June 3, 1996
TO: TAX COMMITTEE No. 19-96
PENSION COMMITTEE No. 21-96
RE: TREASURY PROPOSAL TO ISSUE INFLATION-INDEXED SECURITIES
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The Treasury Department has requested comments on a new type of Treasury
obligation, an "inflation-protection" security, that Treasury intends to issue as a multi-year
experiment. Treasury envisions that these securities, which would be issued with a minimum
denomination of $1,000, could be purchased either directly (from the Treasury Department or
through brokers) or indirectly (through pooled investment vehicles such as regulated
investment companies ("RICs")).
Treasury presently is considering the following three structures for the securities, which
are described in the attached materials. Under the first, or "Canadian," structure, the bond
would make semiannual interest payments equal to a fixed percentage of an inflation-adjusted
principal amount. At maturity, the bond would pay the inflation-adjusted principal amount. To
illustrate this structure, assume an inflation-protection bond issued for $1,000 that pays 4
percent interest (or $40 in Year 1). Further assume that inflation was 3 percent during Year 1. In
this example, the bonds interest payment in the second year would be 4 percent of $1,030
($1,000 purchase price plus a 3 percent inflation adjustment to principal) or $41.20. At maturity,
the investor would receive the inflation-adjusted principal amount.
The first "alternative" structure would be a zero-coupon inflation-protection bond that
made only one payment of interest and principal, both adjusted for inflation, at maturity. The
second "alternative" under consideration would make periodic payments of interest and
principal. Each payment would have the same inflation-adjusted value, though the portion of
each payment attributable to interest and principal would change.
The tax treatment of inflation-protection securities is mentioned briefly in Treasurys
"Questions and Answers" memorandum. The explanation indicates that, for a security
structured similarly to a Canadian inflation-indexed bond, both principal appreciation and
accrued/paid interest would be included currently in taxable income. The explanation provides
that other tax details would be announced before the first issue. RICs holding inflation-
protection bonds could be faced with cash-flow issues similar to those created by zero coupon
bonds, to the extent that inflation-protection bonds were generating taxable income (e.g.,
principal appreciation) that was not being distributed currently to bond holders.
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Treasury has requested that comments on design details, possible terms and conditions
of the new securities and other issues be submitted by June 19, 1996. Non-tax-related comments
should be submitted to Alex Gavis, an attorney in the Institutes Securities and Financial
Regulation Department, at 202/326-5923 by June 7, 1996. Any tax-related comments should be
directed to the undersigned at 202/326-5832 by June 11, the date of the next Tax and Pension
Committee meetings.
We will keep you informed of developments.
Keith D. Lawson
Associate Counsel - Tax
Attachment