Stated redemption price at maturity under I.R.C. 1273(a)(2) means all payments on the obligation, including interest, except to the extent that a payment is considered “qualified stated interest” (QSI). If all interest payable on the obligation is QSI, the stated redemption price to maturity is simply equal to the stated principal amount of the obligation.
In the case of an obligation with a fixed term of one year or less (e.g., certain TRANs and similar obligations), no payments of interest are considered QSI. The means that all interest on short-term obligations is considered OID. This rule prohibiting QSI on a short-term obligation does not have an exception for tax-exempt obligations. Normally this wouldn’t matter because the difference between QSI and OID is generally of no consequence – both are considered “interest” that can be excludable from gross income for federal income tax purposes. However, the distinction is relevant for subsequent purchasers of the bond, if the bond was originally issued at a price in excess of its stated principal amount.
Example: N issues a one-year tax-exempt bond with a face amount of $10 million and a stated interest rate of 5%. The price is 101% of the face amount – i.e., the bond is sold at a premium ($100,000), and that sale price is the purchaser’s basis in the bond. The yield on the bond, due to the premium, is approximately 3.98% (interest is payable once at maturity). Three months after the issuance of the bond, O purchases the bond at par (at $10 million – i.e. 100%) plus accrued interest of 1.25%. If the stated interest (the $500,000 due on the bond at maturity) is QSI, O’s entire return to maturity is tax-exempt interest. However, if the interest is treated as OID, O has acquired the bond for 101.25% (100% + 1.25% accrued interest) at a time when its adjusted issue price (daily compounding) is 101.9855%. Thus, by the time the bond matures, O’s basis will have increased to only 104.2645% and O will have taxable gain of 0.7355 percent of the bond’s face amount.
The temporary regulations preceding Treas. Reg. 1.1273-1(c)(5) suggested that tax-exempt obligations would be excluded from the special rule for short-term obligations. Due to the confusion created by the final regulations that do not make reference to the exclusion, the IRS issues Notice 94-84, which permits owners of tax-exempt bonds to treat the interest either as OID or as QSI.