United States: Debt Exchanges (Debt Restructuring)

Article by Linda Z. Swartz *

I. INTRODUCTION

This article focuses on one of the crucial issues in any debt restructuring—whether changes to the terms of outstanding debt typically sought by lenders would constitute a deemed exchange of the debt pursuant to section 1001¹ and the corresponding Treasury regulations.² The first part of the article discusses the regulations. The second part of the article discusses the adverse tax consequences to debt holders of a deemed debt exchange under the regulations, including the collateral effects of a possible recharacterization of the modified debt as equity. The third part of the article discusses the tax consequences if modified debt is subject to the original issue discount ("OID") rules. Finally, the article discusses strategies to avoid the pitfalls commonly associated with debt exchanges.

II. DEEMED EXCHANGES OF DEBT

A. Regulations

Many of the modifications commonly sought by lenders to the terms of troubled debt would cause a deemed exchange of the debt; in many cases, a single modification would be sufficient to cause a deemed exchange. However, several provisions in the regulations represent a significant extension of case law and rulings insofar as the regulations would trigger a deemed exchange of debt where no exchange would otherwise occur.³ Proposed regulations were issued on December 2, 1992, in response to the Supreme Court's decision in Cottage Savings Association v. Commissioner⁴ that a deemed exchange of property occurs if the "legal entitlements" of the exchanged properties are not identical, which decision significantly lowered the threshold for deemed exchanges.⁵ The proposed regulations, with certain changes, were finalized on June 26, 1996, effective for any alteration of the terms of a debt instrument on or after September 24, 1996.⁶

1. Modifications

The regulations employ a two-part test to determine whether a deemed exchange occurs when debt is modified. Under this test a specific change to a debt instrument triggers a deemed exchange if the change constitutes a "modification," and the modification is "significant."⁷ As a threshold matter, it is important to note that although the modifications made to debt in a workout context where debt is in default often address unique issues, the Internal Revenue Service (the "IRS") has generally treated the context in which modifications are made as irrelevant.⁸ This past practice is continued in the regulations, which provide that a deemed exchange may not be avoided simply because the borrower is insolvent or bankrupt.⁹ The regulations broadly define a modification as any change in a legal right or obligation of the issuer or holder of the debt instrument, with some exceptions.¹⁰

A change that occurs pursuant to the original terms of a debt instrument is not a modification.¹¹ An alteration that occurs by operation of the terms may occur automatically (for example, an annual resetting of the interest rate based on the value of an index or a specified increase in the interest rate if the value of the collateral declines from a specified level) or may occur as a result of the exercise of an option provided to an issuer or a holder to change a term of a debt instrument.

The following alterations, however, are modifications even if the alterations occur by operation of the terms of a debt instrument:

• An alteration that results in the substitution of a new obligor,¹² the addition or deletion of a co-obligor, or a change (in whole or in part) in the recourse nature of the instrument (from recourse to nonrecourse or from nonrecourse to recourse);¹³
• An alteration that results in an instrument or property right that is not debt for federal income tax purposes unless the alteration occurs pursuant to a holder's option under the terms of the instrument to convert the instrument into equity of the issuer;¹⁴ and
• An alteration that results from the exercise of an option provided to an issuer or a holder to change a term of a debt instrument, unless:
  
  
  • The option is unilateral; and
  • In the case of an option exercisable by a holder, the exercise of the option does not result in (or, in the case of a variable or contingent payment, is not reasonably expected to result in) a deferral of, or a reduction in, any scheduled payment of interest or principal.¹⁵

An option is unilateral only if, under the terms of the instrument or under local law, (i) at the time the option is exercised, or as a result of the exercise, there is no right of the other party to alter or terminate the instrument or put the instrument to a person related to the issuer;¹⁶ (ii) the exercise of the option does not require the consent or approval of the other party, a person related to the other party or a court or arbitrator; and (iii) the exercise of the option does not require consideration (other than incidental costs and expenses relating to the exercise of the option), unless, on the issue date of the instrument, the consideration is a de minimis amount, a specified amount, or an amount that is based on a formula that uses objective financial information.¹⁷

An issuer's failure to perform its obligations under a debt instrument is also not a modification.¹⁸ An agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds two years following the issuer's initial failure to perform, and any additional period during which the parties conduct good faith negotiations or during which the issuer is in a Title 11 or similar case.¹⁹

Although a change in the currency denomination of a debt instrument is generally considered a modification, Treasury regulations provide an exception for a change in denomination to the euro.²⁰ The advent of the euro, on January 1, 1999, as the single currency of participating members of the European Union²¹ initially raised concerns that the conversion of the national currencies of those members ("legacy currencies") to the euro would be a taxable exchange.²² Responding to those concerns, the IRS issued temporary, and then final regulations providing nonrealization treatment for the conversion of a legacy currency to the euro.²³ The regulations apply broadly to a change in rights and obligations denominated in a legacy currency if the change results solely from the conversion of the legacy currency to the euro.²⁴

For example, a change in the currency denomination of a bond from French francs to euros as a result of the conversion of the franc to the euro is not a "modification" under the section 1001 regulations.²⁵

If a party to a debt instrument has an option to change a term of an instrument, the failure of the party to exercise that option is not a modification.²⁶

A modification is tested when the parties agree to a change, even if the change is not immediately effective.²⁷ The regulations provide exceptions for a change in a term that is agreed to by the parties but is subject to reasonable closing conditions or that occurs as a result of bankruptcy proceedings.²⁸ In these cases, a modification occurs on the date the change in the term becomes effective.²⁹ Thus, if the conditions do not occur (and the change in the term does not become effective), a modification does not occur.

2. Significant Modifications

As stated above, a modification must be "significant" to trigger a deemed exchange. The regulations describe categories of modifications that generally would be considered significant and add a general rule for types of modifications for which specific rules are not provided.³⁰ Under this general rule (the "general significance rule"), a modification is significant if, based on all the facts and circumstances, the legal rights or obligations being changed and the degree to which they are being changed are economically significant.³¹

When testing a modification under the general significance rule, all modifications made to the instrument (other than those for which specific bright-line rules are provided) are considered collectively. Thus, a series of related modifications, each of which independently is not significant under the general significance rule, may together constitute a significant modification.³² The general significance rule also applies to a type of modification for which specific rules are provided if the modification is effective upon the occurrence of a substantial contingency.³³ Moreover, the general significance rule will apply to certain types of modifications that are effective on a substantially deferred basis.³⁴

B. Comparison of Regulations and Case Law/Rulings

1. Increased Principal Amount

The IRS generally has not viewed an increase in the principal amount of debt attributable to accrued, unpaid interest as causing a deemed exchange. The regulations, by contrast, treat capitalization of accrued but unpaid interest as a deemed exchange if the capitalization changes the yield on the debt instrument by more than the greater of 25 basis points or 5% of the original yield on the instrument.⁷¹ This issue often arises in debt restructurings, where it is common for accrued but unpaid interest payments to be capitalized and added to the principal amount of the restructured debt.⁷²

2. Change from Annual Pay to Monthly Pay

Debt is often modified in restructurings to change annual arrears interest payments to monthly advance payments. In most cases, a change from annual pay to monthly pay without a corresponding decrease in interest rate will cause more than a 25 basis point increase in the annual yield of the debt. Before the regulations were adopted, the IRS took the position that a more than de minimis change in yield caused a deemed exchange.⁷³ Under the regulations, the change from annual to monthly pay (without a reduction in interest rate) will cause a deemed exchange of the debt, since any change of more than 25 basis points (or 5% of the original yield, if greater) in the annual yield of a debt instrument causes a deemed exchange.⁷⁴ This type of change is often engendered by the borrower's use of funds earmarked for debt service to satisfy more immediate cash needs.

3. Forbearance of Remedies

While lenders often continue to reserve their right to charge default interest after a borrower's failure to make its annual interest payment has matured into a default, a debt restructuring may include a waiver of the right to charge such default interest. Under case law and the IRS' ruling position, the forbearance of remedies (including a waiver of the current payment of interest continuing to accrue) generally does not cause a deemed exchange.⁷⁵ Under the regulations, a party's waiver of a right under an instrument will cause a deemed exchange unless the waiver is unilateral and, in the case of an option exercisable by a holder, the exercise does not result in a deferral of, or reduction in, any scheduled payment of interest or principal.⁷⁶ Absent a written or oral agreement to alter other terms of the instrument, an agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right is not a modification unless and until the forbearance remains in effect for a period that exceeds two years following the issuer's initial failure to perform, and any additional period during which the parties conduct good faith negotiations or during which the issuer is in a Title 11 or similar case.⁷⁷

4. Extension of Maturity Date

Almost every restructuring includes some extension of the maturity date on the debt. Under case law and IRS rulings predating the regulations, an extension of maturity did not cause a deemed exchange of the debt.⁷⁸ Under the regulations, an extension of the maturity date on the debt is a significant modification if it results in the material deferral of scheduled payments.⁷⁹ The regulations allow the deferral of payments within a safe-harbor period (the lesser of five years or 50% of the original term of the instrument) if the deferred amounts are unconditionally payable at the end of that period.⁸⁰ Thus, meaningful extensions of the term of debt will be severely curtailed under the regulations. In particular, there may be virtually no ability to extend maturity under the regulations where debt being restructured has already been refinanced for only a short term. Moreover, even if a deferral does not trigger a deemed exchange of the debt, deferring interest may transform non-OID debt into OID debt.⁸¹

5. Changes in Obligor or Collateral

The IRS has not viewed the addition of a guarantee as triggering a deemed exchange.⁸² Although there is no authority regarding the release of a guarantee, such a release should not trigger a deemed exchange according to the IRS' view. Under the regulations, the release of a guarantee of nonrecourse debt generally causes a deemed exchange of the debt instrument, whereas the release of a guarantee of recourse debt causes a deemed exchange of the debt instrument if the modification results in a change in payment expectations.⁸³ Lenders often agree to release guarantees of either interest or principal in connection with a debt restructuring, generally because the guarantees are of little practical value due to the fact that the guarantors (often related parties) are also in financial distress. A change in an amount of nonrecourse debt collateral that is not substantial generally will not result in a deemed exchange under either IRS rulings⁸⁴ or the regulations.⁸⁵

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Footnotes

* The author would like to thank Hoon Lee, Aliza R. Levine, Jean M. Bertrand, John T. Thomas, Gary T. Silverstein and Christopher Slimm for their invaluable assistance in updating this article.

1 All section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and to the Treasury Regulations promulgated thereunder.

2 Treas. Reg. § 1.1001-3, added by T.D. 8675, 1996-29 I.R.B. 5 (June 26, 1996).

3 See generally New York State Bar Association, Tax Section, Report of Ad Hoc Committee on Provisions of the Revenue Reconciliation Act of 1990 Affecting Debt-for-Debt Exchanges, 51 TAX NOTES 79 (Apr. 8, 1991).

4 499 U.S. 554 (1991).

5 Prop. Treas. Reg. § 1.1001-3, 57 Fed. Reg. 57,034 (Dec. 2, 1992); Cottage Savings Association v. Commissioner, 499 U.S. 554, (1991). For background on the proposed regulations, see Lawrence H. Brenman, Tax-Oriented Investments: Proposed Regulations Regarding Debt Modification Issued in Response to Cottage Savings Decision, 10 J. Partnership Tax'n 175 (1993); Richard M. Lipton, IRS Issues Proposed Regulations on Debt Modifications, 71 Taxes 67 (1993); Linda Z. Swartz, Troubled Real Estate Partnerships: What Options Are Available to Foreign Lenders?, 12 J. Partnership Tax'n 196 (1995).

6 Treas. Reg. § 1.1001-3, added by T.D. 8675, 1996-29 I.R.B. 5 (June 26, 1996).

7 Treas. Reg. § 1.1001-3; see also Priv. Ltr. Rul. 1999-50-022 (Sept. 16, 1999) (holding that an investor that exchanges a pool of securities matching in number and type the securities represented by a specified number of units in an investment trust is not considered to have materially altered its ownership position in the securities, and is not required to recognize gain or loss with respect to the securities for purposes of section 1001).

8 Priv. Ltr. Rul. 84-51-012 (Aug. 23, 1984) (constructive sale of notes under section 1001 where maturity date and interest rate of notes was materially and involuntarily altered by the New York State Emergency Moratorium Act); supplementing Priv. Ltr. Rul. 80-52- 023 (Sept. 25, 1980). By contrast, some courts have treated troubled debt restructurings more liberally than they have restructurings in the absence of economic distress. See, e.g., Mutual Loan & Savings Co. v. Commissioner, 184 F.2d 161 (5th Cir. 1950); Newberry v. Commissioner, 4 T.C.M. (CCH) 576 (1945). Moreover, the IRS Chief Counsel stated in 1977 that "as a matter of policy" the IRS will not litigate the issue of whether a deemed debt exchange has occurred when involuntary changes are made to a debt instrument that is in default, unless the bonds were acquired "in contemplation of realizing a gain from the change in terms." G.C.M. 37,002 (Feb. 10, 1977). Although the IRS has not retracted this General Counsel Memorandum, it is doubtful whether it continues to represent the IRS' position in light of the regulations.

9 See Treas. Reg. § 1.1001-3(c)(6)(iii) (providing that a "modification" occurs upon the effective date of a plan of reorganization in a Title 11 or similar case if a change in a term of a debt instrument occurs pursuant to such plan); see also Treas. Reg. § 1.1001-3(c)(4), (d), Ex. 13.

10 Treas. Reg. § 1.1001-3(c)(1)(i); see also Priv. Ltr. Rul. 2011-39-003 (Sept. 30, 2011) (subsidy payments made by loan servicer on behalf of borrower who was a member of the armed services was not a modification because subsidy payments were an arrangement between the borrower and the loan servicer that did not change the mortgage owners' legal relationship with the borrower).

11 Treas. Reg. § 1.1001-3(c)(1)(ii).

12 Under temporary and proposed regulations issued under section 1001, an exchange or assignment of derivatives (including notional principal contracts) by a dealer or clearing organization to another dealer or clearing organization is not a taxable event, even if a third party's consent is required. Temp. Reg. § 1.1001-4T(a)(1)-(2). If, however, the terms of the derivative instrument are otherwise modified, the assignment may result in a taxable exchange under section 1001. Temp. Reg. § 1.1001-4T(a)(3); see also Marie Sapirie, Proposed Regs Address Derivative Contract Assignments, TAX NOTES (July 25, 2011).

13 Treas. Reg. § 1.1001-3(c)(2)(i). Note that the obligor of a tax-exempt bond is the entity that actually issues the bond and not a conduit borrower of bond proceeds. Treas. Reg. § 1.1001-3(f)(6)(i); see also Priv. Ltr. Rul. 2000-47-046 (Aug. 30, 2000) (parent obligor's removal of subsidiary as co-obligor on conduit loans securing industrial revenue bonds ("IRBs") was a modification occurring by operation of the terms of the IRBs where the loan terms allowed the removal of the subsidiary as co-obligor without the consent of the holders of the IRBs; change-in-obligor exception did not apply because neither the parent nor the subsidiary were considered obligors with respect to the IRBs, which are obligations of the issuing state or local governments or agencies).

14 Treas. Reg. § 1.1001-3(c)(2)(ii).

15 Treas. Reg. § 1.1001-3(c)(2)(iii).

16 It should be noted that this is an absolute test—even an economically insignificant right of the other party to alter the instrument may prevent the option from being unilateral. Obviously, a de minimis exception in this regard would be welcome. See also Priv. Ltr. Rul. 2011-49-017 (Dec. 9, 2011) (no significant modification after unilateral option resulting in mandatory tender by holders; in accordance with bond terms because the mandatory tender was not equivalent to a holder's right to alter or terminate the bonds).

17 Treas. Reg. § 1.1001-3(c)(3).

18 Treas. Reg. § 1.1001-3(c)(4)(i).

19 Treas. Reg. § 1.1001-3(c)(4)(ii).

20 Treas. Reg. § 1.1001-5.

21 Only eleven members of the European Union initially participated in the conversion of their national currencies to the euro. The eleven members were: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal and Spain. Today, sixteen of the twenty-seven member states of the European Union have adopted the euro as their official currency.

22 See, e.g., Deloitte & Touche Joins Microsoft and Others in Seeing Euro Conversion as "Non-Event," 98 TNT 93-35 (Apr. 30, 1998).

23 Treas. Reg. § 1.1001-5(a); T.D. 8776, 1998-33 I.R.B. 6 (July 29, 1998) (temporary regulations); T.D. 8927, 2001-11 I.R.B. 807 (Jan. 10, 2001) (final regulations).

24 Treas. Reg. § 1.1001-5(b) (effective for tax years ending after July 29, 1998).

25 Treas. Reg. § 1.1001-5(b).

26 Treas. Reg. § 1.1001-3(c)(5).

27 Treas. Reg. § 1.1001-3(c)(6)(i).

28 See Treas. Reg. § 1.1001-3(c)(6)(ii), (iii).

29 Treas. Reg. § 1.1001-3(c)(6)(ii), (iii).

30 Treas. Reg. § 1.1001-3(e).

31 Treas. Reg. § 1.1001-3(e)(1).

32 Treas. Reg. § 1.1001-3(e)(1); Rev. Rul. 81-169, 1981-1 C.B. 429 (holding that reduction in interest rate, extension of maturity and elimination of sinking fund requirement, "taken together," constituted a material modification); Priv. Ltr. Rul. 98-44-021 (Oct. 30, 1998) (modifications of the terms of bonds involving interest, repayment, security, and redemption rights conferred legally distinct entitlements sufficient to trigger a deemed exchange under section 1001); FSA 1999-665 (Aug. 9, 1993) (during the time period the proposed debt exchange regulations were outstanding, the IRS stated that a significant modification due to a change in yield can result from a change in either the amount or timing of payments); but see Priv. Ltr. Rul. 98-19-043 (May 8, 1998) (ruling that a proposed modification of notes did not constitute a significant modification because each step in the series of modifications did not alter the legal rights and obligations of the parties to any economically significant degree).

33 Treas. Reg. § 1.1001-3(f)(1)(ii).

34 Treas. Reg. § 1.1001-3(f)(1)(iii).

35 Treas. Reg. § 1.1001-3(e)(2)(i). Under the prior proposed regulations, a change to the terms of a debt instrument that caused the annual yield of the instrument to change by more than ¼ of 1% (25 basis points) constituted a significant modification. Three separate tests were used to determine whether alterations in the terms of a debt instrument caused such a change in the yield of an instrument. First, any change of more than 25 basis points in the stated interest rate of a debt instrument that provided for current interest payments was a significant modification. Second, a change in the index, formula, or other mechanism that was used to determine the interest rate on a variable rate debt instrument was a significant modification only if the change could reasonably be expected to affect the annual yield on the debt instrument by more than 25 basis points. Third, any other change to a debt instrument that changed the yield on the instrument by more than 25 basis points was a significant modification. Prop. Treas. Reg. § 1.1001-3(e)(1); see also FSA 1999-665 (Aug. 9, 1993) (during the time period the proposed regulations were outstanding, the IRS stated that a change in yield that causes a significant modification can result from a change in either the amount or timing of payments).

36 See Treas. Reg. § 1.1001-3(e)(2)(iii)(B).

37 Treas. Reg. § 1.1001-3(e)(3)(i). The regulations do not address acceleration of payments, which presumably would be a modification, but not a significant modification. Query whether the sale of coupon rights back to the issuer would be treated simply as prepayments or as a modification of the entire debt instrument. Such a sale may also be treated as a bond-stripping transaction under section 1286. See James M. Peaslee, Modifications of Nondebt Financial Instruments as Deemed Exchanges, 95 TAX NOTES 737, 771-73 (Apr. 29, 2002).

38 Treas. Reg. § 1.1001-3(e)(3)(ii).

39 Treas. Reg. § 1.1001-3(e)(3)(i).

40 Treas. Reg. § 1.1001-3(e)(3)(i).

41 Prop. Treas. Reg. § 1.1001-3(e)(2)(i).

42 Prop. Treas. Reg. § 1.1001-3(e)(2)(ii).

43 Prop. Treas. Reg. § 1.1001-3(e)(2)(iii), (g), Ex. 3.

44 Prop. Treas. Reg. § 1.1001-3(e)(2)(iv).

45 Treas. Reg. § 1.1275-2(j).

46 See Section IV below for a more detailed description of the OID rules.

47 Treas. Reg. § 1.1001-3(e)(4)(ii).

48 Treas. Reg. § 1.1001-3(e)(4)(i). See Priv. Ltr. Rul. 2007-42-016 (October 19, 2007) (ruling that substituting the guarantor as the primary obligor and releasing the borrower from liability was a significant modification).

49 Treas. Reg. § 1.1001-3(e)(4)(i)(B),(C),(E). See, e.g., Priv. Ltr. Rul. 97-11-024 (Mar. 14, 1997) (ruling that in a tax-free spinoff under section 355, the substitution of the controlled corporation for the distributing corporation as obligor was not a significant modification; the transaction was an acquisition of substantially all the assets of distributing corporation under Treas. Reg. § 1.1001- 3(e)(4)(i)(C), it did not result in a significant alteration, and payment expectations did not change); see also Priv. Ltr. Rul. 2007-09-013 (March 2, 2007) (ruling that there was not a significant modification of the debt of a company that converted from a corporation to a limited liability company and was partially acquired by a third-party because under state law there was no change in the creditors' rights against the company or the company's obligations under state law and each step of the transaction where a new obligor was substituted qualified for an exception under Treas. Reg. § 1.1001-3(e)(4)(i)(B) or (C)); Priv. Ltr. Rul. 2010-10-015 (Mar. 12, 2010) (ruling that there was not a significant modification of the debt of a subsidiary that converted into an LLC as part of its parent's reorganization, because the transaction would not affect the legal rights or obligations between the debt holders and the subsidiary or otherwise result in a change in payment expectations).

50 Treas. Reg. § 1.1001-3(e)(4)(i)(G).

51 Treas. Reg. § 1.1001-3(e)(4)(i)(D).

52 Treas. Reg. § 1.1001-3(e)(4)(i)(B).

53 Treas. Reg. § 1.1001-3(e)(4)(i)(F).

54 Treas. Reg. § 1.1001-3(e)(4)(vi)(A).

55 Treas. Reg. § 1.1001-3(e)(4)(vi)(B). An obligor's capacity includes any source for payment, including collateral, guarantees or other credit enhancement.

56 Treas. Reg. § 1.1001-3(e)(4)(iii).

57 Treas. Reg. § 1.1001-3(e)(4)(iv)(A), (v).

58 Treas. Reg. § 1.1001-3(e)(4)(iv)(B). It is not clear whether the term "substantial amount of" qualifies only the collateral for a nonrecourse debt or also the guarantee or other credit enhancement for the debt. Arguably, only an alteration of a substantial amount of a guarantee on or credit enhancement for a nonrecourse debt should trigger a deemed exchange, and a fungibility concept should apply so that a substitution of a guarantor that produces an equally valuable guarantee (e.g., same credit quality) should not be a significant modification.

59 Treas. Reg. § 1.1001-3(e)(4)(iv)(B).

60 Treas. Reg. § 1.1001-3(e)(5)(i).

61 Treas. Reg. § 1.1001-3(e)(5)(i). The preamble to the 1996 final regulations explained that for purposes of Treasury regulation section 1.1001-3, "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 (June 25, 1996). However, the actual language of the final regulations limits this qualification only to a modification under paragraph (e)(5)(1), and thus the qualification does not literally apply to a modification that would be treated as significant under any of the other subsections of Treasury regulation section 1.1001-3. The government recognized this confusion, and recently issued final Treasury regulations clarifying that any deterioration in the financial condition of the issuer is generally not taken into account to determine if the modified instrument is debt (unless there is a change in obligor), even if the modification is treated as significant under the other provisions of Treasury regulation section 1.1001-3. Treas. Reg. § 1.1001-3(f)(7)(ii)(A). For a discussion of these regulations, see Richard M. Lipton, Proposed Regulations Address Impact of a Decline in Debt Issuer's Financial Status under Debt Modification Regulations—or Do They? 13 J. Passthrough Entities 4 (July-Aug. 2010).

62 Prop. Treas. Reg. § 1.1001-3(e)(4)(iv). Under the proposed regulations, each of the following changes was a significant modification: (i) changing a fixed rate instrument to a variable rate or contingent payment instrument; (ii) changing a variable rate instrument to a fixed or contingent rate instrument; (iii) changing a contingent payment instrument to a fixed rate or variable rate instrument; or (iv) changing the currency in which payment under the debt instrument is made. Prop. Treas. Reg. § 1.1001-3(e)(4)(ii). The final regulations lack these bright-line rules, and so the significance of any change in method of calculating payments is determined under the general significance rule.

63 Treas. Reg. § 1.1001-3(e)(5)(ii)(A)

64 Treas. Reg. § 1.1001-3(e)(5)(ii)(A).

65 Treas. Reg. § 1.1001-3(e)(5)(ii)(B)(1). The defeasance will not be a significant modification if it occurs pursuant to the terms of the indenture for the original bonds and the issuer places in trust government securities or tax-exempt government bonds reasonably expected to provide interest and principal to cover payment obligations under the bonds.

66 Treas. Reg. § 1.1001-3(e)(5)(ii)(B)(2).

67 Treas. Reg. § 1.1001-3(e)(5)(ii)(B)(2).

68 For a discussion of the meaning of the terms "recourse" and "nonrecourse" in the context of debt of disregarded entities, see Terence Floyd Cuff, Indebtedness of a Disregarded Entity, 81 Taxes 303 (Mar. 2003).

69 For arguments in favor of allowing taxpayers to choose classification of debt, see James M. Peaslee, Modifications of Nondebt Financial Instruments as Deemed Exchanges, 95 TAX NOTES 737 (Apr. 29, 2002)

70 See Priv. Ltr. Rul. 2006-30-002 (June 28, 2006) (conversion of old parent of consolidated group into a limited liability company owned by new parent does not result in modification of nonrecourse debt issued by old parent where holders' legal rights against old parent with respect to payment and remedies, and old parent's obligations and covenants to the holders, were unchanged under state law); Priv. Ltr. Rul. 2003-15-001 (Sept. 19, 2002) (same).

71 Treas. Reg. § 1.1001-3(e)(2).

72 See FSA 2000-06-003 (Feb. 11, 2000) (U.S. corporation liable for withholding tax for accrued but unpaid interest when interest was contributed as paid in capital by the foreign parent).

73 See, e.g., Rev. Rul. 89-122, 1989-2 C.B. 200 (holding that reduction in annual interest rate from 10% to 6.25% constituted a material modification); Rev. Rul. 87-19, 1987-1 C.B. 249 (holding that waiver of right to receive increase in interest rate from 7% to 8.56% resulted in a deemed exchange); TAM 91-27-003 (Mar. 18, 1991) (holding that 87.5 basis point reduction constituted a material modification under section 1001); Priv. Ltr. Rul. 88-34-090 (June 3, 1988) (assuming for ruling purposes that 20 basis point change in yield constituted a material modification); cf. Priv. Ltr. Rul. 89-32- 067 (May 17, 1989) (ruling that a less than 12.5 basis point change in yield did not constitute a material modification); Priv. Ltr. Rul. 88- 35-050 (June 8, 1988) (ruling that reduction in yield by less than 3 basis points was de minimis).

74 Treas. Reg. § 1.1001-3(e)(2)(ii).

75 Priv. Ltr. Rul. 89-20-047 (Feb. 17, 1989); see also West Missouri Power Co. v. Commissioner, 18 T.C. 105 (1952), acq., 1952-2 C.B. 3; Motor Products Corp. v. Commissioner, 47 B.T.A. 983 (1942), aff'd, 142 F.2d 449 (6th Cir. 1944), acq., 1946-1 C.B. 3; Farmers Trust Co. v. Hoey, 52 F. Supp. 665 (S.D.N.Y. 1942), aff'd, 138 F.2d 1023 (2d Cir. 1943).

76 See Treas. Reg. § 1.1001-3(c)(2)(iii).

77 See Treas. Reg. § 1.1001-3(c)(4).

78 See Rev. Rul. 73-160, 1973-1 C.B. 365; see also Priv. Ltr. Rul. 90- 43-060 (Aug. 1, 1990); Priv. Ltr. Rul. 88-48-033 (Sept. 1, 1988); Priv. Ltr. Rul. 88-29-028 (Apr. 20, 1988); Priv. Ltr. Rul. 87-53-014 (Oct. 2, 1987); Priv. Ltr. Rul. 87-42-032 (July 20, 1987); Priv. Ltr. Rul. 87-31-011 (May 1, 1987); Priv. Ltr. Rul. 87-08-017 (Nov. 21, 1986); Priv. Ltr. Rul. 85-34-064 (May 28, 1985); Priv. Ltr. Rul. 83- 46-104 (Aug. 18, 1983). In a 1989 private ruling, deferral of interest payments was permitted under a net cash flow workout where deferred interest bore interest on a compound basis. Priv. Ltr. Rul. 89-20-047 (Feb. 17, 1989) (citing Motor Products Corp. v. Commissioner, 47 B.T.A. 983; (1942), aff'd per curiam, 142 F.2d 449 (6th Cir. 1944) and West Missouri Power Co. v. Commissioner, 18 T.C. 105 (1942), acq., 1952-2 C.B. 3).

79 Treas. Reg. § 1.1001-3(e)(3)(i).

80 Treas. Reg. § 1.1001-3(e)(3)(ii).

81 See Treas. Reg. § 1.1275-2(j).

82 Priv. Ltr. Rul. 85-34-064 (May 28, 1985).

83 Treas. Reg. § 1.1001-3(e)(4)(iv); see also Priv. Ltr. Rul. 2000-47- 046 (Aug. 30, 2000); Priv. Ltr. Rul. 1999-04-017 (Oct. 29, 1998) (parent's assumption of indirect subsidiary's debt was not a significant modification because the assumption did not cause a change in payment expectations); Priv. Ltr. Rul. 2000-47-046 (Aug. 30, 2000) (removal of subsidiary as guarantor was not a significant modification because the subsidiary's earnings and assets would continue to provide parent with payment capacity, causing no change in payment expectations).

84 See Priv. Ltr. Rul. 98-01-047 (Oct. 3, 1997) (reducing the principal amount of U.S. Government obligations to be delivered as substitute collateral to obtain the release of a lien on real property from 125% to 100% of the outstanding balance of mortgage loan was not a significant modification because the amendment did not release a substantial amount of collateral and the obligation to repay the entire mortgage loan remained fully secured).

85 Treas. Reg. § 1.1001-3(e)(4)(iv).

Copyright 2012 by LexisNexis Matthew Bender, reprinted with permission from Collier on Bankruptcy Taxation and Volume 15 of Collier on Bankruptcy, 15th Ed. Revised by M. Sheinfeld, F. Witt, and M. Hyman; Alan N. Resnick and Henry J. Sommer, Editors-in-Chief. All rights reserved.

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