The IRS has issued final and temporary regulations under sections 171 and 1275 (T.D. 9609) related to original issue discount (OID) on bond premium carryforwards and certain debt instruments known as Treasury inflation-protect securities (TIPS).
TIPS – Treasury issues TIPS, which are debt instruments that provide for the principal to be adjusted for inflation or deflation related to the U.S. dollar. Generally, a positive "inflation adjustment" to the principal amount of TIPS gives rise to OID, and a negative "deflation adjustment" reduces interest that is includible related to a TIPS.
TIPS generally bear a fixed rate of interest that is payable based on a principal amount that is indexed to the consumer price index. Treas. Reg. Sec. 1.1275-7 provides that one of two methods will apply to a debt instrument, which constitutes an inflation-indexed debt instrument: (i) the coupon method under Treas. Reg. Sec. 1.1275-7(d) or (ii) the discount method under Treas. Reg. Sec. 1.1275-7(e). 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. The discount method, however, is more complex.
Under Treas. Reg. Sec. 1.1275-7(d)(2)(i), the coupon bond method is not available with respect to inflation-indexed debt instruments that are issued with more than a de minimis amount of premium (as determined under Section 1273). Before 2011, TIPS had not been issued with more than a de minimis amount of premium. Because of recent financial conditions, TIPS were issued at a premium more than a de minimis amount.
The final regulations under Treas. Reg. Sec. 1.1275-7(g)(2) provide that notwithstanding Treas. Reg. Sec. 1.1275-2(d)(2)(i), the coupon method applies to TIPS with more than a de minimis amount of premium, and provide an example that illustrates the application of the coupon method to such a debt instrument.
Bond premium – A holder acquires a bond at a premium if, immediately after its acquisition, the holder's basis in the bond exceeds the sum of all amounts payable on the bond after the acquisition date. Such excess is bond premium, which is amortizable under Treas. Reg. Sec. 1.171-2.
Section 171(a)(1) provides that "amortizable bond premium" relating to a taxable bond (i.e., not a bond whose interest is excludable from gross income) is allowed as a deduction. Section 171, however, applies to a taxable bond only if the taxpayer elects for it to apply under Section 171(c).
Under Treas. Reg. Sec. 1.171-2(a)(1), a bond holder offsets the qualified stated interest allocable to an accrual period with the allocable bond premium for such accrual period. If the allocable bond premium for an accrual period exceeds the qualified stated interest allocable to such an accrual period, the excess is a bond premium deduction under Section 171(a)(1) for such an accrual period. Under Treas. Reg. Sec. 1.171-2(a)(4), however, the amount treated as a bond premium deduction is limited to the excess of (i) the amount of the holder's total interest inclusions on the bond in prior accrual periods, over (ii) the total amount treated by the holder as a bond premium deduction on the bond in prior accrual periods (the "interest limitation"). If the interest limitation applies, the excess allocable bond premium is carried forward to the next accrual period and is treated as bond premium allocable to that period.
Pursuant to Treas. Reg. Sec. 1.1016-5(b), a holder's basis in a bond is reduced by the amount of bond premium used to offset the qualified stated interest. Thus, if the interest limitation applies and the holder disposes the bond, the bond premium allocable for a period subject to an interest limitation would still be included in the basis of the bond in determining the gain or loss from the disposition of such a bond.
The newly issued Treas. Reg. Sc. 1.171-2T(a)(4)(i)(C) (1) provides that if there is a bond premium carryforward as of the end of the holder's accrual period in which a bond is disposed, the holder treats the amount of the carryforward as a bond premium deduction under Section 171(a)(1) and the holder's basis in the bond is reduced by the amount of the bond premium allowed as a deduction for purposes of Treas. Reg. Sec. 1.1016-5.
In the preamble to Treas. Reg. Sec. 1.171-2T(a)(4)(i)(C) (1), the IRS stated that the interest limitation would apply to a zero coupon debt instrument, including a TIPS, because there is no qualified stated interest. Thus, absent Treas. Reg. Sec. 1.171-2T(a)(4)(i)(C) (1), the holder would have a capital loss related to bond premium carryforward.
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