[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: 26CFR1.1275-7]
[Page 584-590]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1_INCOME TAXES--Table of Contents
Sec. 1.1275-7 Inflation-indexed debt instruments.
(a) Overview. This section provides rules for the Federal income tax
treatment of an inflation-indexed debt instrument. If a debt instrument
is an inflation-indexed debt instrument, one of two methods will apply
to the instrument: the coupon bond method (as described in paragraph (d)
of this section) or the discount bond method (as described in paragraph
(e) of this section). Both methods determine the amount of OID that is
taken into account each year by a holder or an issuer of an inflation-
indexed debt instrument.
(b) Applicability--(1) In general. Except as provided in paragraph
(b)(2) of this section, this section applies to an inflation-indexed
debt instrument as
[[Page 585]]
defined in paragraph (c)(1) of this section. For example, this section
applies to Treasury Inflation-Indexed Securities.
(2) Exceptions. This section does not apply to an inflation-indexed
debt instrument that is also--
(i) A debt instrument (other than a tax-exempt obligation) described
in section 1272(a)(2) (for example, U.S. savings bonds, certain loans
between natural persons, and short-term taxable obligations); or
(ii) A debt instrument subject to section 529 (certain debt
instruments issued by qualified state tuition programs).
(c) Definitions. The following definitions apply for purposes of
this section:
(1) Inflation-indexed debt instrument. An inflation-indexed debt
instrument is a debt instrument that satisfies the following conditions:
(i) Issued for cash. The debt instrument is issued for U.S. dollars
and all payments on the instrument are denominated in U.S. dollars.
(ii) Indexed for inflation and deflation. Except for a minimum
guarantee payment (as defined in paragraph (c)(5) of this section), each
payment on the debt instrument is indexed for inflation and deflation. A
payment is indexed for inflation and deflation if the amount of the
payment is equal to--
(A) The amount that would be payable if there were no inflation or
deflation over the term of the debt instrument, multiplied by
(B) A ratio, the numerator of which is the value of the reference
index for the date of the payment and the denominator of which is the
value of the reference index for the issue date.
(iii) No other contingencies. No payment on the debt instrument is
subject to a contingency other than the inflation contingency or the
contingencies described in this paragraph (c)(1)(iii). A debt instrument
may provide for--
(A) A minimum guarantee payment as defined in paragraph (c)(5) of
this section; or
(B) Payments under one or more alternate payment schedules if the
payments under each payment schedule are indexed for inflation and
deflation and a payment schedule for the debt instrument can be
determined under Sec. 1.1272-1(c). (For purposes of this section, the
rules of Sec. 1.1272-1(c) are applied to the debt instrument by
assuming that no inflation or deflation will occur over the term of the
instrument.)
(2) Reference index. The reference index is an index used to measure
inflation and deflation over the term of a debt instrument. To qualify
as a reference index, an index must satisfy the following conditions:
(i) The value of the index is reset once a month to a current value
of a single qualified inflation index (as defined in paragraph (c)(3) of
this section). For this purpose, a value of a qualified inflation index
is current if the value has been updated and published within the
preceding six month period.
(ii) The reset occurs on the same day of each month (the reset
date).
(iii) The value of the index for any date between reset dates is
determined through straight-line interpolation.
(3) Qualified inflation index. A qualified inflation index is a
general price or wage index that is updated and published at least
monthly by an agency of the United States Government (for example, the
non-seasonally adjusted U.S. City Average All Items Consumer Price Index
for All Urban Consumers (CPI-U), which is published by the Bureau of
Labor Statistics of the Department of Labor).
(4) Inflation-adjusted principal amount. For any date, the
inflation-adjusted principal amount of an inflation-indexed debt
instrument is an amount equal to--
(i) The outstanding principal amount of the debt instrument
(determined as if there were no inflation or deflation over the term of
the instrument), multiplied by
(ii) A ratio, the numerator of which is the value of the reference
index for the date and the denominator of which is the value of the
reference index for the issue date.
(5) Minimum guarantee payment. In general, a minimum guarantee
payment is an additional payment made at maturity on a debt instrument
if the total amount of inflation-adjusted principal paid on the
instrument is less than the instrument's stated principal amount. The
amount of the additional
[[Page 586]]
payment must be no more than the excess, if any, of the debt
instrument's stated principal amount over the total amount of inflation-
adjusted principal paid on the instrument. An additional payment is not
a minimum guarantee payment unless the qualified inflation index used to
determine the reference index is either the CPI-U or an index designated
for this purpose by the Commissioner in the Federal Register or the
Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii) of this chapter).
See paragraph (f)(4) of this section for the treatment of a minimum
guarantee payment.
(d) Coupon bond method--(1) In general. This paragraph (d) describes
the method (coupon bond method) to be used to account for qualified
stated interest and inflation adjustments (OID) on an inflation-indexed
debt instrument described in paragraph (d)(2) of this section.
(2) Applicability. The coupon bond method applies to an inflation-
indexed debt instrument that satisfies the following conditions:
(i) Issued at par. The debt instrument is issued at par. A debt
instrument is issued at par if the difference between its issue price
and principal amount for the issue date is less than the de minimis
amount. For this purpose, the de minimis amount is determined using the
principles of Sec. 1.1273-1(d).
(ii) All stated interest is qualified stated interest. All stated
interest on the debt instrument is qualified stated interest. For
purposes of this paragraph (d), stated interest is qualified stated
interest if the interest is unconditionally payable in cash, or is
constructively received under section 451, at least annually at a single
fixed rate. Stated interest is payable at a single fixed rate if the
amount of each interest payment is determined by multiplying the
inflation adjusted principal amount for the payment date by the single
fixed rate.
(3) Qualified stated interest. Under the coupon bond method,
qualified stated interest is taken into account under the taxpayer's
regular method of accounting. The amount of accrued but unpaid qualified
stated interest as of any date is determined by using the principles of
Sec. 1.446-3(e)(2)(ii) (relating to notional principal contracts). For
example, if the interval between interest payment dates spans two
taxable years, a taxpayer using an accrual method of accounting
determines the amount of accrued qualified stated interest for the first
taxable year by reference to the inflation-adjusted principal amount at
the end of the first taxable year.
(4) Inflation adjustments--(i) Current accrual. Under the coupon
bond method, an inflation adjustment is taken into account for each
taxable year in which the debt instrument is outstanding.
(ii) Amount of inflation adjustment. For any relevant period (such
as the taxable year or the portion of the taxable year during which a
taxpayer holds an inflation-indexed debt instrument), the amount of the
inflation adjustment is equal to--
(A) The sum of the inflation-adjusted principal amount at the end of
the period and the principal payments made during the period, minus
(B) The inflation-adjusted principal amount at the beginning of the
period.
(iii) Positive inflation adjustments. A positive inflation
adjustment is OID.
(iv) Negative inflation adjustments. A negative inflation adjustment
is a deflation adjustment that is taken into account under the rules of
paragraph (f)(1) of this section.
(5) Example. The following example illustrates the coupon bond
method:
Example: (i) Facts. On October 15, 1997, X purchases at original
issue, for $100,000, a debt instrument that is indexed for inflation and
deflation. The debt instrument matures on October 15, 1999, has a stated
principal amount of $100,000, and has a stated interest rate of 5
percent, compounded semiannually. The debt instrument provides that the
principal amount is indexed to the CPI-U. Interest is payable on April
15 and October 15 of each year. The amount of each interest payment is
determined by multiplying the inflation-adjusted principal amount for
each interest payment date by the stated interest rate, adjusted for the
length of the accrual period. The debt instrument provides for a single
payment of the inflation-adjusted principal amount at maturity. In
addition, the debt instrument provides for an additional payment at
maturity equal to the excess, if any, of $100,000 over the inflation-
adjusted principal amount at maturity. X uses the cash receipts and
disbursements method
[[Page 587]]
of accounting and the calendar year as its taxable year.
(ii) Indexing methodology. The debt instrument provides that the
inflation-adjusted principal amount for any day is determined by
multiplying the principal amount of the instrument for the issue date by
a ratio, the numerator of which is the value of the reference index for
the day the inflation-adjusted principal amount is to be determined and
the denominator of which is the value of the reference index for the
issue date. The value of the reference index for the first day of a
month is the value of the CPI-U for the third preceding month. The value
of the reference index for any day other than the first day of a month
is determined based on a straight-line interpolation between the value
of the reference index for the first day of the month and the value of
the reference index for the first day of the next month.
(iii) Inflation-indexed debt instrument subject to the coupon bond
method. Under paragraph (c)(1) of this section, the debt instrument is
an inflation-indexed debt instrument. Because there is no difference
between the debt instrument's issue price ($100,000) and its principal
amount for the issue date ($100,000) and because all stated interest is
qualified stated interest, the coupon bond method applies to the
instrument.
(iv) Reference index values. Assume the following table lists the
relevant reference index values for 1997 through 1999:
------------------------------------------------------------------------
Reference
Date index
value
------------------------------------------------------------------------
Oct. 15, 1997................................................ 100
Jan. 1, 1998................................................. 101
Apr. 15, 1998................................................ 103
Oct. 15, 1998................................................ 105
Jan. 1, 1999................................................. 99
------------------------------------------------------------------------
(v) Treatment of X in 1997. X does not receive any payments of
interest on the debt instrument in 1997. Therefore, X has no qualified
stated interest income for 1997. X, however, must take into account the
inflation adjustment for 1997. The inflation-adjusted principal amount
for January 1, 1998, is $101,000 ($100,000 x 101/100). Therefore, the
inflation adjustment for 1997 is $1,000, the inflation-adjusted
principal amount for January 1, 1998 ($101,000) minus the principal
amount for the issue date ($100,000). X includes the $1,000 inflation
adjustment in income as OID in 1997.
(vi) Treatment of X in 1998. In 1998, X receives two payments of
interest: On April 15, 1998, X receives a payment of $2,575 ($100,000 x
103/100 x .05/2), and on October 15, 1998, X receives a payment of
$2,625 ($100,000 x 105/100 x .05/2). Therefore, X's qualified stated
interest income for 1998 is $5,200 ($2,575 + $2,625). X also must take
into account the inflation adjustment for 1998. The inflation-adjusted
principal amount for January 1, 1999, is $99,000 ($100,000 x 99/100).
Therefore, the inflation adjustment for 1998 is negative $2,000, the
inflation-adjusted principal amount for January 1, 1999 ($99,000) minus
the inflation-adjusted principal amount for January 1, 1998 ($101,000).
Because the amount of the inflation adjustment is negative, it is a
deflation adjustment. Under paragraph (f)(1)(i) of this section, X uses
this $2,000 deflation adjustment to reduce the interest otherwise
includible in income by X with respect to the debt instrument in 1998.
Therefore, X includes $3,200 in income for 1998, the qualified stated
interest income for 1998 ($5,200) minus the deflation adjustment
($2,000).
(e) Discount bond method--(1) In general. This paragraph (e)
describes the method (discount bond method) to be used to account for
OID on an inflation-indexed debt instrument that does not qualify for
the coupon bond method.
(2) No qualified stated interest. Under the discount bond method, no
interest on an inflation-indexed debt instrument is qualified stated
interest.
(3) OID. Under the discount bond method, the amount of OID that
accrues on an inflation-indexed debt instrument is determined as
follows:
(i) Step one: Determine the debt instrument's yield to maturity. The
yield of the debt instrument is determined under the rules of Sec.
1.1272-1(b)(1)(i). In calculating the yield under those rules for
purposes of this paragraph (e)(3)(i), the payment schedule of the debt
instrument is determined as if there were no inflation or deflation over
the term of the instrument.
(ii) Step two: Determine the accrual periods. The accrual periods
are determined under the rules of Sec. 1.1272-1(b)(1)(ii). However, no
accrual period can be longer than 1 month.
(iii) Step three: Determine the percentage change in the reference
index during the accrual period. The percentage change in the reference
index during the accrual period is equal to--
(A) The ratio of the value of the reference index at the end of the
period to the value of the reference index at the beginning of the
period,
(B) Minus one.
(iv) Step four: Determine the OID allocable to each accrual period.
The OID allocable to an accrual period (n) is determined by using the
following formula:
[[Page 588]]
OID((n) = AIP(n) x [r + inf(n) + (r x
inf(n))]
in which,
r = yield of the debt instrument as determined under paragraph (e)(3)(i)
of this section (adjusted for the length of the accrual period);
inf(n) = percentage change in the value of the reference
index for period (n) as determined under paragraph (e)(3)(iii) of
this section; and
AIP(n) = adjusted issue price at the beginning of period (n).
(v) Step five: Determine the daily portions of OID. The daily
portions of OID are determined and taken into account under the rules of
Sec. 1.1272-1(b)(1)(iv). If the daily portions determined under this
paragraph (e)(3)(v) are negative amounts, however, these amounts
(deflation adjustments) are taken into account under the rules for
deflation adjustments described in paragraph (f)(1) of this section.
(4) Example. The following example illustrates the discount bond
method:
Example: (i) Facts. On November 15, 1997, X purchases at original
issue, for $91,403, a zero-coupon debt instrument that is indexed for
inflation and deflation. The principal amount of the debt instrument for
the issue date is $100,000. The debt instrument provides for a single
payment on November 15, 2000. The amount of the payment will be
determined by multiplying $100,000 by a fraction, the numerator of which
is the CPI-U for September 2000, and the denominator of which is the
CPI-U for September 1997. The debt instrument also provides that in no
event will the payment on November 15, 2000, be less than $100,000. X
uses the cash receipts and disbursements method of accounting and the
calendar year as its taxable year.
(ii) Inflation-indexed debt instrument. Under paragraph (c)(1) of
this section, the instrument is an inflation-indexed debt instrument.
The debt instrument's principal amount for the issue date ($100,000)
exceeds its issue price ($91,403) by $8,597, which is more than the de
minimis amount for the debt instrument ($750). Therefore, the coupon
bond method does not apply to the debt instrument. As a result, the
discount bond method applies to the debt instrument.
(iii) Yield and accrual period. Assume X chooses monthly accrual
periods ending on the 15th day of each month. The yield of the debt
instrument is determined as if there were no inflation or deflation over
the term of the instrument. Therefore, based on the issue price of
$91,403 and an assumed payment at maturity of $100,000, the yield of the
debt instrument is 3 percent, compounded monthly.
(iv) Percentage change in reference index. Assume that the CPI-U for
September 1997 is 160; for October 1997 is 161.2; and for November 1997
is 161.7. The value of the reference index for November 15, 1997, is
160, the value of the CPI-U for September 1997. Similarly, the value of
the reference index for December 15, 1997, is 161.2, and for January 15,
1998, is 161.7. The percentage change in the reference index from
November 15, 1997, to December 15, 1997, (inf1) is 0.0075
(161.2/160-1); the percentage change in the reference index from
December 15, 1997, to January 15, 1998, (inf2) is 0.0031
(161.7/161.2-1).
(v) Treatment of X in 1997. For the accrual period ending on
December 15, 1997, r is .0025 (.03/12), inf1 is .0075, and
the product of r and inf1 is .00001875. Under paragraph
(e)(3) of this section, the amount of OID allocable to the accrual
period ending on December 15, 1997, is $916. This amount is determined
by multiplying the issue price of the debt instrument ($91,403) by
.01001875 (the sum of r, inf1, and the product of r and
inf1). The adjusted issue price of the debt instrument on
December 15, 1997, is $92,319 ($91,403+$916). For the accrual period
ending on January 15, 1998, r is .0025 (.03/12), inf2 is
.0031, and the product of r and inf2 is .00000775. Under
paragraph (e)(3) of this section, the amount of OID allocable to the
accrual period ending on January 15, 1998, is $518. This amount is
determined by multiplying the adjusted issue price of the debt
instrument ($92,319) by .00560775 (the sum of r, inf2, and
the product of r and inf2). Because the accrual period ending
on January 15, 1998, spans two taxable years, only $259 of this amount
($518/30 daysx15 days) is allocable to 1997. Therefore, X includes
$1,175 of OID in income for 1997 ($916+$259).
(f) Special rules. The following rules apply to an inflation-indexed
debt instrument:
(1) Deflation adjustments--(i) Holder. A deflation adjustment
reduces the amount of interest otherwise includible in income by a
holder with respect to the debt instrument for the taxable year. For
purposes of this paragraph (f)(1)(i), interest includes OID, qualified
stated interest, and market discount. If the amount of the deflation
adjustment exceeds the interest otherwise includible in income by the
holder with respect to the debt instrument for the taxable year, the
excess is treated as an ordinary loss by the holder for the taxable
year. However, the amount treated as an ordinary loss is limited to the
amount by which the holder's
[[Page 589]]
total interest inclusions on the debt instrument in prior taxable years
exceed the total amount treated by the holder as an ordinary loss on the
debt instrument in prior taxable years. If the deflation adjustment
exceeds the interest otherwise includible in income by the holder with
respect to the debt instrument for the taxable year and the amount
treated as an ordinary loss for the taxable year, this excess is carried
forward to reduce the amount of interest otherwise includible in income
by the holder with respect to the debt instrument for subsequent taxable
years.
(ii) Issuer. A deflation adjustment reduces the interest otherwise
deductible by the issuer with respect to the debt instrument for the
taxable year. For purposes of this paragraph (f)(1)(ii), interest
includes OID and qualified stated interest. If the amount of the
deflation adjustment exceeds the interest otherwise deductible by the
issuer with respect to the debt instrument for the taxable year, the
excess is treated as ordinary income by the issuer for the taxable year.
However, the amount treated as ordinary income is limited to the amount
by which the issuer's total interest deductions on the debt instrument
in prior taxable years exceed the total amount treated by the issuer as
ordinary income on the debt instrument in prior taxable years. If the
deflation adjustment exceeds the interest otherwise deductible by the
issuer with respect to the debt instrument for the taxable year and the
amount treated as ordinary income for the taxable year, this excess is
carried forward to reduce the interest otherwise deductible by the
issuer with respect to the debt instrument for subsequent taxable years.
If there is any excess remaining upon the retirement of the debt
instrument, the issuer takes the excess amount into account as ordinary
income.
(2) Adjusted basis. A holder's adjusted basis in an inflation-
indexed debt instrument is determined under Sec. 1.1272-1(g). However,
a holder's adjusted basis in the debt instrument is decreased by the
amount of any deflation adjustment the holder takes into account to
reduce the amount of interest otherwise includible in income or treats
as an ordinary loss with respect to the instrument during the taxable
year. The decrease occurs when the deflation adjustment is taken into
account under paragraph (f)(1) of this section.
(3) Subsequent holders. A holder determines the amount of
acquisition premium or market discount on an inflation-indexed debt
instrument by reference to the adjusted issue price of the instrument on
the date the holder acquires the instrument. A holder determines the
amount of bond premium on an inflation-indexed debt instrument by
assuming that the amount payable at maturity on the instrument is equal
to the instrument's inflation-adjusted principal amount for the day the
holder acquires the instrument. Any premium or market discount is taken
into account over the remaining term of the debt instrument as if there
were no further inflation or deflation. See section 171 for additional
rules relating to the amortization of bond premium and sections 1276
through 1278 for additional rules relating to market discount.
(4) Minimum guarantee. Under both the coupon bond method and the
discount bond method, a minimum guarantee payment is ignored until the
payment is made. If there is a minimum guarantee payment, the payment is
treated as interest on the date it is paid.
(5) Temporary unavailability of a qualified inflation index.
Notwithstanding any other rule of this section, an inflation-indexed
debt instrument may provide for a substitute value of the qualified
inflation index if and when the publication of the value of the
qualified inflation index is temporarily delayed. The substitute value
may be determined by the issuer under any reasonable method. For
example, if the CPI-U is not reported for a particular month, the debt
instrument may provide that a substitute value may be determined by
increasing the last reported value by the average monthly percentage
increase in the qualified inflation index over the preceding twelve
months. The use of a substitute value does not result in a reissuance of
the debt instrument.
[[Page 590]]
(g) Reopenings. For rules concerning a reopening of Treasury
Inflation-Indexed Securities, see paragraphs (d)(2) and (k)(3)(iii) of
Sec. 1.1275-2.
(h) Effective date. This section applies to an inflation-indexed
debt instrument issued on or after January 6, 1997.
[T.D. 8709, 62 FR 618, Jan. 6, 1997. Redesignated by T.D. 8838, 64 FR
48547, Sept. 7, 1999, as amended by T.D. 8840, 64 FR 60343, Nov. 5,
1999; T.D. 8934, 66 FR 2817, Jan. 12, 2001]