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Inflation-indexed debt instruments.

On May 16, 1996, the Treasury Department announced plans to issue securities that provide protection against inflation. The Treasury Inflation-Protection Securities (TIPSs) were issued on Jan. 29, 1997. Notice 96-51, released Sept. 25, 1996, describes, in general terms, these new debt instruments. In addition, the Service has recently issued proposed and temporary regulations under Secs. 1275(d) and 1286 to give guidance on tax issues involving TIPSs and inflation-indexed debt instruments in general.

TIPS

A TIPS will provide for semiannual payments of interest and a payment of principal at maturity. Each payment will be adjusted to take into account any changes inflation that occur between the security's issue date and the payment date. The principal amount of such a security will be adjusted based on monthly changes in the nonseasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U).

Each semiannual payment of interest will be determined by multiplying a single fixed rate of interest by the inflation-adjusted principal amount of the security for the date of the interest payment. As a result, the interest rate will be fixed, but the amount of each interest payment will vary with changes in the principal of the security as adjusted for changes in inflation.

A TIPS also will provide for an additional payment at maturity if the security's inflation-adjusted principal amount for the maturity date is less than the security's principal amount at issuance. The amount of the additional payment will equal the excess of the security's principal amount at issuance over the security's inflation-adjusted principal amount for the maturity date.

Other Inflation-Indexed Debt

Instruments

Temp. Regs. Sec. 1.1275-7T also applies to other non-treasury issued inflation-indexed debt instruments. An inflation-indexed debt instrument must satisfy the following conditions:

* The debt instrument must be issued for US. dollars and all payments of principal and interest on the instruments must be in US. dollars.

* Each payment on the debt instrument must be indexed for changes in inflation or deflation (except for a minimum guarantee payment as defined in Temp. Regs. Sec.1.1275-7T(c)(5)).

* A payment is indexed for inflation or deflation if the payment is equal to the amount scheduled to be paid under the debt instrument multiplied by a ratio, the numerator of which is the value of the reference index at payment date and the denominator of which is the value of the reference index at issue date.

* A reference index is based on a qualified inflation index (a general price or wage index updated and published at least monthly by a US. government agency) and whose value is reset at least once a month to reflect a value of the general index that is not more than six months old.

* The payments on the debt instrument cannot be subject to any contingencies other than the inflation contingency, except for a minimum guaranteed payment or an alternative schedule (as determined under Regs. Sec. 1.1272-1(c)) which must also be indexed for inflation or deflation.

Minimum Guarantee Payment

A debt imtrument will not fail to qualify as an inflation-adjusted debt instrument merely because it provides a minimum guarantee payment. A minimum guarantee payment is an additional payment that is made at maturity if the debt instrument's inflation-adjusted principal amount for the maturity date is less than the instruments principal amount at issuance. The amount of the additional payment must be no more than the excess of the debt instrument's principal amount at issuance over the instrument's inflation-adjusted principal amount for the maturity date. An additional payment is not a minimum guarantee payment unless the qualified inflation index used to determine the reference index is either the nonseasonably adjusted CPI-U or an index designated by the IRS.

Application of Bond Methods

Debt instruments that qualify as inflation-indexed debt will be subject to one of two methods to account for qualified stated interest and original issue discount (OID) on the instrument: the coupon bond method or the discount bond method.

Coupon bond method: The coupon bond method (under Temp. Regs. Sec. 1.1275-7T(d)) will apply to inflation-indexed debt instruments when there is no more than a de minimis difference between the debt instruments issue price and its principal amount at issuance, and all stated interest payable on the debt instrument is qualified stated interest. To be qualified stated interest, the interest must be unconditionally payable in cash at least annually. This simplified method win apply to TIPSs not stripped into principal and interest components.

The qualified stated interest payable on an inflation-indexed debt instrument will be taken into account under the taxpayer's regular method of accounting. Any increase in the inflation-adjusted principal amount will be treated as OID for the period in which the increase occurs. Any decrease in the inflation-adjusted amount (a deflation adjustment) will be taken into account under the rules for deflation adjustments described below.

Discount bond method: An inflation-indexed debt instrument that does not qualify for the coupon bond method is subject to the discount bond method under Temp. Regs. Sec. 1.1275-7T(e). The discount bond method will require taxpayers to make current adjustments to their OID accruals on the debt instrument to account for changes in the inflation-adjusted principal amount. Under the discount bond method, a taxpayer will accrue OID in a manner similar to Regs. Sec. 1.1272-1(b)(1); see Temp. Regs. Sec. 1.275-7T(e)(3). The debt instruments yield to maturity will be determined as of the issue date by assuming no inflation or deflation. A separate formula will be used to determine the OID allocable to a given accrual period. If the formula produces a negative amount of OID, this amount (deflation adjustment) will be taken into account under the rules for deflation adjustments described below. Unlike Notice 96-51, the proposed and temporary regulations provide that no interest payments subject to the discount bond method are qualified stated interest.

Deflation Adjustments

Under Temp. Regs. Sec. 1.1275-T(f)(1), a deflation adjustment will generally reduce the amount of interest includible in income by a holder with respect to the debt instrument for the tax year under either the coupon bond method or the discount bond method. If the amount of the deflation adjustment exceeds the interest otherwise includible in income for the tax year, the excess will be treated as an ordinary loss by the holder for be tax year. However, the amount treated as an ordinary loss will be limited to the amount by which the holders total interest inclusions on the debt instrument in prior tax years exceeds the total amount treated by the holder as an ordinary loss on the debt instrument in prior tax years.

If the deflation adjustment exceeds the interest otherwise includible in income by the holder with respect to the debt instrument for the tax year and the amount treated as an ordinary loss for the tax year, this excess will be carried forward to offset interest income on the debt instrument in subsequent tax years. In general, any excess remaining on the sale, exchange or retirement of the debt instrument will result in a loss to the holder for Federal income tax purposes. Similar rules will apply to determine an issuers interest deductions and income for the debt instrument.

Minimum Guarantee

Under both methods, a minimum guarantee payment generally will be ignored until the payment is made. If there is a minimum guarantee payment, the payment will be treated as a payment of interest, see Temp. Regs. Sec. 1.1275-7T(f)(4).

Subsequent Holders

For purposes of determining whether a holder acquires an inflation-indexed debt instrument at a premium or with market discount, the amount payable at maturity on the instrument will be treated as equal to the instruments inflation-adjusted principal amount for the day the holder acquires the instrument. Any premium or market discount will be taken into account over the instrument's remaining term by making the same assumption.

STRIPs

A TIPS will be eligible on issuance for the Treasury Departments Separate Trading of Registered Interest and Principal of Securities (STRIPS) program. Under this program, the interest and principal components of a TIPS may be transferred as separate instruments (stripped bonds and coupons). In general, Sec. 1286 treats the holder of a stripped bond (or coupon) as if the holder purchased a newly issued debt instrument with OID. The proposed and temporary regulations provide that the holder of a TIPS component that is stripped under the Treasury STRIP program must use the discount bond method to account for OID on the component.

Reopenings

Temp. Regs. Sec. 1.1275-7T(g) treats a reopening of a TIPS as a qualified reopening for purposes of Regs. Sec. 1.1275-2(d)(2) provided the reopening occurs not more than one year after the original securities were first issued to the public, and the terms of the TIPS issued in the reopenings are the same as the original ones.

Effective Date

The regulations will apply to debt instruments issued on or after Dec. 31, 1996, the date they were published in the Federal Register.
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Author:Garay, Mark
Publication:The Tax Adviser
Date:Mar 1, 1997
Words:1514
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