Proposed contingent debt regulations.

• Author: Brenner, Jonathan

On Dec. 16, 1994, the IRS issued a Notice of Proposed Rulemaking relating to the tax treatment of contingent debt instruments. In general, Prop. Regs. Sec. 1.1275-4 represents a major departure from the existing tax treatment of such instruments. It is built around the concept of a noncontingent bond method, which treats the projected amount of a contingent payment as if it were a fixed payment.

The noncontingent bond method applies to a contingent payment debt instrument issued for money or publicly traded property. Under the noncontingent bond method, a projected payment schedule is determined for a debt instrument, and interest accrues on the debt instrument based on this schedule. If the actual amount of a contingent payment differs from its projected amount, appropriate adjustments are taken into account to reflect this difference.

The projected payment schedule for a debt instrument consists of all noncontingent payments and a projected amount for each contingent payment. Under Prop. Regs. Sec. 1.1275-4(b)(4), contingent payments are either quotable contingent payments or nonquotable contingent payments.

A quotable contingent payment is a contingent payment substantially similar to a property right for which forward price quotes are readily available. In general, the projected amount of a quotable contingent payment is the property right's forward price. If a contingent payment is substantially similar to an option and forward price quotes are not readily available for the option, the projected amount of the payment is the option's spot price on the issue date (if readily available), compounded at the applicable Federal rate (AFR) from the issue date to the date the payment is due.

A nonquotable contingent payment is any contingent payment that is not a quotable contingent payment. For example, contingent payments based on oil production or the issuer's gross receipts are generally nonquotable contingent payments. The projected amount of a nonquotable contingent payment is generally based on the projected yield of the contingent payment debt instrument. The projected yield is a reasonable rate for the debt instrument that, as of the issue date, reflects general market conditions, the credit quality of the issuer and the terms and conditions of the debt instrument.

Prop. Regs. See. 1.12754(b)(4)(iv) provides that, generally, all holders of a contingent payment debt instrument are bound by the issuer's projected payment schedule and...