Commentator Criticizes Proposed Debt Modification Regs.

Arthur J. Lieberman of CRI, Inc., Rockville, Md., has criticized the proposed regulations under section 1001 concerning modifications of debt instruments. In his judgment, the proposed regs impose an "unacceptable level of complexity and inequity" on relatively benign loan modifications. Lieberman contends that the Service seems to believe workout negotiations are "sinister conspiracies" to avoid the original issue discount rules when, in reality, circumventing the OID rules is the last thing most lenders and borrowers have on their minds.

Lieberman recommends several changes to the proposed regs. First, the Service should make clear that nonyield changes to a debt instrument do not cause a deemed exchange. Second, a meaningful safe harbor should be provided for changes in yield. Third, in no instance should lender forbearance be treated as a deemed exchange. And fourth, the Service should eliminate the artificial distinction between a writedown of principal on a single note and the complete forgiveness of one of a series of notes.

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May 7, 1993

Internal Revenue Service

Attention: CC:CORP:T:R (FI-31-92)

Re: Comments on Notice of Proposed Rulemaking Proposed

Dear Sir/Madam:

I would like to take this opportunity to submit comments on Proposed Regulation section 1.1001-3. In promulgating these proposed regulations, it seems as if Treasury and the IRS inappropriately used the Cottage Savings Ass'n. v. Commissioner (111 S. Ct. 1503 (1991)) decision as a vehicle to address imagined abuses of the Original Issue Discount rules by lenders and borrowers when existing loans are modified in the normal course of doing business.

Let me state unequivocally that the last thing that the vast majority of lenders and borrowers have on their minds when they enter into workout negotiations is circumventing the OID rules. Workout negotiations tend to be very serious discussions centering around salvaging an existing economic relationship outside of bankruptcy. Workout negotiations are NOT about sinister conspiracies to avoid OID rules. Yet the regulations do not give the taxpayer the benefit of the doubt that workouts and the loan modifications that result are driven by non-tax considerations. This approach results in an unacceptable level of complexity and inequity.

Prior to the issuance of Proposed Regulation section 1.1001-3, there was extensive (although admittedly not exhaustive) authority on when modifications to existing loans constituted deemed exchanges under section 1001 of the Code. Cottage Savings did not mandate a change in any of this authority because Cottage Savings dealt with an actual exchange of property, not a modification to existing property. It is inappropriate for Treasury and the IRS to impose this kind of complexity and inequity upon relatively benign loan modifications that should not attract the attention of the taxing authorities. These complexities and inequities include:

o Possible creation of OID or imputed interest, including

o Possible conversion of market discount into OID.

o Possible creation of cancellation of indebtedness income, or

o Possible creditor recognition of exchange gain, particularly

o Possible negative effects under section 382(l)(5) ("old and

o Loss of grandfather status of the "new" debt under many

o Reevaluation of debt v. equity status for contingent payment

o Possible negative effects on REMICS holding renegotiated debt

o Possible negative effect on "fixed investment trusts" that are

o Probable loss of tax exempt status for renegotiated pre-1986

All of these effects are not justified by the government's attempt to foreclose evasion of the OID provisions. If taxpayers enter into lending arrangements with an agreement to later modify that arrangement in such a manner as to avoid application of the OID rules, surely the Treasury and IRS can find another way to attack such an abuse without subjecting the rest of us to these burdensome regulations.

The approach the regulations should take is painfully clear. First, state clearly that Cottage Savings does not change any of the existing law in this area. Second, provide that ANY non-yield changes to a debt instrument will not cause a section 1001 exchange. This includes extensions of maturities, and changes in timing of payments where yield-to-maturity remains constant. Third, provide a MEANINGFUL safe harbor for changes in yield, measured by either the change in nominal yield or the change in yield relative to the AFR at issuance versus the AFR as of the modification date, at the taxpayer's election. Fourth, provide that in no instance will lender forbearance cause a deemed exchange. And finally, end the artificial distinction between a writedown of principal on a single note and complete forgiveness of a one of a series of notes. The tax result should be the same for both. This approach to the section 1.1001-3 regulations would greatly further the goal of simplicity and equity in the tax law at little or no expense to the fisc.

If you have any questions or comments about this letter, please do not hesitate to contact the undersigned.

Very truly yours,

Arthur J. Lieberman