ABA Members Propose Changes to Debt Instrument Modification Regs

Dear Commissioner Koskinen:

Enclosed please find proposals for revisions to the regulations dealing with significant modifications of debt instruments ("Comments"). These Comments are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss the Comments with you or your staff if that would be helpful.

Sincerely,

Karl Walli, Senior Counsel (Financial Products), Department of the Treasury

William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service

Helen Hubbard, Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service

Diana Imholtz, Special Counsel to the Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service

Principal responsibility for preparing these Comments was exercised by a working group of the Section's Financial Transactions Committee (the "Committee") comprised of Elizabeth Bouzis, Gerald Feige, David Garlock, Craig Gibian, Richard Larkins, Eileen Marshall, Michael Shulman, Nathan Tasso, and Michael Yaghmour. Substantive contributions were made by Micah Bloomfield, Lucy Farr, Robert Kantowitz, Jim Peaslee, Steve Rosenthal, Michael Schler, Matthew Stevens, Jonathan Zelnick, and Lee Zimet. The Comments were reviewed by Michael Shulman, Chair of the Committee. The Comments were further reviewed by Gary Wilcox, the Section's Council Director for the Committee, and Julian Y. Kim, the Section's Vice Chair (Government Relations).

Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contacts:

These Comments make 25 recommendations for revision of the Regulations. The authors of the Comments acknowledge that certain of these recommendations are more important than others. Hence, we have assigned a "rating" to each recommendation of 1 for the most important recommendations, 2 for the middle category and 3 for the least critical recommendations. In addition, we recognize that certain recommendations are more easily implemented than others. Accordingly, we have designated recommendations that we believe could be easily implemented with the letter "E." The recommendations appear in parentheses in the heading of each recommendation below.

A. General Recommendations

Under Regulation section 1.1001-3(c), any alteration to a debt instrument must be tested to determine whether a "modification" has occurred. If a modification has occurred, then the modification must be tested for significance under Regulation section 1.1001-3(e). If a modification is significant, the alteration results in a deemed exchange of the unmodified debt instrument for the modified debt instrument.

Regulation section 1.1001-3(c)(1)(i) defines a modification as "any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties or otherwise." With certain exceptions, alterations that occur by operation of the terms of a debt instrument or pursuant to the exercise of certain unilateral options are not considered modifications.⁴ One exception to this rule, however, provides that when either a change in obligor or a change in the recourse nature of a debt instrument occurs, the change is a modification that must be tested for significance (the "Operation of the Terms Exception") even if such change occurs pursuant to the original terms of the debt instrument.⁵

The Regulations do not define what constitutes a "legal right" for purposes of Regulation section 1.1001-3(c)(1)(i) and do not address whether a change solely in the tax law characterization of the obligor on the instrument or the nature of an instrument is included in the meaning of a "legal right." However, in a 2006 private letter ruling⁶ ("PLR") and an advice memorandum in 2011,⁷ the Service⁸ interpreted the Operation of the Terms Exception in a way that suggests that a change in the tax status of the obligor (from regarded to disregarded or vice versa) could be viewed as a change in a legal right for purposes of the Regulations, while a 2003 PLR⁹ indicates that such a change should not be considered a change in a legal right for such purposes.

In PLR 200315001 (the "2003 Modification PLR"), Parent was the issuer of publicly traded recourse debt. Parent underwent a restructuring pursuant to section 368(a).¹⁰ After the restructuring, Parent was a disregarded LLC owned by New Parent. The restructuring did not require consent of the holders and did not alter the legal rights and obligations under the debt instruments. In its analysis, the Service noted that the legal rights and obligations referred to in Regulation section 1.1001-3(c) are rights that are determined under state law and further noted, "the restructuring will not affect an alteration that results in either a change of obligor or a change in the recourse nature of the [d]ebt for purposes of [the Operation of the Terms Exception]." Accordingly, the 2003 Modification PLR held that the restructuring did not result in a modification for purposes of the Regulations.

Essentially the same facts were present in PLR 200630002¹¹ (the "2006 Modification PLR"), but the analysis and conclusion were notably different. Consistent with the 2003 Modification PLR, the analysis in the 2006 Modification PLR notes that (i) the restructuring cannot result in the creation of any new legal rights or obligations between the holders and New Parent; and (ii) there is no change in the recourse nature of the debt instrument. The analysis in the 2006 Modification PLR, however, diverges from the 2003 Modification PLR by failing to address directly whether the restructuring is a modification. Rather, the 2006 Modification PLR holds that the restructuring does not result in a significant modification under Regulation section 1.1001-3(e). By specifically concluding that (i) there was no change in the recourse nature of the debt instrument and (ii) the restructuring was not a significant modification, the 2006 Modification PLR could be interpreted as implying that the restructuring was a modification that needed to be tested for significance notwithstanding its determination that no legal rights or obligations had changed. Alternatively, the Service might be viewed as having determined that it did not need to address the more difficult question of whether the restructuring was a modification, in effect ruling that even if it were a modification, it was not a significant modification.

Advice Memorandum 2011-003¹² (the "2011 Advice Memorandum") addresses the tax consequences of a check-the-box election by an insolvent foreign subsidiary of a domestic corporation. The foreign subsidiary was a corporation owned 80% by the domestic corporation and 20% by another foreign subsidiary of the domestic corporation. As a consequence of the check-the-box election, the foreign subsidiary was deemed to distribute its assets and liabilities to its shareholders, and then the shareholders were deemed to contribute the assets and liabilities to a new partnership. The check-the-box election did not affect the liabilities of the subsidiary with respect to its creditors under local law, but the Service explicitly held that the obligor's change in entity status from a corporation to a partnership was a change in obligor for tax purposes (i.e., a modification).¹³ Nevertheless, the Service concluded that, regardless of whether the liabilities were nonrecourse or recourse, the modification was not significant for purposes of the Regulations: If the liabilities were nonrecourse, Regulation section 1.1001-3(e)(4)(ii) provides a per se rule that a change in obligor is not significant, and if the liabilities were recourse, the change in obligor would fall within the exception of Regulation section 1.1001-3(e)(4)(i)(C) where substantially all the assets and liabilities of the original obligor are acquired, there is no change in payment expectations, and there is no alteration to the terms of the debt.

Reasons for Change

The fact that the Operation of the Terms Exception requires that all changes to an obligor or the nature of a debt instrument be analyzed as modifications for significance may lead taxpayers to believe that changes to the tax characterization of a party to, or the nature of, a debt instrument are required to be tested for significance, even when the legal obligor and legal nature of the debt instrument have not changed. To further complicate matters, it is unclear what constitutes a change in obligor or a change in the nature of a debt instrument from recourse to nonrecourse (or vice versa). The Regulations, as discussed in greater detail below, do not define the terms "recourse" and "nonrecourse." Consequently, in fairly common transactions, it is unclear whether a change to the tax law characterization of an issuer (by itself or in conjunction with other changes) results in the recognition of gain or loss on a debt instrument.

For example, consider the following situation: P owns S, a disregarded entity. P owns a substantial amount of assets in addition to its interest in S. S issues a recourse debt instrument to H. S subsequently makes an election to be treated as a corporation for federal income tax purposes. As a result of the check-the-box election, the parties are treated for income tax purposes as if P had contributed the assets actually held by S (but not the assets held outside of S) to newly formed S and S had assumed the debt owed to H. In other words, as a consequence, S rather than P is now treated for tax purposes as the obligor on S's debt instrument. If the tax law definition of obligor controls, this would be a significant modification of the debt for H because the obligor has changed and, because less than substantially all of P's assets were transferred to S, the exception in Regulation section 1.1001-3(e)(4)(i)(C) does not apply.

H's legal rights, however, have not changed: upon default, H has always had a right to collect only against S's assets and cannot demand payment from P. In fact, P and S may not even notify H that a check-the-box election has been made. In this example, we believe that the result under the Regulations should be clear: no modification has occurred that must be tested for significance because H's legal rights and entitlements did not change.

In our view, the implication of the 2006 Modification PLR and the conclusion in the 2011 Advice Memorandum and certain other private letter rulings that a change in the tax status of the obligor is a modification for purposes of the Regulations is incorrect.¹⁴ A change that solely impacts the way the tax law would characterize a debt instrument does not, by definition, change the legal obligations and entitlements of the issuer and the holder, nor does it change the nature of the debt instrument.

Proposal

We recommend that Regulation section 1.1001-3(c)(1)(i) be clarified to state that whether a modification of a debt instrument is deemed to occur is determined solely by reference to the changes, if any, in the legal rights and obligations under the instrument. Thus, a modification does not include changes that occur solely as a result of elections to treat an entity as regarded or disregarded for tax purposes, unless there are also changes to the legal rights and obligations under the debt instrument. For instance, an example could be added to Regulation section 1.1001-3(c)(1)(i) to confirm that a mere change in the tax characterization of an issuer of a debt instrument that has no effect on the legal rights and obligations of the parties to the debt instrument is not a modification for purposes of the Regulations. On the other hand, in cases where the legal rights and obligations under the debt instrument are affected, these changes should be treated as modifications and tested for significance regardless of whether the entities involved are treated as a single taxpayer for tax purposes. For example, where a disregarded entity assumes the debt of its owner, the obligor is not treated as changing from a tax perspective (i.e., the owner remains the tax obligor) but the legal obligor has changed, and the transaction should be tested under the Regulations applicable to the substitutions and additions of obligors.

As discussed above, the Operation of the Terms Exception provides that any change in obligor on a debt instrument is a modification, even if it occurs pursuant to the terms of the instrument.

Reasons for Change

If a debt instrument gives the original obligor the right to substitute a different obligor (typically, an affiliated corporation or other related party), the holder would have no change in its legal rights under the instrument since it consented to the change in obligor when it bought the instrument. Thus, consistent with the preceding recommendation, the holder arguably should have no taxable event when the change actually occurs. On the other hand, the obligor's credit quality is so fundamental to the debtor/creditor relationship that, even if the original obligor has the right to substitute a new obligor pursuant to the terms of the instrument, an actual substitution and release of the original obligor justifiably could be treated as a change in the holder's rights and therefore as a modification. Balancing the importance of the change with the fact that its possibility was bargained for by the parties at issuance, we conclude that a change in obligor should be treated as a modification, but not as a significant modification, provided that the change in obligor does not result in a change in payment expectations.

Proposal

We recommend that the Operation of the Terms Exception be retained, but that an additional exception in Regulation section 1.1001-3(e)(4) be added providing that a change in obligor is not a significant modification if it does not result in a change in payment expectations. We emphasize, however, that even though a change in the tax obligor may not result in a significant modification of the debt from the standpoint of the holder, it will still have tax consequences to the old and new obligor. Our proposal 5 below recommends that this point be explicitly clarified in the Regulations.

Although our first two recommendations are not explicitly alternatives, we acknowledge that if our first recommendation above is adopted, the need for this second recommended change diminishes considerably. It is commonplace for an issuer that is a disregarded entity to elect to be taxed as a corporation without the consent of the debt holder, but considerably less common for an issuer to substitute a new obligor without remaining as a co-obligor, or at least as a guarantor.¹⁵

We also note that, if our proposal 7 is adopted to remove the distinction between recourse and nonrecourse debt, described in more detail below, one of the main functions of the Operation of the Terms Exception would be eliminated. Consequently, it may be advisable, if both proposal 1 and proposal 7 are adopted, to simply remove the Operation of the Terms Exception, in which case a change in obligor or in the recourse nature of the debt instrument by operation of the terms of the instrument would not be a modification. If the Operation of the Terms Exception is deleted, either Regulation section 1.1001-3(g) Ex. 5 should be removed or a conforming change should be made to reflect that the change in obligor in that example is not a modification and thus is not tested for significance.

Under Regulation section 1.1001-3(b), a significant modification of a debt instrument results in a deemed exchange of the unmodified debt instrument for the modified debt instrument. The Regulations do not address the tax consequences that result from a modification that is not considered significant under the Regulations. Under Regulation section 1.1275-2(j), if a modification is not significant but results in the deferral of one or more payments, then, solely for purposes of sections 1272 and 1273, the debt instrument is treated as retired and reissued for its adjusted issue price on the date of modification. No published guidance has been issued, however, as to the treatment of a modified debt instrument that was not significantly modified other than the case in which payments are deferred.

The OID rules also provide a mechanism to account for contingent payments that are made contrary to the issuer's expectations at original issuance. In that case, solely for purposes of the OID rules, the debt instrument is treated as retired and reissued on the date of the change of circumstances.¹⁶ Further, under the noncontingent bond method (applicable to a contingent payment debt instrument ("CPDI") issued for money or publicly traded property), payments made contrary to original expectations are tax accounted for using positive and negative adjustments.¹⁷ Finally, if a remote or incidental contingency occurs, a debt instrument is deemed retired and reissued for all purposes of sections 163 (excluding Applicable High Yield Discount Obligation ("AHYDO") testing) and 1271 through 1275.¹⁸

Although no published guidance addresses how to tax account for a modification that is not significant and does not defer payments, the Service has privately ruled on the treatment of consent fees paid to modify debt instruments. In PLR 201105016 (Feb. 4, 2011), an issuer paid a consent fee to modify a debt instrument that was not a CPDI in a manner that did not defer payments and was not a significant modification under the Regulations. The PLR held that the consent fee was a payment under the debt instrument that was treated as interest to the extent of the accrued but unpaid interest and then as a payment of principal under Regulation section 1.446-2(e)(1).¹⁹ Accordingly, the payment was deductible by the issuer as repurchase premium under Regulation section 1.163-7(c) only when the modified instrument was retired, rather than causing the debt to be deemed retired and reissued at the time of the payment, which would have resulted in the excess of the stated redemption price at maturity over the adjusted issue price being taken into account as OID. A separate PLR held that a payment made in connection with a non-significant modification to a CPDI to which the noncontingent bond method applied should be accounted for as a positive adjustment, and thus the payment was immediately deductible by the issuer.²⁰

Reasons for Change

We believe that the principles of Regulation section 1.1275-2(j) should be extended to any change to the terms of a debt instrument that does not result in a significant modification but nevertheless changes the yield or payment schedule of the instrument. That is, such a debt instrument should be deemed reissued for purposes of the OID rules even though no retirement and reissuance would occur for other tax purposes. This will allow OID principles to continue to apply to the modified debt in all cases, regardless of the type of modification that caused the change in yield. In particular, we believe that if an issuer of a debt instrument pays a consent fee in connection with a modification that is not significant, the issuer should deduct that fee as OID over the remaining life of the debt because the change benefits the issuer over the entire remaining term of the debt. The same deemed reissuance rule should apply to holders.

Proposal

We recommend that Regulation section 1.1275-2(j) be expanded to apply to all modifications of debt instruments other than CPDIs that change the yield or payment schedule of the instrument. Hence, in the case in which an issuer makes a consent payment to a holder that is not large enough to cause a significant modification, the payment would reduce the adjusted issue price of the debt instrument and would give rise to OID deductible by the issuer over the remaining term of the debt. The holder would also have OID, although in most cases a consent fee that is small enough not to cause a significant modification will give rise to only a de minimis amount of OID, limiting the obligation of holders to take into account such payment prior to sale or retirement of the debt instrument. For purposes of testing whether the OID on the deemed reissued debt is de minimis, we recommend that if the debt instrument was originally issued with a de minimis amount of OID, such OID should be ignored in determining whether the modified instrument has more than a de minimis amount of OID.

We note that, as a practical matter, holders of debt instruments receiving consent payments might well expect that the payment would be treated as ordinary income in the year in which the right to the payment becomes fixed. Tax disclosures in consent solicitations routinely disclose that this could be the tax treatment. While we do not believe that this result is the better answer in theory, it would be simpler to administer and would likely not deter debt holders from granting consents. Thus, we think the Service might consider an alternative to our proposal under which consent fees would be treated as immediately taxable ordinary interest income to the holders receiving the payment but still deductible by issuers as OID over the remaining term of the debt.

Given that the CPDI rules have a mechanism to account for changes in the timing and amount of payments, we think that such modifications should be accounted for under Regulation section 1.1275-4. We recommend that the CPDI regulations be amended to reflect that modifications to CPDIs that are not significant should be treated as the occurrence of a contingency that was not reflected in the projected payment schedule and that any payment made in connection with such modification should be treated as a positive adjustment under Regulation section 1.1275-4.²¹ We considered a recommendation that would result in consistent treatment of consent fees paid on CPDIs and non-CPDIs but concluded that it was not possible to achieve such a result without deviating significantly from either the basic OID rules or the CPDI rules.

Section 1001 requires a taxpayer to recognize gain or loss from the sale or other disposition of property. Under Regulation section 1.1001-3(b), a significant modification to a debt instrument results in an exchange of the unmodified debt instrument for the modified debt instrument. If a debt instrument is significantly modified, a holder of the debt instrument recognizes gain or loss under section 1001 equal to the difference between the holder's adjusted basis in the unmodified debt instrument and the issue price of the modified debt instrument.²² The issuer, on the other hand, does not recognize gain or loss under section 1001 because it does not receive property in exchange for payment of its liability.²³ Rather, an issuer generally (1) recognizes cancellation of indebtedness income under section 61(a)(12) if the issue price of the modified debt instrument is less than the adjusted issue price of the debt instrument,²⁴ or (2) takes into account, subject to certain limitations, repurchase premium under section 163 if the consideration paid to retire the debt instrument is greater than the adjusted issue price of the debt instrument.²⁵

The Regulations provide rules for determining whether a modification of the terms of a debt instrument results in an exchange under Regulation section 1.1001-1(a). The scope of the Regulations, found in Regulation section 1.1001-3(a), provides that the Regulations are applicable when a debt instrument is amended or is exchanged for a new debt instrument. Additionally, it clarifies that it does not apply to exchanges of debt instruments between holders.

Reasons for Change

Section 1001 governs the taxation of sales or exchanges of property. From the perspective of the issuer, a debt instrument is not property but an obligation. Hence, the Regulations under section 1001 do not technically govern the tax consequences to the issuer resulting from a significant modification, such as the discharge of indebtedness or repurchase premium. These consequences are governed by sections 61 and 163, respectively.

Regulation section 1.61-12, which governs cancellation of debt income, provides that a repurchase of a debt instrument includes "the exchange (including an exchange under section 1001) of a newly issued debt instrument for an existing debt instrument."²⁶ Regulation section 1.163-7(c), which governs repurchase premium deductions, provides that a repurchase includes a debt-for-debt exchange. However, neither provision explicitly cross-references the Regulations. Moreover, the Regulations do not state explicitly that the rules set forth in the Regulations apply to issuers as well as holders.

Proposal

We recommend that it be stated explicitly that the Regulations apply to both issuers and holders. This clarification can be made by adding an explicit cross-reference to the Regulations in Regulation section 1.163-7, stating that the deduction on repurchase described in Regulation section 1.163-7(c) is permitted when a modification to a debt instrument is significant as described in the Regulations. A specific reference to the Regulations (in addition to the general reference to section 1001) could also be added to Regulation section 1.61-12(c)(2)(i).

Furthermore, we recommend that it be clarified that the economic significance of a modification to a debt instrument is determined solely by reference to the effect that changes to the debt instrument have on both the holder and the issuer of the instrument. In such case, consequences of a change to the terms of a debt instrument that affect only the holder or only the issuer would not be relevant to the determination of whether there has been a significant modification of the debt. For example, if changes to the terms of a debt have critical significance to the issuer's financial accounting treatment for the debt, but those changes are not meaningful to the holder, the economic importance of those changes to the issuer would be ignored in determining whether such changes represent a significant modification.

B. Recommendations Related to a Change in an Instrument's Obligor

The Regulations provide rules for determining whether a modification of the terms of a debt instrument results in an exchange for purposes of Regulation section 1.1001-1(a). Regulation section 1.1001-3(a)(1) establishes the scope of these rules, but does not clearly state that, even if a modification is not significant so that an exchange does not result, the modification may have other tax consequences, particularly if the effect of the modification is a change in obligor.

Reasons for Change

The absence of a taxable exchange of debt instruments under the Regulations does not necessarily mean that the transaction is disregarded for tax purposes and has no other tax consequences. For example, a change in the tax obligor on a debt instrument (e.g., as the result of an election to change the tax status of the obligor from regarded to disregarded or vice versa) almost certainly will have tax consequences to the old and new obligor. The failure to make this point explicitly in the Regulations has been a source of confusion and may be partially responsible for the Service's change in position in the private rulings and Advice Memorandum discussed in proposal 1 above.

Proposal

We recommend that a new Regulation section 1.1001-3(a)(3) be added, including one or more examples, to clarify that, if there is a change of obligor for tax purposes, the absence of a significant modification for the holder of the debt does not preclude tax consequences to the old and new obligor. For example, if P owns property subject to a mortgage loan, and P sells the property subject to the debt to a third party, P would include the adjusted issue price of the mortgage loan in P's amount realized on the sale,²⁷ even though the holder of the mortgage loan would not have any tax consequences from the change in the obligor. The regulations might also add an example involving debt owed from a regarded LLC to its 100 percent owner that disappears for tax purposes when the LLC is checked to become a disregarded entity. In that case, there may well be tax consequences relating to the debt ceasing to exist for tax purposes, but these do not arise as a result of the debt having been significantly modified.

Under present law, the addition or deletion of a co-obligor on a debt instrument is a significant modification if the addition or deletion of the co-obligor results in a change in payment expectations.²⁸ The substitution of a new obligor on a recourse debt instrument is a significant modification, unless an exception applies;²⁹ and the substitution of a new obligor on a nonrecourse debt instrument is not a significant modification.³⁰ A modification that releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification.³¹ On the other hand, a modification that releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for a recourse debt is a significant modification only if the modification results in a change in payment expectations.³² A change in payment expectations is defined in Regulation section 1.1001-3(e)(4)(vi) as a substantial enhancement of the obligor's capacity to meet the payment obligations under a debt instrument (from speculative to adequate) or a substantial impairment of the obligor's capacity to meet the payment obligations under a debt instrument (from adequate to speculative).

Co-obligors generally must be jointly and severally liable to the creditor(s) with respect to any amount due under the debt instrument. A guarantee, however, can take one of several forms; for example, a guarantee may be a guarantee of payment or a guarantee of collection. A guarantee of payment generally provides that the guarantor is liable for all amounts due under the debt instrument without requiring that the creditor attempt to collect from the primary obligor first. A guarantee of collection generally provides that the guarantor is liable for amounts due to a creditor under a debt instrument only after the creditor has exhausted all of its remedies under the debt instrument in an attempt to collect payment from the primary obligor. Very often, guarantees are drafted imprecisely, so that it is not entirely clear the extent to which remedies must be pursued before the obligation of the guarantor is triggered. Once the guarantor's obligation has arisen, however, the rights and obligations of co-obligors and guarantors (whether of payment or collection) are similar. Both co-obligors and guarantors are liable for the full amount of the debt. Co-obligors generally are entitled to a right of contribution from the other co-obligors to the extent that they are required to satisfy more than their share of the debt. Similarly, guarantors (whether of payment or collection) generally have a right of subrogation against the primary obligor to the extent that they are required to satisfy the debt.

Reasons for Change

As the credit markets have evolved, most guarantees are written as guarantees of payment. Given the direct and unconditional nature of the guarantor's obligation to the creditor under a guarantee of payment, there is little if any substantive difference between a guarantor of payment and a co-obligor for purposes of the Regulations.³³ Furthermore, a guarantee of collection requires the guarantor to provide substantially the same credit support with respect to the debt as a guarantee of payment, since upon default of the obligor and exhaustion of remedies, the guarantor would be obligated to pay the full amount of the debt. Therefore, we are of the view that the distinction that the Regulations maintain between a co-obligor and a guarantor, and any remaining distinction between guarantees of payment and collection, are no longer useful distinctions for purposes of the Regulations and are, in addition, difficult to determine precisely.

Treating a guarantor as distinct from a co-obligor for purposes of the Regulations can produce anomalous results in certain circumstances. For example, if a parent guarantees recourse debt of its subsidiary and the parent later assumes the debt and the subsidiary is released as the primary obligor, the existing rules generally would treat this transaction as a change of obligor from the subsidiary to the parent even though the parent's obligation to the creditor is not materially altered by the assumption (i.e., the parent, as guarantor, was already unconditionally liable to the creditor). If treated as a change of obligor, the assumption may be treated as a significant modification if one of the exceptions in Regulation section 1.1001-3(e)(4)(i) is not available. If, on the other hand, the assumption transaction were treated for purposes of the Regulations as the deletion of a co-obligor rather than a change of obligor, the transaction would be treated as a significant modification under Regulation section 1.1001-3(e)(4)(iii) only if it resulted in a change in payment expectations; a more appropriate standard given the circumstances. Treating the parent guarantor as a co-obligor under these circumstances is consistent with the conclusion reached by the Service in PLR 199904017.

Proposal

We recommend that guarantors be included in a new definition of a co-obligor for purposes of Regulation section 1.1001-3(e)(4)(iii). The portion of the rule in Regulation section 1.1001-3(e)(4)(iv) relating to guarantees would be eliminated.³⁴ We recommend, however, that the existing rules relating to changes in collateral for a debt instrument contained in Regulation section 1.1001-3(e)(4)(iv) be retained.

C. Recommendation Related to the Recourse-Nonrecourse Distinction

The Regulations contain numerous rules that require a determination of whether debt is "recourse" or "nonrecourse." Those rules are found in Regulation sections 1.1001-3(c)(2)(i) (a change in the recourse nature of a debt instrument is a modification even if occurring by operation of the terms of the debt), -3(e)(4)(i) (substitution of a new obligor is significant if the debt is recourse (subject to various exceptions), not significant if it is nonrecourse), -3(e)(4)(iv) (different rules for change in security or credit enhancement for recourse and nonrecourse debt), -3(e)(5)(ii) (rules on when a change from recourse to nonrecourse or vice versa is a significant modification), and -3(e)(6) (special rule treating tax-exempt bonds as recourse, except those that finance conduit loans).

The Regulations do not contain a definition of "recourse" or "nonrecourse," nor is there a generally applicable definition of these terms for tax purposes. Regulation section 1.752-1(a) defines a partnership recourse liability as one for which any partner or related person bears the economic risk of loss, and a nonrecourse liability as one for which no partner or related person bears the economic risk of loss. These definitions, however, are expressly limited to partnership liabilities for purposes of section 752.³⁵

In common parlance, a recourse loan is one for which the borrower is personally liable and a nonrecourse loan is one in which the creditor's rights upon a default are limited to taking the collateral securing the loan. Based on this usage, it is clear in many cases whether debt is recourse or nonrecourse. Thus, debt secured by specified property and that by its terms gives the lender no recourse other than foreclosure is clearly nonrecourse debt for tax purposes. On the other hand, a general obligation of an individual or active business entity is plainly recourse debt.

In cases involving special purpose entities, however, especially those that are disregarded for tax purposes, the distinction between recourse and nonrecourse debt blurs. For example, suppose corporation C wholly owns an LLC that is disregarded for tax purposes and the LLC issues debt that is recourse against the LLC but not against C. Is the debt considered recourse or nonrecourse for tax purposes? Does it matter what assets are held, or can be held, by C and the LLC?

It is useful to consider three cases: (1) C owns nothing other than the LLC and the LLC is engaged in an active business, (2) C is engaged in an active business with significant assets other than the LLC and the LLC owns a single piece of real property, (3) C and the LLC are both engaged in active businesses, C owns significant assets other than LLC, and the LLC has significant equity to support the debt. In the first case, it seems relatively clear that the debt should be considered recourse, because recourse against the LLC is tantamount to recourse against C, although one might hesitate over the possibility that C could later acquire assets that would be beyond the reach of the creditors of the LLC. In the second case, the debt is functionally nonrecourse debt (because the LLC owns only one asset, so the recourse against the LLC gives the creditor no meaningful additional rights) and likely would be so treated for tax purposes.³⁶

The third case is unclear. One could argue that the debt is recourse because there is legal recourse against the legal borrower and that recourse is not meaningless (as it was in the second case). On the other hand, one could argue that the debt is nonrecourse because the creditor has no recourse against C, and C is the borrower for tax purposes.³⁷ It is also possible that the determination would be based on all the facts and circumstances, including the relative value of the LLC's assets to C's total assets.

One way to resolve the definitional problem would be to acknowledge that debt can provide some recourse to the borrower, but limited recourse, and to write tax rules that accommodate "partially recourse debt" in some manner. Regulation section 1.1001-3(e)(5)(ii) takes a small step in this direction by its use of the parenthetical phrases "or substantially all recourse" after the word "recourse" and "or substantially all nonrecourse" after the word "nonrecourse."³⁸ In general, however, the Regulations require a yes-or-no determination of whether debt is recourse or nonrecourse and provide no rules for debt that gives the creditor partial recourse.

Reasons for Change

Dramatically different tax consequences can arise when debt is modified depending on whether it is recourse or nonrecourse. For example, if debt is recourse debt, a change in obligor generally gives rise to a significant modification while in the case of nonrecourse debt such a change is irrelevant. Conversely, in the case of nonrecourse debt, a change in collateral is almost always a significant modification while in the case of recourse debt it generally is not (unless the substitution causes a change in payment expectations).

As noted above, the presence of disregarded entities greatly complicates the determination of whether debt is recourse or nonrecourse. If our proposal 1 above is accepted and extended to the determination of whether debt is recourse or nonrecourse, the problem is greatly diminished, although not eliminated entirely.³⁹ Thus, especially if our proposal 1 is not adopted, given the prevalence of entities that are disregarded for tax purposes, and given these differences in tax consequences, the Regulations should either provide a workable definition of "recourse" and "nonrecourse" or eliminate the differences in the rules under the Regulations that depend on this distinction. For the reasons described below, we favor the latter approach.

The choice of approach depends essentially on weighing the difficulty of providing a workable definition of "recourse" and "nonrecourse" against the problems that would arise from amending the Regulations to eliminate the recourse/nonrecourse distinction. As to the former, we do not believe that debt issued by a disregarded entity and with full recourse to that disregarded entity can sensibly be considered per se as either recourse or nonrecourse debt. The examples above illustrate that in some cases such debt is functionally nonrecourse and should be so treated for tax purposes; in other cases the debt is functionally fully recourse, and in some cases the debt is in between. A facts and circumstances test would be difficult to administer and would preserve the "cliff effect" of the current Regulations -- a modification could be considered significant or not depending entirely on whether the debt is determined to be recourse or nonrecourse. Further, having a separate set of rules or a sliding scale for partially recourse debt seems unworkable.

On the other hand, the existing distinctions in the Regulations between recourse and nonrecourse debt have considerable merit. For example, it seems sensible in general to treat a change in obligor on a recourse debt as significant because the creditor has legal rights against a different borrower, and to treat a change in obligor on a nonrecourse debt as not significant, because the creditor's legal rights are only with respect to the property. Similarly, it generally appears reasonable to treat changes in collateral on a nonrecourse debt as significant modifications but changes in collateral on a recourse debt as being significant only if such changes cause a change in payment expectations.

Nevertheless, these differences in result are not as compelling as first appears. In some cases, a change in obligor on a recourse debt can have hardly any effect on the holder of the debt, as the Regulations acknowledge by carving out several exceptions to the general rule. Conversely, a change in obligor as a result of a change in ownership of property securing a nonrecourse debt can be highly significant to the holder of the debt, especially if the debt is underwater.⁴⁰ The current owner may be on the verge of abandoning the property while the new owner may be fully dedicated to rehabilitating the property with a view toward eventually paying off the debt and benefitting from any additional appreciation in the value of the property.

Similarly, the rule on changes in collateral is generally sensible, but not the only possible approach. Even if debt is fully recourse, a change in the collateral securing the debt can be highly significant even if both the old and new collateral are adequate at the time of the collateral substitution. After the change, depending on the nature of the collateral, the value of the old collateral might plummet while the value of the new collateral remains high or vice versa. This could significantly affect the value of the secured debt, especially if the borrower has other creditors.

We believe our proposals below for dealing with changes in obligor and changes in collateral are an improvement over the distinctions drawn by the current Regulations and have the added advantage of not requiring a determination of whether debt is recourse or nonrecourse.

Proposal⁴¹

We believe that the Regulations should continue the general rule for recourse debt that a change in the legal obligor is a significant modification with appropriate exceptions (including, as discussed above, where such change is pursuant to the terms of the instrument and there is no change in payment expectations), and that the rule for nonrecourse debt should be transformed into an additional exception to that general rule. The existing exceptions to the general rule are premised on the principle that a change in obligor is not significant for tax purposes if the creditor has a claim against fundamentally the same assets and business operations before and after the change. In our view, this is essentially the same principle that underlies the rule for nonrecourse debt. Thus, our first proposal is to eliminate the limitation in Regulation section 1.1001-3(e)(4)(i) to recourse debt and to replace the rule in Regulation section 1.1001-3(e)(4)(ii) with a new exception to Regulation section 1.1001-3(e)(4)(i) to the effect that a change in obligor on a debt is not a significant modification if (i) the property securing or otherwise available to satisfy the debt does not change materially and (ii) such property is the only substantial source of funds to repay the debt. Under this test, the focus would shift from whether the debt is nonrecourse to whether the recourse against the legal debtor, if any, beyond the property available to satisfy the debt is economically meaningful. Of course, in the case of traditional nonrecourse debt, the new test would be functionally equivalent to the existing test and so would not affect the tax result in those cases.⁴²

Our next proposal deals with (i) the rules in Regulation section 1.1001-3(e)(4)(iv) relating to changes in collateral securing a debt and (ii) the rules in Regulation section 1.1001-3(e)(5)(ii) relating to changes in recourse rights against the debtor.⁴³ The former provides that a change in collateral on a recourse debt is a significant modification if (and, by implication, only if) the modification results in a change in payment expectations while a change in a substantial amount of collateral on a nonrecourse debt is per se a significant modification (with an exception for collateral consisting of fungible units). The latter rule says that, with certain limited exceptions, a change in the nature of a debt instrument from recourse to nonrecourse or vice versa is a significant modification. In our experience, it is rare in commercial practice for parties to make one of these changes without also changing the payment terms of the obligation, and hence rare for either of these rules (and not the rules relating to changes in payment terms) to govern whether a significant modification has occurred. As described below, we propose that the "change in payment expectations" standard apply in both cases and without regard to whether the debt is recourse or nonrecourse. Alternatively, the General Economic Significance Test could apply in either one or both cases.

The Committee's preferred approach in each case would be to apply the "change in payment expectations" standard. As defined in Regulation section 1.1001-3(e)(4)(vi), the "change in payment expectations" test rarely results in a significant modification, for it is highly unusual for a debt modification to change payment expectations from adequate to speculative or vice versa.⁴⁴ Thus, the first alternative would result in few if any significant modifications under either of these tests and hence would be easy to administer.

An alternative in each case would be to delete the special rule, making the General Economic Significance Test applicable in these cases. The alternative would arguably produce more "accurate" results, but would make the rule more difficult to apply in practice. The Committee believes that administrability and certainty are the more important considerations.

As an example of a transaction that would be affected by the change in collateral rule, suppose L holds a note issued by B that is secured by multiple parcels of land, and B wants to free up one of the parcels to sell to a third party. B offers to substitute another parcel of land of equivalent value and L agrees. Under the "change in payment expectations" alternative, the substitution would not be a significant modification since a substitution of collateral with equivalent value generally would not change payment expectations. Under the alternative that would place this case under the general "economic significance" test, whether the substitution of collateral would be a significant modification would depend on many factors, including the value of the other collateral securing the loan relative to the amount of the loan, whether there was any meaningful possibility that L would have to foreclose on the collateral, and the economic similarities and differences between the old and new collateral.

A transaction involving a change in the degree of recourse the lender had against the borrower would be quite unusual standing alone. A lender having full recourse against a borrower would generally not relinquish it and, on the other hand, an owner of property securing nonrecourse debt would not likely volunteer personal liability on that debt. Thus, we think this special rule could be deleted. However, as an alternative, we would propose to apply the "change in payment expectations" standard.

Legal defeasances are a special case involving both a change in collateral and a change in recourse nature.⁴⁵ Example 6 in Regulation section 1.1001-3(d) makes it clear that a legal defeasance of a bond is a modification of the bond but does not go further in spelling out the tax consequences to the issuer and holders of the bond. From the issuer's perspective, the defeasance should be treated as a retirement of the debt, regardless of whether the transaction is a significant modification of the debt, because the issuer has effectively transferred property in satisfaction of the debt and is no longer legally liable on the debt. The debt should be deemed retired for the fair market value of the property, and the property should be deemed to have been sold for the same amount.⁴⁶ We think that this represents current law and would recommend that the regulations confirm this point.

The holder's treatment is more complex. If the defeasance requires the consent of the holder, the transaction should be treated by the holder as it is for the issuer; that is, as an exchange of the debt for the defeasance property, with the holder being taxable after the defeasance on the interest or OID income from that property.⁴⁷ However, the appropriate treatment for the holder if a legal defeasance occurs pursuant to a unilateral right of the issuer is not clear, and there is no consensus among the authors of these Comments regarding whether the holder should be treated as receiving the property in full satisfaction of the defeased instrument or simply continuing to hold the defeased instrument. On the one hand, one could argue that the tax treatment of a legal defeasance should be reciprocal, such that if such a defeasance is treated as a satisfaction of the instrument from the issuer's perspective (which we believe is the case), then such treatment must also apply to the holder (even if it had no role in consenting to the defeasance). On the other hand, a legal defeasance occurring pursuant to an exercise by the issuer of a unilateral option would not be a modification under our proposal 1 and hence generally would not be a taxable exchange to the holder. We recommend that the government clarify whether a legal defeasance occurring pursuant to a unilateral option of the issuer is treated as a taxable exchange to the holder.

D. Recommendations Related to the Application of the Credit Quality Look-Back Rule to the Modified Instrument

Under present law, alterations of legal rights or obligations that occur by operation of the terms of a debt instrument generally are not modifications that are required to be taken into account in determining whether a deemed exchange of the debt instrument has occurred.⁴⁸ One exception to this general rule, however, is an alteration that results in an instrument or property right that is not debt for federal income tax purposes.⁴⁹ This type of alteration, regardless of whether it occurs by operation of the terms of the debt instrument, is treated as a modification, and further as a significant modification, unless it occurs pursuant to a holder's option to convert the instrument into equity of the issuer.⁵⁰ Thus, any debt modification that results in an instrument that is not debt, other than a conversion under the terms of the debt into stock of the issuer, will trigger a deemed exchange.⁵¹

Debt modifications often occur when the issuer is in financial distress. If the issuer's financial condition at the time of the modification were required to be considered in assessing whether changes to a debt instrument resulted in an instrument that is not debt for federal income tax purposes, debt workouts would tend to be impeded because of the possibility of equity characterization.⁵² To avoid imposing "a significant barrier to restructuring distressed debt instruments"⁵³ and further burdening financially troubled issuers, the Regulations provide that the debt/equity determination generally is made without taking into account any deterioration in the financial condition of the obligor since the issue date of the debt instrument. Specifically, the Regulations state that "in making a determination as to whether an instrument resulting from an alteration or modification of a debt instrument will be recharacterized as an instrument or property right that is not debt, any deterioration in the financial condition of the obligor between the issue date of the debt instrument and the date of the alteration or modification (as it relates to the obligor's ability to repay the debt instrument) is not taken into account"⁵⁴ (the "Credit Quality Look-Back Rule"). The Regulations provide as an example that any decrease in the fair market value of a debt instrument is ignored to the extent attributable to the deterioration in the obligor's financial condition and not to a change in the terms of the instrument.⁵⁵ Under present law, the Credit Quality Look-Back Rule does not apply if there is a substitution of a new obligor or the addition or deletion of a co-obligor.

In general, apart from the Credit Quality Look-Back Rule, the determination of whether an instrument resulting from an alteration or modification of a debt instrument will be characterized as an instrument or property right that is not debt for federal income tax purposes takes into account all of the factors relevant to such a determination.⁵⁶

Reasons for Change

The application of the Credit Quality Look-Back Rule is unclear when a debt instrument is significantly modified on more than one occasion. When a significant modification occurs, the modified instrument is treated as issued at the time of the modification in exchange for the debt instrument being modified.⁵⁷ Under the Credit Quality Look-Back Rule, any deterioration in the financial condition of the obligor since the issue date of the debt instrument is disregarded in determining whether the instrument resulting from an alteration or modification is debt or equity.⁵⁸ Thus, with respect to debt that is significantly modified more than once, the Regulations read literally would disregard only the decline in the obligor's credit quality since the time of the last significant modification (when the modified debt is treated as having been issued), rather than any decline since the original issue date of the unmodified debt.

That is, if the original issue date of the debt is "time 1" and the first significant modification and deemed exchange of the original debt for the modified debt occurs at "time 2," any look-back upon a subsequent significant modification ("time 3") would appear to extend only to time 2, even though the earlier decline in the obligor's creditworthiness (from time 1 to time 2) would have been ignored under the Credit Quality Look-Back Rule in determining whether the instrument was debt or equity at time 2. This could lead to results inconsistent with the apparent purpose of the rule. For example, consider an obligor that is not creditworthy when its debt is significantly modified at time 2. The deterioration in the obligor's financial condition from time 1 to time 2 would be ignored at time 2 in assessing whether the modified instrument was debt or equity. If the obligor's lack of creditworthiness persists (even if it does not get worse) from time 2 to time 3, the subsequently modified instrument at time 3 nevertheless might be recharacterized as equity because of the obligor's financial condition at time 2 (when the debt was treated as issued, since it was significantly modified). The Credit Quality Look-Back Rule on its face does not permit the parties to look back to the obligor's creditworthiness at time 1, nor to compare the obligor's creditworthiness at time 2 and time 3 and conclude that, since there has been no further decline, debt characterization is warranted at time 3.

Proposal

We recommend that the Credit Quality Look-Back Rule be clarified with respect to debt instruments that are significantly modified more than once, so that, in making a determination as to whether an instrument resulting from an alteration or modification will be recharacterized as an instrument or property right that is not debt, any deterioration in the financial condition of the obligor between the original issue date of the debt instrument (before any modifications) and the date of the latest alteration or modification is not taken into account.

An anti-abuse rule might be needed to prevent related parties from relying on the Credit Quality Look-Back Rule in order to extend distressed debt indefinitely, or employing it as a timing option as to when a realization or recognition event would occur with respect to the debt. Therefore, related parties should be permitted to rely on the Credit Quality Look-Back Rule only if they could demonstrate that they were acting in the same manner as unrelated parties would act.⁵⁹ For this purpose, we would suggest that parties be considered related if they are related within the meaning of section 267(b) or section 707(b) or are entities under common control that are treated as a single employer under section 414(b) or (c).

The change to the Credit Quality Look-Back Rule recommended above should not apply in any case where a prior modification resulted in an instrument or property right that was not debt (despite the application of the Credit Quality Look-Back Rule to that prior modification). This change also should not apply in any case where the Credit Quality Look-Back Rule did not apply to a prior modification because the prior modification involved the substitution of a new obligor or addition or deletion of a co-obligor that was itself a significant modification.⁶⁰ In that case, the look-back approach would extend only to the time of the prior modification.

Under present law, the Credit Quality Look-Back Rule is the only explicit departure from the general rule that the determination of whether an instrument resulting from an alteration or modification of a debt instrument will be characterized as an instrument or property right that is not debt for federal income tax purposes is made taking into account all of the factors relevant to such a determination.⁶¹ One such factor that commonly would be considered relevant is the existence of a guarantee, such as a parent guarantee of its subsidiary's debt. Under the principles outlined in Plantation Patterns, Inc., v. Commissioner,⁶² a parent guarantee of a thinly capitalized subsidiary's debt may result in the parent being treated as the true obligor for tax purposes. The theory underlying the Plantation Patterns doctrine for re-casting the arrangement is that in substance the lender made the loan directly to the parent, who then contributed the funds to the capital of the subsidiary.

Reasons for Change

It is unclear under current law whether a guaranteed debt instrument that is modified must be re-tested under Regulation sections 1.1001-3(e)(5) and (f)(7) to determine whether the legal debtor should continue to be treated as such for tax purposes or whether the taxpayer must re-assess the potential application of the Plantation Patterns doctrine. If such a re-assessment were required, it could lead to a conclusion that, while the modified instrument remains debt for tax purposes, it should be treated as debt of the guarantor rather than of the legal borrower, based on the relative financial condition of the parties at the time of the modification.

We believe that, in keeping with the principle reflected in the Credit Quality Look-Back Rule, if guaranteed debt is modified at a time when the debtor is in financial difficulty, it is not appropriate to (re)apply the principles of Plantation Patterns to re-cast the instrument as debt of the guarantor (and with a resulting deemed transfer of value from the guarantor to the debtor). Just as it is appropriate in a two-party troubled debt workout to continue to respect the roles of the parties as debtor and creditor, so too in a three-party situation it is appropriate to respect the roles of the parties as debtor, guarantor and creditor.

Proposal

We recommend that Regulation section 1.1001-3(f)(7) be clarified to exclude the potential for a re-testing under Regulation section 1.1001-3 to be used as an occasion to re-apply the Plantation Patterns doctrine.

Under present law, although the determination of whether a modified instrument remains debt generally is made without taking into account any deterioration in the financial condition of the obligor, the Credit Quality Look-Back Rule does not by its terms permit declines in the value of the property securing a debt instrument to be similarly ignored. In the case of a modification of nonrecourse debt, the Credit Quality Look-Back Rule, applied literally, would not be helpful to the determination of debt status, since the lender would look to the value of the underlying property for repayment, and the obligor's financial condition would not be directly relevant. The same issue could arise in varying degrees even if the property securing the debt is not the lender's only source of recovery. To the extent that the source of repayment is specific property, the financial attributes of that property, rather than of the obligor generally, would be pertinent to the analysis. Under present law, however, modifications of unsecured debt and secured debt (particularly debt with limited recourse beyond the collateral) may be treated inconsistently, in that the issuer of unsecured debt can avail itself of the benefits of the Credit Quality Look-Back Rule for purposes of any re-testing of debt status, but the issuer of secured debt may not be able to do so effectively because it is not clear that declines in the value of the property securing the debt can be similarly ignored. Instead, the determination with respect to modification of secured debt might "take into account all of the factors relevant to such a determination," apparently including any decline in the value of the collateral.

Reasons for Change

The purpose of the Credit Quality Look-Back Rule is to avoid imposing "a significant barrier to restructuring distressed debt instruments,"⁶³ and the spirit of the rule is that declines in credit quality, in whatever form, between the issue date of the debt instrument and the date of the alteration or modification should not be taken into account in any determination of whether a modified instrument remains debt. Given the rule that ignores declines in the obligor's credit quality in determining whether an alteration results in an instrument that is not debt for tax purposes, it makes sense to extend explicitly this rule to ignore declines in the value of the property securing the debt as well.

Proposal

To ensure that the Credit Quality Look-Back Rule applies sensibly to secured debt, it should be revised so that, in making a determination as to whether an instrument resulting from an alteration or modification of a debt instrument will be recharacterized as an instrument or property right that is not debt, any decline in the value of property securing the obligations under the instrument and any deterioration in the financial condition of the obligor between the original issue date of the debt instrument (before any modifications) and the date of the alteration or modification (as it relates to the obligor's ability to repay or the lender's ability to obtain repayment of the debt instrument) are not taken into account.

Under present law, if there is a substitution of a new obligor or the deletion or addition of a co-obligor on a debt instrument,⁶⁴ the Credit Quality Look-Back Rule does not apply and the status of the instrument as debt or equity must be re-tested taking into account the financial condition of the obligor, regardless of whether the substitution, deletion or addition occurs by operation of the terms of the instrument or in a transaction that does not otherwise rise to the level of a significant modification.

For example, consider a substitution of obligor that occurs as a result of a merger of the original obligor into the new obligor.⁶⁵ The substitution of a new obligor is treated as a modification⁶⁶ and, under the current Regulations, the Credit Quality Look-Back Rule does not apply. Thus, even if no other changes are made to the instrument and there is no change in payment expectations, the character of the instrument as debt or equity must be re-tested taking into account the financial condition of the new obligor at the time of the substitution.⁶⁷

Reasons for Change

If the substitution of a new obligor or the deletion or addition of a co-obligor on a debt instrument does not constitute a significant modification because it falls within one of the exceptions in Regulation section 1.1001-3(e)(4), then the financial condition of the new obligor at the time of the modification should not be taken into account for purposes of determining the status of the modified instrument as debt or equity. The same principles that inform the exceptions in Regulation section 1.1001-3(e)(4) are equally relevant here. The existing exceptions in Regulation section 1.1001-3(e)(4) and the new exception in proposal 7 generally are premised on the principle that, where the creditor's claims before and after the change in obligor are against essentially the same assets and business operations, the change in obligor is not a significant modification of the debt. The new exception in proposal 2 is based on the idea that, if the terms of the debt provide for the possibility of a change in obligor, the holder is merely getting the benefit (or detriment) of the bargain if the change is actually made. It does not make sense that the same facts nevertheless could result in a significant modification under debt/equity principles because of the financial condition of the new obligor, particularly since each of the exceptions implicitly or explicitly incorporates a requirement that there has been no change in payment expectations. This change is consistent with the purpose and spirit of the Credit Quality Look-Back Rule not to impede workouts of distressed debt and to base debt/equity determinations on the changed terms of the modified instrument, rather than any deterioration in credit quality since the issue date.

Proposal

We recommend that the exceptions under Regulation section 1.1001-3(e)(4) also be exceptions under Regulation section 1.1001-3(f)(7)(ii), which would be modified to provide that the financial condition of the new obligor is ignored for purposes of making any debt/equity determination where the substitution of a new obligor or addition or deletion of a co-obligor would not constitute a significant modification. Instead, only the other modifications to the terms of the instrument (if any) should be considered when making that determination.

E. Recommendations Related to Changes in Yield

The Yield Test provides that a modification of a debt instrument that changes its yield is a significant modification if the yield of the modified instrument varies from the annual yield of the unmodified instrument by more than the greater of (i) 25 basis points or (ii) 5% of the annual yield of the unmodified instrument.⁶⁸ For this purpose, the yield of the modified instrument is the annual yield of an instrument with an issue price equal to the adjusted issue price of the unmodified instrument on the date of the modification (increased by any accrued but unpaid interest and decreased by any accrued bond issuance premium not yet taken into account, and increased or decreased by any payments made in consideration for the modification), with payments equal to the payments on the modified instrument from the date of the modification.⁶⁹

The adjusted issue price of an unmodified instrument originally issued at a discount, as determined under section 1272(a)(4) and Regulation section 1.1275-1(b)(1), is the original issue price of the instrument, increased by any OID includible on the instrument and decreased by the amount of any payment on the instrument other than a payment of qualified stated interest. Where an instrument is originally issued with de minimis OID under section 1273(a)(3), the holder of the instrument generally treats the OID as zero and hence includes no OID in income.⁷⁰ Thus, the adjusted issue price of an instrument issued with de minimis OID does not increase over the term of the instrument to reflect the accrual of discount. However, because the Yield Test determines the yield of the modified instrument by reference to the adjusted issue price of the unmodified instrument and the remaining payments on the modified instrument, the test results in an artificial increase in the yield of the modified instrument (ignoring any actual modifications that are made), and the increase becomes greater the closer the instrument is to maturity when the modification occurs. As a result, when a modification occurs to an instrument issued with de minimis OID, the yield of the modified instrument determined under a mechanical application of the rule could vary significantly from the yield of the unmodified instrument, even though the true economic yield of the instrument has not changed by an amount that would be treated as significant under the Yield Test.

By way of example, assume a corporation issued a 5-year debt instrument on January 1, 2012 with a principal amount of $1,000 and a stated coupon of 5% compounded annually, at an issue price of $990. Under section 1273 and the regulations thereunder, the $10 discount is considered de minimis OID. Thus, the instrument should have an adjusted issue price of $990 throughout its term. Under these facts, the yield to maturity of the instrument is 5.23%.

Assume that the instrument is modified on December 31, 2015 to increase the principal amount payable at maturity on December 31, 2016 to $1,000.01. In that case, a mechanical application of the Yield Test would appear to require using an adjusted issue price of $990 for the modified instrument, in which case the yield of the modified instrument on the modification date would be 6.06%. Thus, a significant modification would result because the yield of the modified instrument (6.06%) exceeds the yield of the unmodified instrument (5.23%) by 83 basis points, which is more than the greater of (i) 25 basis points or (ii) 5% of the annual yield of the unmodified instrument (26 basis points). Accordingly, a mechanical application of the Yield Test would result in a taxable event with respect to the instrument even though, as an economic matter, the true economic yield of the instrument is nearly identical before and after the modification.⁷¹

It is not clear that this is the way the current Regulations would be applied in practice, because it may be reasonable to interpret the rule in section 1273(a)(3) that treats de minimis OID as zero as also deeming the debt instrument to have an issue price equal to its stated redemption amount,⁷² which will necessarily be equal to the stated principal amount if the OID is de minimis.

Reasons for Change

As the example above demonstrates, a mechanical application of the Yield Test to an instrument issued with de minimis OID can result in a significant modification of the instrument where the economics of the instrument have not been altered in a material manner. To treat such an instrument as undergoing a taxable exchange in such a circumstance can lead to inappropriate tax consequences for both issuers and holders. For example, if an instrument with de minimis OID is trading at a premium, an issuer could undertake a significant modification without a material economic effect (e.g., by agreeing to pay an insignificant amount of additional principal, as in the example above) and recognize a repurchase premium deduction under Regulation section 1.163-7(c).⁷³

We believe that these results were unintended by the drafters of the Regulations.

Proposal

We recommend that the Yield Test as applied to instruments issued with de minimis OID be modified to eliminate (or at least minimize) the distortive results outlined above.

There are a number of ways that the Regulations could be amended to address this issue. First, if a debt instrument was issued with a de minimis amount of OID, the Regulations could treat the adjusted issue price of the unmodified instrument as equal to its stated principal amount for purposes of calculating the annual yield of the modified instrument under the Yield Test. This approach benefits from its relative simplicity, because holders would not be required to undertake a calculation of OID accruals they would not otherwise have been required to make (because the instrument had been treated as having no OID), and holders could determine with relative ease the yield of the modified instrument. Another advantage of this approach is that it does not require holders to inquire as to whether the instrument was issued with no OID or with a positive but de minimis amount of OID. This approach does not attempt to determine the true economic change in yield of the instrument, and so in certain (relatively narrow) circumstances, it may result in other distortions.

An alternative approach for addressing modifications of instruments issued with de minimis OID would be to determine the adjusted issue price of the unmodified instrument as if de minimis OID on the instrument were taken into account in the same manner as non-de minimis OID. That is, under this approach, solely for purposes of determining the yield of the modified instrument, the adjusted issue price of the unmodified instrument at the time of the modification would be its issue price, increased by any OID inclusions that would have been taken into account had the de minimis OID on the unmodified instrument been accrued as OID. This approach would provide an economically correct comparison between the unmodified instrument and the modified instrument, but would be more complicated to implement than the first approach.

We believe that either approach is far preferable to the current situation, in that either approach reduces the instances where the application of the Yield Test will lead to inappropriate results.

Regulation section 1.1272-1(c) provides rules for determining the yield to maturity of a debt instrument that is subject to one or more alternative payment schedules applicable upon the occurrence of one or more contingencies. Under those rules, if one payment schedule among the alternatives is significantly more likely than not to occur, the yield to maturity is computed based upon that payment schedule.⁷⁴ Options with respect to the debt instrument that would result in an alternative payment schedule are deemed to be exercised in a manner that minimizes the yield (in the case of an issuer option) or maximizes the yield (in the case of a holder option).⁷⁵ If a contingency occurs (or does not occur), and its occurrence or non-occurrence is contrary to the assumptions made pursuant to these rules, the debt instrument is treated for purposes of sections 1272 and 1273 as retired and re-issued on the date of the change in circumstances for an amount equal to its adjusted issue price on that date.⁷⁶

The current Regulations specifically provide that modifications of debt instruments subject to Regulation section 1.1272-1(c) are subject to the Yield Test,⁷⁷ but the Regulations do not provide rules regarding how to apply the test to the modification of an instrument where the unmodified instrument was accounted for under the rules of Regulation section 1.1272-1(c). For instance, where the yield to maturity of the unmodified instrument was originally determined based upon a particular payment schedule that was significantly more likely than not to occur, it is not clear whether the yield of the modified instrument should be determined based upon that same payment schedule regardless of whether, based on changes in circumstances occurring after the issue date, such payment schedule would not have been used if the instrument were newly issued on the date of the modification.

Reasons for Change

If different payment schedules are applied to the unmodified instrument and the modified instrument for purposes of determining each instrument's yield under the Yield Test, such differing payment schedules would, in many instances, result in a significant modification where the changes to the instrument would not otherwise give rise to a significant modification. In many cases, the modification of a debt instrument is not related to the contingencies that gave rise to the alternative payment schedules with respect to the unmodified instrument. Accordingly, where the modification of a debt instrument would not itself have given rise to a deemed retirement and reissuance under Regulation section 1.1272-1(c)(6), we believe that it is inappropriate to apply a revised payment schedule to the modified instrument (potentially causing a significant modification).

By way of example, assume that on January 1, 2012, a corporation issued at par a 10-year debt instrument with a principal amount of $1,000 and an annual coupon of 5%, but which is subject to a single contingency unrelated to the issuer that, if it occurs before January 1, 2016, will result in the corporation increasing the coupon to 7% as of January 1, 2016. On the issue date, it is determined that there is a 10% likelihood that the contingency will occur by that date, and therefore it is significantly more likely than not that the contingency will not occur. Thus, under Regulation section 1.1272-1(c)(2), the annual yield to maturity of the instrument upon issuance is 5% because the payment schedule showing no contingent payment being made is significantly more likely than not to occur.

Assume further that, on January 1, 2015, the instrument is modified in a manner that is not otherwise significant, but results in the issuer making a consent payment to the holder of $1. At this time, the contingency has not yet occurred but it is determined that, under the present circumstances, there is an 80% likelihood that the contingency will occur by January 1, 2016. Thus, at the time of the modification the contingency is significantly more likely than not to occur. If the yield of the modified instrument were tested using the original payment schedule, the modification would not result in a taxable event under the Yield Test (because the yield to maturity of the modified instrument would be approximately 5.02%). If a new payment schedule that took into account the occurrence of the contingency were applied to the modified instrument, however, the annual yield to maturity of the modified instrument would increase to more than 6% and thus a significant modification of the instrument would occur (even though the actual change to the instrument was very small).

Proposal

We recommend that the Yield Test be amended to clarify that, as a general rule, the yield for both the unmodified and the modified instrument be calculated using the original payment schedule for the unmodified instrument as determined under Regulation section 1.1272-1(c).⁷⁸ For example, under the general rule, even if circumstances have changed (which are unrelated to the modification) such that a different payment schedule other than the original payment schedule is now significantly more likely to occur (or no alternative payment schedule is significantly more likely than not to occur), the issuer and holder would nonetheless use the original payment schedule to determine the yield of the modified instrument, with appropriate changes to the payment schedule based on the modified terms. We believe that this general rule is consistent with the operation of the alternative payment schedule rules of Regulation section 1.1272-1(c), which do not require re-testing of payment schedule assumptions unless a contingency occurs contrary to the original assumptions.⁷⁹

Where a debt instrument is modified⁸⁰ to change its interest rate from a fixed rate to a variable rate or from a variable rate to a fixed rate (in either case, a "Fixed-Floating Change"), the Regulations do not automatically treat such change as a significant modification. Instead, such a change must first be analyzed to determine whether it violates the Yield Test (by using, in place of the variable rate, the annual yield of the equivalent fixed rate debt instrument (as defined in Regulation section 1.1275-5(e) ("EFRDI")) as of the date of the modification. If the change in yield does not violate the Yield Test, although not clear, the change may be required to be analyzed to determine whether it is "economically significant" within the meaning of the General Economic Significance Test.

The proposed regulations upon which the Regulations were based (the "Proposed Regulations")⁸¹ provided that a Fixed-Floating Change was per se a significant modification.⁸² The Regulations, when finalized, did not adopt the per se rule for Fixed-Floating Changes. The preamble to the final Regulations stated: "Under the proposed regulations, certain changes in the types of payments under a debt instrument (for example, a change from a fixed rate debt instrument to a variable rate or CPDI) are significant modifications. These rules have not been included in the final regulations because the general significance rule provides adequate guidance."⁸³

Reasons for Change

As an initial matter, we note that in the context of an instrument held by a person unrelated to the issuer, a Fixed-Floating Change typically is a significant modification because the yield of the EFRDI varies from the fixed rate yield by an amount that violates the Yield Test.⁸⁴ Where that is not the case (for instance where the yield curve is so flat that short-term and long-term rates are nearly the same), it is unclear how to determine whether a Fixed-Floating Change is considered economically significant under the General Economic Significance Test.

Some practitioners believe that a Fixed-Floating Change is always economically significant because of the introduction of uncertainty (where the modified rate is a floating rate) or the elimination of such uncertainty (where the modified rate is a fixed rate) in interest payments to be received over the instrument's remaining term. Other practitioners take the position that a Fixed-Floating Change that does not violate the Yield Test is not economically significant because of the elimination of the per se rule contained in the Proposed Regulations. This uncertainty creates an environment where either position may be supportable, but no taxpayer can be certain as to the correct treatment.

Further, it is difficult to identify the factual situations where a Fixed-Floating Change would be viewed as economically significant and the factual situations where it would not. More specifically, except in unusual cases (e.g., where the modification occurs shortly before the maturity or where the floating rate has a cap and a floor that provide for little variation in the rate), it is unclear what facts need to be present to make one type of Fixed-Floating Change more economically significant than another type of Fixed-Floating Change. In other words, it appears to us that either all Fixed-Floating Changes should be considered economically significant or none should be considered economically significant, except where the Yield Test is violated using the EFRDI, and in the interests of administrability and consistency, the Regulations should provide a clear rule in this regard.

Proposal

Given the importance of the change in an interest rate calculation that occurs by virtue of a Fixed-Floating Change (and either the introduction of uncertainty in the amount of interest to be paid on the instrument or the elimination of such uncertainty), we recommend that a Fixed-Floating Change be treated as a per se significant modification. We recommend that a new Regulation section 1.1001-3(e)(2)(v) be added to provide that, subject to the exceptions noted below, a modification is per se significant if it changes a fixed rate instrument to be a variable rate instrument or it changes a variable rate instrument to be a fixed rate instrument. We believe, however, that such a change should not be considered per se significant, and instead should be evaluated under the General Economic Significance Test, where (i) a Fixed-Floating Change applies to some but not all of the remaining interest accruals on the instrument, (ii) the amount of all future interest accruals has already been determined or (iii) a Fixed-Floating Change occurs when there is only one full remaining accrual period prior to the maturity date (and thus the change will affect the accrual of interest for only a single accrual period).

Certain variable rate debt instruments ("VRDIs") provide the issuer with an option to select among two or more floating rates. For example, a VRDI may allow the issuer to choose to have interest accrue either (i) at a rate equal to a floating "base rate" (which is typically the highest of two or more rates) plus a spread or (ii) at a rate equal to one-month LIBOR plus a spread. Generally, a borrower may be expected to choose the rate that minimizes the yield of the instrument. In some cases, however, for non-tax commercial reasons, a borrower may select a rate that does not minimize the yield of the instrument.

Regulation section 1.1001-3(e)(2)(iv) provides that, for purposes of the Yield Test, the annual yield of a VRDI (whether it is the unmodified instrument or the modified instrument) is the annual yield of the EFRDI constructed based on the terms of the instrument as of the date of the modification. The yield of the EFRDI is determined by applying Regulation section 1.1275-5(e) as of the date of the modification. Under Regulation section 1.1275-5(e), if the VRDI provides for stated interest at one or more qualified floating rates, the yield of the EFRDI generally is determined by reference to the value, as of the issue date, of the qualified floating rate(s).

Reasons for Change

When an instrument that provides the issuer with an option to select among two or more variable rates is modified, it is unclear how the annual yield of the EFRDI for the unmodified and modified instruments should be determined. More specifically, it is not clear which rate should be used to determine the annual yield of the EFRDI. The annual yield of the EFRDI arguably could be determined to be either: (1) the value on the date of the modification of the lowest floating rate that the issuer can elect under the terms of the instrument (i.e., deeming the issuer to minimize the yield of the instrument) or (2) the value on the date of the modification of the qualified floating rate that the issuer has actually elected as of the date of the modification. In most circumstances, these two alternatives will lead to the same result because the issuer will have elected to use the rate that will minimize the yield. However, in cases where these two rates differ, it is unclear how the Yield Test should be applied.

Proposal

We believe that the Yield Test is intended to capture the change in yield that results from the modification of the instrument rather than any change in yield resulting from the issuer's selection among two or more variable rates for the instrument. Accordingly, we recommend that the yield of the EFRDI for both the unmodified and modified instruments be determined by reference to the variable rate that minimizes the issuer's yield (because that reflects the economic right of the issuer pursuant to the terms of the instrument), regardless of whether the issuer has actually elected to use such rate.⁸⁵

Accordingly, both the unmodified instrument and the modified instrument would be deemed to provide for payments at a fixed rate equal to the lowest variable rate available under the instrument on the date of the modification, regardless of whether the issuer has elected to use such rate. This approach would provide a consistent rule that ensures that the Yield Test is implicated only by real economic changes to the terms of the instrument caused by the modification and not by the issuer's selection among the available variable interest rates.

Example 3 of Regulation section 1.1001-3(g) ("Example 3") involves a debt instrument issued at par with a 10-year term, a $100,000 principal amount and annual interest payments at a 10% rate. After five years, the principal amount is reduced to $80,000 by the agreement of the borrower and the lender. Regulation section 1.1001-3(e)(2)(iii)(1) provides that, for purposes of the Yield Test, the yield of the modified instrument is computed by deeming the issue price of the modified instrument to be equal to the adjusted issue price of the unmodified instrument on the date of the modification, subject to certain adjustments not relevant to these facts. The example accordingly states that the yield of the modified instrument is computed using the adjusted issue price of the modified instrument, or $100,000; however, the principal amount of the instrument has been reduced to $80,000, and the remaining interest payments will be equal to 10% of the reduced principal amount, or $8,000 per year. Thus, the yield of the modified instrument is only 4.332% when calculated with an adjusted issue price of $100,000. Therefore, the example concludes that the reduction in principal amount causes a significant modification of the instrument under the Yield Test.⁸⁶

If, on the other hand, the borrower and lender were to agree to a $20,000 prepayment of principal at the end of the fifth year, the yield of the modified instrument would be decreased to reflect the $20,000 payment to the lender as consideration for the $20,000 reduction in principal due at the end of the tenth year and corresponding reduction in interest payments. In such case, if the instrument were otherwise modified at the time of the principal repayment, the yield of the modified instrument, computed using an adjusted issue price of $80,000, would be equal to the 10% yield of the unmodified instrument. As a result, the yield of the instrument would remain unchanged.

Reasons for Change

We believe that a pro rata reduction in the payments due under a debt instrument should not be treated for purposes of the Yield Test in a manner that differs from a pro rata prepayment on the instrument. In both cases, the yield of the unmodified instrument should be compared to the yield that will accrue on the remaining principal amount going forward in order to determine the amount of any change in the instrument's yield. The difference between a pro rata prepayment and a pro rata forgiveness of principal should be reflected in the income, gain or loss of the issuer and holder with respect to the portion of the principal that has been prepaid or forgiven rather than in differences in the yield of the instrument with respect to the principal amount that remains outstanding.

Numerous other comment letters have been submitted with respect to both Revenue Ruling 89-122 and Example 3.⁸⁷ The prior comment letters, which frequently compared a reduction in the principal amount with other transactions, asserted that:

Proposal

We recommend that Regulation section 1.1001-3(e)(2)(iii)(A)(1) and Example 3 be amended to provide that, when there is a pro rata reduction of all payments under a debt instrument and no other changes to the terms of the instrument (other than changes that would not by themselves cause a significant modification to the terms of the remaining instrument), such reduction is treated in the same manner as a pro rata prepayment under Regulation section 1.1275-2(f) (i.e., as a forgiveness of a pro rata portion of the debt and a continuation without modification of the remaining portion of the debt). This would have the effect of reducing the principal amount and adjusted issue price of the remaining debt in proportion to amount of the debt that is forgiven relative to the total amount of the debt prior to the forgiveness.

While similar proposals were dismissed in finalizing the Regulations, we encourage the government to reconsider its position with respect to Example 3.

F. Recommendations Related to Changes in the Timing of Payments

Under present law, a "modification that changes the timing of payments . . . due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments."⁸⁹ The deferral may relate to either payments of principal due at maturity or interest payments due during the term of the debt.⁹⁰ The materiality of a payment deferral is based on all of the facts and circumstances, including the length of the deferral, both in absolute terms and relative to the term of the debt instrument, and the amount of the payment being deferred.⁹¹

The rules contain a safe harbor for deferrals that are less than or equal to the lesser of (a) 5 years or (b) 50 percent of the original term of the instrument.⁹² The safe-harbor period begins on the due date for the first payment being deferred.⁹³ For this purpose, the term of the instrument is determined without regard to any option to extend the term.⁹⁴ Further, to the extent a deferral is within the safe-harbor period, the "unused portion" of the safe-harbor period is available for subsequent deferrals.⁹⁵

Reasons for Change

By using a safe-harbor period that is the lesser of 5 years and 50 percent of the original term, the deferral safe harbor may operate in a manner that does not reflect the actual economic significance of a deferral of payments. Further, there is uncertainty regarding how to test modifications that entail the deferral of payments beyond the safe harbor.

From an economic perspective, as a debt instrument nears its maturity date, the impact of a payment deferral becomes more significant. For example, if a debt instrument had an original term of 8 years, the safe-harbor period under the current rules would be 4 years. Thus, if the payment of the principal on such debt instrument were deferred for 3 years just 1 month prior to maturity, the deferral would be within the safe-harbor period. This deferral, however, would appear to be more significant than if the same extension of the maturity date occurred shortly after issuance.

In addition, for debt with a long remaining term (e.g., 20 years or more), the 5-year period may be too short from an economic perspective.

For deferrals of interest payments, the safe harbor is rather vague because it depends on whether there is a "material" deferral of scheduled payments. The Regulations say that whether a deferral is material depends on all the facts and circumstances, which include, among other factors, the amount of the payment deferred and the length of the deferral. One might infer that the deferral of say a $100 payment for two years is equivalent in terms of materiality to a deferral of a $200 payment for one year, but this is not explicitly the rule in the Regulations nor implied by any example.

Also, the current safe harbor may apply in an anomalous manner to interest payments, because the safe-harbor period begins with the due date for the first scheduled payment that is deferred. If any payments are deferred beyond the lesser of 5 years or 50 percent of the original term of the instrument, the safe-harbor is not available. If a payment of interest on a 10-year instrument is deferred in year 2 until year 3, the safe-harbor period extends until year 7. If another payment of interest on the same instrument is deferred from year 8 to year 9, a literal reading of the rules could lead to the conclusion that the modification is outside of the safe-harbor period (even though each payment is deferred by no more than 1 year).

Finally, there is uncertainty with respect to how to test payment deferrals that extend beyond the safe-harbor period. Some practitioners view the safe harbor as going well beyond what would be permitted under the General Economic Significance Test, so that any deferral beyond the safe harbor is necessarily a significant modification, while others would weigh the circumstances to determine whether a deferral outside the safe harbor triggers a significant modification.

Proposals

We recommend the following changes to the rules governing deferrals of payments:

• The rule for simple extensions of the maturity of a debt instrument should be changed from a safe harbor to a per se rule, so that maturity date deferrals within the specified period do not alone cause a significant modification (although they may cause a significant modification under the Yield Test) and maturity date deferrals outside the specified period always constitute a significant modification.

• The specified period should be the greater of (1) one-half of the remaining term of the debt instrument and (2) one year. As discussed above, the economic significance of a deferral of the maturity date of a debt depends on its remaining term, not its original term. On the other hand, we think that a deferral of up to one year should be permitted in part because one year is not a particularly long deferral period and in part in recognition of the reality that many borrowers and lenders do not work out the terms of a debt extension until only a few months remain until maturity, and in that case a restriction to one-half of the remaining term would be unduly restrictive. Other aspects of our proposal below are designed to prevent taxpayers from abusing the one-year rule with successive extensions of a debt instrument.

• For deferrals other than simple extensions of the maturity of the debt, including deferrals of only interest payments, the Regulations should adopt a mechanical rule that takes into account both the amount of each deferred payment and the length of time for which it is deferred. Specifically, the taxpayer would be required to compute the product of the amount of each deferred payment and the period of the deferral and to sum these amounts for all deferred payments, whether interest or principal. The deferral would be considered significant if, and only if, the sum of these products exceeded the product of the principal amount of the debt instrument and the specified deferral period described above (i.e., the bright line test for deferrals of maturity date).

• If payments due under a debt instrument are deferred more than once, in addition to testing each deferral under the specified period described above, such modification would be treated as a significant modification if the aggregate deferral extends the maturity date beyond one-half the original term of the debt instrument.

• Modifications taking place at substantially the same time would be treated as a single modification. For example, if a debt had an original term of 10 years but a remaining term of four years, and if the parties extended that term by two years, thereby leaving six years to maturity, they could not immediately extend the term by another three years and remain within the safe harbor.

• A deferral of a pro rata portion of all remaining payments due under a debt instrument would be treated as a modification of only that portion of the debt instrument. This rule would also apply to "substantially pro rata" deferrals, as is the case with pro rata prepayments. Where this rule applies to treat only a portion of a debt instrument as significantly modified, the parties would be required to treat that portion of the instrument and the remaining, unmodified portion as two separate instruments for all tax purposes.

• If these recommendations are not adopted, we would suggest that the existing safe harbor be revised so that the safe-harbor period applies separately to each deferred payment. We would also suggest that an example be added to Regulation section 1.1001-3(g) describing a deferral of interest payments that would not be considered a material deferral, even though the deferral would fall outside of the safe-harbor period.⁹⁶

• 18. Revise the rules relating to the acceleration of the timing of payments (2)

The current rules relating to a change in timing of payments (discussed above) refer to payment deferrals only and are silent with respect to modifications that accelerate payments under a debt instrument.

Reasons for Change

Some tax practitioners believe that the current rules under Regulation section 1.1001-3(e)(3) do not address modifications that accelerate, rather than defer, payments under a debt instrument, and hence accelerations are governed by the General Economic Significance Test. Other tax practitioners believe that implicit in the language regarding changes in the timing of payments under Regulation section 1.1001-3(e)(3) is a per se rule that the acceleration of payments due under a debt instrument is not, in itself, a significant modification. This has led to uncertainty regarding how to test modifications that involve the acceleration of payments on a debt instrument.

Proposal

Given the lack of clarity regarding how the acceleration of payments should be treated under the Regulations, we recommend that payment accelerations be tested under the same bright line test proposed above for payment deferrals. That is, an acceleration of the maturity date of a debt instrument would cause a significant modification if such acceleration exceeds the greater of one-half of the remaining term of the debt instrument or one year.⁹⁷ For other timing accelerations, including changes in the timing of interest payments only, we recommend the same test as for deferrals, which would take into account both the amount and the timing of the payments accelerated. Similarly, an acceleration of a pro rata portion of the remaining payments due under a debt instrument would be a modification only of the portion accelerated, not of the entire debt instrument. Where this rule applies to treat only a portion of a debt instrument as significantly modified, the parties would be required to treat that portion of the instrument and the remaining, unmodified portion as two separate instruments for all tax purposes.

If these recommendations are not adopted, we would suggest adding an example illustrating when an acceleration of payments is a significant modification (assuming such modification would not otherwise cause a significant modification under the Yield Test).

Under present law, except for certain alterations occurring by operation of the terms of a debt instrument, any alteration of a legal right or obligation of the issuer or a holder of a debt instrument is a modification that must be tested for significance, whether the alteration is evidenced by an express oral or written agreement, conduct of the parties, or otherwise.⁹⁸ The Regulations clarify that the failure of an issuer to perform its obligations under a debt instrument is not itself an alteration of a legal right or obligation, and therefore is not a modification.⁹⁹ Further, in order to give the issuer and holder sufficient time to negotiate modified terms for the defaulted debt, the Regulations provide that, absent a written or oral agreement to alter other terms of the debt instrument, 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 exceeding two years following the issuer's initial failure to perform plus any additional period during which the parties conduct good faith negotiations or during which the issuer is in a title 11 or similar case (as defined in section 368(a)(3)(A)) (the "Temporary Forbearance Rule").¹⁰⁰

As originally proposed, the Regulations did not include an explicit statement of the length of time that a stay of collection or waiver of acceleration would be considered temporary. The Proposed Regulations merely stated that "[an] agreement by the holder to temporarily stay collection or waive an acceleration clause or similar default right is not a modification."¹⁰¹ An example in the Proposed Regulations, however, indicated that a three-month waiver was temporary.¹⁰² Commentators were understandably concerned that the example may have implied that the meaning of "temporary" under the Regulations was a period significantly shorter than often would be necessary to resolve troubled debt workouts.¹⁰³ The Temporary Forbearance Rule was promulgated to allay these concerns, putting certain parameters around the meaning of "temporary," while acknowledging "that a holder's waiver or non-enforcement of default rights might not itself evidence an agreement with respect to new terms."¹⁰⁴ The Temporary Forbearance Rule provides guidance as to when a holder goes from merely refraining from enforcing its rights to altering the terms of the instrument by the conduct of the parties.

Reasons for Change

Despite the additional specificity of the Temporary Forbearance Rule as compared to the Proposed Regulations, issues persist as to the boundaries of the temporary period, particularly the end point. The Temporary Forbearance Rule extends the initial two-year timeframe by any additional period during which the parties conduct good faith negotiations or during which the issuer is in a title 11 or similar case. The purpose of this part of the Temporary Forbearance Rule is to acknowledge that parties who are still negotiating have not yet come to terms with respect to the defaulted debt, meaning that the debt has not yet been modified. Indeed, the holder's temporary forbearance does not itself signify that an agreement will ever be reached with respect to modified terms. Instead, the holder at any time could decide to enforce its rights under the original terms. For this reason, it is not clear how the deemed modification that would take place at the end of the permitted forbearance period should be tested for significance, given that there will have been no legal change to the terms of the instrument.

The Regulations do not provide any guidance with respect to the nature or extent of the negotiations required to extend the temporary forbearance period. The appropriate end point of the period may be particularly difficult to identify in the related party context, where a rule designed to provide for only temporary forbearance may be stretched indefinitely by continued (and possibly intermittent or half-hearted) negotiations. Related parties may engage in negotiations intended to be just sufficient to avoid a deemed modification, using the Temporary Forbearance Rule as a timing option with respect to a deemed retirement of the defaulted debt. In contrast, there is no reason why an unrelated creditor would indulge the borrower in this fashion.

There is also some uncertainty regarding the beginning of the forbearance period. It is not entirely clear whether the period begins immediately upon the issuer's initial failure to perform, or only upon an express agreement by the holder to stay collection or waive an acceleration clause or similar default right. The Temporary Forbearance Rule refers to "an agreement by the holder," which might not exist merely because the holder refrains from enforcing its rights. On the other hand, it is possible that the holder's inaction evidences its agreement to stay collection or temporarily waive acceleration.

In addition to the issues relating to the time period covered by the Temporary Forbearance Rule (and what happens once the period elapses), it is not clear whether the rule applies only to payment defaults or also to covenant defaults (such as operational covenants, or financial covenants like debt-to-equity or interest coverage ratios). As practitioners often quip, the borrower is always in default under a well-drafted loan agreement,¹⁰⁵ and lenders routinely waive acceleration when loan covenants are not satisfied. In situations where the borrower continues to make timely payments, but is not in compliance with the loan covenants, there arguably should not be a deemed modification regardless of how long the lender refrains from exercising its acceleration rights.

The Regulations include a separate rule for covenant modifications, which provides that "a modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification" (the "Covenant Amendment Rule").¹⁰⁶ Thus, it would seem that, even if the periods under the Temporary Forbearance Rule were exceeded, such that the debt were treated as modified by virtue of a covenant default, the modification should not be regarded as significant, since the actual modification of a defaulted covenant typically would not be significant under the Covenant Amendment Rule.¹⁰⁷ Further, if the modification of an accounting or financial covenant were material, the obligor generally would be required to pay consideration in order to make the change, which would be tested under the Yield Test.¹⁰⁸ Therefore, if little or no consideration were required for the change, or if the lender were content to ignore the covenant default without renegotiating the covenants, there would not seem to be a reason to subject this type of covenant default to the Temporary Forbearance Rule in the absence of a payment default.

Proposal

We propose that the Temporary Forbearance Rule be revised so that its end point applies only to related party debt. Unrelated parties have no particular incentive to extend the period of forbearance beyond a commercially reasonable timeframe, and can be assumed to behave in an economically rational manner. Therefore, if debt is in default and no agreement has been reached to restructure it, but an unrelated holder nevertheless refrains from enforcing its rights, there would appear to be no reason to treat the debt as if it were modified, regardless of how long the forbearance persists. The same may not be true in the related party context, where the related parties may have myriad reasons for wanting to avoid or time the tax consequences with respect to defaulted debt.

More specifically, we would replace the current Temporary Forbearance Rule with a rule stating that, absent a written or oral agreement to alter other terms of the debt instrument, if an unrelated holder stays collection or waives an acceleration clause or similar payment default right (including such a waiver following the exercise of a right to demand payment in full), the holder's forbearance will not constitute a modification. On the other hand, with respect to debt held by a party that is related to the debtor, if the forbearance continues for more than two years after the debtor's initial failure to make a payment, then on the second anniversary of the due date of that payment, the debt would be deemed to be exchanged for a demand loan. In that case, the demand loan would be subject to, among other rules, Regulation section 1.1272-1(d) (which is applicable to debt instruments that provide for a fixed yield), the section 7872 regime for below market interest rate loans and the section 482 safe harbor interest rates.

We also recommend that the language of the Temporary Forbearance Rule be clarified by deleting the reference to "an agreement by the holder," so that the starting point of the temporary period clearly would begin at the time of the obligor's initial failure to perform.

Finally, we recommend that the Regulations be amended to state expressly that the Temporary Forbearance Rule applies only to payment defaults and not to forbearance with respect to covenant defaults. That is, a lender can choose to ignore or waive any covenant default indefinitely without that constituting a modification to the debt instrument. If our previous proposal is adopted, this change would apply only to loans between related parties.

G. Other Recommendations

Regulation section 1.1001-3(e)(6) (the Covenant Amendment Rule) provides that a modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. Presumably the limitation to "customary" covenants was intended to prevent changes that are not really changes to covenants from masquerading as such.

Reasons for Change

The determination of whether a financial or accounting covenant is "customary" is often difficult because each lending agreement is unique and market practice with respect to covenants is constantly evolving. In most cases, taxpayers and their advisors are able to reach the conclusion that a covenant that appears in a commercial lending agreement is "customary," but some uncertainty always remains.

We are unaware of any situation in which a taxpayer could plausibly add or delete a provision in a loan agreement that would otherwise constitute a significant modification but would escape such treatment if it could qualify as a customary financial or accounting covenant. Furthermore, even without the restriction to "customary" covenants, a change to a loan agreement would have to qualify as a financial or accounting covenant to qualify for the Covenant Amendment Rule, and changes not plausibly considered to be changes to such covenants would not be within the rule.

Proposal

We recommend that the word "customary" be deleted from the Covenant Amendment Rule. Alternatively, if the Treasury and the Service remain concerned that the limitation to "customary" is necessary to deter potential abuses, we recommend that this limitation be applied only to loans between related parties.

Regulation section 1.1001-3(c)(6)(i) generally provides that "an agreement to change a term of a debt instrument is a modification at the time the issuer and holder enter into the agreement, even if the change in the term is not immediately effective." Where the change in the term of the debt instrument is subject to meeting reasonable closing conditions, Regulation section 1.1001-3(c)(6)(ii) sets forth an exception to the general rule. In such circumstances, the modification is not treated as occurring until the closing conditions are met. Examples of reasonable closing conditions provided in the Regulations are "shareholder, regulatory or senior creditor approval, or additional financing."

Reasons for Change

Many modifications addressing payment defaults, particularly in the consumer loan context, are conditioned on the borrower showing that it can make certain reduced payments over a trial period of time. In this context, the lender may agree to a reduced payment schedule if the borrower can show it can meet the revised schedule over the required period of time. If the borrower does not make the payments under the reduced schedule, the modification is not permanent and principal and interest are determined and due under the terms of the original instrument. These types of modifications are especially prevalent under certain government-sponsored home loan modification programs.

Under current law, it is unclear whether meeting certain performance triggers (such as the one described above) could be treated as reasonable closing conditions. Although such conditions are not necessarily similar to those conditions listed in the Regulations, the fact that such conditions have been prevalent (and even part of government-sponsored home loan modification programs) could be viewed as meeting the definition of a reasonable closing condition.

Finally, treating the modification as occurring when the agreement is reached rather than at the time the performance triggers are met (assuming the modification constitutes a significant modification) adds unneeded complexity in the circumstances where the performance triggers are not ultimately achieved. In such situations, under the current tax rules, the lender and the borrower must properly account for the fact that the loan reverts back to the original payment schedule (including with respect to earlier accruals of interest). Because this occurs pursuant to the terms of the instrument, it is not likely a modification and, thus, is likely governed by the rule of Regulation section 1.1272-1(c)(6), which treats the instrument as redeemed and reissued solely for the purpose of determining OID. In the context of consumer loans, where these situations are most likely to arise, the application of those rules for the consumer can be complex. Moreover, treating the modification as occurring when the agreement is reached does not, in our view, achieve a better tax policy result.

Proposal

We recommend that the Regulations be modified to provide that modifications that do not become permanent unless certain payment performance triggers, not extending past 18 months, are met are not treated as modifications until the triggers are met.

We suggest adding an example in Regulation section 1.1001-3(d) to illustrate this change.

Moreover, if this proposal is implemented, we suggest explicit rules dealing with how the borrower and lender should accrue interest during the trial period. We recommend that the borrower and lender accrue coupon interest pursuant to the revised terms during the trial period, and not under the original terms of the instrument. Although at first blush this appears contrary to our proposal that the modification is not treated as occurring until the borrower makes all the required payments, we believe this approach is consistent with both basic accrual principles and the doubtful collectability exception.¹⁰⁹ Alternatively, the borrower and lender could be required to accrue interest based on the original terms of the debt instrument; consequently, the borrower would have to recognize income and the lender a deduction if and when the modification becomes permanent. However, the characterization of that income and deduction would not be clear. Accordingly, if such approach is taken, we recommend explicit rules dealing with the effect of the modification for both the borrower and the lender on interest that accrued at the higher rate.

Regulation section 1.1001-3(c)(1)(i) provides that "any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument" is a modification.

Where the lender and borrower agree to increase the size of a loan without changing any terms, there is some uncertainty as to whether the upsize of the loan is a modification of the entire loan or merely a new lending with the same terms as the earlier loan.

Reasons for Change

Although we believe it is relatively clear that the mere upsize of a loan does not result in a modification with respect to the entire loan but is simply a new lending, we believe clarification of this conclusion would be helpful.

Proposal

We recommend that an example be added to the Regulations showing that an increase in the principal amount of a loan in exchange for an advance of cash equal to the fair market value of the increased principal amount is not treated as a modification if no other terms are changed, but rather would be treated as an additional borrowing that may or may not be treated as part of the same issue as the original loan, depending on the application of the reopening rules.

Section 1274(c)(4) provides that section 1274 and section 483 are inapplicable where a debt instrument is assumed in connection with the sale or exchange of property (or property is acquired subject to an existing debt instrument) unless other terms of the debt instrument are modified in connection with the assumption. The legislative history to section 1274(c)(4) indicates that Congress did not want the imputed interest rules of sections 1274 and 483 to apply where an existing debt instrument with a below-market interest rate was assumed (as opposed to situations where a new debt instrument with a below-market interest rate was issued) as such existing debts were not viewed to have the same potential for the tax avoidance planning that sections 1274 and 483 were intended to combat.

If section 1274 would otherwise apply, but is made inoperative as a result of section 1274(c)(4), the issue price of an assumed debt instrument, where the assumption transaction results in a significant modification for purposes of the Regulations, is determined under section 1273(b)(4).

Reasons for Change

Example 6 of Regulation section 1.1001-3(g) illustrates a situation where a recourse debt instrument (a mortgage loan) is assumed in connection with the sale of the property securing the mortgage loan. In connection with the assumption, no other terms of the debt instrument are modified. The example concludes that the assumption results in a change in obligor under the instrument. Moreover, because no exceptions apply under Regulation section 1.1001-3(e)(4)(i), the assumption results in a significant modification of the debt instrument. The example further determines that, pursuant to section 1274(c)(4), "the debt instrument is not retested to determine whether it provides for adequate stated interest." Example 6, however, is silent as to how the issue price of the modified instrument is determined. As described above, as a result of section 1274(c)(4), the issue price of the debt instrument is determined under section 1273(b)(4).

We suggest that Treasury and the Service consider regulations under section 1274 that would limit section 1274(c)(4) to its intended purpose and prevent certain unintended tax results that would flow from a literal application of the rule. Unintended tax results would occur, for example, where a debt instrument that does not provide for qualified stated interest is assumed in connection with a sale or exchange of property, and although the debt instrument is not otherwise modified, the assumption results in a significant modification. In such circumstances, the issue price of the modified debt instrument under section 1273(b)(4) is its stated redemption price at maturity, which in this scenario is inflated because it includes all interest on the debt instrument. As a result, the amount realized for the seller on the sale of the property under Regulation section 1.1001-1(g) and the basis of the property to the buyer under Regulation section 1.1012-1(g)(1) is the inflated issue price.¹¹⁰ Furthermore, the debt instrument does not have any interest (or OID) going forward because the stated redemption price at maturity is equal to the issue price. We do not believe such results were intended when section 1274(c)(4) was enacted. Accordingly, we recommend that the rule be revised so that it merely limits the imputation of interest under sections 1274 and 483. This can be accomplished by applying the rules of section 1274 to instruments described in section 1274(c)(4) but subjecting the calculation of the imputed principal amount under section 1274(b)(1) to a floor equal to the stated principal amount.

Proposal

We recommend that Regulation section 1.1274-5 be revised to indicate that section 1274(c)(4) only applies to limit the application of the imputed interest rules of sections 1274 and 483. In addition, we suggest modifying Example 6 of Regulation section 1.1001-3(g) to illustrate the application of the revised regulation.

A modification of a debt instrument that changes the currency in which the debt instrument is denominated is not governed by a specific rule under Regulation section 1.1001-3(e). Accordingly, the change must be tested under the General Economic Significance Test.

If the interest rate of the instrument is also changed, the Yield Test would apply by its terms. However, where the underlying currency of the instrument is altered, a comparison of the yield of the unmodified instrument to the modified instrument is not helpful because interest rates are inherently linked to the underlying currency. If the yield remains unchanged, the "true" yield of the instrument may in fact have changed to a material extent.

Reasons for Change

We believe that, under the General Economic Significance Test, a change in the currency of the debt instrument is almost always economically significant and thus results in a significant modification. The change in the underlying currency of a debt instrument is a fundamental change in the debt instrument itself. The only exception of which we are aware is in the case of two currencies that are explicitly linked, such as currencies of smaller countries that are linked to the U.S. dollar or the Euro.

Although we feel strongly that a change in the currency of a debt instrument is always a significant modification under current law (except in certain cases involving linked currencies), we are aware of the Service challenging this position on examination. In our view, these disputes are unnecessary and guidance should resolve the issue to reduce the administrative burden. Accordingly, we suggest that the Regulations be amended to explicitly provide that a modification of a debt instrument that alters the currency in which a debt instrument is denominated results in a significant modification, except in the case of a change from one currency to another currency to which the first currency is explicitly linked by government policy. In the case of linked currencies, we think that the General Economic Significance Test should continue to apply, so that the change in currencies would not be a significant modification only in cases in which the two currencies involved were highly likely to remain linked for the remaining term of the debt.

Proposal

Provide a new regulation or example that specifically states that a modification to a debt instrument that changes the currency in which the debt instrument is denominated is a significant modification.

Where one or more terms of a debt instrument are modified and the modification is not described in Regulation section 1.1001-3(e)(2)-(6), the modification is a significant modification only if the alteration of the terms, based on all of the facts and circumstances, is economically significant.

Reasons for Change

The General Economic Significance Test provides little indication of how to determine whether the alteration of the terms of a debt instrument is economically significant. Importantly, such phrase can take either a qualitative or quantitative meaning. In certain circumstances, a qualitative approach is likely to be the preferred approach. For example, a change in the currency in which the debt instrument is denominated may have very little quantitative significance -- that is, the value of the debt instrument may remain the same immediately after the modification and a consent fee may not be necessary -- but in our view is nearly always qualitatively significant because the currency in which the debt is denominated is a fundamental term of the debt instrument.

In other circumstances, we believe that a quantitative approach is superior. In particular, where a cash payment is made as consideration for the alteration of one or more terms of a debt instrument (presumably because the alteration eliminates or reduces one or more rights of the consenting party), a quantitative approach appears to be the better determination of whether the modification is economically significant (assuming the modification is tested under the General Economic Significance Test). Moreover, in our view, the amount of the consent payment provides the best indication of the economic significance of the modification. As the payment of the consent fee is already tested under the Yield Test, we believe that if the consent fee does not trigger a significant modification under the Yield Test, the modifications for which the consent fee serve as consideration should be presumed not economically significant.

Proposal

We recommend that the Regulations provide that where a cash payment is made as sole consideration for one or more modifications that are tested under the General Economic Significance Test, if the amount of the cash payment does not result in a significant modification under the Yield Test, the modifications to the instrument that resulted in the cash payment are presumed to not be economically significant.

We believe that the presumption should be limited to situations where all of the modifications to the instrument that would be tested under the general rule favor the party making the cash payment, so that the consent fee is an indication of the total magnitude of the modifications to be tested under the General Economic Significance Test. In addition, if other terms of the instrument are modified that would also affect the yield of the instrument, the presumption would only apply if the payment of the consent fee, when tested independently from the other modifications that would affect the yield, does not result in a significant modification under the Yield Test.

Finally, we recommend that Example 1 of Regulation section 1.1001-3(g) be revised to incorporate this change.

² T.D. 8675, 1996-29 I.R.B. 50.

³ 462 F.2d 712 (5th Cir. 1972), cert. denied, 409 U.S. 1076 (1972).

⁴ Reg. §§ 1.1001-3(c)(1)(ii), (2)(iii) and (3).

⁵ Reg. § 1.1001-3(c)(2)(i).

⁶ PLR 200709013 (Mar. 3, 2007).

⁷ AM 2011-003 (Aug. 18, 2011).

⁸ All references to the "Service" refer to the agency issuing the advice, which may include the Internal Revenue Service ("IRS"), IRS Office of Chief Counsel, and Treasury Department.

⁹ PLR 200315001 (April 11, 2003).

¹⁰ References to a "section" are to a section of the Internal Revenue Code of 1986, as amended (the "Code"), unless otherwise indicated.

¹¹ July 28, 2006.

¹² AM 2011-003 (Aug. 18, 2011).

¹³See also PLR 200709013 (Nov. 22, 2006) (stating explicitly that the proposed transaction steps resulted in the substitution of a new obligor and a modification of the debt, but not a significant modification) and PLR 20100015 (Nov. 5, 2009) (referring to the conversion of a corporation into a disregarded single member LLC as resulting in the substitution of a new obligor that does not result in a significant modification).

¹⁴ The Service may have changed the basis for its conclusion because of a perceived inconsistency between treating a change in tax status of the obligor as not a modification at all, while nevertheless giving effect to the change for other tax purposes. Our proposal 5, which clarifies that a change in tax obligor can have tax consequences to the old and new tax obligor even if the change does not result in a deemed exchange under the Regulations, should allay this concern.

¹⁵ As to the case in which a new obligor is added and the original obligor becomes a guarantor, see our Proposal 6 below. If that proposal is not adopted, this proposal has greater importance.

¹⁶ Reg. § 1.1272-1(c)(6).

¹⁷See Reg. § 1.1275-4(b). If a CPDI is issued for nonpublicly traded property, a contingent payment is generally taken into account in the year it is made. See Reg. § 1.1275-4(c).

¹⁸See Reg. § 1.1275-2(h).

¹⁹ Allocating a portion of the payment first to accrued interest changes slightly the timing but does not change the total amount treated as a return of basis. That is because any amount treated as a payment of accrued interest reduces the amount treated as a payment of interest on the next scheduled interest payment date by the same amount (since the same interest cannot be paid twice).

²⁰ PLR 201431003 (Aug. 1, 2014); see also PLR 201546009 (Nov. 13, 2015).

²¹ For a debt instrument with contingent payments that at issuance was not subject to the CPDI regulations (for example, because one payment schedule was significantly more likely than not to occur, or the contingent payments were remote), under our proposal, the contingencies would not be retested upon a deemed reissuance to determine whether the CPDI regulations applied. Instead, similar to our proposal 12, we would propose that the original payment schedule, with appropriate adjustments to take into account the actual alterations to the debt instrument, be used for purposes of determining the yield and maturity of the modified instrument.

²² I.R.C. § 1271(a)(1); Reg. § 1.1001-3(b).

²³Fairbanks v. United States, 306 U.S. 436 (1939).

²⁴ I.R.C. § 108(e)(10).

²⁵ Reg. § 1.163-7(c) (generally permitting an interest deduction for repurchase premium, except where the issue price of the new debt instrument in a debt-for-debt exchange is determined under section 1273(b)(4) or 1274, in which case such deduction must be amortized over the term of the new debt instrument in the same manner as if it were OID).

²⁶ Reg. § 1.61-12(c)(2).

²⁷See Reg. § 1.1001-2. See also Reg. § 1.1001-3(g), Example 5, which could be modified to emphasize this point.

²⁸ Reg. § 1.1001-3(e)(4)(iii). If the addition or deletion of a co-obligor is part of a transaction or series of transactions that results in the substitution of a new obligor, the transaction is tested under the rules for substitutions.

²⁹ Reg. § 1.1001-3(e)(4)(i). The exceptions are for section 381 transactions and certain asset acquisition where there is no change in payment expectations and no significant alterations by operation of the terms of the debt, as well as for tax-exempt bonds where the new obligor is related to the original obligor and the collateral securing the debt includes the original collateral.

³⁰ Reg. § 1.1001-3(e)(4)(ii).

³¹ Reg. § 1.1001-3(e)(4)(iv)(B).

³² Reg. § 1.1001-3(e)(4)(iv)(A). Note that our proposal 6 below would eliminate the distinction between the treatment of recourse and nonrecourse debt.

³³ In PLR 199904017 (Oct. 29, 1998), for example, the Service concluded that, for purposes of the debt modification rules of Regulation section 1.1001-3(e)(4), a guarantor that "unconditionally guarantees all of Y's debts" and "waives diligence, presentment, demand of payment, filing of claims with a court in the event of merger or bankruptcy of Y, and any right to require a proceeding first against Y" should be treated as a co-obligor rather than a guarantor. The Service, however, has not always followed the logic contained in the ruling. In PLR 200742016 (June 21, 2007), the Service treated a guarantor relationship and a co-obligor relationship as distinct for purposes of Regulation section 1.1001-3(e)(4) without discussion of whether the guarantee in question was one of payment or collection.

³⁴ In certain limited circumstances, a guarantee may be restricted to a certain amount of the debt. In those circumstances, the existing rule governing guarantees may be more appropriate. Accordingly, rather than eliminating the existing guarantor rule altogether, it may be appropriate to limit the application of the rule to situations where the guarantee does not extend to all or substantially all of the principal and interest on the debt.

³⁵ We note that under Prop. Regulation section 1.752-2(k), a recourse liability of a partnership that otherwise would be allocated to a partner that is a disregarded entity would be allocated to such partner only to the extent of the net value of the disregarded entity (excluding for this purpose the value of the disregarded entity's interest in the partnership).

³⁶ The Tax Court reached essentially this conclusion in Great Plains Gasification v. Comm'r, T.C. Memo 2006-276, 92 T.C.M. (CCH) 534 (2006).

³⁷ The Service took this position in determining the amount realized on the transfer of assets to creditors in PLR 201644018 (July 28, 2016), holding (11). The ruling contains no analysis of the issue discussed in these Comments. A counterargument would be that, under Regulation section 301.7701-3(b), a wholly owned LLC is not entirely "disregarded" for tax purposes; the regulation merely provides that the LLC is "disregarded as an entity separate from its owner." Thus, if the LLC is treated as part of its owner C, recourse against the LLC is considered recourse against C. Still, the recourse against C would be limited to only the portion of C's assets owned by the LLC, and so the recourse against C is limited.

³⁸ If an instrument is not substantially all recourse or not substantially all nonrecourse either before or after a modification, the significance of the modification is determined under the General Economic Significance Test. Reg. § 1.1001-3(e)(5)(ii)(A) (last sentence).

³⁹ As discussed above, debt issued by a limited liability company with essentially only a single asset and not guaranteed by the owner(s) of the entity is functionally equivalent to nonrecourse debt secured by that asset.

⁴⁰ If the owner of the property has the unilateral right to transfer the property subject to the debt and does so, this would not be a modification under our proposal 1 and hence would not be a taxable exchange for the holder, no matter how great the economic significance of the transfer to the holder of the debt.

⁴¹ In addition to the recommendations in this section, proposal 1 would delete -3(c)(2)(i) in its entirety, thereby eliminating the first instance in which the Regulations require a determination of whether debt is recourse or nonrecourse.

⁴² We note that this change would only apply to modifications as determined under -3(c) subject to our recommended changes in proposal 2.

⁴³ Our proposal is not premised on the view that the Regulations must eliminate all considerations of the extent to which a lender has recourse, only that there should not be a binary distinction between recourse and nonrecourse debt. Hence, retaining a rule that references a change in recourse rights is not inconsistent with our proposal.

⁴⁴ As a commercial matter, if the borrower and lender are unrelated, the lender would never agree to the former and the borrower generally would not agree to the latter (although this might occur if a troubled debtor company merges with a company with better credit). Hence, as a practical matter, a change in payment expectations only occurs on loans between related parties, and then only when the parties are not acting at arm's length.

⁴⁵ In a legal defeasance, the issuer no longer has any legal obligation on the debt once it has posted the required collateral to defease the debt. By contrast, in an "in-substance" defeasance (sometimes referred to as a "covenant" defeasance), the issuer remains legally obligated on the debt, so the transaction is merely a posting of collateral on a recourse debt. Generally, the posting of collateral on a recourse debt should not be a significant modification under either current law or the changes we are proposing.

⁴⁶ Defeasances typically require that the property used to defease the bond be Treasury obligations or other high-grade investments. Hence, the cost of defeasing a bond is generally higher than the bond's adjusted issue price plus accrued interest at the time of the defeasance. Also, the issuer generally purchases the defeasance property on the same day that it uses it to defease the bond. Accordingly, a legal defeasance typically results in a deduction for retirement premium on the bond and no gain or loss on the defeasance property.

⁴⁷ Regulation section 1.61-13(b) provides that if an issuer posts collateral in a "sinking fund" for a bond, the issuer remains taxable on any income or gain from the property posted as collateral. If our proposed treatment is adopted, it would be helpful to amend this regulation to clarify that it does not apply to legal defeasances in which the holder is treated as exchanging the recourse debt for the defeasance property.

⁴⁸ §§ 1.1001-3(c)(1)(ii).

⁴⁹ Reg. § 1.1001-3(c)(2)(ii). Under present law, the general rule for alterations by operation of the terms of a debt instrument also does not apply (1) if a new obligor is substituted on the instrument or a co-obligor is added or deleted or the recourse nature of the instrument is modified or (2) to an alteration resulting from the exercise of an option that is not unilateral or that is a holder option and results in a deferral of or reduction in a scheduled payment of principal or interest. As discussed above in these Comments, under our proposal 2, the substitution of a new obligor or the addition or deletion of a co-obligor, if occurring by the operation of the terms of the instrument, would not be a significant modification if there is no change in payment expectations.

⁵⁰ Reg. §§ 1.1001-3(c)(2)(ii) and (e)(5)(i).

⁵¹ Similarly, a modification of a non-debt financial instrument, regardless of whether it occurs by operation of the terms of the instrument, may be required to be tested under section 1001 to determine whether a taxable exchange will be deemed to have occurred. See, e.g., Reg. § 1.1001-1(a); Reg. § 1.1001-4; Rev. Rul. 90-109, 1990-2 C.B. 191 (exercise of option to change insured on life insurance policy is sale or exchange under section 1001). Depending on its terms, the non-debt financial instrument as modified could be recharacterized as a debt instrument. The Service has stated that the Regulations "do not limit or otherwise affect the 'fundamental change' concept articulated in Rev. Rul. 90-109," for contracts that are not debt instruments. T.D. 8675, 61 Fed. Reg. 32926 (1996).

⁵² We note that no case has ever held modified debt to be equity on the ground that at the time of the modification the borrower could not have borrowed fresh funds on the same terms as in the modified debt. Accordingly, it is an open question whether, in testing the modified debt for whether it is to be respected as debt for tax purposes, the test should be whether the lender would be willing to make a new loan on the modified terms or whether the modifications are consistent with the lender continuing to act in its capacity as a creditor rather than as an equity investor.

⁵³ T.D. 8675, 61 Fed. Reg. 32926 (1996) and REG-106750-10, 75 Fed. Reg. 31736 (2010). See also New York State Bar Association, Report on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments (Jan. 26,1994), available at 94 TNT 21-44 ; Committee on Taxation of Corporations of the Association of the Bar of the City of New York, Comments on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments (Apr. 14, 1993), available at 93 TNT 87-22 .

⁵⁴ Reg. § 1.1001-3(f)(7)(ii)(A).

⁵⁵Id.

⁵⁶ Reg. § 1.1001-3(f)(7)(i). See Notice 94-47, 1994-1 C.B. 357 (listing certain relevant factors).

⁵⁷ Reg. § 1.1001-3(b).

⁵⁸ Reg. § 1.1001-3(f)(7)(ii)(A) (emphasis added).

⁵⁹ The final regulations under section 385 include a documentation rule that is intended to make the Credit Quality Look-Back Rule inapplicable to related party debt covered by the regulations (generally, debt issued by a domestic corporation to a corporation that is 80% related (by vote or value) to the issuer but is not part of the same U.S. consolidated group as the issuer). Specifically, the third documentation requirement under the section 385 rules must be satisfied with documents establishing that, as of the date of issuance (including a deemed issuance under Regulation section 1.1001-3), "the issuer's financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations." Reg. § 1.385-2(c)(2)(iii). The regulations under section 385 provide that "[f]or purposes of determining whether an [expanded group interest] originally treated as indebtedness ceases to be treated as indebtedness by reason of this section, the rules of this section apply before the rules of § 1.1001-3. Thus, an [expanded group interest] initially treated as indebtedness may be recharacterized as stock regardless of whether the indebtedness is altered or modified (as defined in § 1.1001-3(c)) and, in determining whether indebtedness is recharacterized as stock, § 1.1001-3(f)(7)(ii)(A) does not apply." Reg. § 1.385-2(e)(3)(ii). Representatives of the IRS have stated publicly that this rule is intended to "turn off" the Credit Quality Look-Back Rule in the context of related party debt to which the final section 385 regulations apply. Our recommendation with respect to related party debt is that the Credit Quality Look-Back Rule should apply if the related parties can demonstrate that they were acting in the same manner as unrelated parties would act.

⁶⁰ We note that, in many cases where the creditor has a claim against substantially the same assets despite the change in obligor, the substitution of an obligor or addition or deletion of a co-obligor will not be a significant modification unless there is a change in payment expectations from adequate to speculative, or vice versa, which is very unusual in practice. Further, if a change in obligor is treated as a significant modification because there has been a positive change in payment expectations, it is likely that the modified instrument would not be recharacterized as equity as a result of the change in obligor, despite the fact that the Credit Quality Look-Back Rule does not apply, because the rule requires that the obligor's capacity to meet the payment obligations under the instrument is adequate after the modification. Thus, the main risk of equity recharacterization where the Credit Quality Look-Back Rule does not apply is where there has been a significant modification as a result of a negative change in payment expectations (from adequate to speculative). In that case, equity recharacterization may be appropriate.

⁶¹ Reg. § 1.1001-3(f)(7)(i). See Notice 94-47, 1994-1 C.B. 357 (listing certain relevant factors).

⁶² 462 F.2d 712 (5th Cir. 1972), cert. denied, 409 U.S. 1076 (1972).

⁶³ T.D. 8675, 61 Fed. Reg. 32926 (1996) and REG-106750-10, 75 Fed. Reg. 31736 (2010).

⁶⁴ Reg. § 1.1001-3(f)(7)(ii)(B).

⁶⁵ Assume that section 381(a) applies to the merger or that the new obligor acquires substantially all the assets of the original obligor, as required by Regulation sections 1.1001-3(e)(4)(i)(B) and (C) in order to avoid significant modification treatment.

⁶⁶ Under our proposal 2, if the substitution occurs by operation of the terms of the debt instrument, it would be considered a modification, but not a significant modification, provided that the change in obligor does not result in a change in payment expectations.

⁶⁷ As noted in footnote 41 above, it does not necessarily follow from existing case law that the modified debt would be characterized as equity merely because the borrower could no longer have borrowed the same amount on the same terms from a new lender at the time of the modification.

⁶⁸ Reg. § 1.1001-3(e)(2)(ii).

⁶⁹ Reg. § 1.1001-3(e)(2)(iii).

⁷⁰ An exception to the general rule for de minimis OID is where the holder has elected to take into account all interest on the instrument as OID pursuant to Regulation section 1.1272-3.

⁷¹ For further examples, including an example demonstrating that a decrease in interest payable at maturity can result in a yield increase and a taxable event under the Yield Test, see New York State Bar Association Tax Section, Effect of de Minimis OID under Reg. § 1.1001-3(e)(2) (Report No. 1226, Dec. 22, 2010).

⁷² OID is the difference between the stated redemption price at maturity and issue price. Therefore, if OID is deemed to be zero, the issue price is effectively deemed to be equal to the stated redemption price.

⁷³ New York State Bar Association Tax Section, Effect of de Minimis OID under Reg. § 1.1001-3(e)(2) (Report No. 1226, Dec. 22, 2010) at 5.

⁷⁴ Reg. § 1.1272-1(c)(2).

⁷⁵ Reg. § 1.1272-1(c)(5).

⁷⁶ Reg. § 1.1272-1(c)(6).

⁷⁷ Reg. § 1.1001-3(e)(2)(i).

⁷⁸ If the modification is treated as a significant modification after applying this test, we would expect Regulation section 1.1272-1(c) to apply to the modified instrument in the same manner as a newly issued instrument with the same terms.

⁷⁹ We acknowledge that, in certain circumstances, it may be that the modification itself is the sole or principal reason that a different payment schedule (or no alternative payment schedule) would apply to the modified instrument were it newly issued. Nevertheless, we do not recommend providing a specific exception to the proposed general rule to cover circumstances where a modification affects the likelihood of the payment schedule occurring because such an exception, which would require taxpayers to analyze the effect that a modification has on the likelihood of the occurrence of any number of payment schedules, would be difficult to administer. Instead, we believe that any such changes should be analyzed under the General Economic Significance Test and the other tests for testing modifications.

⁸⁰ Many changes from a fixed to a floating rate or vice versa occur pursuant to the terms of the instrument or pursuant to a unilateral option held by one of the parties to the debt, and hence are not modifications at all. These situations are not the subject of this proposal.

⁸¹ FI-31-91, 1992-2 C.B. 683.

⁸² Specifically, under the heading "Changes in the nature of the instrument," Proposed Regulation section 1.1001-3(e)(4)(ii) provided:

⁸⁴ The yield on the EFRDI is simply the yield on the floating rate debt instrument at the time of the modification, which is generally a short-term rate based on the interval between interest resets. The yield on fixed rate debt instrument should reflect a market yield on the debt's entire remaining term, which is typically a higher rate than the market rate based on the reset interval.

⁸⁵ Alternatively, the rate actually elected by the issuer that is effective at the time of the modification could be used to determine the yield of the EFRDI for both the unmodified and modified instruments.

⁸⁶ Example 3 is consistent with the holding in Rev. Rul. 89-122, 1989-2 C.B. 200 (situation 2).

⁸⁷See 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," available at 91 TNT 69-37 (Mar. 25, 1991) (criticizing Revenue Ruling 89-122); Chicago Bar Association Federal Taxation Committee, "Comments on the Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments," available at 93 TNT 39-29 (Feb. 11, 1993) (recommending that a pro rata cancellation of principal be treated in the same manner as a prepayment of principal); Association of the Bar of the City of New York Committee on Taxation of Corporations, "Comments on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments," available at 93 TNT 87-22 (Apr. 14, 1993); Arthur J. Lieberman, "Comments on Notice of Proposed Rulemaking Proposed Regulation Section 1.1001-3; Modification of Debt Instruments," available at 93 TNT 108-88 (May 7, 1993) (recommending that the Government "end the artificial distinction between a write-down of principal on a single note and complete forgiveness of one of a series of notes"); New York State Bar Association Tax Section, "Report on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments," available at 94 TNT 21-44 (Jan. 26, 1994) ("the rule should be that a creditor does not have a sale or exchange when all or part of a debt is canceled"); American Bar Association Tax Section Committee on Sales, Exchanges and Basis, "Comments on Proposed Treasury Regulation Section 1.1001-3 Relating to Modifications of Debt Instruments," available at 94 TNT 115-23 (Apr. 26, 1994).

⁸⁸ T.D. 8675, 1996-2 C.B. 9.

⁸⁹ Reg. § 1.1001-3(e)(3)(i).

⁹⁰Id.

⁹¹Id.

⁹² Reg. § 1.1001-3(e)(3)(ii).

⁹³Id.

⁹⁴Id.

⁹⁵Id.

⁹⁶ Under the facts of Regulation section 1.1001-3(g), Ex. 4, beginning in the eleventh year of a 20-year debt instrument, interest payments are deferred until maturity. Because the deferred interest compounds at the stated coupon rate, there is no change in yield. The safe-harbor period thus begins at the end of the eleventh year and ends at the end of the sixteenth year. Because deferral of interest payments extends beyond the end of the sixteenth year, the example correctly concludes that the deferral extends beyond the safe-harbor period. The example concludes that the modification results in a "material deferral" and thus a significant modification, with no further analysis. By finding a significant modification without further explanation, the example could be read to support a bright line approach as opposed to a safe harbor approach for testing payment deferrals. If the current safe harbor approach is maintained, it would be helpful to add more detail to Example 4, explaining why this particular deferral of interest is considered a "material deferral" based on the relevant facts and circumstances. Ideally, a contrasting example could be added that concludes that a deferral beyond the safe-harbor period is not a "material deferral" based on the relevant facts (for example, because it is a deferral of a single coupon or is not far beyond the safe-harbor period).

⁹⁷ Arguably an acceleration of one-half of the remaining term is more economically significant than a deferral of the same period and a more appropriate rule for accelerations would be one-third of the remaining term. This would make the rule apply in the same way regardless of whether the debt with the shorter term was the old debt or the new debt. For example, compare a 2-year extension of the maturity of debt with 4 years remaining to a 2-year acceleration of the maturity of a debt with 6 years remaining. In the first instance, the debt's term is increased by 50% while in the latter case, the debt's term is shortened by 33%.

⁹⁸ Reg. § 1.1001-3(c)(1)(i).

⁹⁹ Reg. § 1.1001-3(c)(4)(i)(A).

¹⁰⁰ Reg. § 1.1001-3(c)(4)(ii)(B).

¹⁰¹ Prop. Reg. § 1.1001-3(c)(2)(ii). The Proposed Regulations also provided that an alteration occurring through one party's waiver of a right under a debt instrument was considered to be by operation of the original terms, and therefore generally was not a modification, provided that the waiver was unilateral. This proposed rule was dropped when the Regulations were finalized, on the grounds that "it is often impossible to distinguish between a unilateral waiver of a right and a workout agreed to by the parties in which only the holder of the instrument makes meaningful concessions." T.D. 8675, 61 Fed. Reg. 32926 (1996).

¹⁰² Prop. Reg. § 1.1001-3(d), Ex. 9.

¹⁰³See, e.g., V. Aquilino, J. Berry and S. Conlon, Comments on the Proposed Regulation Relating to Modifications of Debt Instruments (Jan. 26, 1993), available at 93 TNT 26-86 ; R. Lipton, Proposed Regulations under Section 1001 (Jan. 29, 1993), available at 93 TNT 37-65 ; Report of Chicago Bar Association on Proposed Regulation Section 1.1001-3 relating to Modifications of Debt Instruments (Feb. 11, 1993), available at 93 TNT 39-29 ; Committee on Taxation of Corporations of the Association of the Bar of the City of New York, Comments on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments (Apr. 14, 1993), available at 93 TNT 87-22 .

¹⁰⁴ T.D. 8675, 61 Fed. Reg. 32926 (1996).

¹⁰⁵ R. Lipton, Proposed Regulations under Section 1001 (Jan. 29, 1993), available at 93 TNT 37-65 .

¹⁰⁶ Reg. § 1.1001-3(e)(6).

¹⁰⁷ It is not always clear, however, whether the accounting and financial covenants in a particular loan agreement are customary, as required by the Covenant Amendment Rule. See proposal 20 below.

¹⁰⁸ Committee on Taxation of Corporations of the Association of the Bar of the City of New York, Comments on Proposed Regulation Section 1.1001-3 Relating to Modification of Debt Instruments (Apr. 14, 1993), available at 93 TNT 87-22 .

¹⁰⁹See, e.g., Corn Exchange Bank v. United States, 37 F.2d 34 (2d Cir. 1930). If the borrower does not make the required payments, the taxpayer is unlikely to be able to collect the additional interest. If the borrower does make the payments, the taxpayer has no right to receive the additional interest.

¹¹⁰ Under both regulatory provisions, an issue price generally is reduced by the unstated interest determined under section 483; however, section 1274(c)(4) turns off the unstated interest rules of section 483.