Rev. Rul. 82-10

ISSUES

Is the yield method a reasonable method of amortizing bond premium under section 171 of the Internal Revenue Code?

FACTS

Taxpayer, a corporation, uses the accrual method of accounting and files its returns on a calendar-year basis. Taxpayer has acquired bonds, purchased at a premium, for investment purposes. The bonds purchased by the taxpayer are of two types: either the interest payable to the holder of the bond is fully excludable from gross income (tax-exempt bonds) or fully includable in gross income (taxable bonds). Both the tax-exempt and taxable bonds purchased by taxpayer have a maturity date or earlier call date of 10 years from the date they were issued.

Taxpayer has adjusted the bases of both the tax-exempt and taxable bonds by amortizing the premiums. Premium represents the excess of a bond's basis over the amount payable at maturity, or, in the case of callable bonds, the earlier call date. With respect to taxable bonds, taxpayer deducts the amount of premium amortized in computing taxable income.

In determining the amount of amortizable premium, taxpayer has regularly employed the yield method of amortization (also known as the scientific method) for both income tax and financial reporting purposes. Under the yield method of amortization, the annual yield rate of a particular bond is first determined as follows:

     (1) AI = I - P / N AI = Average Income

(1) the annual stated interest rate is applied against the face amount of the bond;

(2) the annual yield rate is applied against the taxpayer's basis or adjusted basis in the bond; and

(3) the amount in (2) is subtracted from the amount in (1).

The computations and operations of the yield method of bond premium amortization are illustrated by the following example:

Taxpayer purchased for $10,800 a 10-year tax-exempt bond, with a face amount of $10,000 and a stated interest rate of 6% payable semi-annually. The annual yield rate of this bond is 5%, determined as follows:

(1) AI = I - P / N

First month

Section 171(b)(3) of the Code provides that the amount of bond premium amortizable in a tax year will be determined (A) according to the method of amortizing bond premium regularly employed by the holder of the bond, if the method is reasonable; and (B) in all other cases, according to regulations prescribing reasonable methods of amortizing bond premium prescribed by the Secretary.

Section 1.171-2(f)(1) of the regulations provides that a determination of amortizable bond premium on any bond to which section 171 applies will be made according to (i) the method of amortization regularly employed by the taxpayer, if it is reasonable; or (ii) in all other cases, the method of amortization prescribed by this section.

The method prescribed by section 1.171-2(f)(2)(i) of the regulations is the straight-line method. Under the straight-line method, the amortizable bond premium is an amount that bears the same ratio to the bond premium on the bond as the number of months in the tax year during which the bond is held by the taxpayer bears to the number of months from the beginning of the tax year (or, if the bond was acquired in the tax year, from the date of acquisition) to the date of maturity or earlier call date.

Section 171(b)(3) of the Code, in addition to referring to reasonable methods prescribed by the regulations, allows any other method of bond premium amortization to be used if it is regularly used and is reasonable. Section 1.171-2(f) of the regulations, in prescribing a bond premium amortization method in which a constant amount is amortized on a monthly basis (straight-line method), also expressly recognizes the use of another method if it is regularly used and is reasonable.

Under the yield method, (1) the amount of premium amortized rises progressively over the life of the bond, (2) the amount of the taxpayer's yield on its investment (interest payable on bond less premium amortization) decreases over the bond's life, and (3) the annual yield rate on the taxpayer's investment remains constant during the bond's life.

HOLDING

The yield method is a reasonable method of amortizing bond premium under section 171 of the Code.

Any change in the taxpayer's present method of accounting to the method described in this revenue ruling is a change in method of accounting to which the provisions of sections 446 and 481 of the Code apply.