SECTION 1. PURPOSE

Referring to nonconvertible debt instruments to ascertain the comparable yield is more consistent with the economic rationale underlying the comparable yield methodology, although using the nonconversion yield of convertible debt instruments would minimize the cliff effect and discontinuity in tax treatment that result when a contingent convertible debt instrument ceases to be eligible for the exclusion and becomes subject to the comparable yield methodology.

Similarly, changing the rule disregarding remote and incidental contingencies, which applies to nonconvertible debt instruments as well as convertible debt instruments, could have broader effects than simply reducing the cliff effect of adding contingent interest to a convertible debt instrument. The rule generally simplifies administration by avoiding the necessity of applying the comparable yield methodology (and the associated requirements for payment projections and adjustments for differences between projected payments and actual payments) to instruments having contingent payments that are insignificant in amount or unlikely to occur. Any expansion of the rule could cause the universe of instruments to which the comparable yield methodology is inapplicable to include cases in which the possibility of contingent payments has a significant depressing effect on the noncontingent yield on the instrument. The result would be the accrual of income and deduction in amounts less than the true economic yield on the instrument.

- - The Service and the Treasury are concerned whenever issuers and their counsel

are uncertain about the tax consequences of new financial instruments that are widely used and broadly traded in the capital markets. The capital markets operate most efficiently when the tax treatment of various financial instruments is clear. To resolve the existing controversy and to eliminate confusion in the marketplace, Rev. Rul. 2002–31 sets forth the position of the Service and the Treasury regarding the tax treatment of contingent convertible debt instruments under current law and regulations. This notice invites comments and suggestions for changes in the relative tax treatment of

straight convertible debt instruments and contingent convertible debt instruments to eliminate or reduce the disparity in treatment of these instruments.

The Service and the Treasury invite comments and suggestions for the use of existing regulatory authority (including regulatory authority under § 1275(d)), as well as other administrative measures, to modify the rules governing the tax treatment of straight convertible debt instruments and contingent convertible debt instruments. Specifically, comments and suggestions are invited on whether the exclusion from the noncontingent bond method for straight convertible debt instruments should be eliminated, expanded, or modified; whether the rules for determining a comparable yield for purposes of applying the noncontingent bond method to a contingent convertible debt instrument should be revised to require comparison with a straight convertible debt instrument; and whether the rule that remote and incidental contingencies are disregarded in determining whether a debt instrument is a contingent debt instrument should be modified.

As part of the discussion of the tax treatment of contingent convertible debt instruments, some commentators also have raised issues regarding whether it is appropriate as a matter of public policy to allow issuers deductions for interest accruals on convertible debt instruments to the extent that payment of the accrued interest can ultimately be effected only by the issuance of the issuer’s stock. Sections 163( l ) and 249 contain restrictions on the deductibility of amounts based on the value of an issuer’s stock, but those restrictions have limited scope. See the discussion of §§ 163( l ) and 249 in Rev. Rul. 2002–31. Persons responding to this request for comments may want to include a discussion of how the policies underlying §§ 163( l ) and 249 relate to suggestions they may make for changes in regulations or other administrative measures.

The Service and the Treasury note that in Notice 2000–29, 2000–1 C.B. 1241, they had previously requested comments on certain federal tax consequences of options to acquire partnership interests and partnership debt instruments convertible into partnership interests. Persons responding to this invitation for com

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