WASHINGTON -- In a bid to help derivatives issuers and investors, the Internal Revenue Service cleared up the tax treatment of certain debt instruments.

Uncertainty in tax law allowed issuers of and investors in structured notes to set up transactions to avoid paying taxes, the IRS said. Murkiness in this area also prevented organizations from achieving tax results that were consistent with the instruments' actual economic outcome.

Not all structured notes will be affected by the proposed IRS rules, just debt obligations that have contingent interest or principal payments. These would include instruments whose principal is indexed to a specific stock or to a group of stocks.

Issuers of these instruments will be allowed, under the changes, to take tax deductions for the future interest they will pay to holders of the instruments. And holders will have to recognize income that comes from interest over the instruments' life, based on a rate determined by pricing.

Until now, issuers and holders had to wait until payment to figure both deductions and interest income stemming from transactions with the instruments.

Special rules will allow issuers -- who commonly hedge a debt security -- to integrate the hedge and the debt instrument and treat them as a single security, which will be taxed according to its economics, the new rule stipulates.

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