposes of this paragraph (c)(1)(vi), as meeting the requirements of the preceding sentence. (vii) Neither the Sec. 1.1275-6 hedge nor the qualifying debt instrument was, with respect to the taxpayer, part of a straddle (as defined in section 1092(c)) prior to the issue date of the synthetic debt instrument. (2) Integration by Commissioner. The Commissioner may treat a qualifying debt instrument and a financial instrument (whether entered into by the taxpayer or by a related party) as an integrated transaction if the combined cash flows on the qualifying debt instrument and financial instrument are substantially the same as the combined cash flows required for the financial instrument to be a Sec. 1.1275-6 hedge. The Commissioner, however, may not integrate a transaction unless the qualifying debt instrument either is subject to Sec. 1.1275-4 or is subject to Sec. 1.1275-5 and pays interest at an objective rate. The circumstances under which the Commissioner may require integration include, but are not limited to, the following: (i) A taxpayer fails to identify a qualifying debt instrument and the Sec. 1.1275-6 hedge under paragraph (e) of this section. (ii) A taxpayer issues or acquires a qualifying debt instrument and a related party (within the meaning of section 267(b) or 707(b)(1)) enters into the Sec. 1.1275-6 hedge. (iii) A taxpayer issues or acquires a qualifying debt instrument and enters into the Sec. 1.1275-6 hedge with a related party (within the meaning of section 267(b) or 707(b)(1)). (iv) The taxpayer legs out of an integrated transaction and within 30 days enters into a new Sec. 1.1275-6 hedge with respect to the same qualifying debt instrument or another debt instrument that is part of the same issue. (d) Special rules for legging into and legging out of an integrated transaction--(1) Legging into--(i) Definition. Legging into an integrated transaction under this section means that a Sec. 1.1275-6 hedge is entered into after the date the qualifying debt instrument is issued or acquired by the taxpayer, and the requirements of paragraph (c)(1) of this section are satisfied on the date the Sec. 1.1275-6 hedge is entered into (the leg-in date). (ii) Treatment. If a taxpayer legs into an integrated transaction, the taxpayer treats the qualifying debt instrument under the applicable rules for taking interest and OID into account up to the leg-in date, except that the day before the leg-in date is treated as [[Page 579]] the end of an accrual period. As of the leg-in date, the qualifying debt instrument is subject to the rules of paragraph (f) of this section. (iii) Anti-abuse rule. If a taxpayer legs into an integrated transaction with a principal purpose of deferring or accelerating income or deductions on the qualifying debt instrument, the Commissioner may-- (A) Treat the qualifying debt instrument as sold for its fair market value on the leg-in date; or (B) Refuse to allow the taxpayer to integrate the qualifying debt instrument and the Sec. 1.1275-6 hedge. (2) Legging out--(i) Definition--(A) Legging out if the taxpayer has integrated. If a taxpayer has integrated a qualifying debt instrument and a Sec. 1.1275-6 hedge under paragraph (c)(1) of this section, legging out means that, prior to the maturity of the synthetic debt instrument, the Sec. 1.1275-6 hedge ceases to meet the requirements for a Sec. 1.1275-6 hedge, the taxpayer fails to meet any requirement of paragraph (c)(1) of this section, or the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or Sec. 1.1275-6 hedge. If the taxpayer fails to meet the requirements of paragraph (c)(1) of this section but meets the requirements of paragraph (c)(2) of this section, the Commissioner may treat the taxpayer as not legging out. (B) Legging out if the Commissioner has integrated. If the Commissioner has integrated a qualifying debt instrument and a financial instrument under paragraph (c)(2) of this section, legging out means that, prior to the maturity of the synthetic debt instrument, the requirements for Commissioner integration under paragraph (c)(2) of this section are not met or the taxpayer fails to meet the requirements for taxpayer integration under paragraph (c)(1) of this section and the Commissioner agrees to allow the taxpayer to be treated as legging out. (C) Exception for certain nonrecognition transactions. If, in a single nonrecognition transaction, a taxpayer disposes of, or ceases to be primarily liable on, the qualifying debt instrument and the Sec. 1.1275-6 hedge, the taxpayer is not treated as legging out. Instead, the integrated transaction is treated under the rules governing the nonrecognition transaction. For example, if a holder of an integrated transaction is acquired in a reorganization under section 368(a)(1)(A), the holder is treated as disposing of the synthetic debt instrument in the reorganization rather than legging out. If the successor holder is not eligible for integrated treatment, the successor is treated as legging out. (ii) Operating rules. If a taxpayer legs out (or is treated as legging out) of an integrated transaction, the following rules apply: (A) The transaction is treated as an integrated transaction during the time the requirements of paragraph (c) (1) or (2) of this section, as appropriate, are satisfied. (B) Immediately before the taxpayer legs out, the taxpayer is treated as selling or otherwise terminating the synthetic debt instrument for its fair market value and, except as provided in paragraph (d)(2)(ii)(D) of this section, any income, deduction, gain, or loss is realized and recognized at that time. (C) If, immediately after the taxpayer legs out, the taxpayer holds or remains primarily liable on the qualifying debt instrument, adjustments are made to reflect any difference between the fair market value of the qualifying debt instrument and the adjusted issue price of the qualifying debt instrument. If, immediately after the taxpayer legs out, the taxpayer is a party to a Sec. 1.1275-6 hedge, the Sec. 1.1275-6 hedge is treated as entered into at its fair market value. (D) If a taxpayer legs out of an integrated transaction by disposing of or otherwise terminating a Sec. 1.1275-6 hedge within 30 days of legging into the integrated transaction, then any loss or deduction determined under paragraph (d)(2)(ii)(B) of this section is not allowed. Appropriate adjustments are made to the qualifying debt instrument for any disallowed loss. The adjustments are taken into account on a yield to maturity basis over the remaining term of the qualifying debt instrument. (E) If a holder of a debt instrument subject to Sec. 1.1275-4 legs into an integrated transaction with respect to the instrument and subsequently legs out [[Page 580]] of the integrated transaction, any gain recognized under paragraph (d)(2)(ii) (B) or (C) of this section is treated as interest income to the extent determined under the principles of Sec. 1.1275- 4(b)(8)(iii)(B) (rules for determining the character of gain on the sale of a debt instrument all of the payments on which have been fixed). If the synthetic debt instrument would qualify as a variable rate debt instrument, the equivalent fixed rate debt instrument determined under Sec. 1.1275-5(e) is used for this purpose. (e) Identification requirements. For each integrated transaction, a taxpayer must enter and retain as part of its books and records the following information-- (1) The date the qualifying debt instrument was issued or acquired (or is expected to be issued or acquired) by the taxpayer and the date the Sec. 1.1275-6 hedge was entered into by the taxpayer; (2) A description of the qualifying debt instrument and the Sec. 1.1275-6 hedge; and (3) A summary of the cash flows and accruals resulting from treating the qualifying debt instrument and the Sec. 1.1275-6 hedge as an integrated transaction (i.e., the cash flows and accruals on the synthetic debt instrument). (f) Taxation of integrated transactions--(1) General rule. An integrated transaction is generally treated as a single transaction by the taxpayer during the period that the transaction qualifies as an integrated transaction. Except as provided in paragraph (f)(12) of this section, while a qualifying debt instrument and a Sec. 1.1275-6 hedge are part of an integrated transaction, neither the qualifying debt instrument nor the Sec. 1.1275-6 hedge is subject to the rules that would apply on a separate basis to the debt instrument and the Sec. 1.1275-6 hedge, including section 1092 or Sec. 1.446-4. The rules that would govern the treatment of the synthetic debt instrument generally govern the treatment of the integrated transaction. For example, the integrated transaction may be subject to section 263(g) or, if the synthetic debt instrument would be part of a straddle, section 1092. Generally, the synthetic debt instrument is subject to sections 163(e) and 1271 through 1275, with terms as set forth in paragraphs (f) (2) through (13) of this section. (2) Issue date. The issue date of the synthetic debt instrument is the first date on which the taxpayer entered into all of the components of the synthetic debt instrument. (3) Term. The term of the synthetic debt instrument is the period beginning on the issue date of the synthetic debt instrument and ending on the maturity date of the qualifying debt instrument. (4) Issue price. The issue price of the synthetic debt instrument is the adjusted issue price of the qualifying debt instrument on the issue date of the synthetic debt instrument. If, as a result of entering into the Sec. 1.1275-6 hedge, the taxpayer pays or receives one or more payments that are substantially contemporaneous with the issue date of the synthetic debt instrument, the payments reduce or increase the issue price as appropriate. (5) Adjusted issue price. In general, the adjusted issue price of the synthetic debt instrument is determined under the principles of Sec. 1.1275-1(b). (6) Qualified stated interest. No amounts payable on the synthetic debt instrument are qualified stated interest within the meaning of Sec. 1.1273-1(c). (7) Stated redemption price at maturity--(i) Synthetic debt instruments that are borrowings. In general, if the synthetic debt instrument is a borrowing, the instrument's stated redemption price at maturity is the sum of all amounts paid or to be paid on the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts received or to be received on the Sec. 1.1275-6 hedge. (ii) Synthetic debt instruments that are held by the taxpayer. In general, if the synthetic debt instrument is held by the taxpayer, the instrument's stated redemption price at maturity is the sum of all amounts received or to be received by the taxpayer on the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by any amounts paid or to be paid by the taxpayer on the Sec. 1.1275-6 hedge. (iii) Certain amounts ignored. For purposes of this paragraph (f)(7), if an amount paid or received on the Sec. 1.1275- [[Page 581]] 6 hedge is taken into account under paragraph (f)(4) of this section to determine the issue price of the synthetic debt instrument, the amount is not taken into account to determine the synthetic debt instrument's stated redemption price at maturity. (8) Source of interest income and allocation of expense. The source of interest income from the synthetic debt instrument is determined by reference to the source of income of the qualifying debt instrument under sections 861(a)(1) and 862(a)(1). For purposes of section 904, the character of interest from the synthetic debt instrument is determined by reference to the character of the interest income from the qualifying debt instrument. Interest expense is allocated and apportioned under regulations under section 861 or under Sec. 1.882-5. (9) Effectively connected income. If the requirements of paragraph (c)(1)(iv) of this section are satisfied, any interest income resulting from the synthetic debt instrument entered into by the foreign person is treated as effectively connected with a U.S. trade or business, and any interest expense resulting from the synthetic debt instrument entered into by the foreign person is allocated and apportioned under Sec. 1.882-5. (10) Not a short-term obligation. For purposes of section 1272(a)(2)(C), a synthetic debt instrument is not treated as a short- term obligation. (11) Special rules in the event of integration by the Commissioner. If the Commissioner requires integration, appropriate adjustments are made to the treatment of the synthetic debt instrument, and, if necessary, the qualifying debt instrument and financial instrument. For example, the Commissioner may treat a financial instrument that is not a Sec. 1.1275-6 hedge as a Sec. 1.1275-6 hedge when applying the rules of this section. The issue date of the synthetic debt instrument is the date determined appropriate by the Commissioner to require integration. (12) Retention of separate transaction rules for certain purposes. This paragraph (f)(12) provides for the retention of separate transaction rules for certain purposes. In addition, by publication in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter), the Commissioner may require use of separate transaction rules for any aspect of an integrated transaction. (i) Foreign persons that enter into integrated transactions giving rise to U.S. source income not effectively connected with a U.S. trade or business. If a foreign person enters into an integrated transaction that gives rise to U.S. source interest income (determined under the source rules for the synthetic debt instrument) not effectively connected with a U.S. trade or business of the foreign person, paragraph (f) of this section does not apply for purposes of sections 871(a), 881, 1441, 1442, and 6049. These sections of the Internal Revenue Code are applied to the qualifying debt instrument and the Sec. 1.1275-6 hedge on a separate basis. (ii) Relationship between taxpayer and other persons. Because the rules of this section affect only the taxpayer that enters into an integrated transaction (i.e., either the issuer or a particular holder of a qualifying debt instrument), any provisions of the Internal Revenue Code or regulations that govern the relationship between the taxpayer and any other person are applied on a separate basis. For example, taxpayers must comply with any reporting or disclosure requirements on any qualifying debt instrument as if it were not part of an integrated transaction. Thus, if required under Sec. 1.1275-4(b)(4), an issuer of a contingent payment debt instrument subject to integrated treatment must provide the projected payment schedule to holders. Similarly, if a U.S. corporation enters into an integrated transaction that includes a notional principal contract, the source of any payment received by the counterparty on the notional principal contract is determined under Sec. 1.863-7 as if the contract were not part of an integrated transaction, and, if received by a foreign person who is not engaged in a U.S. trade or business, the payment is non-U.S. source income that is not subject to U.S. withholding tax. (13) Coordination with consolidated return rules. If a taxpayer enters into a Sec. 1.1275-6 hedge with a member of the same consolidated group (the counterparty) and the Sec. 1.1275-6 hedge is part of an integrated transaction for the taxpayer, the Sec. 1.1275-6 hedge is not [[Page 582]] treated as an intercompany transaction for purposes of Sec. 1.1502-13. If the taxpayer legs out of integrated treatment, the taxpayer and the counterparty are each treated as disposing of its position in the Sec. 1.1275-6 hedge under the principles of paragraph (d)(2) of this section. If the Sec. 1.1275-6 hedge remains in existence after the leg-out date, the Sec. 1.1275-6 hedge is treated under the rules that would otherwise apply to the transaction (including Sec. 1.1502-13 if the transaction is between members). (g) Predecessors and successors. For purposes of this section, any reference to a taxpayer, holder, issuer, or person includes, where appropriate, a reference to a predecessor or successor. For purposes of the preceding sentence, a predecessor is a transferor of an asset or liability (including an integrated transaction) to a transferee (the successor) in a nonrecognition transaction. Appropriate adjustments, if necessary, are made in the application of this section to predecessors and successors. (h) Examples. The following examples illustrate the provisions of this section. In each example, assume that the qualifying debt instrument is a debt instrument for Federal income tax purposes. No inference is intended, however, as to whether the debt instrument is a debt instrument for Federal income tax purposes. Example 1. Issuer hedge--(i) Facts. On January 1, 1997, V, a domestic corporation, issues a 5-year debt instrument for $1,000. The debt instrument provides for annual payments of interest at a rate equal to the value of 1-year LIBOR and a principal payment of $1,000 at maturity. On the same day, V enters into a 5-year interest rate swap agreement with an unrelated party. Under the swap, V pays 6 percent and receives 1-year LIBOR on a notional principal amount of $1,000. The payments on the swap are fixed and made on the same days as the payments on the debt instrument. On January 1, 1997, V identifies the debt instrument and the swap as an integrated transaction in accordance with the requirements of paragraph (e) of this section. (ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The swap is a Sec. 1.1275-6 hedge because it is a financial instrument and a yield to maturity on the combined cash flows of the swap and the debt instrument can be calculated. V has met the identification requirements, and the other requirements of paragraph (c)(1) of this section are satisfied. Therefore, the transaction is an integrated transaction under this section. (iii) Treatment of the synthetic debt instrument. The synthetic debt instrument is a 5-year debt instrument that has an issue price of $1,000 and provides for annual interest payments of $60 and a principal payment of $1,000 at maturity. Under paragraph (f)(6) of this section, no amounts payable on the synthetic debt instrument are qualified stated interest. Thus, under paragraph (f)(7)(i) of this section, the synthetic debt instrument has a stated redemption price at maturity of $1,300 (the sum of all amounts to be paid on the qualifying debt instrument and the swap, reduced by amounts to be received on the swap). The synthetic debt instrument, therefore, has $300 of OID. Example 2. Issuer hedge with an option--(i) Facts. On December 31, 1996, W, a domestic corporation, issues for $1,000 a debt instrument that matures on December 31, 1999. The debt instrument has a stated principal amount of $1,000 payable at maturity. The debt instrument also provides for a payment at maturity equal to $10 times the increase, if any, in the value of a nationally known composite index of stocks from December 31, 1996, to the maturity date. On December 31, 1996, W purchases from an unrelated party an option that pays $10 times the increase, if any, in the stock index from December 31, 1996, to December 31, 1999. W pays $250 for the option. On December 31, 1996, W identifies the debt instrument and option as an integrated transaction in accordance with the requirements of paragraph (e) of this section. (ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The option is a Sec. 1.1275-6 hedge because it is a financial instrument and a yield to maturity on the combined cash flows of the option and the debt instrument can be calculated. W has met the identification requirements, and the other requirements of paragraph (c)(1) of this section are satisfied. Therefore, the transaction is an integrated transaction under this section. (iii) Treatment of the synthetic debt instrument. Under paragraph (f)(4) of this section, the issue price of the synthetic debt instrument is equal to the issue price of the debt instrument ($1,000) reduced by the payment for the option ($250). As a result, the synthetic debt instrument is a 3-year debt instrument with an issue price of $750. Under paragraph (f)(7) of this section, the synthetic debt instrument has a stated redemption price at maturity of $1,000 (the $250 payment for the option is not taken into account). The synthetic debt instrument, therefore, has $250 of OID. Example 3. Hedge with prepaid swap--(i) Facts. On January 1, 1997, H purchases for [pound]1,000 a 5-year debt instrument that provides [[Page 583]] for semiannual payments based on 6-month pound LIBOR and a payment of the [pound]1,000 principal at maturity. On the same day, H enters into a swap with an unrelated third party under which H receives semiannual payments, in pounds, of 10 percent, compounded semiannually, and makes semiannual payments, in pounds, of 6-month pound LIBOR on a notional principal amount of [pound]1,000. Payments on the swap are fixed and made on the same dates as the payments on the debt instrument. H also makes a [pound]162 prepayment on the swap. On January 1, 1997, H identifies the swap and the debt instrument as an integrated transaction in accordance with the requirements of paragraph (e) of this section. (ii) Eligibility for integration. The debt instrument is a qualifying debt instrument. The swap is a Sec. 1.1275-6 hedge because it is a financial instrument and a yield to maturity on the combined cash flows of the swap and the debt instrument can be calculated. Although the debt instrument is denominated in pounds, the swap hedges only interest rate risk, not currency risk. Therefore, the transaction is an integrated transaction under this section. See Sec. 1.988-5(a) for the treatment of a debt instrument and a swap if the swap hedges currency risk. (iii) Treatment of the synthetic debt instrument. Under paragraph (f)(4) of this section, the issue price of the synthetic debt instrument is equal to the issue price of the debt instrument ([pound]1,000) increased by the prepayment on the swap ([pound]162). As a result, the synthetic debt instrument is a 5-year debt instrument that has an issue price of [pound]1,162 and provides for semiannual interest payments of [pound]50 and a principal payment of [pound]1,000 at maturity. Under paragraph (f)(6) of this section, no amounts payable on the synthetic debt instrument are qualified stated interest. Thus, under paragraph (f)(7)(ii) of this section, the synthetic debt instrument's stated redemption price at maturity is [pound]1,500 (the sum of all amounts to be received on the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by all amounts to be paid on the Sec. 1.1275-6 hedge other than the [pound]162 prepayment for the swap). The synthetic debt instrument, therefore, has [pound]338 of OID. Example 4. Legging into an integrated transaction by a holder--(i) Facts. On December 31, 1996, X corporation purchases for $1,000,000 a debt instrument that matures on December 31, 2006. The debt instrument provides for annual payments of interest at the rate of 6 percent and for a payment at maturity equal to $1,000,000, increased by the excess, if any, of the price of 1,000 units of a commodity on December 31, 2006, over $350,000, and decreased by the excess, if any, of $350,000 over the price of 1,000 units of the commodity on that date. The projected amount of the payment at maturity determined under Sec. 1.1275-4(b)(4) is $1,020,000. On December 31, 1999, X enters into a cash-settled forward contract with an unrelated party to sell 1,000 units of the commodity on December 31, 2006, for $450,000. On December 31, 1999, X also identifies the debt instrument and the forward contract as an integrated transaction in accordance with the requirements of paragraph (e) of this section. (ii) Eligibility for integration. X meets the requirements for integration as of December 31, 1999. Therefore, X legged into an integrated transaction on that date. Prior to that date, X treats the debt instrument under the applicable rules of Sec. 1.1275-4. (iii) Treatment of the synthetic debt instrument. As of December 31, 1999, the debt instrument and the forward contract are treated as an integrated transaction. The issue price of the synthetic debt instrument is equal to the adjusted issue price of the qualifying debt instrument on the leg-in date, $1,004,804 (assuming one year accrual periods). The term of the synthetic debt instrument is from December 31, 1999, to December 31, 2006. The synthetic debt instrument provides for annual interest payments of $60,000 and a principal payment at maturity of $1,100,000 ($1,000,000 + $450,000 - $350,000). Under paragraph (f)(6) of this section, no amounts payable on the synthetic debt instrument are qualified stated interest. Thus, under paragraph (f)(7)(ii) of this section, the synthetic debt instrument's stated redemption price at maturity is $1,520,000 (the sum of all amounts to be received by X on the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by all amounts to be paid by X on the Sec. 1.1275-6 hedge). The synthetic debt instrument, therefore, has $515,196 of OID. Example 5. Abusive leg-in--(i) Facts. On January 1, 1997, Y corporation purchases for $1,000,000 a debt instrument that matures on December 31, 2001. The debt instrument provides for annual payments of interest at the rate of 6 percent, a payment on December 31, 1999, of the increase, if any, in the price of a commodity from January 1, 1997, to December 31, 1999, and a payment at maturity of $1,000,000 and the increase, if any, in the price of the commodity from December 31, 1999 to maturity. Because the debt instrument is a contingent payment debt instrument subject to Sec. 1.1275-4, Y accrues interest based on the projected payment schedule. (ii) Leg-in. By late 1999, the price of the commodity has substantially increased, and Y expects a positive adjustment on December 31, 1999. In late 1999, Y enters into an agreement to exchange the two commodity based payments on the debt instrument for two payments on the same dates of $100,000 each. Y identifies the transaction as an integrated transaction in accordance with the requirements of paragraph (e) of this section. Y disposes of the hedge in early 2000. (iii) Treatment. The legging into an integrated transaction has the effect of deferring [[Page 584]] the positive adjustment from 1999 to 2000. Because Y legged into the integrated transaction with a principal purpose to defer the positive adjustment, the Commissioner may treat the debt instrument as sold for its fair market value on the leg-in date or refuse to allow integration. Example 6. Integration of offsetting debt instruments--(i) Facts. On January 1, 1997, Z issues two 10-year debt instruments. The first, Issue 1, has an issue price of $1,000, pays interest annually at 6 percent, and, at maturity, pays $1,000, increased by $1 times the increase, if any, in the value of the S&P 100 Index over the term of the instrument and reduced by $1 times the decrease, if any, in the value of the S&P 100 Index over the term of the instrument. However, the amount paid at maturity may not be less than $500 or more than $1,500. The second, Issue 2, has an issue price of $1,000, pays interest annually at 8 percent, and, at maturity, pays $1,000, reduced by $1 times the increase, if any, in the value of the S&P 100 Index over the term of the instrument and increased by $1 times the decrease, if any, in the value of the S&P 100 Index over the term of the instrument. The amount paid at maturity may not be less than $500 or more than $1,500. On January 1, 1997, Z identifies Issue 1 as the qualifying debt instrument, Issue 2 as a Sec. 1.1275-6 hedge, and otherwise meets the identification requirements of paragraph (e) of this section. (ii) Eligibility for integration. Both Issue 1 and Issue 2 are qualifying debt instruments. Z has met the identification requirements by identifying Issue 1 as the qualifying debt instrument and Issue 2 as the Sec. 1.1275-6 hedge. The other requirements of paragraph (c)(1) of this section are satisfied. Therefore, the transaction is an integrated transaction under this section. (iii) Treatment of the synthetic debt instrument. The synthetic debt instrument has an issue price of $2,000, provides for a payment at maturity of $2,000, and, in addition, provides for annual payments of $140. Under paragraph (f)(6) of this section, no amounts payable on the synthetic debt instrument are qualified stated interest. Thus, under paragraph (f)(7)(i) of this section, the synthetic debt instrument's stated redemption price at maturity is $3,400 (the sum of all amounts to be paid on the qualifying debt instrument and the Sec. 1.1275-6 hedge, reduced by amounts to be received on the Sec. 1.1275-6 hedge other than the $1,000 payment received on the issue date). The synthetic debt instrument, therefore, has $1,400 of OID. Example 7. Integrated transaction entered into by a foreign person-- (i) Facts. X, a foreign person, enters into an integrated transaction by purchasing a qualifying debt instrument that pays U.S. source interest and entering into a notional principal contract with a U.S. corporation. Neither the income from the qualifying debt instrument nor the income from the notional principal contract is effectively connected with a U.S. trade or business. The notional principal contract is a Sec. 1.1275-6 hedge. (ii) Treatment of integrated transaction. Under paragraph (f)(8) of this section, X will receive U.S. source income from the integrated transaction. However, under paragraph (f)(12)(i) of this section, the qualifying debt instrument and the notional principal contract are treated as if they are not part of an integrated transaction for purposes of determining whether tax is due and must be withheld on income. Accordingly, because the Sec. 1.1275-6 hedge would produce foreign source income under Sec. 1.863-7 to X if it were not part of an integrated transaction, any income on the Sec. 1.1275-6 hedge generally will not be subject to tax under sections 871(a) and 881, and the U.S. corporation that is the counterparty will not be required to withhold tax on payments under the Sec. 1.1275-6 hedge under sections 1441 and 1442. (i) [Reserved] (j) Effective date. This section applies to a qualifying debt instrument issued on or after August 13, 1996. This section also applies to a qualifying debt instrument acquired by the taxpayer on or after August 13, 1996, if-- (1) The qualifying debt instrument is a fixed rate debt instrument or a variable rate debt instrument; or (2) The qualifying debt instrument and the Sec. 1.1275-6 hedge are acquired by the taxpayer substantially contemporaneously. [T.D. 8674, 61 FR 30155, June 14, 1996]