United States: Debt Restructurings

IRS Finalizes Regulations Clarifying that an Issuer's Financial Condition Will Generally Not Be Taken into Account in Determining Whether a Modified Debt Instrument Will Continue to Be Treated as Indebtedness

SUMMARY

This morning, the IRS released final regulations (the "Final Regulations") clarifying that the deterioration of an issuer's credit quality will generally be disregarded for the purpose of determining whether a modified debt instrument will continue to be characterized as debt under U.S. federal income tax law. Before today's amendment, the regulations governing the modification of debt instruments (the "1001 Regulations") were ambiguous on this point. The Final Regulations are substantively the same as the proposed regulations that the IRS issued on this topic in June 2010 (the "Proposed Regulations")¹ and apply to modifications occurring on or after January 7, 2011, although taxpayers may rely on the Final Regulations to evaluate debt instruments that were modified by earlier transactions.

BACKGROUND

The 1001 Regulations generally specify that a "significant" modification to a debt instrument causes that obligation to be treated as exchanged for new property in a taxable transaction. A special rule in the 1001 Regulations disregards, except in limited cases, any deterioration in the credit quality of an obligor between the issue date of a debt instrument and the date of a modification, for the purpose of determining whether that modification is "significant." According to the original preamble of the 1001 Regulations, this special rule also applied (even prior to today's change) to the determination of whether a modified debt instrument would continue to be characterized as indebtedness after it had been modified.² However, whether this conclusion was supported by the literal text of the 1001 Regulations before today's revision is unclear.

During workouts, changes to the terms of a debt obligation will often cause a "significant modification" to occur. The conflict described above made it difficult for practitioners, issuers and holders to determine how "new" instruments that were deemed received in such transactions should be characterized, because an issuer's ability to satisfy the terms of an obligation is a significant factor in determining whether that instrument is, in fact, debt for U.S. federal income tax purposes. In June 2010, the IRS issued the Proposed Regulations, which provide textual support for the conclusion drawn by the preamble to the 1001 Regulations.

THE FINAL REGULATIONS

The Final Regulations make minor, clarifying changes, but are substantively identical to the Proposed Regulations. Under the Final Regulations, whether a modified debt instrument is debt, equity or another property right must be evaluated de novo, taking all relevant factors (apart from—in cases where there has been no addition, removal or substitution of an obligor—a deterioration in the issuer's financial condition and ability to pay) into account. Accordingly, a debt instrument that has undergone a "significant modification" but retains debt-like terms will generally continue to be treated as indebtedness, even if the borrower's credit quality has deteriorated to a level that could raise questions regarding whether a new offering with similar terms would constitute equity under U.S. federal income tax principles. However, a debt modification that renders the terms of an obligation more "equity-like" may trigger a change in the U.S. federal income tax status of the instrument.

The Final Regulations are scheduled to be published in the Federal Register on January 7, 2011, and will be effective for transactions occurring on or after that date. However, taxpayers will be entitled to rely on the Final Regulations to characterize debt instruments that were modified on earlier occasions.

Footnotes

1 See Prop. Treas. Reg. §1.1001-3(f), 75 Fed. Reg. 31736. The Proposed Regulations are discussed in the Sullivan & Cromwell LLP publication entitled "Debt Restructuring: IRS Issues Proposed Regulations Clarifying that an Issuer's Financial Condition Will Generally Not Be Taken into Account in Determining Whether a Modified Debt Instrument Is Treated as Debt" (June 3, 2010), which may be obtained by following the instructions at the end of this publication.

2 In particular, the preamble provided that "for purposes of this regulation, unless there is a substitution of a new obligor, any deterioration in the financial condition of the issuer is not considered in determining whether the modified instrument is properly characterized as debt." T.D. 8675, 61 Fed. Reg. 32926 (Sept. 24, 1996).

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