WASHINGTON - The Internal Revenue Service yesterday proposed rules on the tax treatment of debt instruments with original issue discount such as zero coupon bonds.

The rules would revise a set of regulations that the IRS proposed in 1986 but never finalized, agency officials said. Those rules were criticized by industry officials for being too restrictive, they said, adding that the new rules would be more flexible.

The IRS said in the notice issued yesterday that it would hold a public hearing on the proposed rules on Feb. 16. The agency said it must receive requests to speak at the hearing by Jan. 26.

If adopted, the rules would become effective 60 days after being issued in final form, the notice says.

The proposed rules would give issuers more flexibility in how they can accrue interest for debt instruments with original issue discount, an IRS official said. He said bonds have original issue discount generally when they are issued at less than their redemption price.

The proposed rules are more flexible than the previous ones in part because they allow for variations in the accrual periods that issuers must use, the official said.

The rules are important for holders of tax-exempt bonds because they get an increase in the basis of their bonds every time interest accrues, the official said. This is to ensure that when the bond is redeemed, the holder does not get a big capital gains hit that negates the benefit of the bonds' tax-exempt status, he said.

For example, a $100 bond that is redeemed for $200 in 10 years has the economic equivalent of paying $100 of principal and $100 of interest at maturity. If the bond has a yield of 7.5%, the holder would accrue $7.50 of interest in the first year so that the basis in the bonds would increase to $107.50.

The rules also contain an antihedging provision that applies only to tax-exempt variable-rate bonds whose interest rate is pegged to a so-called "objective rate," which is generally property such as gold.

Under the provision, an issuer that sells such bonds and simultaneously hedges to offset its liability from them must comply with the contingent payment rules that the IRS is in the process of finalizing. As a result, the issuer's accrued interest may be deemed as a taxable payment rather than accrued interest.

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