Inflation-indexed debt instruments.

Inflation-indexed debt instruments protect the holder against the risks of both inflation and deflation, through periodic adjustments of the principal amount to reflect changes in the Consumer Price Index.

This article addresses the income taxation of these securities in the context of the general discount and premium rules and the regulations on inflation-indexed debt instruments.

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Treasury began issuing inflation-indexed securities in early 1997. These debt instruments protect the holder against both inflation and deflation. Specifically, the principal amount is adjusted periodically to reflect changes in the Consumer Price Index (CPI); the interest to be paid is determined by applying the fixed coupon rate to the inflation-adjusted principal amount. At maturity, the holder will receive the greater of the bond's inflation-adjusted principal amount or its original face value.

For tax purposes, these instruments are subject to the general rules that govern discounts and premiums on traditional debt securities, as well as the specific rules that govern adjustments to principal as a result of inflation and deflation. This article presents a brief overview of the tax law on discounts and premiums arising on the acquisition of traditional debt instruments, then addresses the taxation of inflation-indexed securities in the context of those rules and the more specific regulations on this form of contingent-payment obligation.

Noncontingent Payment Debt Instruments

Debtors commonly issue securities at prices other than face value. A debt security is sold at a discount when the prevailing market rate is greater than the instrument's coupon (face rate) or when the issuer's credit rating declines between the time the coupon rate is set and the date the security is issued. Conversely, a debt instrument is sold at a premium when its coupon rate is greater than the market rate when it is issued or when the issuer's credit rating improves after the coupon rate is set. In either event, the discount or premium reflects a yield that corresponds with market conditions when it is issued. The pricing of outstanding issues in secondary trades is affected by subsequent market changes, which give rise to their own discounts or premiums in later acquisitions. For a Treasury security, the original issue and secondary market prices are affected only by a disparity between the instrument's coupon rate and the prevailing market rate; neither price is affected by credit considerations.

OID

Regs. Sec. 1.1272-1 provides that a discount arising on a debt instrument's original issue (OID) is ordinary income that accrues over the security's term under the constant-yield method. (1) Similarly, for a debt security issued at a premium, Regs. Sec. 1.171-1 allows the holder to deduct the premium under the constant-yield method over the instrument's term. In effect, the income tax consequences are determined with reference to the security's effective yield, rather than its cashflow.

For a security issued at a discount, the focus on the effective yield affects both the timing and character of income recognition, because the discount substitutes for interest. Thus, Regs. Sec. 1.1272-1 requires the holder to recognize the OID as ordinary income over the instrument's life under the constant-yield method, rather than as capital gain when the debt matures. (This rule applies to the original security holder and to all subsequent purchasers.) Similarly, allowing a bond premium to offset ordinary interest income over the debt's term (instead of taking a capital loss at maturity) ensures a symmetry between the tax law and the true economic yield.

Secondary Market Discounts and Premiums

A discount arising on an acquisition in the secondary market is treated differently from one arising on original issue. As noted above, a taxpayer who acquires an instrument in the secondary market must continue accruing any OID under the constant-yield method. However, under Sec. 1276(a), a discount arising in a secondary trade because of changes in market conditions must be included as ordinary income when the instrument is disposed of (or, if held to maturity, when redeemed). (2) In contrast, a bond premium (whether arising on original issue or in the secondary market) is amortizable over the term under the Regs. Sec. 1.171-1 and -2 constant-yield method.

In general, for a security acquired at original issue, the premium is the excess of the purchase price over the principal payable at maturity. (3) For an instrument acquired in the secondary market, the premium (which the OID regulations refer to as an acquisition premium) represents the excess of the purchase price over the instrument's adjusted issue price (AIP) at the time of sale (the AIP, by definition, would reflect any OID accrued by previous holders under the constant-yield method). (4)

Income Taxation of Inflation-Indexed Debt Instruments

In General

The income tax treatment accorded obligations indexed for inflation is governed by Regs. Sec. 1.1275-7, which distinguishes instruments based on whether they were acquired at par or at a discount or a premium. Subsequent trades complicate the taxation of these securities. Regs. Sec. 1.1275-7(a), however, provides that a debt instrument indexed for inflation is accounted for under either the coupon-bond method or the discount-bond method, whether acquired at original issue or in the secondary market. Either method has the following primary consequences: (1) inflation adjustments to the debt's principal amount are ordinary income and deflation adjustments are deductible against such income; and (2) these adjustments are taxable or deductible (as the case may be) for the year to which they relate, even though they could be eliminated by subsequent changes in the reference index (resulting in either a timing benefit or burden).

Coupon-Bond Method

Under Regs. Sec. 1.1275-7(d)(2), the coupon-bond method applies to an instrument originally issued at par, without regard to whether it is later acquired in the secondary market at a premium or discount. (5) Regs. Sec. 1.1275-7 (d) (3) requires the holder to take all qualified stated interest into account under his or her regular accounting method. In addition, under Regs. Sec. 1.1275-7(d)(4), the holder must include any positive inflation adjustment as ordinary income for the year of the adjustment. (6)

In contrast, a negative adjustment for deflation reduces the holder's includible interest income under Regs. Sec. 1.1275-7(d)(4)(iv). Any excess gives rise to an ordinary loss. However, Regs. Sec. 1.1275-7(f)(1)(i) limits such loss to the amount by which ordinary income included by the holder on the instrument in prior years (which includes any accruals of market discount, any positive inflation adjustments and any receipts or accruals of stated interest) exceeds the negative adjustments in those years. Any remaining negative adjustment is carried forward to reduce the holder's ordinary income in subsequent years. A payment required at maturity in the event the debt's principal amount is less than the stated principal amount (a minimum guarantee payment), is ordinary interest income at that time, under Regs. Sec. 1.1275-7 (f) (4). (7)

Example 1: A $100,000 face value inflation-indexed security issued at par in January 2001 bears 5% interest and matures in four years. Coupons are paid annually. The original CPI is 100 and inflation is 6% for the first two years. Prices fall at a 1% rate for each of the final two years. Exhibit 1 at right shows the holder's cashflow and tax consequences over the instrument's life.

The inflation adjustments during each of the first two years cause the holder to report more in taxable income than he or she would realize in cashflow generated by the instrument. The negative adjustments to principal as the inflation index declines over the last two years, on the other hand, would have just the opposite effect; the holder receives more in the form of coupon payments than he or she would report as taxable income for each of those years (the $10,124 net increase in the principal amount payable at maturity would have been reported as income in prior years, and the $100,000 face amount would represent a tax-free return of capital).

The disparity between the cashflows and taxable amounts is more significant when the CPI moves consistently up or down for each year of the instrument's life. For instance, had inflation continued at 6% in Example 1, the principal amount payable at maturity would include a cumulative inflation adjustment of $26,247.70. Of this amount, $19,101.60 would have been included as income as it accrued over the first three years of the bond's life. The remaining $7,146.10 would be subject to taxation when it accrues in the final year. The same deficiency arises from the opposite perspective when the instrument's life is marked by consistent deflation (i.e., the holder would report less taxable income than the coupon payments actually received in that year). Thus, negative principal adjustments for deflation can give rise to a timing benefit.

Discount-Bond Method

Bonds originally issued at discount: Regs. Sec. 1.1275-7 (e) (1) states that the discount-bond method applies to any inflation-indexed debt instrument that does not qualify for the coupon method (i.e., for any such instrument originally issued at a price other than par).Thus, this method applies to any such instrument originally issued at a discount, without regard to the price at which it may subsequently trade. Regs. Sec. 1.1275-7(e)(2) states that no interest is qualified stated interest under the discount-bond method. According to Regs. Sec. 1.1275-7(e)(3), the income a holder must include under this method in any given year is a function of:

* The instrument's yield to maturity calculated under the constant-yield method (i.e., the discount rate that, when calculating the present value of all principal and interest payments, produces the issue price);

* The accrual period (which generally corresponds to the interval between scheduled payment dates under the instrument);

* The percentage change in the reference index for determining the level of inflation or deflation during the accrual period;

* The OID allocable to the accrual period, determined under the following formula: (AIP x (yield to maturity + inflation + (yield to maturity x inflation))); and

* The daily portions of OID allocable to the accrual period (i.e., for each day during the period that the taxpayer held the instrument).

The discount-bond method has the effect of combining, as OID, the accrual of any OID and the inflation adjustment for any given period.

As under the coupon method, a deflation adjustment under the discount method can give rise to an ordinary loss for the adjustment year to the extent the loss exceeds the sum off (1) the OID required to be accrued for the year, (2) any stated interest payable under the instrument and (3) any market discount included as ordinary income for the year. The amount deductible as an ordinary loss, however, is limited to the excess of the ordinary income included by the holder for the instrument in prior years (including accruals of OID, market discount, positive inflation adjustments and stated interest) over the negative deflation adjustments in those years. Any negative adjustment that remains after this limit is carried forward to future years to reduce the OID, market discount, stated interest and positive inflation adjustments that the holder is otherwise required to include in those years. Finally, like the coupon method, the discount method treats any minimum guarantee payment as ordinary income for the year in which it is received.

Bonds originally issued at premium: A bond originally issued at a premium is taxed under the discount method; the amount includible as income in any given year is determined under the formula set forth above for instruments issued at a discount. (8)

A bond indexed for inflation is deemed to have been purchased at a premium if its adjusted basis exceeds the debt's principal. (9) Under Regs. Sec. 1.171-3(b), the premium is determined assuming there will be no inflation or deflation over the instrument's remaining term; the premium is allocated among the accrual periods based on the same assumption. Finally, any premium allocable to an accrual period will be treated as a deflation adjustment to the extent it exceeds the qualified stated interest for the period.

Example 2: The facts are the same as in Example 1, except that the bond is issued at $96,535, producing a 6% effective yield to maturity. Deflation is 1% per year over the first two years of the bond's life, followed by 3% inflation for each of the final two years. Exhibit 2 below reflects the three components of taxable income for the instrument: (1) the current adjustment for changes in price level, (2) the actual coupon payment and (3) the OID accrual.

Exhibit 2 illustrates that an inflation-indexed security issued at a discount or premium is subject to the same general tax principles as one issued at par. Negative adjustments for deflation will offset a portion of the interest that would otherwise be taxable; positive adjustments for inflation will increase that amount. Further, positive adjustments will be included in taxable income concurrently with each change in the CPI over the instrument's life, even though the holder may never realize the related cash payments (which are not due until maturity) because of subsequent negative adjustments for deflation (as noted above, a holder would later use Sec. 1341 when the amount ultimately payable becomes fixed at maturity).

Bridging the Gap

The regulations that govern inflation-indexed debt instruments are derived from the general OID regulations that apply to traditional debt securities. Thus, it is not surprising that both types of securities are subject to the same fundamental rules.

This regulatory symmetry works well when the rules are applied to either a traditional or an inflation-indexed bond subject to a discount (whether arising on original issue or in a subsequent trade). It breaks down, however, for certain securities acquired at a premium in the secondary market. Specifically, an apparent oversight in the general OID regulations might imply that the holder of a traditional debt instrument acquired in the secondary market at a price in excess of its principal amount is exempt from the obligation to accrue, as taxable income, any discount that arose when the debt was originally issued. The rules that apply to inflation-indexed instruments appear to have filled this void.

Definitions

Premiums: The disparity stems from the regulatory definitions of premium and acquisition premium. According to Regs. Secs. 1.171-1 and -2, and 1.1272-2, a premium generally represents the excess of the debt security's purchase price over its principal amount. (10) This definition applies to any bond, without regard to whether it was acquired at original issue or in the secondary market. (11) As noted above, Regs. Sec. 1.1272-2(a) specifically exempts from the OID roles any holder who purchases a debt instrument at a premium.

Acquisition premiums: In contrast with a premium, Regs. Sec. 1.1272-2(b)(3) provides that an "acquisition premium" arises when a holder's basis in the security is both (1) less than or equal to the debt's principal amount and (2) greater than its AIP. Unlike a holder who acquires a security at a premium, a holder who pays an acquisition premium must accrue any OID that arose when the instrument was originally issued.

In the context of an instrument indexed for inflation, this obligation extends to positive inflation adjustments, which the regulations treat as OID. To give effect to the economics reflected in the purchase price, however, the holder can amortize his or her acquisition premium to offset the OID accrual, thereby correlating the taxable income with the instrument's true yield. (As noted earlier, an inflation-indexed security acquired in the secondary market, after having been originally issued at a discount, is governed by the discount method, which combines, as OID, each periodic accrual of the OID and any inflation adjustment.)

The general definition of an acquisition premium is broad enough to capture a traditional bond traded in the secondary market at a price greater than its AIP, but less than its principal amount (such as when the prevailing interest rate is greater than the instrument's face rate, but less than the market rate at the time the debt was originally issued). Thus, a holder who acquires such a security is required to accrue OID. Yet, the definition is too narrow to reach a traditional debt instrument traded in the secondary market at a price in excess of its principal amount. In such case, the security is defined as having been acquired in the secondary market at a premium (as opposed to an acquisition premium), thereby technically excusing the holder from any obligation to include OID in gross income.

The regulations that govern inflation-indexed securities do not lend themselves to the possibility of such an unusual result. Rather, they obviate the issue by defining an acquisition premium solely with reference to the instrument's AIP when acquired, and by deleting any reference to the debt's principal amount. (12) Thus, unlike a traditional debt instrument, an inflation-indexed security is subject to an acquisition premium (rather than a premium) when it is traded in the secondary market at a price in excess of its principal amount. Accordingly, every holder who acquires such a security must accrue any OID associated with the instrument.

In short, the subtle distinction between the measure of an acquisition premium in the different contexts of traditional debt instruments, on the one hand, and inflation-indexed securities, on the other, is sufficient to bridge the apparent gap in the general OID regulations and bring within the scope of those rules the holder of every inflation-indexed instrument. Thus, the regulations that govern these securities appear to have been more artfully drafted than those that apply to traditional debt instruments.

Conclusion

Investors need to understand the tax consequences of an inflation-indexed debt instrument if they are to properly determine its true market value. After-tax yield is one of the most important variables in evaluating the performance of an investment; any influence that reduces the after-tax yield of an investment without affecting its risk characteristics will make it less attractive.

Issuers are also affected by the manner in which bondholders are taxed. Participants in the bond markets realize that cashflows from future interest payments will become less valuable during periods of inflation. For this reason, investors demand a higher return (in the form of an inflation premium) as protection against inflation-related risks posed by traditional debt securities. Accordingly, and by definition, a borrower who can design a bond not influenced by inflation will be able to avoid paying such a premium and borrow at a lower cost. Such was the genesis of debt instruments indexed for inflation. Although the desire to fund the national debt more cheaply was a major consideration in the design and issuance of Treasury inflation-indexed securities, the potential to reduce borrowing costs can be thwarted (at least, in part) by the negative tax consequences posed by existing regulations.

In particular, the timing disparity between the recognition of taxable income and the receipt of cash interest payments should make inflation-indexed bonds less attractive than more traditional securities taxed under different rules. As a result, Treasury would have to lower the price of these instruments in order to sell them, thereby increasing the effective interest cost and defeating the very purpose of indexing the debt to protect the holder against the risk of inflation.

The extent to which the tax law cuts against the cost-savings potential of inflation-indexed debt securities is an empirical question that remains unanswered. This is so largely because of the dearth of sufficient market data and the absence of a widely accepted and tested pricing model for these securities. Further study of market prices is needed; meaningful research depends on understanding the tax consequences of an investment in inflation-indexed debt instruments.

EXECUTIVE SUMMARY

* An inflation-indexed debt instrument issued at par must be accounted for under the coupon-bond method; the discount-bond method applies to other inflation-indexed debt instruments.

* A positive inflation adjustment produces ordinary income for the year of the adjustment; a negative deflation adjustment would reduce interest income.

* The timing disparity between the recognition of taxable income and the receipt of cash interest payments can make inflation-indexed bonds less attractive than other bonds.

Exhibit 1: Coupon-bond method

Year                                               2001          2002

Index           Prior index x
                  (1 + inflation rate)              106        112.36
Adjusted face   Face value x (index/100)        106,000       112,360
Coupon          Adjusted face x 0.05              5,300         5,618
Inflation *     Adjusted face - prior
                  adjusted face                   6,000         6,360
Taxable         Coupon + inflation               11,300        11,978

Year                                               2003          2004

Index           Prior index x
                  (1 + inflation rate)           111.24        110.12
Adjusted face   Face value x (index/lO0)     111,236.40    110,124.04
Coupon          Adjusted face x 0.05           5,561.82      5,506.20
Inflation *     Adjusted face - prior
                  adjusted face                1,123.60      1,112.36
Taxable         Coupon + inflation             4,438.22      4,393.84

* The holder will not receive any of the positive inflation adjustments
in cash as they accrue; rather, the net cumulative adjustment for
inflation and deflation will be paid only when the debt matures.

Exhibit 2: Discount-bond method

Year                                                       2001

Taxable yield    Yield + inflation rate +
                   (yield x inflation rate)                0.0494
Index            Prior index x (1 + inflation rate)        99
Adjusted face    Face value x (index/100)                  99,000
AIP              Prior AIP + prior discount
                   + prior inflation                       96,534.89
Inflation        Adjusted face - prior adjusted face       (1,000)
Coupon           Adjusted face x 0.05                      4,950
Discount         Taxable - coupon + inflation              818.82

Year                                                       2002

Taxable yield    Yield + inflation rate +
                   (yield x inflation rate)                0.0494
Index            Prior index x (1 + inflation rate)        98.01
Adjusted face    Face value x (index/100)                  98,010
AIP              Prior AIP + prior discount
                   + prior inflation                       96,353.71
Inflation        Adjusted face - prior adjusted face       (990)
Coupon           Adjusted face x 0.05                      4,900
Discount         Taxable - coupon + inflation              849.37

Year                                                       2003

Taxable yield    Yield + inflation rate +
                   (yield x inflation rate)                0.0918
Index            Prior index x (1 + inflation rate)        100.95
Adjusted face    Face value x (index/100)                  100,950.30
AIP              Prior AIP + prior discount
                   + prior inflation                       96,213.08
Inflation        Adjusted face - prior adjusted face       2,940.30
Coupon           Adjusted face x 0.05                      5,047.52
Discount         Taxable - coupon + inflation              844.54

Year                                                       2004

Taxable yield    Yield + inflation rate +
                   (yield x inflation rate)                0.0918
Index            Prior index x (1 + inflation rate)        103.98
Adjusted face    Face value x (index/100)                  103,978.80
AIP              Prior AIP + prior discount
                   + prior inflation                       99,997.92
Inflation        Adjusted face - prior adjusted face       3,028.51
Coupon           Adjusted face x 0.05                      5,198.94
Discount         Taxable - coupon + inflation              952.36

(1) Regs. Sec. 1.1273-1(d) sets forth a de minimis rule that treats OID as zero unless it exceeds 0.0025 times the product of the instrument's stated redemption price at maturity times the number of years to maturity from the issue date.

(2) A holder may, however, elect under Sec. 1278(b) to include a market discount as income over the period he or she holds the instrument, either under a ratable accrual or under the constant-interest method.

(3) See Regs. Sec. 1.1272-2(b)(2).

(4) Curiously, Regs. Sec. 1.1272-2(b)(3) limits the definition of a secondary market acquisition premium to an instrument acquired with a basis both (1) less than or equal to the principal amount payable under the debt and (2) greater than its AIP (i.e., when the market rate at acquisition is less than the rate on which the OID was based, but still greater than the instrument's face rate).

(5) A taxpayer who pays a premium in the secondary market (an acquisition premium) would amortize it under the constant-yield method as an of[set against interest income. According to Regs. Sec. 1.127-5 7(f)(3), the bond premium paid for an inflation-indexed security is determined by assuming that the amount payable at maturity equals the inflation-adjusted principal amount on the day the holder acquires it. A discount on a secondary market acquisition (a market discount), on the other hand, would, at the taxpayer's option, either be (1) treated as ordinary income to the extent of accrued market discount at the time the taxpayer redeems or otherwise disposes of the instrument; or (2) accrued as interest income ratably over the period he or she holds the bond. The market discount is the excess of an instrument's stated redemption price at maturity over the price paid in the secondary market. For an inflation-indexed security, the stated redemption price would include the principal amount as of the acquisition date, adjusted for inflation.

(6) The regulations provide that a positive inflation adjustment for any period is OID, thereby implying that the holder is required to include only a portion of the adjustment in ordinary income for the year in which the adjustment arose (i.e., a manner consistent with the accrual of OID under the constant-yield method).The Example at Regs. Sec. 1.1275-7(d)(5) clearly requires that the entire adjustment be included as ordinary income in that year.

(7) See Regs. Sec. 1.1275-7(c)(5) for the definition of a minimum guarantee payment.

(8) Premiums paid for inflation-indexed securities are treated somewhat differently, depending on whether they arose at original issue or in the secondary market. The difference results from the fact that the discount method (which applies to instruments originally issued at a price other than par) combines the premium amortization and the inflation adjustment in one formula; the coupon method which applies only to instruments originally issued at par) takes them into account separately.

(9) The definition of premium applies both to instruments purchased at original issue and to those acquired in subsequent transactions; see Regs. Sec. 1.1272-2(b)(2).

(10) The regulations provide that a debt instrument is purchased at a premium if its adjusted basis, immediately after its purchase by the holder (including a purchase at original issue), exceeds the sum of all amounts payable on the instrument after the purchase date, other than payments of qualified stated interest.

(11) Id.

(12) According to Regs. Sec. 1.1275-7 (f) (3), a holder determines the amount of acquisition premium or market discount on an inflation-indexed debt instrument by reference to the instrument's AIP on the date acquired.

Frederick R. Parker, Jr., MBA,

L.L.M., CPA

Associate Professor of Accounting and Business Law

Louisiana State University in Shreveport

Shreveport, LA

Timothy W. Vines, Ph.D.

Associate Professor of Finance

Louisiana State University in Shreveport

Shreveport, LA