Proposed contingent debt regulations.

On Dec. 16, 1994, the IRS issued a Notice of Proposed Rulemaking relating to the tax treatment of contingent debt instruments. In general, Prop. Regs. Sec. 1.1275-4 represents a major departure from the existing tax treatment of such instruments. It is built around the concept of a noncontingent bond method, which treats the projected amount of a contingent payment as if it were a fixed payment.

The noncontingent bond method applies to a contingent payment debt instrument issued for money or publicly traded property. Under the noncontingent bond method, a projected payment schedule is determined for a debt instrument, and interest accrues on the debt instrument based on this schedule. If the actual amount of a contingent payment differs from its projected amount, appropriate adjustments are taken into account to reflect this difference.

The projected payment schedule for a debt instrument consists of all noncontingent payments and a projected amount for each contingent payment. Under Prop. Regs. Sec. 1.1275-4(b)(4), contingent payments are either quotable contingent payments or nonquotable contingent payments.

A quotable contingent payment is a contingent payment substantially similar to a property right for which forward price quotes are readily available. In general, the projected amount of a quotable contingent payment is the property right's forward price. If a contingent payment is substantially similar to an option and forward price quotes are not readily available for the option, the projected amount of the payment is the option's spot price on the issue date (if readily available), compounded at the applicable Federal rate (AFR) from the issue date to the date the payment is due.

A nonquotable contingent payment is any contingent payment that is not a quotable contingent payment. For example, contingent payments based on oil production or the issuer's gross receipts are generally nonquotable contingent payments. The projected amount of a nonquotable contingent payment is generally based on the projected yield of the contingent payment debt instrument. The projected yield is a reasonable rate for the debt instrument that, as of the issue date, reflects general market conditions, the credit quality of the issuer and the terms and conditions of the debt instrument.

Prop. Regs. See. 1.12754(b)(4)(iv) provides that, generally, all holders of a contingent payment debt instrument are bound by the issuer's projected payment schedule and that an issuer must provide the schedule to the holders.

Under the noncontingent bond method, if the actual amount of a contingent payment differs from its projected amount, the difference results in either a positive or negative adjustment that must be taken into account by the taxpayer.

If the actual amount of a contingent payment is greater than its projected amount, the difference is treated by the taxpayer as additional interest for the year. if the actual amount of a contingent payment is less than its projected amount, the difference first offsets the interest that accrued on the debt instrument for the year based on the projected payment schedule. Any additional negative adjustment is treated first as an ordinary loss by the holder or as ordinary income by the issuer, first to the extent that the holder's (issuer's) total prior interest inclusions (deductions) on the debt instrument exceed the total net negative adjustments on the debt instrument previously treated as ordinary loss (income) by the holder (issuer), then as a negative adjustment that occurs on the first day of the succeeding tax year (thus offsetting interest accruals on the debt instrument in future tax years) and, finally, any unused portion is treated as a reduction in the amount realized by the holder on the instrument's sale, exchange or retirement.

Under the noncontingent bond method, any gain recognized by a holder on the sale, exchange or retirement of a contingent payment debt instrument is treated as interest income. Any loss is treated as ordinary loss to the extent of prior interest inclusions on the instrument. Any additional loss is capital.

Prop. Regs. Sec. 1.1275-4(c) also provides a method for contingent payment debt instruments not subject to the noncontingent bond method, such as nonpublicly traded debt instruments issued in a sale or exchange of nonpublicly traded property. This method is generally similar to the rules prescribed earlier in Prop. Regs. Sec. 1.1275-4(c).

Under Prop. Regs. Sec. 1.12754(c)(2), the payments on a contingent payment debt instrument (the overall debt instrument) are divided into (1) a noncontingent component, consisting of all noncontingent payments and the projected amounts of any quotable contingent payments and (2) a contingent component, consisting of all nonquotable contingent payments.

The noncontingent component is treated as a separate debt instrument and, in general, is taxed under the general original issue discount rules (including the noncontingent bond method if the separate debt instrument provides for quotable contingent payments). The issue price of the separate debt instrument is the issue price of the overall debt instrument.

In general, a nonquotable contingent payment is not taken into account until the payment is made. When a nonquotable contingent payment (other than a contingent payment accompanied by a payment of adequate stated interest) is made, a portion of the payment is treated as principal, based on discounting the payment at the AFR from the payment date to the issue date, and the remainder is treated as interest.

In general, Prop. Regs. Sec. 1.1275-4 is effective for debt instruments issued 60 days after publication of final regulations. The proposed regulations issued in 1986 and amended in 1991 have been superseded.

From Jonathan Brenner, J.D., New York, N.Y., and Jim Banks CPA, Washington, D.C.