[Code of Federal Regulations]
[Title 26, Volume 2]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.148-4]
[Page 671-682]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Sec. 1.148-4 Yield on an issue of bonds.
(a) In general. The yield on an issue of bonds is used to apply
investment yield restrictions under section 148(a) and to compute rebate
liability under section 148(f). Yield is computed under the economic
accrual method using any consistently applied compounding interval of
not more than one year. A short first compounding interval and a short
last compounding interval may be used. Yield is expressed as an annual
percentage rate that is calculated to at least four decimal places
(e.g., 5.2525 percent). Other reasonable, standard financial
conventions, such as the 30 days per month/360 days per year convention,
may be used in computing yield but must be consistently applied. The
yield on an issue that would be a purpose investment (absent section
148(b)(3)(A)) is equal to the yield on the conduit financing issue that
financed that purpose investment. The Commissioner may permit issuers of
qualified mortgage bonds or qualified student loan bonds to use a single
yield for two or more issues.
(b) Computing yield on a fixed yield issue--(1) In general--(i)
Yield on an issue. The yield on a fixed yield issue is the discount rate
that, when used in computing the present value as of the issue date of
all unconditionally payable payments of principal, interest, and fees
for qualified guarantees on the issue and amounts reasonably expected to
be paid as fees for qualified guarantees on the issue, produces an
amount equal to the present value, using the same discount rate, of the
aggregate issue price of bonds of the issue as of the issue date.
Further, payments include certain amounts properly allocable to a
qualified hedge. Yield on a fixed yield issue is computed as of the
issue date and is not affected by subsequent unexpected events, except
to the extent provided in paragraphs (b)(4) and (h)(3) of this section.
(ii) Yield on a bond. Yield on a fixed yield bond is computed in the
same manner as yield on a fixed yield issue.
(2) Yield on certain fixed yield bonds subject to mandatory or
contingent early redemption--(i) In general. The yield on a fixed yield
issue that includes a bond subject to mandatory early redemption or
expected contingent redemption is computed by treating that bond as
redeemed on its reasonably expected early redemption date for an amount
equal to its value on that date. Reasonable expectations are determined
on the issue date. A bond is subject to mandatory early redemption if it
is unconditionally payable in full before its final maturity date. A
bond is subject to a contingent redemption if it must be, or is
reasonably expected to be, redeemed prior to final maturity upon the
occurrence of a contingency. A contingent redemption is taken into
account only if the contingency is reasonably expected to occur, in
which case the date of occurrence of the contingency must be reasonably
estimated. For example, if bonds are reasonably expected to be redeemed
early using excess revenues from general or special property taxes or
benefit assessments or similar amounts, the reasonably expected
redemption schedule is used to determine yield. For purposes of this
paragraph (b)(2)(i), excess proceeds calls for issues for which the
requirements of Sec. 1.148-2(e) (2) or (3) are satisfied, calamity
calls, and refundings do not cause a bond to be subject to early
redemption. The value of a bond is determined under paragraph (e) of
this section.
(ii) Substantially identical bonds subject to mandatory early
redemption. If substantially identical bonds of an issue are subject to
specified mandatory redemptions prior to final maturity (e.g., a
mandatory sinking fund redemption requirement), yield on that issue is
computed by treating those bonds as redeemed in accordance with the
redemption schedule for an amount equal to their value. Generally, bonds
are substantially identical if the stated interest rate, maturity, and
payment dates are the same. In computing the yield on an issue
containing bonds described in this paragraph (b)(2)(ii), each
[[Page 672]]
of those bonds must be treated as redeemed at its present value, unless
the stated redemption price at maturity of the bond does not exceed the
issue price of the bond by more than one-fourth of one percent
multiplied by the product of the stated redemption price at maturity and
the number of years to the weighted average maturity date of the
substantially identical bonds, in which case each of those bonds must be
treated as redeemed at its outstanding stated principal amount, plus
accrued, unpaid interest. Weighted average maturity is determined by
taking into account the mandatory redemption schedule.
(3) Yield on certain fixed yield bonds subject to optional early
redemption--(i) In general. If a fixed yield bond is subject to optional
early redemption and is described in paragraph (b)(3)(ii) of this
section, the yield on the issue containing the bond is computed by
treating the bond as redeemed at its stated redemption price on the
optional redemption date that would produce the lowest yield on the
issue.
(ii) Fixed yield bonds subject to special yield calculation rule. A
fixed yield bond is described in this paragraph (b)(3)(ii) only if it--
(A) Is subject to optional redemption within five years of the issue
date, but only if the yield on the issue computed by assuming all bonds
in the issue subject to redemption within 5 years of the issue date are
redeemed at maturity is more than one-eighth of one percentage point
higher than the yield on that issue computed by assuming all bonds
subject to optional redemption within 5 years of the issue date are
redeemed at the earliest date for their redemption;
(B) Is issued at an issue price that exceeds the stated redemption
price at maturity by more than one-fourth of one percent multiplied by
the product of the stated redemption price at maturity and the number of
complete years to the first optional redemption date for the bond; or
(C) Bears interest at increasing interest rates (i.e., a stepped
coupon bond).
(4) Yield recomputed upon transfer of certain rights associated with
the bond. For purposes of Sec. 1.148-3, as of the date of any transfer,
waiver, modification, or similar transaction (collectively, a transfer)
of any right that is part of the terms of a bond or is otherwise
associated with a bond (e.g., a redemption right), in a transaction that
is separate and apart from the original sale of the bond, the issue is
treated as if it were retired and a new issue issued on the date of the
transfer (reissued). The redemption price of the retired issue and the
issue price of the new issue equal the aggregate values of all the bonds
of the issue on the date of the transfer. In computing yield on the new
issue, any amounts received by the issuer as consideration for the
transfer are taken into account.
(5) Special aggregation rule treating certain bonds as a single
fixed yield bond. Two variable yield bonds of an issue are treated in
the aggregate as a single fixed yield bond if--
(i) Aggregate treatment would result in the single bond being a
fixed yield bond; and
(ii) The terms of the bonds do not contain any features that could
distort the aggregate fixed yield from what the yield would be if a
single fixed yield bond were issued. For example, if an issue contains a
bond bearing interest at a floating rate and a related bond bearing
interest at a rate equal to a fixed rate minus that floating rate, those
two bonds are treated as a single fixed yield bond only if neither bond
may be redeemed unless the other bond is also redeemed at the same time.
(6) Examples. The provisions of this paragraph (b) may be
illustrated by the following examples.
Example 1. No early call--(i) Facts. On January 1, 1994, City A
issues an issue consisting of four identical fixed yield bonds. The
stated final maturity date of each bond is January 1, 2004, and no bond
is subject to redemption before this date. Interest is payable on
January 1 of each year at a rate of 6.0000 percent per year on the
outstanding principal amount. The total stated principal amount of the
bonds is $20 million. The issue price of the bonds $20,060,000.
(ii) Computation. The yield on the issue is computed by treating the
bonds as retired at the stated maturity under the general rule of
Sec. 1.148-4(b)(1). The bonds are treated as redeemed for their stated
redemption prices. The yield on the issue is 5.8731 percent per year
compounded semiannually, computed as follows:
[[Page 673]]
------------------------------------------------------------------------
PV (5.8731
Date Payments percent)
------------------------------------------------------------------------
1/1/1995..................................... $1,200,000 $1,132,510
1/1/1996..................................... 1,200,000 1,068,816
1/1/1997..................................... 1,200,000 1,008,704
1/1/1998..................................... 1,200,000 951,973
1/1/1999..................................... 1,200,000 898,433
1/1/2000..................................... 1,200,000 847,903
1/1/2001..................................... 1,200,000 800,216
1/1/2002..................................... 1,200,000 755,210
1/1/2003..................................... 1,200,000 712,736
1/1/2004..................................... 21,200,000 11,883,498
-------------
20,060,000
------------------------------------------------------------------------
Example 2. Mandatory calls. (i) Facts. The facts are the same as in
Example 1. In this case, however, the bonds are subject to mandatory
sinking fund redemption on January 1 of each year, beginning January 1,
2001. On each sinking fund redemption date, one of the bonds is chosen
by lottery and is required to be redeemed at par plus accrued interest.
(ii) Computation. Because the bonds are subject to specified
redemptions, yield on the issue is computed by treating the bonds as
redeemed in accordance with the redemption schedule under Sec. 1.148-
4(b)(2)(ii). Because the bonds are not sold at a discount, the bonds are
treated as retired at their stated redemption prices. The yield on the
issue is 5.8678 percent per year compounded semiannually, computed as
follows:
------------------------------------------------------------------------
PV (5.8678
Date Payments percent)
------------------------------------------------------------------------
1/1/1995..................................... $1,200,000 $1,132,569
1/1/1996..................................... 1,200,000 1,068,926
1/1/1997..................................... 1,200,000 1,008,860
1/1/1998..................................... 1,200,000 952,169
1/1/1999..................................... 1,200,000 898,664
1/1/2000..................................... 1,200,000 848,166
1/1/2001..................................... 6,200,000 4,135,942
1/1/2002..................................... 5,900,000 3,714,650
1/1/2003..................................... 5,600,000 3,327,647
1/1/2004..................................... 5,300,000 2,972,407
-------------
$20,060,000
------------------------------------------------------------------------
Example 3. Optional early call. (i) Facts. On January 1, 1994, City
C issues an issue consisting of three bonds. Each bond has a stated
principal amount of $10 million dollars and is issued for par. Bond X
bears interest at 5 percent per year and matures on January 1, 1999.
BondY bears interest at 6 percent per year and matures on January 1,
2002. Bond Z bears interest at 7 percent per year and matures on January
1, 2004. Bonds Y and Z are callable by the issuer at par plus accrued
interest after December 31, 1998.
(ii) Computation. (A) The yield on the issue computed as if each
bond is outstanding to its maturity is 6.0834 percent per year
compounded semiannually, computed as follows:
------------------------------------------------------------------------
PV (6.0834
Date Payments percent)
------------------------------------------------------------------------
1/1/1995..................................... $1,800,000 $1,695,299
1/1/1996..................................... 1,800,000 1,596,689
1/1/1997..................................... 1,800,000 1,503,814
1/1/1998..................................... 1,800,000 1,416,342
1/1/1999..................................... 11,800,000 8,744,830
1/1/2000..................................... 1,300,000 907,374
1/1/2001..................................... 1,300,000 854,595
1/1/2002..................................... 11,300,000 6,996,316
1/1/2003..................................... 700,000 408,190
1/1/2004..................................... 10,700,000 5,876,551
-------------
30,000,000
------------------------------------------------------------------------
(B) The yield on the issue computed as if all bonds are called at
the earliest date for redemption is 5.9126 percent per year compounded
semiannually, computed as follows:
------------------------------------------------------------------------
PV (5.9126
Date Payments percent)
------------------------------------------------------------------------
1/1/1995..................................... $1,800,000 $1,698,113
1/1/1996..................................... 1,800,000 1,601,994
1/1/1997..................................... 1,800,000 1,511,315
1/1/1998..................................... 1,800,000 1,425,769
1/1/1999..................................... 31,800,000 23,762,809
-------------
30,000,000
------------------------------------------------------------------------
(C) Because the yield on the issue computed by assuming all bonds in
the issue subject to redemption within 5 years of the issue date are
redeemed at maturity is more than one-eighth of one percentage point
higher than the yield on the issue computed by assuming all bonds
subject to optional redemption within 5 years of the issue date are
redeemed at the earliest date for their redemption, each bond is treated
as redeemed on the date that would produce the lowest yield for the
issue. The lowest yield on the issue would result from a redemption of
all the bonds on January 1, 1999. Thus, the yield on the issue is 5.9126
percent per year compounded semiannually.
(c) Computing yield on a variable yield issue--(1) In general. The
yield on a variable yield issue is computed separately for each
computation period. The yield for each computation period is the
discount rate that, when used in computing the present value as of the
first day of the computation period of all the payments of principal and
interest and fees for qualified guarantees that are attributable to the
computation period, produces an amount equal to the present value, using
the same discount rate, of the aggregate issue price (or deemed issue
price, as determined in paragraph (c)(2)(iv) of this section) of the
bonds of the issue as of the first day of the computation period. The
yield on a variable yield bond
[[Page 674]]
is computed in the same manner as the yield on a variable yield issue.
Except as provided in paragraph (c)(2) of this section, yield on any
fixed yield bond in a variable yield issue is computed in the same
manner as the yield on a fixed yield issue as provided in paragraph (b)
of this section.
(2) Payments on bonds included in yield for a computation period--
(i) Payments in general. The payments on a bond that are attributable to
a computation period include any amounts actually paid during the period
for principal on the bond. Payments also include any amounts paid during
the current period both for interest accruing on the bond during the
current period and for interest accruing during the prior period that
was included in the deemed issue price of the bond as accrued unpaid
interest at the start of the current period under this paragraph (c)(2).
Further, payments include any amounts properly allocable to fees for a
qualified guarantee of the bond for the period and to any amounts
properly allocable to a qualified hedge for the period.
(ii) Payments at actual redemption. If a bond is actually redeemed
during a computation period, an amount equal to the greater of its value
on the redemption date or the actual redemption price is a payment on
the actual redemption date.
(iii) Payments for bonds outstanding at end of computation period.
If a bond is outstanding at the end of a computation period, a payment
equal to the bond's value is taken into account on the last day of that
period.
(iv) Issue price for bonds outstanding at beginning of next
computation period. A bond outstanding at the end of a computation
period is treated as if it were immediately reissued on the next day for
a deemed issue price equal to the value from the day before as
determined under paragraph (c)(2)(iii) of this section.
(3) Example. The provisions of this paragraph (c) may be illustrated
by the following example.
Example. On January 1, 1994, City A issues an issue of identical
plain par bonds in an aggregate principal amount of $1,000,000. The
bonds pay interest at a variable rate on each June 1 throughout the term
of the issue. The entire principal amount of the bonds plus accrued,
unpaid interest is payable on the final maturity date of January 1,
2000. No bond year is selected. On June 1, 1994, 1995, 1996, 1997, and
1998, interest in the amounts of $30,000, $55,000, $57,000, $56,000, and
$45,000 is paid on the bonds. From June 1, 1998, to January 1, 1999,
$30,000 of interest accrues on the bonds. From January 1, 1999, to June
1, 1999, another $35,000 of interest accrues. On June 1, 1999, the
issuer actually pays $65,000 of interest. On January 1, 2000, $1,000,000
of principal and $38,000 of accrued interest are paid. The payments for
the computation period starting on the issue date and ending on January
1, 1999, include all annual interest payments paid from the issue date
to June 1, 1998. Because the issue is outstanding on January 1, 1999, it
is treated as redeemed on that date for amount equal to its value
($1,000,000 plus accrued, unpaid interest of $30,000 under paragraph
(e)(1) of this section). Thus, $1,030,000 is treated as paid on January
1, 1999. The issue is then treated as reissued on January 1, 1999, for
$1,030,000. The payments for the next computation period starting on
January 1, 1999, and ending on January 1, 2000, include the interest
actually paid on the bonds during that period ($65,000 on June 1, 1999,
plus $38,000 paid on January 1, 2000). Because the issue was actually
redeemed on January 1, 2000, an amount equal to its stated redemption
price is also treated as paid on January 1, 2000.
(d) Conversion from variable yield issue to fixed yield issue. For
purposes of determining yield under this section, as of the first day on
which a variable yield issue would qualify as a fixed yield issue if it
were newly issued on that date (a conversion date), that issue is
treated as if it were reissued as a fixed yield issue on the conversion
date. The redemption price of the variable yield issue and the issue
price of the fixed yield issue equal the aggregate values of all the
bonds on the conversion date. Thus, for example, for plain par bonds
(e.g., tender bonds), the deemed issue price would be the outstanding
principal amount, plus accrued unpaid interest. If the conversion date
occurs on a date other than a computation date, the issuer may continue
to treat the issue as a variable yield issue until the next computation
date, at which time it must be treated as converted to a fixed yield
issue.
(e) Value of bonds--(1) Plain par bonds. Except as otherwise
provided, the value of a plain par bond is its outstanding stated
principal amount, plus accrued unpaid interest. The value of a plain
[[Page 675]]
par bond that is actually redeemed or treated as redeemed is its stated
redemption price on the redemption date, plus accrued, unpaid interest.
(2) Other bonds. The value of a bond other than a plain par bond on
a date is its present value on that date. The present value of a bond is
computed under the economic accrual method taking into account all the
unconditionally payable payments of principal, interest, and fees for a
qualified guarantee to be paid on or after that date and using the yield
on the bond as the discount rate, except that for purposes of
Sec. 1.148-6(b)(2) (relating to the universal cap), these values may be
determined by consistently using the yield on the issue of which the
bonds are a part. To determine yield on fixed yield bonds, see paragraph
(b)(1) of this section. The rules contained in paragraphs (b)(2) and
(b)(3) of this section apply for this purpose. In the case of bonds
described in paragraph (b)(2)(ii) of this section, the present value of
those bonds on any date is computed using the yield to the final
maturity date of those bonds as the discount rate. In determining the
present value of a variable yield bond under this paragraph (e)(2), the
initial interest rate on the bond established by the interest index or
other interest rate setting mechanism is used to determine the interest
payments on that bond.
(f) Qualified guarantees--(1) In general. Fees properly allocable to
payments for a qualified guarantee for an issue (as determined under
paragraph (f)(6) of this section) are treated as additional interest on
that issue under section 148. A guarantee is a qualified guarantee if it
satisfies each of the requirements of paragraphs (f)(2) through (f)(4)
of this section.
(2) Interest savings. As of the date the guarantee is obtained, the
issuer must reasonably expect that the present value of the fees for the
guarantee will be less than the present value of the expected interest
savings on the issue as a result of the guarantee. For this purpose,
present value is computed using the yield on the issue, determined with
regard to guarantee payments, as the discount rate.
(3) Guarantee in substance. The arrangement must create a guarantee
in substance. The arrangement must impose a secondary liability that
unconditionally shifts substantially all of the credit risk for all or
part of the payments, such as payments for principal and interest,
redemption prices, or tender prices, on the guaranteed bonds. Reasonable
procedural or administrative requirements of the guarantee do not cause
the guarantee to be conditional. In the case of a guarantee against
failure to remarket a qualified tender bond, commercially reasonable
limitations based on credit risk, such as limitations on payment in the
event of default by the primary obligor or the bankruptcy of a long-term
credit guarantor, do not cause the guarantee to be conditional. The
guarantee may be in any form. The guarantor may not be a co-obligor.
Thus, the guarantor must not expect to make any payments other than
under a direct-pay letter of credit or similar arrangement for which the
guarantor will be reimbursed immediately. The guarantor and any related
parties together must not use more than 10 percent of the proceeds of
the portion of the issue allocable to the guaranteed bonds.
(4) Reasonable charge--(i) In general. Fees for a guarantee must not
exceed a reasonable, arm's-length charge for the transfer of credit
risk. In complying with this requirement, the issuer may not rely on the
representations of the guarantor.
(ii) Fees for services other than transfer of credit risk must be
separately stated. A fee for a guarantee must not include any payment
for any direct or indirect services other than the transfer of credit
risk, unless the compensation for those other services is separately
stated, reasonable, and excluded from the guarantee fee. Fees for the
transfer of credit risk include fees for the guarantor's overhead and
other costs relating to the transfer of credit risk. For example, a fee
includes payment for services other than transfer of credit risk if--
(A) It includes payment for the cost of underwriting or remarketing
bonds or for the cost of insurance for casualty to bond-financed
property;
(B) It is refundable upon redemption of the guaranteed bond before
the final maturity date and the amount of the
[[Page 676]]
refund would exceed the portion of the fee that had not been earned; or
(C) The requirements of Sec. 1.148-2(e)(2) (relating to temporary
periods for capital projects) are not satisfied, and the guarantor is
not reasonably assured that the bonds will be repaid if the project to
be financed is not completed.
(5) Guarantee of purpose investments. Except for guarantees of
qualified mortgage loans and qualified student loans, a guarantee of
payments on a purpose investment is a qualified guarantee of the issue
if all payments on the purpose investment reasonably coincide with
payments on the related bonds and the payments on the purpose investment
are unconditionally payable no more than 6 months before the
corresponding interest payment and 12 months before the corresponding
principal payments on the bonds. This paragraph (f)(5) only applies if,
in addition to satisfying the other requirements of this paragraph (f),
the guarantee is, in substance, a guarantee of the bonds allocable to
that purpose investment and to no other bonds except for bonds that are
equally and ratably secured by purpose investments of the same conduit
borrower.
(6) Allocation of qualified guarantee payments--(i) In general.
Payments for a qualified guarantee must be allocated to bonds and to
computation periods in a manner that properly reflects the proportionate
credit risk for which the guarantor is compensated. Proportionate credit
risk for bonds that are not substantially identical may be determined
using any reasonable, consistently applied method. For example, this
risk may be based on the ratio of the total principal and interest paid
and to be paid on a guaranteed bond to the total principal and interest
paid and to be paid on all bonds of the guaranteed issue. An allocation
method generally is not reasonable, for example, if a substantial
portion of the fee is allocated to the construction portion of the issue
and a correspondingly insubstantial portion is allocated to the later
years covered by the guarantee. Reasonable letter of credit set up fees
may be allocated ratably during the initial term of the letter of
credit. Upon an early redemption of a variable yield bond, fees
otherwise allocable to the period after the redemption are allocated to
remaining outstanding bonds of the issue or, if none remain outstanding,
to the period before the redemption.
(ii) Safe harbor for allocation of qualified guarantee fees for
variable yield issues. An allocation of non-level payments for a
qualified guarantee for variable yield bonds is treated as meeting the
requirements of paragraph (f)(6)(i) of this section if, for each bond
year for which the guarantee is in effect, an equal amount (or for any
short bond year, a proportionate amount of the equal amount) is treated
as paid as of the beginning of that bond year. The present value of the
annual amounts must equal the fee for the guarantee allocated to that
bond, with present value computed as of the first day the guarantee is
in effect by using as the discount rate the yield on the variable yield
bonds covered by the guarantee, determined without regard to any fee
allocated under this paragraph (f)(6)(ii).
(7) Refund or reduction of guarantee payments. If as a result of an
investment of proceeds of a refunding issue in a refunding escrow, there
will be a reduction in, or refund of, payments for a guarantee
(savings), the savings must be treated as a reduction in the payments on
the refunding issue.
(g) Yield on certain mortgage revenue and student loan bonds. For
purposes of section 148 and this section, section 143(g)(2)(C)(ii)
applies to the computation of yield on an issue of qualified mortgage
bonds or qualified veterans' mortgage bonds. For purposes of applying
section 148 and section 143(g) with respect to purpose investments
allocable to a variable yield issue of qualified mortgage bonds,
qualified veterans' mortgage bonds, or qualified student loan bonds that
is reasonably expected as of the issue date to convert to a fixed yield
issue, the yield may be computed over the term of the issue, and, if the
yield is so computed, paragraph (d) of this section does not apply to
the issue. As of any date, the yield over the term of the issue is based
on--
(1) With respect to any bond of the issue that has not converted to
a fixed and determinable yield on or before that date, the actual
amounts paid or
[[Page 677]]
received to that date and the amounts that are reasonably expected (as
of that date) to be paid or received with respect to that bond over the
remaining term of the issue (taking into account prepayment assumptions
under section 143(g)(2)(B)(iv), if applicable); and
(2) With respect to any bond of the issue that has converted to a
fixed and determinable yield on or before that date, the actual amounts
paid or received before that bond converted, if any, and the amount that
was reasonably expected (on the date that bond converted) to be paid or
received with respect to that bond over the remaining term of the issue
(taking into account prepayment assumptions under section
143(g)(2)(B)(iv), if applicable).
(h) Qualified hedging transactions--(1) In general. Payments made or
received by an issuer under a qualified hedge (as defined in paragraph
(h)(2) of this section) relating to bonds of an issue are taken into
account (as provided in paragraph (h)(3) of this section) to determine
the yield on the issue. Except as provided in paragraphs (h)(4) and
(h)(5)(ii)(E) of this section, the bonds to which a qualified hedge
relates are treated as variable yield bonds from the issue date of the
bonds. This paragraph (h) applies solely for purposes of sections
143(g), 148, and 149(d).
(2) Qualified hedge defined. Except as provided in paragraph (h)(5)
of this section, the term qualified hedge means a contract that
satisfies each of the following requirements:
(i) Hedge--(A) In general. The contract is entered into primarily to
modify the issuer's risk of interest rate changes with respect to a bond
(a hedge). For example, the contract may be an interest rate swap, an
interest rate cap, a futures contract, a forward contract, or an option.
(B) Special rule for fixed rate issues. If the contract modifies the
issuer's risk of interest rate changes with respect to a bond that is
part of an issue that, absent the contract, would be a fixed rate issue,
the contract must be entered into--
(1) No later than 15 days after the issue date (or the deemed issue
date under paragraph (d) of this section) of the issue; or
(2) No later than the expiration of a qualified hedge with respect
to bonds of that issue that satisfies paragraph (h)(2)(i)(B)(1) of this
section; or
(3) No later than the expiration of a qualified hedge with respect
to bonds of that issue that satisfies either paragraph (h)(2)(i)(B)(2)
of this section or this paragraph (h)(2)(i)(B)(3).
(C) Contracts with certain acquisition payments. If a hedge provider
makes a single payment to the issuer (e.g., a payment for an off-market
swap) in connection with the acquisition of a contract, the issuer may
treat a portion of that contract as a hedge provided--
(1) The hedge provider's payment to the issuer and the issuer's
payments under the contract in excess of those that it would make if the
contract bore rates equal to the on-market rates for the contract
(determined as of the date the parties enter into the contract) are
separately identified in a certification of the hedge provider; and
(2) The payments described in paragraph (h)(2)(i)(C)(1) of this
section are not treated as payments on the hedge.
(ii) No significant investment element--(A) In general. The contract
does not contain a significant investment element. Except as provided in
paragraph (h)(2)(ii)(B) of this section, a contract contains a
significant investment element if a significant portion of any payment
by one party relates to a conditional or unconditional obligation by the
other party to make a payment on a different date. Examples of contracts
that contain a significant investment element are a debt instrument held
by the issuer; an interest rate swap requiring any payments other than
periodic payments, within the meaning of Sec. 1.446-3 (periodic
payments) (e.g., a payment for an off-market swap or prepayment of part
or all of one leg of a swap); and an interest rate cap requiring the
issuer's premium for the cap to be paid in a single, up-front payment.
(B) Special level payment rule for interest rate caps. An interest
rate cap does not contain a significant investment element if--
(1) All payments to the issuer by the hedge provider are periodic
payments;
(2) The issuer makes payments for the cap at the same time as
periodic
[[Page 678]]
payments by the hedge provider must be made if the specified index
(within the meaning of Sec. 1.446-3) of the cap is above the strike
price of the cap; and
(3) Each payment by the issuer bears the same ratio to the notional
principal amount (within the meaning of Sec. 1.446-3) that is used to
compute the hedge provider's payment, if any, on that date.
(iii) Parties. The contract is entered into between the issuer or
the political subdivision on behalf of which the issuer issues the bonds
(collectively referred to in this paragraph (h) as the issuer) and a
provider that is not a related party (the hedge provider).
(iv) Hedged bonds. The contract covers, in whole or in part, all of
one or more groups of substantially identical bonds in the issue (i.e.,
all of the bonds having the same interest rate, maturity, and terms).
Thus, for example, a qualified hedge may include a hedge of all or a pro
rata portion of each interest payment on the variable rate bonds in an
issue for the first 5 years following their issuance. For purposes of
this paragraph (h), unless the context clearly requires otherwise,
hedged bonds means the specific bonds or portions thereof covered by a
hedge.
(v) Interest based contract. The contract is primarily interest
based. A contract is not primarily interest based unless--
(A) The hedged bond, without regard to the contract, is either a
fixed rate bond, a variable rate debt instrument within the meaning of
Sec. 1.1275-5 provided the rate is not based on an objective rate other
than a qualified inverse floating rate or a qualified inflation rate, a
tax-exempt obligation described in Sec. 1.1275-4(d)(2), or an inflation-
indexed debt instrument within the meaning of Sec. 1.1275-7; and
(B) As a result of treating all payments on (and receipts from) the
contract as additional payments on (and receipts from) the hedged bond,
the resulting bond would be substantially similar to either a fixed rate
bond, a variable rate debt instrument within the meaning of Sec. 1.1275-
5 provided the rate is not based on an objective rate other than a
qualified inverse floating rate or a qualified inflation rate, a tax-
exempt obligation described in Sec. 1.1275-4(d)(2), or an inflation-
indexed debt instrument within the meaning of Sec. 1.1275-7. For this
purpose, differences that would not prevent the resulting bond from
being substantially similar to another type of bond include a difference
between the index used to compute payments on the hedged bond and the
index used to compute payments on the hedge where one index is
substantially the same, but not identical to, the other; the difference
resulting from the payment of a fixed premium for a cap (e.g., payments
for a cap that are made in other than level installments); and the
difference resulting from the allocation of a termination payment where
the termination was not expected as of the date the contract was entered
into.
(vi) Payments closely correspond. The payments received by the
issuer from the hedge provider under the contract correspond closely in
time to either the specific payments being hedged on the hedged bonds or
specific payments required to be made pursuant to the bond documents,
regardless of the hedge, to a sinking fund, debt service fund, or
similar fund maintained for the issue of which the hedged bond is a
part.
(vii) Source of payments. Payments to the hedge provider are
reasonably expected to be made from the same source of funds that,
absent the hedge, would be reasonably expected to be used to pay
principal and interest on the hedged bonds.
(viii) Identification. The contract must be identified by the actual
issuer on its books and records maintained for the hedged bonds not
later than 3 days after the date on which the issuer and the hedge
provider enter into the contract. The identification must specify the
hedge provider, the terms of the contract, and the hedged bonds. The
identification must contain sufficient detail to establish that the
requirements of this paragraph (h)(2) and, if applicable, paragraph
(h)(4) of this section are satisfied. In addition, the existence of the
hedge must be noted on the first form relating to the issue of which the
hedged bonds are a part that is filed with the Internal Revenue Service
on or after the date on which the contract is identified pursuant to
this paragraph (h)(2)(viii).
[[Page 679]]
(3) Accounting for qualified hedges--(i) In general. Except as
otherwise provided in paragraph (h)(4) of this section, payments made or
received by the issuer under a qualified hedge are treated as payments
made or received, as appropriate, on the hedged bonds that are taken
into account in determining the yield on those bonds. These payments are
reasonably allocated to the hedged bonds in the period to which the
payments relate, as determined under paragraph (h)(3)(iii) of this
section. Payments made or received by the issuer include payments deemed
made or received when a contract is terminated or deemed terminated
under this paragraph (h)(3). Payments reasonably allocable to the
modification of risk of interest rate changes and to the hedge
provider's overhead under this paragraph (h) are included as payments
made or received under a qualified hedge.
(ii) Exclusions from hedge. If any payment for services or other
items under the contract is not expressly treated by paragraph (h)(3)(i)
of this section as a payment under the qualified hedge, the payment is
not a payment with respect to a qualified hedge.
(iii) Timing and allocation of payments. Except as provided in
paragraphs (h)(3)(iv) and (h)(5) of this section, payments made or
received by the issuer under a qualified hedge are taken into account in
the same period in which those amounts would be treated as income or
deductions under Sec. 1.446-4 (without regard to Sec. 1.446-4(a)(2)(iv))
and are adjusted as necessary to reflect the end of a computation period
and the start of a new computation period.
(iv) Termination payments--(A) Termination defined. A termination of
a qualified hedge includes any sale or other disposition of the hedge by
the issuer or the acquisition by the issuer of an offsetting hedge. A
deemed termination occurs when the hedged bonds are redeemed or when a
hedge ceases to be a qualified hedge of the hedged bonds. In the case of
an assignment by a hedge provider of its remaining rights and
obligations under the hedge to a third party or a modification of the
hedging contract, the assignment or modification is treated as a
termination with respect to the issuer only if it results in a deemed
exchange of the hedge and a realization event under section 1001 to the
issuer.
(B) General rule. A payment made or received by an issuer to
terminate a qualified hedge, including loss or gain realized or deemed
realized, is treated as a payment made or received on the hedged bonds,
as appropriate. The payment is reasonably allocated to the remaining
periods originally covered by the terminated hedge in a manner that
reflects the economic substance of the hedge.
(C) Special rule for terminations when bonds are redeemed. Except as
otherwise provided in this paragraph (h)(3)(iv)(C) and in paragraph
(h)(3)(iv)(D) of this section, when a qualified hedge is deemed
terminated because the hedged bonds are redeemed, the fair market value
of the qualified hedge on the redemption date is treated as a
termination payment made or received on that date. When hedged bonds are
redeemed, any payment received by the issuer on termination of a hedge,
including a termination payment or a deemed termination payment,
reduces, but not below zero, the interest payments made by the issuer on
the hedged bonds in the computation period ending on the termination
date. The remainder of the payment, if any, is reasonably allocated over
the bond years in the immediately preceding computation period or
periods to the extent necessary to eliminate the excess.
(D) Special rules for refundings. To the extent that the hedged
bonds are redeemed using the proceeds of a refunding issue, the
termination payment is accounted for under paragraph (h)(3)(iv)(B) of
this section by treating it as a payment on the refunding issue, rather
than the hedged bonds. In addition, to the extent that the refunding
issue is redeemed during the period to which the termination payment has
been allocated to that issue, paragraph (h)(3)(iv)(C) of this section
applies to the termination payment by treating it as a payment on the
redeemed refunding issue.
(E) Safe harbor for allocation of certain termination payments. A
payment to terminate a qualified hedge does not result in that hedge
failing to satisfy the
[[Page 680]]
applicable provisions of paragraph (h)(3)(iv)(B) of this section if the
payment is allocated in accordance with this paragraph (h)(3)(iv)(E).
For an issue that is a variable yield issue after termination of a
qualified hedge, an amount must be allocated to each date on which the
hedge provider's payment, if any, would have been made had the hedge not
been terminated. The amounts allocated to each date must bear the same
ratio to the notional principal amount (within the meaning of
Sec. 1.446-3) that would have been used to compute the hedge provider's
payment, if any, on that date, and the sum of the present values of
those amounts must equal the present value of the termination payment.
Present value is computed as of the day the qualified hedge is
terminated, using the yield on the hedged bonds, determined without
regard to the termination payment. The yield used for this purpose is
computed for the period beginning on the first date the qualified hedge
is in effect and ending on the date the qualified hedge is terminated.
On the other hand, for an issue that is a fixed yield issue after
termination of a qualified hedge, the termination payment is taken into
account as a single payment on the date it is paid.
(4) Certain variable yield bonds treated as fixed yield bonds--(i)
In general. Except as otherwise provided in this paragraph (h)(4), if
the issuer of variable yield bonds enters into a qualified hedge, the
hedged bonds are treated as fixed yield bonds paying a fixed interest
rate if:
(A) Maturity. The term of the hedge is equal to the entire period
during which the hedged bonds bear interest at variable interest rates,
and the issuer does not reasonably expect that the hedge will be
terminated before the end of that period.
(B) Payments closely correspond. Payments to be received under the
hedge correspond closely in time to the hedged portion of payments on
the hedged bonds. Hedge payments received within 15 days of the related
payments on the hedged bonds generally so correspond.
(C) Aggregate payments fixed. Taking into account all payments made
and received under the hedge and all payments on the hedged bonds (i.e.,
after netting all payments), the issuer's aggregate payments are fixed
and determinable as of a date not later than 15 days after the issue
date of the hedged bonds. Payments on bonds are treated as fixed for
purposes of this paragraph (h)(4)(i)(C) if payments on the bonds are
based, in whole or in part, on one interest rate, payments on the hedge
are based, in whole or in part, on a second interest rate that is
substantially the same as, but not identical to, the first interest rate
and payments on the bonds would be fixed if the two rates were
identical. Rates are treated as substantially the same if they are
reasonably expected to be substantially the same throughout the term of
the hedge. For example, an objective 30-day tax-exempt variable rate
index or other objective index may be substantially the same as an
issuer's individual 30-day interest rate.
(ii) Accounting. Except as otherwise provided in this paragraph
(h)(4)(ii), in determining yield on the hedged bonds, all the issuer's
payments on the hedged bonds and all payments made and received on a
hedge described in paragraph (h)(4)(i) of this section are taken into
account. If payments on the bonds and payments on the hedge are based,
in whole or in part, on variable interest rates that are substantially
the same within the meaning of paragraph (h)(4)(i)(C) of this section
(but not identical), yield on the issue is determined by treating the
variable interest rates as identical. For example, if variable rate
bonds bearing interest at a weekly rate equal to the rate necessary to
remarket the bonds at par are hedged with an interest rate swap under
which the issuer receives payments based on a short-term floating rate
index that is substantially the same as, but not identical to, the
weekly rate on the bonds, the interest payments on the bonds are treated
as equal to the payments received by the issuer under the swap for
purposes of computing the yield on the bonds.
(iii) Effect of termination--(A) In general. Except as otherwise
provided in this paragraph (h)(4)(iii) and paragraph (h)(5) of this
section, the issue of which the hedged bonds are a part is treated
[[Page 681]]
as if it were reissued as of the termination date of the qualified hedge
covered by paragraph (h)(4)(i) of this section in determining yield on
the hedged bonds for purposes of Sec. 1.148-3. The redemption price of
the retired issue and the issue price of the new issue equal the
aggregate values of all the bonds of the issue on the termination date.
In computing the yield on the new issue for this purpose, any
termination payment is accounted for under paragraph (h)(3)(iv) of this
section, applied by treating the termination payment as made or received
on the new issue under this paragraph (h)(4)(iii).
(B) Effect of early termination. Except as otherwise provided in
this paragraph (h)(4)(iii), the general rules of paragraph (h)(4)(i) of
this section do not apply in determining the yield on the hedged bonds
for purposes of Sec. 1.148-3 if the hedge is terminated or deemed
terminated within 5 years after the issue date of the issue of which the
hedged bonds are a part. Thus, the hedged bonds are treated as variable
yield bonds for purposes of Sec. 1.148-3 from the issue date.
(C) Certain terminations disregarded. This paragraph (h)(4)(iii)
does not apply to a termination if, based on the facts and circumstances
(e.g., taking into account both the termination and any qualified hedge
that immediately replaces the terminated hedge), there is no change in
the yield.
(5) Contracts entered into before issue date of hedged bond--(i) In
general. A contract does not fail to be a hedge under paragraph
(h)(2)(i) of this section solely because it is entered into before the
issue date of the hedged bond. However, that contract must be one to
which either paragraph (h)(5)(ii) or (h)(5)(iii) of this section
applies.
(ii) Contracts expected to be closed substantially contemporaneously
with the issue date of hedged bond--(A) Application. This paragraph
(h)(5)(ii) applies to a contract if, on the date the contract is
identified, the issuer reasonably expects to terminate or otherwise
close (terminate) the contract substantially contemporaneously with the
issue date of the hedged bond.
(B) Contract terminated. If a contract to which this paragraph
(h)(5)(ii) applies is terminated substantially contemporaneously with
the issue date of the hedged bond, the amount paid or received, or
deemed to be paid or received, by the issuer in connection with the
issuance of the hedged bond to terminate the contract is treated as an
adjustment to the issue price of the hedged bond and as an adjustment to
the sale proceeds of the hedged bond for purposes of section 148.
Amounts paid or received, or deemed to be paid or received, before the
issue date of the hedged bond are treated as paid or received on the
issue date in an amount equal to the future value of the payment or
receipt on that date. For this purpose, future value is computed using
yield on the hedged bond without taking into account amounts paid or
received (or deemed paid or received) on the contract.
(C) Contract not terminated. If a contract to which this paragraph
(h)(5)(ii) applies is not terminated substantially contemporaneously
with the issue date of the hedged bond, the contract is deemed
terminated for its fair market value as of the issue date of the hedged
bond. Once a contract has been deemed terminated pursuant to this
paragraph (h)(5)(ii)(C), payments on and receipts from the contract are
no longer taken into account under this paragraph (h) for purposes of
determining yield on the hedged bond.
(D) Relation to other requirements of a qualified hedge. Payments
made in connection with the issuance of a bond to terminate a contract
to which this paragraph (h)(5)(ii) applies do not prevent the contract
from satisfying the requirements of paragraph (h)(2)(vi) of this
section.
(E) Fixed yield treatment. A bond that is hedged with a contract to
which this paragraph (h)(5)(ii) applies does not fail to be a fixed
yield bond if, taking into account payments on the contract and the
payments to be made on the bond, the bond satisfies the definition of
fixed yield bond. See also paragraph (h)(4) of this section.
(iii) Contracts expected not to be closed substantially
contemporaneously with the issue date of hedged bond--(A) Application.
This paragraph (h)(5)(iii) applies to a contract if, on the date the
contract is identified, the issuer does not reasonably expect to
terminate the
[[Page 682]]
contract substantially contemporaneously with the issue date of the
hedge bond.
(B) Contract terminated. If a contract to which this paragraph
(h)(5)(iii) applies is terminated in connection with the issuance of the
hedged bond, the amount paid or received, or deemed to be paid or
received, by the issuer to terminate the contract is treated as an
adjustment to the issue price of the hedged bond and as an adjustment to
the sale proceeds of the hedged bond for purposes of section 148.
(C) Contract not terminated. If a contract to which this paragraph
(h)(5)(iii) applies is not terminated substantially contemporaneously
with the issue date of the hedged bond, no payments with respect to the
hedge made by the issuer before the issue date of the hedged bond are
taken into account under this section.
(iv) Identification. The identification required under paragraph
(h)(2)(viii) of this section must specify the reasonably expected
governmental purpose, issue price, maturity, and issue date of the
hedged bond, the manner in which interest is reasonably expected to be
computed, and whether paragraph (h)(5)(ii) or (h)(5)(iii) of this
section applies to the contract. If an issuer identifies a contract
under this paragraph (h)(5)(iv) that would be a qualified hedge with
respect to the anticipated bond, but does not issue the anticipated bond
on the identified issue date, the contract is taken into account as a
qualified hedge of any bond of the issuer that is issued for the
identified governmental purpose within a reasonable interval around the
identified issue date of the anticipated bond.
(6) Authority of the Commissioner. The Commissioner, by publication
of a revenue ruling or revenue procedure (see Sec. 601.601(d)(2) of this
chapter), may specify contracts that, although they do not meet the
requirements of paragraph (h)(2) of this section, are qualified hedges
or, although they do not meet the requirements of paragraph (h)(4) of
this section, cause the hedged bonds to be treated as fixed yield bonds.
[T.D. 8476, 58 FR 33524, June 18, 1993; 58 FR 44452, Aug. 23, 1993, as
amended by T.D. 8538, 59 FR 24042, May 10, 1994; T.D. 8718, 62 FR 25507,
May 9, 1997; T.D. 8838, 64 FR 48547, Sept. 7, 1999]