Treasury Issues Proposed Regulation to Section 1001 Pertaining to Debt Modification Rules.
When the terms of a debt instrument (e.g., mortgage, note or bond) are modified by agreement, the modification may be significant enough to result in a deemed taxable exchange of the original debt instrument for a “new” debt instrument. This outcome, which has tax impacts on both the lender and the borrower, was announced in the Supreme Court’s decision in Cottage Savings v. Commissioner, 499 U.S. 554 (1991), and regulations which were issued thereafter under Treas. Reg. §1.1001-3. Under §1001, gain or loss is recognized by the lender and the debtor may find itself with cancellation of indebtedness income which then must be tested under §108 to see if there is a way to exclude the result from the borrower’s gross income.
Treas. Reg. § 1.1001-3(c)(2)(ii) generally provides that a modification to a debt instrument occurs if an alteration changes the instrument to an instrument or property right that is not debt for federal income tax purposes, even if the alteration occurs by operation of the original terms of the debt instrument. Treas. Reg. § 1.1001-3(e)(5)(i) provides that a modification of a debt instrument that results in an instrument or property right that is not debt for federal income tax purposes is a significant modification. For purposes of this regulation, any deterioration in the financial condition of the issuer between the issue date of the unmodified debt instrument and the date of modification (as it relates to the issuer's obligation to repay the debt instrument) is not taken into account, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor.
The rule in Treas. Reg. § 1.1001-3(e)(5)(i) to disregard the worsening (or improving) financial condition of the issuer was originally intended to soften the potential for an adverse income tax impact to a financially troubled issuer. Thus, where a debt instrument is modified to accommodate the borrower in a troubled financial situation context, a hidden tax on the modification would place an additional burden on the borrower and would run adverse as well to the lender’s interest in seeing the adjusted obligated repaid in full. Despite this intent, the regulations can be viewed as imposing a taxable modification of a troubled borrower under certain instances. See Treas. Reg. § 1.1001-3(c)(2)(ii) .
IRS has just issued proposed regulations which clarify the extent to which the deterioration in the financial condition of a debt instrument's issuer is taken into account in determining whether a modified debt instrument is recharacterized as an instrument or property right that is not debt.
Under the proposed regulation, an analysis of all of the factors relevant to a debt determination of the modified instrument are to be analyzed at the time of the modification. However, in making this determination, any deterioration in the financial condition of the issuer between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the issuer's ability to repay the debt instrument) is not taken into account ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ) unless there is a substitution of a new obligor or the addition or deletion of a co-obligor. ( Prop. Reg § 1.1001-3(f)(7)(ii)(B) ) For example, any decrease in the fair market value of a debt instrument (whether or not publicly traded) between the issue date of the debt instrument and the date of the alteration or modification is not taken into account to the extent that the decrease in FMV is attributable to the deterioration in the financial condition of the issuer and not to a modification of the terms of the instrument. ( Prop. Reg § 1.1001-3(f)(7)(ii)(A) ). Where a debt instrument is significantly modified and the issue price of the modified debt instrument is determined under Prop. Reg § 1.1273-2(b) or Prop. Reg § 1.1273-2(c) (relating to a FMV issue price for publicly traded debt), then any increased yield on the modified debt instrument attributable to this issue price generally is not taken into account to determine whether the modified debt instrument is debt or some other property right for federal income tax purposes. However, any portion of the increased yield that is not attributable to a deterioration in the financial condition of the issuer, such as a change in market interest rates, is taken into account. ( Preamble to Prop Reg 06/03/2010 ). Effective date. The proposed regs apply to alterations of the terms of a debt instrument on or after the date the regs are finalized, but taxpayers may rely on them for alterations of the terms of a debt instrument occurring before that date. ( Prop Reg § 1.1001-3(h)(2) ).
