The balance, if any, of the gain shall be considered as long-term capital gain. The amount described in (2) of this subdivision (b) in effect reduces the amount of original issue discount to be treated as ordinary income under this subdivision (b) by the amounts previously includible (regardless of whether included) by all holders (computed, however, as to any holder without regard to any purchase allowance under paragraph (a)(2)(ii) of § 1.1232-3A and without regard to whether any holder purchased at a premium as defined in paragraph (d)(2) of § 1.1232-3 ).
(1) Entire original issue discount (stated redemption price at maturity, $10,000, minus issue price, $7,600) | $2,400 |
(2) Less: Line (1), $2,400, multiplied by months elapsed since date of original issue, 24, divided by months from such date to stated maturity date, 120 | $480 |
(3) Maximum amount includible by A as ordinary income | $1,920 |
Since the amount in line (3) is greater than A's gain, $960, A's entire gain is includible as ordinary income.
(1) Entire original issue discount (as determined in part (i) of this example) | $2,400 |
(2) Less: Line (1), $2,400, multiplied by months elapsed since date of original issue, 108, divided by months from such date to stated maturity date, 120 | $2,160 |
(3) Maximum amount includible by B as ordinary income | $240 |
Since the amount in line (3) is less than B's gain, $270, only $240 of B's gain is includible as ordinary income. The remaining portion of B's gain, $30, is considered long-term capital gain.
And the balance, if any, of the gain shall be considered as long-term capital gain. For the definition of the terms original issue discount and intention to call before maturity, see paragraphs (b) (1) and (4) respectively of this section. See section 1037(b) and paragraph (b) of § 1.1037-1 for special rules which are applicable in applying section 1232(a)(2)(B) and this subparagraph to gain realized on the disposition or redemption of obligations of the United States which were received from the United States in an exchange upon which gain or loss is not recognized because of section 1037(a) (or so much of section 1031 (b) or (c) as relates to section 1037(a)).
(1) | (2) | (3) | (2) * (3) |
Semiannual interest period | Amount payable at 5 percent | Factor for present value discounted at 3 percent per period | Present value of payment |
1 | $1,000 | 0.9709 | $970.90 |
2 | 1,000 | .9426 | 942.60 |
3 | 1,000 | .9151 | 915.10 |
4 | 1,000 | .8885 | 888.50 |
5 | 1,000 | .8626 | 862.60 |
6 | 1,000 | .8375 | 837.50 |
7 | 1,000 | .8131 | 813.10 |
8 | 1,000 | .7894 | 789.40 |
8 | 40,000 | .7804 | 31,576.00 |
Total present value of note discounted at 6 percent, compounded semiannually | 38,595.70 |
The same result may be reached through the use of a standard bond table or by the following present value calculation:
Present value of annuity of $1,000 payable over 8 periods at 3 percent per period = 1000 * 7.0197 = | $7,019.70 |
Add: Present value of principal (as calculated above) | 31,576.00 |
Total | $38,595.70 |
Accordingly, the assumed price at which M's note would have been issued had it been issued without stock purchase warrants, i.e., that portion of the $41,500 price paid by X which is allocable to M's note, is $38,596 (rounded). Since the price payable on redemption of M's note at maturity is $40,000, the original issue discount on M's note is $1,404 ($40,000 minus $38,596). Under the rules stated in § 1.163-3 , M is entitled to a deduction, to be prorated or amortized over the life of the note, equal to this original issue discount on the note. The excess of the price for the unit over the portion of such price allocable to the note, $2,904 ($41,500 minus $38,596), is allocable to and is the basis of the stock purchase warrants acquired by X in connection with M's note. Upon the exercise of X's warrants, M will be allowed no deduction and will have no income. Upon maturity of the note X will receive $40,000 from M, of which $1,404, the amount of the original issue discount, will be taxable as ordinary income. If X were to transfer the note at its face amount to A 2 years after the issue date, X would realize, under section 1232(a)(2)(B), ordinary income of $702 (one-half of $1,404).
(1) | (2) | (3) | (4) | (5) | (4) * (5) |
Interest period | Interest rate differential | Principal | Interest foregone for period (1/2%) | Factor for present value discounted at 31/2 percent per period | Present value of interest foregone |
1 | 1%(7%-6%) | $50,000 | 250 | 0.9662 | $241.53 |
2 | 1% | 50,000 | 250 | .9335 | 233.38 |
3 | 1% | 50,000 | 250 | .9019 | 225.48 |
4 | 1% | 50,000 | 250 | .8714 | 217.85 |
5 | 1% | 50,000 | 250 | .8420 | 210.50 |
6 | 1% | 50,000 | 250 | .8135 | 203.38 |
7 | 1% | 50,000 | 250 | .7860 | 196.50 |
8 | 1% | 50,000 | 250 | .7594 | 189.85 |
9 | 1% | 50,000 | 250 | .7337 | 183.43 |
10 | 1% | 50,000 | 250 | .7089 | 177.25 |
Total present value of interest foregone | $2,079.15 | ||||
Principal | 50,000.00 | ||||
Less: Total present value of interest foregone | 2,079.15 | ||||
Issue price | 47,920.85 |
The calculation of present value of interest foregone may also be made as follows:
Present value of annuity of $250 discounted for 10 periods at 31/2 percent per period = $250 * 8.3166 = $2,079.15.
The total present value of interest foregone, $2,079, is also the original issue discount attributable to the note ($50,000 -$47,921). Under (b) of this subdivision, since the agreed assumed rate of interest of 7 percent is not more than 1 percentage point greater than the actual rate payable on the note, determination of the issue price of the note (and original issue discount) based upon such assumed rate will be presumed to be correct and will not be considered clearly erroneous, provided that both N and Y adhere to such determination. Under the rules in § 1.163-3 , N is entitled to a deduction, to be prorated or amortized over the life of the note, equal to the original issue discount on the note. The excess of the price paid for the unit over the portion of such price allocable to the note, $3,579 ($51,500-$47,921) is allocable to and is the basis of the stock purchase warrants acquired by Y in connection with N's note. Upon the exercise or sale of the warrants by Y, N will be allowed no deduction and will have no income. Upon maturity of the note Y will receive $50,000 from N, of which $2,079, the amount of the original issue discount, will be taxable as ordinary income. If Y were to transfer the note at its face value to B 21/2 years after the issue date, Y would realize, under section 1232(a)(2)(B), ordinary income of $1,039.50 (one-half of $2,079).
(1) | (2) | (3) | (4) | (5) | (6) |
Quarterly interest period | Principal payable | Interest payable (11/2 percent) | Total amount payable (2) + (3) | Factor for present value discounted at 21/8 percent per quarter | Present value of total payment (4) * (5) |
1 | $3,000 | $900 | $3,900 | 0.9792 | $3,818.88 |
2 | 3,000 | 855 | 3,855 | .9588 | 3,696.17 |
3 | 3,000 | 810 | 3,810 | .9389 | 3,577.21 |
4 | 3,000 | 765 | 3,765 | .9193 | 3,461.16 |
5 | 3,000 | 720 | 3,720 | .9002 | 3,348.74 |
6 | 3,000 | 675 | 3,675 | .8815 | 3,239.51 |
7 | 3,000 | 630 | 3,630 | .8631 | 3,133.05 |
8 | 3,000 | 585 | 3,585 | .8452 | 3,030.04 |
9 | 3,000 | 540 | 3,540 | .8276 | 2,929.70 |
10 | 3,000 | 495 | 3,495 | .8104 | 2,832.35 |
11 | 3,000 | 450 | 3,450 | .7935 | 2,737.58 |
12 | 3,000 | 405 | 3,405 | .7770 | 2,645.69 |
13 | 3,000 | 360 | 3,360 | .7608 | 2,556.29 |
14 | 3,000 | 315 | 3,315 | .7450 | 2,469.68 |
15 | 3,000 | 270 | 3,270 | .7295 | 2,385.47 |
16 | 3,000 | 225 | 3,225 | .7143 | 2,303.62 |
17 | 3,000 | 180 | 3,180 | .6994 | 2,224.09 |
18 | 3,000 | 135 | 3,135 | .6849 | 2,147.16 |
19 | 3,000 | 90 | 3,090 | .6706 | 2,072.15 |
20 | 3,000 | 45 | 3,045 | .6567 | 1,999.65 |
Total | 56,608.19 |
This amount ($56,608) is the assumed price at which the note would have been issued had it been issued without stock purchase warrants. The assumed price of $45,000 agreed to by the parties is not presumed to be correct since it is less than the face value adjusted to a yield which is one percentage point greater than the actual rate of interest payable on the obligation. The parties did not have adverse interests in agreeing upon an assumed price (since an excessively large amount of original issue discount would benefit O, the borrower, without adversely affecting Z, an exempt organization which would pay no tax on original issue discount income), and the price agreed to appears to be clearly erroneous when compared to the $56,608 assumed issue price determined under the principles of (a) of this subdivision. Since the maturity value of O's note is $60,000, the original issue discount on O's note is $3,392 ($60,000 minus $56,608). Under the rules in § 1.163-3 , O is entitled to a deduction, to be prorated or amortized over the life of the note, equal to this original issue discount on the note. The excess of the price paid for the unit over the portion of such price allocable to the note, $3,392 ($60,000 minus $56,608), is allocable to and is the basis of the stock purchase warrants acquired by Z in connection with O's note. Upon the exercise or sale of the warrants by Z, O will be allowed no deduction and will have no income.
then the issue price of the obligation or investment unit shall be the fair market value of the property for which such obligation or investment unit is issued, as determined under (c) of this subdivision. Such issue price shall control for purposes of determining the amount realized by the person exchanging the property for the obligation or unit issued and the bases of the property acquired by the holder and issuer.
An obligation which is not traded on an established securities market and which is not part of an issue or investment unit a portion of which is so traded shall not be treated as property described in (1) of this (b) even though the obligation is convertible into property so traded. For purposes of this (b), an obligation, investment unit, or element of an investment unit shall be treated as traded on an established securities market if it is so traded on or within 10 trading days after the date it is issued. Trading days shall mean those days on which an established securities market is open. For purposes of this subdivision (iii), the term established securities market shall have the same meaning as in paragraph (d)(4) of § 1.453-3 (relating to limitations on installment method for purchaser evidences of indebtedness payable on demand or readily tradable).
If a series consists of more than one obligation, the original issue discount allocated to such series shall be apportioned to such obligations in proportion to the stated redemption price of each. Computations under this subdivision (d) may be made using periods other than years, such as, for example, months or periods of 3 months.
Year of maturity | 1973 | 1975 | Total |
(1) Stated redemption price | $50,000 | $50,000 | |
(2) Multiply by years outstanding | 2 | 4 | |
(3) Product of bond years | $100,000 | $200,000 | |
(4) Sum of products | $300,000 | ||
(5) Fractional portion of discount | $100,000 | $200,000 | |
$300,000 | $300,000 | ||
(6) Multiply line (5) by discount for entire issue | $6,000 | $6,000 | |
(7) Discount for each series | $2,000 | $4,000 | |
(8) Issue price (line (1), minus line (7)) | $48,000 | $46,000 |
Assume the same facts as in example (1) except that a separate note is issued for each payment. The result is the same as in example (1).
Year of maturity | 1972 | 1973 | Total |
(1) Stated redemption price | $70 | $1,000 | |
(2) Multiply by years outstanding | 2 | 3 | |
(3) Product of bond years | $140 | $3,000 | |
(4) Sum of products | $3,140 | ||
(5) Fractional portion of discount | $140 | $3,000 | |
$3,140 | $3,140 | ||
(6) Multiply line (5) by discount for entire issue | $70 | $70 | |
(7) Discount for each series | $3.12 | $66.88 | |
(8) Issue price (line 1 minus line (7)) | $66.88 | $933.12 |
60 (months bond is held by A)/120 (months from date of original issue to redemption date) * $25 (original issue discount)
However, $7, which represents the annual stated increase taken into income, is offset against the amount of $12.50, leaving $5.50 of the gain from the sale to be treated as ordinary income.
26 C.F.R. §1.1232-3