Final Regs on Treatment of Stripped Bonds and Stripped Coupons

 [4830-01]

 ACTION: Final Regulations.

 SUMMARY: This document contains final income tax regulations that apply to taxpayers holding stripped bonds and stripped coupons under section 1286 of the Internal Revenue Code. The regulations are needed to provide guidance on the treatment of original issue discount (OID) that arises under section 1286(a) of the Internal Revenue Code. This guidance is intended to simplify and clarify the tax treatment of certain stripped bonds and stripped coupons.

 EFFECTIVE DATE: These regulations are effective August 8, 1991.

 FOR FURTHER INFORMATION CONTACT: Mark S. Smith, telephone 202-622-3920 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Temporary regulations (T.D. 8358) on the tax treatment of certain stripped bonds and stripped coupons were published in the Federal Register on August 13, 1991 (56 FR 38339). The text of these temporary regulations also served as the comment document for a notice of proposed rulemaking (the proposed regulations) (56 FR 38398). No public hearing on these regulations was requested or held, and no written comments were received. Accordingly, the temporary regulations are adopted as revised by this Treasury decision.

EXPLANATION OF PROVISIONS

 Section 1286(a) of the Internal Revenue Code (Code) provides that a stripped bond or stripped coupon is treated by the purchaser as a bond originally issued on the purchase date and having OID equal to the excess of (1) the stated redemption price at maturity (or, in the case of a coupon, the amount payable on the due date of the coupon), over (2) the bond's or coupon's ratable share of the purchase price. Section 1273(a)(3) of the Code provides that if a debt instrument has only a de minimis amount of OID, then the OID shall be treated as zero. Section 1.1286-1(a) of the final regulations provides that the de minimis rule applies to stripped bonds and stripped coupons.

 Section 1.1286-1(b) of the final regulations, which adopts the provisions of section 1.1286-1T(b) without change, authorizes the Internal Revenue Service to publish guidance in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii)(b) of the Statement of Procedural Rules) treating certain stripped bonds as market discount bonds under section 1278, provided that certain criteria are met. This authority was exercised in Rev. Proc. 91-49, 1991-2 C.B. 777, which provides simplified tax treatment for certain mortgages that are stripped bonds.

 The extent to which this Treasury decision revises section 1.1286-1T(a) is discussed below.

WEIGHTED AVERAGE MATURITY RULE

 Section 1.1286-1(a) of the final regulations treats as de minimis any OID determined under Code section 1286(a) with respect to the purchase of a stripped bond or stripped coupon, if the OID "is less than the amount computed under subparagraphs (A) and (B) of section 1273(a)(3) and the regulations thereunder." Code section 1273(a)(3) provides that this amount is 1/4 of 1 percent of the stated redemption price at maturity, multiplied by the number of complete years to maturity. However, in the case of an installment obligation, the multiplier is the debt instrument's weighted average maturity. A special safe harbor rule also is available for certain installment obligations.

 Section 1.1286-1T(a) provided that for purposes of the computation under section 1273(a)(3), the number of complete years to maturity is the number of full years from the date the stripped bond or stripped coupon is purchased to final maturity. This provision was intended not to override the reference in section 1.1286-1T(a) to "section 1273(a)(3) and the regulations thereunder," but, simply, to provide that the number of complete years to maturity is measured from the date the stripped bond or stripped coupon is purchased. This provision has been clarified to remove any arguable ambiguity as to the required use of a weighted average maturity in testing for de minimis OID.

TREATMENT OF OID ON TAX-EXEMPT OBLIGATIONS

 The final regulations also contain a provision that prevents the de minimis rule from causing any tax-exempt portion of OID to become taxable. Under section 1288, the holder of a tax-exempt obligation generally increases its basis in the obligation in a manner designed to prevent tax on accrued OID. Section 1.1286-1(a) of the final regulations prevents the de minimis rule from negating the section 1288 basis adjustment for any tax-exempt portion of OID on stripped bonds and stripped coupons. Without this provision, the tax-exempt portion of de minimis OID would become taxable. Since the provision applies only to any tax-exempt portion of OID, it does not prevent any taxable portion of OID from being treated as zero if the total OID (including any tax-exempt portion thereof) on a tax-exempt obligation is de minimis.

AGGREGATION OF STRIPPED BONDS AND STRIPPED COUPONS

 The final regulations are premised on the assumption that an aggregation approach such as that applicable under Code section 1275 is appropriate in determining whether OID on a stripped bond or stripped coupon is de minimis. The final regulations are premised also on the assumption that stripped coupons may be treated as stated interest with respect to the bonds from which they are stripped and, therefore, may be excluded from stated redemption price at maturity in appropriate circumstances. Without these assumptions, each stripped bond and stripped coupon would be treated as a separate (zero coupon) bond, and the OID with respect to each such separate bond or coupon virtually never would be de minimis.

 Section 1.1286-1T(a) contained a provision concerning the stated redemption price at maturity of a stripped bond or stripped coupon. That provision was omitted from the final regulations to avoid any arguable inconsistency with the assumptions described above. Future regulations under section 1286 will provide specific guidance relating to these assumptions. In anticipation of these regulations, comments are requested on the appropriate rules for aggregating stripped bonds and stripped coupons under section 1286.

SPECIAL ANALYSES

 It has been determined that these final regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Mark S. Smith, Office of the Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR 1.1231-1 THROUGH 1.1297-3T

 Income taxes.

Treasury Decision 8463

AMENDMENT TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the citation for "Section 1.1286-1T" and adding the following citation:

Authority: 26 U.S.C. 7805 * * * Section 1.1286-1 also issued under 26 U.S.C. 1275(d) and 1286(f).

Par. 2. Section 1.1286-1T is removed.

Par. 3. Section 1.1286-1 is added to read as follows:

SECTION 1.1286-1 TAX TREATMENT OF CERTAIN STRIPPED BONDS AND STRIPPED COUPONS.

(a) DE MINIMIS OID. If the original issue discount determined under section 1286(a) with respect to the purchase of a stripped bond or stripped coupon is less than the amount computed under subparagraphs (A) and (B) of section 1273(a)(3) and the regulations thereunder, then the amount of original issue discount with respect to that purchase (other than any tax-exempt portion thereof, determined under section 1286(d)(2)) shall be considered to be zero. For purposes of this computation, the number of complete years to maturity is measured from the date the stripped bond or stripped coupon is purchased.

(b) TREATMENT OF CERTAIN STRIPPED BONDS AS MARKET DISCOUNT BONDS -- (1) IN GENERAL. By publication in the Internal Revenue Bulletin (see section 601.601(d)(2)(ii)(b) of the Statement of Procedural Rules), the Internal Revenue Service may (subject to the limitation of paragraph (b)(2) of this section) provide that certain mortgage loans that are stripped bonds are to be treated as market discount bonds under section 1278. Thus, any purchaser of such a bond is to account for any discount on the bond as market discount rather than original issue discount.

(2) LIMITATION. This treatment may be provided for a stripped bond only if, immediately after the most recent disposition referred to in section 1286(b) --

(i) The amount of original issue discount with respect to the stripped bond is determined under paragraph (a) of this section (concerning de minimis OID); or

(ii) The annual stated rate of interest payable on the stripped bond is no more than 100 basis points lower than the annual stated rate of interest payable on the original bond from which it and any other stripped bond or bonds and any stripped coupon or coupons were stripped.

(c) EFFECTIVE DATE. This section is effective on and after August 8, 1991.