[4830-01-u]
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8709]
RIN  1545-AU44
Inflation-Indexed Debt Instruments
AGENCY:  Internal Revenue Service (IRS), Treasury.
ACTION:  Temporary and final regulations.
SUMMARY:  This document contains temporary regulations relating
to the federal income tax treatment of inflation-indexed debt
instruments, including Treasury Inflation-Indexed Securities. 
The text of the temporary regulations also serves as the text of
the proposed regulations set forth in the notice of proposed
rulemaking on this subject in the Proposed Rules section of this
issue of the Federal Register.  This document also contains
amendments to final regulations to reflect the addition of the
temporary regulations.  The regulations in this document provide
needed guidance to holders and issuers of inflation-indexed debt
instruments.
EFFECTIVE DATE:  The regulations are effective January 6, 1997.
FOR FURTHER INFORMATION CONTACT:  Jeffrey W. Maddrey, (202) 622-
3940, or William E. Blanchard, (202) 622-3950 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
     The Department of the Treasury published final rules
describing the terms and conditions of new debt instruments that
it plans to issue.  The payments on these debt instruments
(Treasury Inflation-Indexed Securities) will be indexed for
inflation and deflation.
     On June 14, 1996, the IRS published final regulations in the
Federal Register relating to certain debt instruments that
provide for contingent payments (61 FR 30133).  The preamble to
the final regulations indicates that the noncontingent bond
method described in 1.1275-4(b) might be inappropriate for the
Treasury Inflation-Indexed Securities.  On October 15, 1996, the
IRS published Notice 96-51 (1996-42 I.R.B. 6), which announced
the IRS's intention to issue temporary and proposed regulations
that would provide guidance on the federal income tax treatment
of the Treasury Inflation-Indexed Securities and other debt
instruments with similar terms.  This document contains the
temporary regulations described in Notice 96-51.
Explanation of provisions
A.  In general.
     The temporary regulations provide rules for the treatment of
certain debt instruments that are indexed for inflation and
deflation, including Treasury Inflation-Indexed Securities.  The
temporary regulations generally require holders and issuers of
inflation-indexed debt instruments to account for interest and
original issue discount (OID) using constant yield principles. 
In addition, the temporary regulations generally require holders
and issuers of inflation-indexed debt instruments to account for
inflation and deflation by making current adjustments to their
OID accruals.
B.  Applicability.
     The temporary regulations apply to inflation-indexed debt
instruments.  In general, an inflation-indexed debt instrument is
a debt instrument that (1) is issued for cash, (2) is indexed for
inflation and deflation (as described below), and (3) is not
otherwise a contingent payment debt instrument.  The temporary
regulations do not apply, however, to certain debt instruments,
such as debt instruments issued by qualified state tuition
programs.
C.  Indexing methodology.
       A debt instrument is considered indexed for inflation and
deflation if the payments on the instrument are indexed by
reference to the change in value of a general price or wage index
over the term of the instrument.  Specifically, the amount of
each payment on an inflation-indexed debt instrument must equal
the product of (1) the amount of the payment that would be
payable on the instrument (determined as if there were no
inflation or deflation over the term of the instrument) and (2)
the ratio of the value of the reference index for the payment
date to the value of the reference index for the issue date.
     The reference index for a debt instrument is the mechanism
for measuring inflation and deflation over the term of the
instrument.  This mechanism associates the value of a single
qualified inflation index for a particular month with a specified
day of a succeeding month.  For example, under the terms of the
Treasury Inflation-Indexed Securities, the reference index for
the first day of a month is the value of a qualified inflation
index for the third preceding month.  The reference index must be
reset once a month to the current value of a qualified inflation
index.  Between reset dates, the value of the reference index is
determined through straight-line interpolation.
     A qualified inflation index is a general price or wage index
that is updated and published at least monthly by an agency of
the United States Government.  A general price or wage index is
an index that measures price or wage changes in the economy as a
whole.  An index is not general if it only measures price or wage
changes in a particular segment of the economy.  For example, the
non-seasonally adjusted U.S. City Average All Items Consumer
Price Index for All Urban Consumers (CPI-U), which is published
by the Bureau of Labor Statistics of the Department of Labor, is
a qualified inflation index because it measures general price
changes in the economy.  By contrast, the gasoline price
component of the CPI-U is not a qualified inflation index because
it only measures price changes in a particular segment of the
economy.
D.  Coupon bond method.
     The temporary regulations provide a simplified method of
accounting for qualified stated interest and inflation
adjustments on certain inflation-indexed debt instruments (the
coupon bond method).  To qualify for the coupon bond method, an
inflation-indexed debt instrument must satisfy two conditions. 
First, there must be no more than a de minimis difference between
the debt instrument's issue price and its principal amount for
the issue date.  Second, all stated interest on the debt
instrument must be qualified stated interest.  Because Treasury
Inflation-Indexed Securities that are not stripped into principal
and interest components satisfy both of these conditions, the
coupon bond method applies to these securities.
     If an inflation-indexed debt instrument qualifies for the
coupon bond method, the stated interest payable on the debt
instrument is taken into account under the taxpayer's regular
method of accounting.  Any increase in the inflation-adjusted
principal amount is treated as OID for the period in which the
increase occurs.  Any decrease in the inflation-adjusted
principal amount is taken into account under the rules for
deflation adjustments described below.
     For example, if a taxpayer holds a Treasury Inflation-
Indexed Security for an entire calendar year and the taxpayer
uses the cash receipts and disbursements method of accounting
(cash method), the taxpayer generally includes in income the
interest payments received on the security during the year.  In
addition, the taxpayer includes in income an amount of OID
measured by subtracting the inflation-adjusted principal amount
of the security at the beginning of the year from the inflation-
adjusted principal amount of the security at the end of the year. 
If the taxpayer uses an accrual method of accounting rather than
the cash method, the taxpayer includes in income the qualified
stated interest that accrued on the debt instrument during the
year and an amount of OID measured by subtracting the inflation-
adjusted principal amount of the security at the beginning of the
year from the inflation-adjusted principal amount of the security
at the end of the year.
E.  Discount bond method.
     If an inflation-indexed debt instrument does not qualify for
the coupon bond method (for example, because it is issued at a
discount), the instrument is subject to the discount bond method. 
In general, the discount bond method requires holders and issuers
to make current adjustments to their OID accruals to account for
inflation and deflation.
     Under the discount bond method, a taxpayer determines the
amount of OID allocable to an accrual period by using steps
similar to those provided in 1.1272-1(b)(1).  First, the
taxpayer determines the yield to maturity of the debt instrument
as if there were no inflation or deflation over the term of the
instrument.  Second, the taxpayer determines the length of the
accrual periods to be used to allocate OID over the term of the
debt instrument, provided no accrual period is longer than one
month.  Third, the taxpayer determines the percentage change in
the value of the reference index during the accrual period by
comparing the value at the beginning of the period to the value
at the end of the period.  Fourth, the taxpayer determines the
OID allocable to the accrual period by using a formula that takes
into account both the yield of the debt instrument and the
percentage change in the value of the reference index during the
period.  Fifth, the taxpayer allocates to each day in the accrual
period a ratable portion of the OID for the accrual period (the
daily portions).  If the daily portions for an accrual period are
positive amounts, these amounts are taken into account under
section 163(e) by an issuer and under section 1272 by a holder. 
If the daily portions for an accrual period are negative amounts,
these amounts are taken into account under the rules for
deflation adjustments described below.
     Under Notice 96-51, the discount bond method would have
allowed qualified stated interest.  The temporary regulations,
however, provide that no interest payments on an inflation-
indexed debt instrument subject to the discount bond method are
qualified stated interest.  The Treasury and the IRS believe that
this change simplifies the taxation of an inflation-indexed debt
instrument subject to the discount bond method.
F.  Deflation adjustments.
     The temporary regulations treat deflation adjustments in a
manner consistent with the treatment of net negative adjustments
on contingent payment debt instruments under
1.1275-4(b)(6)(iii).  If a holder has a deflation adjustment for
a taxable year, the deflation adjustment first reduces the amount
of interest otherwise includible in income with respect to the
debt instrument for the taxable year.  If the amount of the
deflation adjustment exceeds the interest otherwise includible in
income for the taxable year, the holder treats the excess as an
ordinary loss in the taxable year.  However, the amount treated
as an ordinary loss is limited to the amount by which the
holder's total interest inclusions on the debt instrument in
prior taxable years exceed the total amount treated by the holder
as an ordinary loss on the debt instrument in prior taxable
years.  If the deflation adjustment exceeds the interest
otherwise includible in income by the holder with respect to the
debt instrument for the taxable year and the amount treated as an
ordinary loss for the taxable year, the excess is carried forward
to offset interest income on the debt instrument in subsequent
taxable years.  Similar rules apply to determine an issuer's
interest deductions and income for the debt instrument.
G.  Minimum guarantee.
     Certain inflation-indexed debt instruments may provide for
an additional payment at maturity (a minimum guarantee payment)
if the total amount of inflation-adjusted principal paid on the
debt instrument is less than the instrument's stated principal
amount.  Under both the coupon bond method and the discount bond
method, a minimum guarantee payment is ignored until the payment
is made.  If a minimum guarantee payment is made, the payment is
treated as interest on the date it is paid.
     In general, the temporary regulations only allow a debt
instrument that is indexed by reference to the CPI-U to provide
for a minimum guarantee payment.  The Treasury and the IRS
believe that there is only a small possibility that the total
amount of principal paid on a debt instrument indexed to the
CPI-U will be less than the instrument's stated principal amount. 
In this case, it is appropriate to ignore the minimum guarantee
payment until it is paid.
H.  Principal amount for the issue date.
     For purposes of the temporary regulations, if an inflation-
indexed debt instrument is issued with pre-issuance accrued
interest, the principal amount of the instrument for the issue
date includes an adjustment for inflation or deflation.  This
adjustment is measured by the change in the value of the
reference index between the date on which interest starts to
accrue (the dated date in the case of a Treasury Inflation-
Indexed Security) and the issue date.  The stated principal
amount of a debt instrument under the regulations, however, is
not adjusted for inflation or deflation between the date on which
interest starts to accrue and the issue date.  Therefore, the
stated principal amount of the debt instrument is the same
regardless of whether interest accrues on the instrument from the
issue date or from an earlier date.  The stated principal amount
of a Treasury Inflation-Indexed Security is the par amount of the
security, as defined in the final rules published by the Treasury
Department describing the terms and conditions of Treasury
Inflation-Indexed Securities.
     When there is a difference between the stated principal
amount of an inflation-indexed debt instrument and its principal
amount for the issue date, the instrument's principal amount for
the issue date generally is used for purposes of applying the
rules in the temporary regulations to the instrument.  For
example, the debt instrument's principal amount for the issue
date is used to determine whether the instrument qualifies for
the coupon bond method.  The temporary regulations require the
use of a debt instrument's stated principal amount rather than
its principal amount for the issue date to measure the amount of
a minimum guarantee payment.
I.  Strips.
     Treasury Inflation-Indexed Securities are eligible for the
Department of the Treasury's Separate Trading of Registered
Interest and Principal of Securities (STRIPS) program.  Under
this program, the interest and principal components of a Treasury
Inflation-Indexed Security may be transferred as separate
instruments (stripped bonds and coupons).  In general, section
1286 treats the holder of a stripped bond (or coupon) as if the
holder purchased a newly issued debt instrument that has OID. 
The temporary regulations provide that the holder of a component
of a Treasury Inflation-Indexed Security that is stripped under
the Treasury STRIPS program must use the discount bond method to
account for the OID on the component.
J.  Information reporting.
     The temporary regulations do not provide any new information
reporting rules for inflation-indexed debt instruments.  The OID
and any qualified stated interest on an inflation-indexed debt
instrument should be reported on Form 1099-OID.  The IRS plans to
issue guidance for the reporting of OID on Treasury Inflation-
Indexed Securities that are stripped under the STRIPS program.
K.  Effective date.
     The temporary regulations apply to an inflation-indexed debt
instrument issued on or after January 6, 1997.
Special Analyses
     It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866.  Therefore,
a regulatory assessment is not required.  It also has been
determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply to these regulations and,
because the regulations do not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply.  Pursuant to section 7805(f) of the
Internal Revenue Code, these temporary regulations will be
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 the regulations is Jeffrey W.
Maddrey, Office of Assistant Chief Counsel (Financial
Institutions and Products).  However, other personnel from the
IRS and Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
     Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
     Accordingly, 26 CFR part 1 is amended as follows:
Part 1--INCOME TAXES
     Paragraph 1.  The authority citation for part 1 is amended
by adding two entries in numerical order to read as follows:
     Authority:  26 U.S.C. 7805 * * *
Section 1.1275-7T also issued under 26 U.S.C. 1275(d).  * * *
Section 1.1286-2T also issued under 26 U.S.C. 1286(f).  * * *
     Par. 2.  Section 1.1271-0 is amended by--
     1.  Revising the second sentence of paragraph (a); 
     2.  Revising the introductory text of paragraph (b); and
     3.  Adding entries for 1.1275-7T in paragraph (b).
     The revisions and additions read as follows:
1.1271-0  Original issue discount; effective date; table of
contents.
     (a) * * * Taxpayers, however, may rely on these sections (as
contained in 26 CFR part 1 revised April 1, 1996) for debt
instruments issued after December 21, 1992, and before April 4,
1994.
     (b) Table of contents.  This section lists captioned
paragraphs contained in 1.1271-1 through 1.1275-7T.
* * * * *
1.1275-7T  Inflation-indexed debt instruments (temporary).

(a) Overview.
(b) Applicability.
(1) In general.
(2) Exceptions.
(c) Definitions.
(1) Inflation-indexed debt instrument.
(2) Reference index.
(3) Qualified inflation index.
(4) Inflation-adjusted principal amount.
(5) Minimum guarantee payment.
(d) Coupon bond method.
(1) In general.
(2) Applicability.
(3) Qualified stated interest.
(4) Inflation adjustments.
(5) Example.
(e) Discount bond method.
(1) In general.
(2) No qualified stated interest.
(3) OID.
(4) Example.
(f) Special rules.
(1) Deflation adjustments.
(2) Adjusted basis.
(3) Subsequent holders.
(4) Minimum guarantee.
(5) Temporary unavailability of a qualified inflation index.
(g) Reopenings.
(h) Effective date.

* * * * *

     Par. 3.  Section 1.1275-4 is amended by--
     1.  Removing the word "or" from the end of paragraph
(a)(2)(vi);
     2.  Redesignating paragraph (a)(2)(vii) as paragraph
(a)(2)(viii); and
     3.  Adding a new paragraph (a)(2)(vii).
     The addition reads as follows:
1.1275-4  Contingent payment debt instruments.
     (a) * * *
     (2) * * *
     (vii) An inflation-indexed debt instrument (as defined in
1.1275-7T); or
* * * * *
     Par. 4.  Section 1.1275-7T is added to read as follows:
1.1275-7T  Inflation-indexed debt instruments (temporary).
     (a) Overview.  This section provides rules for the federal
income tax treatment of an inflation-indexed debt instrument.  If
a debt instrument is an inflation-indexed debt instrument, one of
two methods will apply to the instrument:  the coupon bond method
(as described in paragraph (d) of this section) or the discount
bond method (as described in paragraph (e) of this section). 
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.
     (b) Applicability--(1) In general.  Except as provided in
paragraph (b)(2) of this section, this section applies to an
inflation-indexed debt instrument as defined in paragraph (c)(1)
of this section.  For example, this section applies to Treasury
Inflation-Indexed Securities. 
     (2) Exceptions.  This section does not apply to an
inflation-indexed debt instrument that is also--
     (i) A debt instrument (other than a tax-exempt obligation)
described in section 1272(a)(2) (for example, U.S. savings bonds,
certain loans between natural persons, and short-term taxable
obligations); or
     (ii) A debt instrument subject to section 529 (certain debt
instruments issued by qualified state tuition programs).  
     (c) Definitions.  The following definitions apply for
purposes of this section:
     (1) Inflation-indexed debt instrument.  An inflation-indexed
debt instrument is a debt instrument that satisfies the following
conditions:
     (i) Issued for cash.  The debt instrument is issued for U.S.
dollars and all payments on the instrument are denominated in
U.S. dollars.
     (ii) Indexed for inflation and deflation.  Except for a
minimum guarantee payment (as defined in paragraph (c)(5) of this
section), each payment on the debt instrument is indexed for
inflation and deflation.  A payment is indexed for inflation and
deflation if the amount of the payment is equal to--
     (A) The amount that would be payable if there were no
inflation or deflation over the term of the debt instrument,
multiplied by
     (B) A ratio, the numerator of which is the value of the
reference index for the date of the payment and the denominator
of which is the value of the reference index for the issue date.
     (iii) No other contingencies.  No payment on the debt
instrument is subject to a contingency other than the inflation
contingency or the contingencies described in this paragraph
(c)(1)(iii).  A debt instrument may provide for--
     (A) A minimum guarantee payment as defined in paragraph
(c)(5) of this section; or
     (B) Payments under one or more alternate payment schedules
if the payments under each payment schedule are indexed for
inflation and deflation and a payment schedule for the debt
instrument can be determined under 1.1272-1(c).  (For purposes
of this section, the rules of 1.1272-1(c) are applied to the
debt instrument by assuming that no inflation or deflation will
occur over the term of the instrument.)
     (2) Reference index.  The reference index is an index used
to measure inflation and deflation over the term of a debt
instrument.  To qualify as a reference index, an index must
satisfy the following conditions:
     (i) The value of the index is reset once a month to a
current value of a single qualified inflation index (as defined
in paragraph (c)(3) of this section).  For this purpose, a value
of a qualified inflation index is current if the value has been
updated and published within the preceding six month period.
     (ii) The reset occurs on the same day of each month (the
reset date).
     (iii) The value of the index for any date between reset
dates is determined through straight-line interpolation.
     (3) Qualified inflation index.  A qualified inflation index
is a general price or wage index that is updated and published at
least monthly by an agency of the United States Government (for
example, the non-seasonally adjusted U.S. City Average All Items
Consumer Price Index for All Urban Consumers (CPI-U), which is
published by the Bureau of Labor Statistics of the Department of
Labor).
     (4) Inflation-adjusted principal amount.  For any date, the
inflation-adjusted principal amount of an inflation-indexed debt
instrument is an amount equal to--
     (i) The outstanding principal amount of the debt instrument
(determined as if there were no inflation or deflation over the
term of the instrument), multiplied by
     (ii) A ratio, the numerator of which is the value of the
reference index for the date and the denominator of which is the
value of the reference index for the issue date.
     (5) Minimum guarantee payment.  In general, a minimum
guarantee payment is an additional payment made at maturity on a
debt instrument if the total amount of inflation-adjusted
principal paid on the instrument is less than the instrument's
stated principal amount.  The amount of the additional payment
must be no more than the excess, if any, of the debt instrument's
stated principal amount over the total amount of inflation-
adjusted principal paid on the instrument.  An additional payment
is not a minimum guarantee payment unless the qualified inflation
index used to determine the reference index is either the CPI-U
or an index designated for this purpose by the Commissioner in
the Federal Register or the Internal Revenue Bulletin (see
601.601(d)(2)(ii) of this chapter).  See paragraph (f)(4) of
this section for the treatment of a minimum guarantee payment.
     (d) Coupon bond method--(1) In general.  This paragraph (d)
describes the method (coupon bond method) to be used to account
for qualified stated interest and inflation adjustments (OID) on
an inflation-indexed debt instrument described in paragraph
(d)(2) of this section.
     (2) Applicability.  The coupon bond method applies to an
inflation-indexed debt instrument that satisfies the following
conditions:
     (i) Issued at par.  The debt instrument is issued at par.  A
debt instrument is issued at par if the difference between its
issue price and principal amount for the issue date is less than
the de minimis amount.  For this purpose, the de minimis amount
is determined using the principles of 1.1273-1(d).
     (ii) All stated interest is qualified stated interest.  All
stated interest on the debt instrument is qualified stated
interest.  For purposes of this paragraph (d), stated interest is
qualified stated interest if the interest is unconditionally
payable in cash, or is constructively received under section 451,
at least annually at a single fixed rate.  Stated interest is
payable at a single fixed rate if the amount of each interest
payment is determined by multiplying the inflation adjusted
principal amount for the payment date by the single fixed rate.
     (3) Qualified stated interest.  Under the coupon bond
method, qualified stated interest is taken into account under the
taxpayer's regular method of accounting.  The amount of accrued
but unpaid qualified stated interest as of any date is determined
by using the principles of 1.446-3(e)(2)(ii) (relating to
notional principal contracts).  For example, if the interval
between interest payment dates spans two taxable years, a
taxpayer using an accrual method of accounting determines the
amount of accrued qualified stated interest for the first taxable
year by reference to the inflation-adjusted principal amount at
the end of the first taxable year.
     (4) Inflation adjustments--(i) Current accrual.  Under the
coupon bond method, an inflation adjustment is taken into account
for each taxable year in which the debt instrument is
outstanding.
     (ii) Amount of inflation adjustment.  For any relevant
period (such as the taxable year or the portion of the taxable
year during which a taxpayer holds an inflation-indexed debt
instrument), the amount of the inflation adjustment is equal to--
     (A) The sum of the inflation-adjusted principal amount at
the end of the period and the principal payments made during the
period, minus
     (B) The inflation-adjusted principal amount at the beginning
of the period.
     (iii) Positive inflation adjustments.  A positive inflation
adjustment is OID.
     (iv) Negative inflation adjustments.  A negative inflation
adjustment is a deflation adjustment that is taken into account
under the rules of paragraph (f)(1) of this section. 
     (5) Example.  The following example illustrates the coupon
bond method:
     Example.  (i) Facts.  On October 15, 1997, X purchases at
original issue, for $100,000, a debt instrument that is indexed
for inflation and deflation.  The debt instrument matures on
October 15, 1999, has a stated principal amount of $100,000, and
has a stated interest rate of 5 percent, compounded semiannually. 
The debt instrument provides that the principal amount is indexed
to the CPI-U.  Interest is payable on April 15 and October 15 of
each year.  The amount of each interest payment is determined by
multiplying the inflation-adjusted principal amount for each
interest payment date by the stated interest rate, adjusted for
the length of the accrual period.  The debt instrument provides
for a single payment of the inflation-adjusted principal amount
at maturity.  In addition, the debt instrument provides for an
additional payment at maturity equal to the excess, if any, of
$100,000 over the inflation-adjusted principal amount at
maturity.  X uses the cash receipts and disbursements method of
accounting and the calendar year as its taxable year.

     (ii) Indexing methodology.  The debt instrument provides
that the inflation-adjusted principal amount for any day is
determined by multiplying the principal amount of the instrument
for the issue date by a ratio, the numerator of which is the
value of the reference index for the day the inflation-adjusted
principal amount is to be determined and the denominator of which
is the value of the reference index for the issue date.  The
value of the reference index for the first day of a month is the
value of the CPI-U for the third preceding month.  The value of
the reference index for any day other than the first day of a
month is determined based on a straight-line interpolation
between the value of the reference index for the first day of the
month and the value of the reference index for the first day of
the next month.

     (iii) Inflation-indexed debt instrument subject to the
coupon bond method.  Under paragraph (c)(1) of this section, the
debt instrument is an inflation-indexed debt instrument.  Because
there is no difference between the debt instrument's issue price
($100,000) and its principal amount for the issue date ($100,000)
and because all stated interest is qualified stated interest, the
coupon bond method applies to the instrument.  

     (iv) Reference index values.  Assume the following table
lists the relevant reference index values for 1997 through 1999:

          Date                     Reference index value
          October 15, 1997              100
          January 1, 1998               101
          April 15, 1998                103
          October 15, 1998              105
          January 1, 1999                99

     (v) Treatment of X in 1997.  X does not receive any payments
of interest on the debt instrument in 1997.  Therefore, X has no
qualified stated interest income for 1997.  X, however, must take
into account the inflation adjustment for 1997.  The inflation-
adjusted principal amount for January 1, 1998, is $101,000
($100,000 x 101/100).  Therefore, the inflation adjustment for
1997 is $1,000, the inflation-adjusted principal amount for
January 1, 1998 ($101,000) minus the principal amount for the
issue date ($100,000).  X includes the $1,000 inflation
adjustment in income as OID in 1997.

     (vi) Treatment of X in 1998.  In 1998, X receives two
payments of interest:  On April 15, 1998, X receives a payment of
$2,575 ($100,000 x 103/100 x .05/2), and on October 15, 1998, X
receives a payment of $2,625 ($100,000 x 105/100 x .05/2). 
Therefore, X's qualified stated interest income for 1998 is
$5,200 ($2,575 + $2,625).  X also must take into account the
inflation adjustment for 1998.  The inflation-adjusted principal
amount for January 1, 1999, is $99,000 ($100,000 x 99/100). 
Therefore, the inflation adjustment for 1998 is negative $2,000,
the inflation-adjusted principal amount for January 1, 1999
($99,000) minus the inflation-adjusted principal amount for
January 1, 1998 ($101,000).  Because the amount of the inflation
adjustment is negative, it is a deflation adjustment.  Under
paragraph (f)(1)(i) of this section, X uses this $2,000 deflation
adjustment to reduce the interest otherwise includible in income
by X with respect to the debt instrument in 1998.  Therefore, X
includes $3,200 in income for 1998, the qualified stated interest
income for 1998 ($5,200) minus the deflation adjustment ($2,000).

     (e) Discount bond method--(1) In general.  This paragraph
(e) describes the method (discount bond method) to be used to
account for OID on an inflation-indexed debt instrument that does
not qualify for the coupon bond method.
     (2) No qualified stated interest.  Under the discount bond
method, no interest on an inflation-indexed debt instrument is
qualified stated interest.
     (3) OID.  Under the discount bond method, the amount of OID
that accrues on an inflation-indexed debt instrument is
determined as follows:
     (i) Step one:  Determine the debt instrument's yield to
maturity.  The yield of the debt instrument is determined under
the rules of 1.1272-1(b)(1)(i).  In calculating the yield under
those rules for purposes of this paragraph (e)(3)(i), the payment
schedule of the debt instrument is determined as if there were no
inflation or deflation over the term of the instrument.
     (ii) Step two:  Determine the accrual periods.  The accrual
periods are determined under the rules of 1.1272-1(b)(1)(ii). 
However, no accrual period can be longer than 1 month.  
     (iii) Step three:  Determine the percentage change in the
reference index during the accrual period.  The percentage change
in the reference index during the accrual period is equal to--
     (A) The ratio of the value of the reference index at the end
of the period to the value of the reference index at the
beginning of the period,
     (B) Minus one.
     (iv) Step four:  Determine the OID allocable to each accrual
period.  The OID allocable to an accrual period (n) is determined
by using the following formula:
     OID(n) = AIP(n)   [r + inf(n) + (r   inf(n))]
     in which,
     r = yield of the debt instrument as determined under
     paragraph (e)(3)(i) of this section (adjusted for the length
     of the accrual period);
     inf(n) = percentage change in the value of the reference
     index for period (n) as determined under paragraph
     (e)(3)(iii) of this section; and
     AIP(n) = adjusted issue price at the beginning of period (n).
     (v) Step five:  Determine the daily portions of OID.  The
daily portions of OID are determined and taken into account under
the rules of 1.1272-1(b)(1)(iv).  If the daily portions
determined under this paragraph (e)(3)(v) are negative amounts,
however, these amounts (deflation adjustments) are taken into
account under the rules for deflation adjustments described in
paragraph (f)(1) of this section.
     (4) Example.  The following example illustrates the discount
bond method:
     Example.  (i) Facts.  On November 15, 1997, X purchases at
original issue, for $91,403, a zero-coupon debt instrument that
is indexed for inflation and deflation.  The principal amount of
the debt instrument for the issue date is $100,000.  The debt
instrument provides for a single payment on November 15, 2000. 
The amount of the payment will be determined by multiplying
$100,000 by a fraction, the numerator of which is the CPI-U for
September 2000, and the denominator of which is the CPI-U for
September 1997.  The debt instrument also provides that in no
event will the payment on November 15, 2000, be less than
$100,000.  X uses the cash receipts and disbursements method of
accounting and the calendar year as its taxable year.

     (ii) Inflation-indexed debt instrument.  Under paragraph
(c)(1) of this section, the instrument is an inflation-indexed
debt instrument.  The debt instrument's principal amount for the
issue date ($100,000) exceeds its issue price ($91,403) by
$8,597, which is more than the de minimis amount for the debt
instrument ($750).  Therefore, the coupon bond method does not
apply to the debt instrument.  As a result, the discount bond
method applies to the debt instrument.

     (iii) Yield and accrual period.  Assume X chooses monthly
accrual periods ending on the 15th day of each month.  The yield
of the debt instrument is determined as if there were no
inflation or deflation over the term of the instrument. 
Therefore, based on the issue price of $91,403 and an assumed
payment at maturity of $100,000, the yield of the debt instrument
is 3 percent, compounded monthly.

     (iv) Percentage change in reference index.  Assume that the
CPI-U for September 1997 is 160; for October 1997 is 161.2; and
for November 1997 is 161.7.  The value of the reference index for
November 15, 1997, is 160, the value of the CPI-U for September
1997.  Similarly, the value of the reference index for December
15, 1997, is 161.2, and for January 15, 1998, is 161.7.  The
percentage change in the reference index from November 15, 1997,
to December 15, 1997, (inf1) is 0.0075 (161.2/160 - 1); the
percentage change in the reference index from December 15, 1997,
to January 15, 1998, (inf2) is 0.0031 (161.7/161.2 - 1).

     (v) Treatment of X in 1997.  For the accrual period ending
on December 15, 1997, r is .0025 (.03/12), inf1 is .0075, and the
product of r and inf1 is .00001875.  Under paragraph (e)(3) of
this section, the amount of OID allocable to the accrual period
ending on December 15, 1997, is $916.  This amount is determined
by multiplying the issue price of the debt instrument ($91,403)
by .01001875 (the sum of r, inf1, and the product of r and inf1). 
The adjusted issue price of the debt instrument on December 15,
1997, is $92,319 ($91,403 + $916).  For the accrual period ending
on January 15, 1998, r is .0025 (.03/12), inf2 is .0031, and the
product of r and inf2 is .00000775.  Under paragraph (e)(3) of
this section, the amount of OID allocable to the accrual period
ending on January 15, 1998, is $518.  This amount is determined
by multiplying the adjusted issue price of the debt instrument
($92,319) by .00560775 (the sum of r, inf2, and the product of r
and inf2).  Because the accrual period ending on January 15,
1998, spans two taxable years, only $259 of this amount ($518/30
days x 15 days) is allocable to 1997.  Therefore, X includes
$1,175 of OID in income for 1997 ($916 + $259).

     (f) Special rules.  The following rules apply to an
inflation-indexed debt instrument:
     (1) Deflation adjustments--(i) Holder.  A deflation
adjustment reduces the amount of interest otherwise includible in
income by a holder with respect to the debt instrument for the
taxable year.  For purposes of this paragraph (f)(1)(i), interest
includes OID, qualified stated interest, and market discount.  If
the amount of the deflation adjustment exceeds the interest
otherwise includible in income by the holder with respect to the
debt instrument for the taxable year, the excess is treated as an
ordinary loss by the holder for the taxable year.  However, the
amount treated as an ordinary loss is limited to the amount by
which the holder's total interest inclusions on the debt
instrument in prior taxable years exceed the total amount treated
by the holder as an ordinary loss on the debt instrument in prior
taxable years.  If the deflation adjustment exceeds the interest
otherwise includible in income by the holder with respect to the
debt instrument for the taxable year and the amount treated as an
ordinary loss for the taxable year, this excess is carried
forward to reduce the amount of interest otherwise includible in
income by the holder with respect to the debt instrument for
subsequent taxable years.
     (ii) Issuer.  A deflation adjustment reduces the interest
otherwise deductible by the issuer with respect to the debt
instrument for the taxable year.  For purposes of this paragraph
(f)(1)(ii), interest includes OID and qualified stated interest. 
If the amount of the deflation adjustment exceeds the interest
otherwise deductible by the issuer with respect to the debt
instrument for the taxable year, the excess is treated as
ordinary income by the issuer for the taxable year.  However, the
amount treated as ordinary income is limited to the amount by
which the issuer's total interest deductions on the debt
instrument in prior taxable years exceed the total amount treated
by the issuer as ordinary income on the debt instrument in prior
taxable years.  If the deflation adjustment exceeds the interest
otherwise deductible by the issuer with respect to the debt
instrument for the taxable year and the amount treated as
ordinary income for the taxable year, this excess is carried
forward to reduce the interest otherwise deductible by the issuer
with respect to the debt instrument for subsequent taxable years. 
If there is any excess remaining upon the retirement of the debt
instrument, the issuer takes the excess amount into account as
ordinary income.
     (2) Adjusted basis.  A holder's adjusted basis in an
inflation-indexed debt instrument is determined under
1.1272-1(g).  However, a holder's adjusted basis in the debt
instrument is decreased by the amount of any deflation adjustment
the holder takes into account to reduce the amount of interest
otherwise includible in income or treats as an ordinary loss with
respect to the instrument during the taxable year.  The decrease
occurs when the deflation adjustment is taken into account under
paragraph (f)(1) of this section.
     (3) Subsequent holders.  A holder determines the amount of
acquisition premium or market discount on an inflation-indexed
debt instrument by reference to the adjusted issue price of the
instrument on the date the holder acquires the instrument.  A
holder determines the amount of bond premium on an inflation-
indexed debt instrument by assuming that the amount payable at
maturity on the instrument is equal to the instrument's
inflation-adjusted principal amount for the day the holder
acquires the instrument.  Any premium or market discount is taken
into account over the remaining term of the debt instrument as if
there were no further inflation or deflation.  See section 171
for additional rules relating to the amortization of bond premium
and sections 1276 through 1278 for additional rules relating to
market discount.
     (4) Minimum guarantee.  Under both the coupon bond method
and the discount bond method, a minimum guarantee payment is
ignored until the payment is made.  If there is a minimum
guarantee payment, the payment is treated as interest on the date
it is paid.
     (5) Temporary unavailability of a qualified inflation index. 
Notwithstanding any other rule of this section, an inflation-
indexed debt instrument may provide for a substitute value of the
qualified inflation index if and when the publication of the
value of the qualified inflation index is temporarily delayed. 
The substitute value may be determined by the issuer under any
reasonable method.  For example, if the CPI-U is not reported for
a particular month, the debt instrument may provide that a
substitute value may be determined by increasing the last
reported value by the average monthly percentage increase in the
qualified inflation index over the preceding twelve months.  The
use of a substitute value does not result in a reissuance of the
debt instrument.
     (g) Reopenings.  For purposes of 1.1275-2(d)(2), a
reopening of Treasury Inflation-Indexed Securities is a qualified
reopening if--
     (1) The terms of the securities issued in the reopening are
the same as the terms of the original securities; and
     (2) The reopening occurs not more than one year after the
original securities were first issued to the public.
     (h) Effective date.  This section applies to an
inflation-indexed debt instrument issued on or after January 6,
1997.
     Par. 5.  Section 1.1286-2T is added to read as follows:
1.1286-2T  Stripped inflation-indexed debt instruments
(temporary).
     Stripped inflation-indexed debt instruments.  If a Treasury
Inflation-Indexed Security is stripped under the Department of
the Treasury's Separate Trading of Registered Interest and
Principal of Securities (STRIPS) program, the holders of the
principal and coupon components must use the discount bond method
(as described in 1.1275-7T(e)) to account for the original issue
discount on the components.

                               /s/ Margaret Milner Richardson
                               Commissioner of Internal Revenue

Approved:

          /s/ Donald C. Lubick
          Acting Assistant Secretary of the Treasury