Treasury Issues Announcement on Inflation-Protection Securities

Washington, DC, September 26, 1996 - The Treasury Department has finalized its plans to issue Treasury obligations providing "protection" against inflation. The first "inflation-protection securities" will be ten-year notes issued quarterly, beginning on January 15, 1997, with a minimum denomination of $1,000. The Treasury Department's announcement indicates that other maturities will be added within a year. The Institute submitted comments on the proposal earlier this year.

General Structure
The inflation-protection securities will be structured similarly to Canada's Real Return Bonds. Under the inflation-protection securities' structure, the principal amount will be adjusted for inflation (payable at maturity) and the semi-annual interest payments will equal a fixed percentage of the inflation-adjusted principal amount. For example, if an investor purchased a $1,000 bond with a 3% real rate of return coupon (payable 1.5% semi-annually), and inflation over the first six months were 1%, the mid-year value of the bond would be $1,010 and the first semi-annual interest payment would be $15.15 ($1,010 times 1.5%). If inflation accelerated during the second half of the year, so that it reached 3% for the full year, the end-of-year value of the bond would be $1,030 and the second semi-annual interest payment would be $15.45 ($1,030 times 1.5%).

To permit holders such as investment companies to know each day the inflation-adjusted principal amount and the appropriate income accruals, inflation adjustments will be based upon Consumer Price Index for Urban Consumers (CPI-U) data that is approximately three months old. Specifically, the "reference CPI" for the first day of any calendar month (e.g., January 1) would be the CPI-U for the first day of the third preceding month (e.g., October 1) as reported during the next month (e.g., November) and the reference CPI for any other day of the month would be calculated by linear interpolation. Thus, the appropriate inflation adjustments for each day in December would be known before the end of November. Also of interest to investment companies, the securities will be eligible for coupon stripping under the Treasury "STRIPS" program as of the first issue date.

Tax Considerations
A separate IRS announcement (Notice 96-51) describes in detail the tax consequences of "inflation-indexed debt instruments," whether issued by Treasury or other entities. Under regulations to be promulgated before January 15, 1997, both the real rate of return coupon and all inflation adjustments to principal will be subject to current taxation as interest income. Taxpayers will be required, as described below, to use either the "coupon bond method" or the "discount bond method" to account for qualified stated interest and original issue discount ("OID") on the instrument. Special rules will apply to deflationary periods to reduce taxable income, create current ordinary deductions, or generate carryforwards of "excess" deflation adjustments (depending on the deflation rate, the coupon rate and prior accruals).

The coupon bond method will apply to Treasury inflation-protection securities that are not stripped into principal and interest components. Under the coupon bond method, the qualified stated interest payable on the debt instrument will be taken into account under the taxpayer's regular method of accounting. Any increase in the inflation-adjusted principal amount will be treated as OID for the period in which the increase occurs.

Holders of a stripped bond or coupon interest in a Treasury inflation-protection security will be treated by section 1286 as purchasing newly issued debt instruments that have OID. Under the regulations, holders of stripped Treasury inflation-protection securities will be required to account for OID using the discount bond method.

Subsequent holders of inflation-indexed debt instruments will determine premium or discount by treating the amount payable at maturity as equal to the instrument's inflation-adjusted principal amount for the day the holder acquires the instrument. Any premium or market discount will be taken into account over the remaining term of the debt instrument by making the same assumption.

The Treasury Department has requested that all comments on the rules described in this notice be submitted on or before October 28, 1996.