Service Urged To Apply Debt Modification Regs On Single Debt Instrument Basis; Deletion Of Material Deferral Rule Advocated.

Vincent M. Aquilino, Jeffrey D. Berry, and Steven D. Conlon of Chapman and Cutler, Chicago, have submitted comments on the proposed regulations relating to modifications of debt instruments.

The three attorneys say that, given the complexity of the regulations and the rather commonplace events constituting a "significant modification," taxpayers will in many cases be unaware that a realization event has occurred. They suggest that some of the complexity stems from the fact that certain key terms, such as "alteration" and "recourse," are not clearly defined.

They also question whether the regulations are to be applied to each debt instrument, to more than one debt instrument held by a single holder, or to an entire issue of debt instruments. They say the regulations should provide that they are to be applied on a debt instrument-by-debt instrument basis, regardless of whether a holder may own more than one debt instrument.

The attorneys urge the Service to delete several provisions from the final regulations, among them the "material deferral rule" set forth in section 1.1001-3(e)(2)(i), the "change in credit enhancement for nonrecourse debt rule" set forth in section 1.1001-3(e)(3)(iii), and the "substantial portion" rule set forth in section 1.1001- 3(e)(3)(iv). They also recommend that the Service take into account the effect of appreciation in the value of collateral in determining whether the transformation of a recourse debt instrument into a nonrecourse debt instrument triggers a realization event.

Aquilino, Berry, and Conlon requested permission to speak at the Service's February 17 public hearing.

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January 26, 1993

Commissioner of the Internal Revenue Service

Re: Comments on the Proposed Regulation Relating to

Dear Commissioner:

The purpose of this letter is to comment on the proposed regulation relating to modifications of debt instruments that was published in the Federal Register on December 2, 1992 (the "Proposed Regulation"). The preamble to the Proposed Regulation indicates that the Proposed Regulation was intended to address various questions that have arisen in light of the Supreme Court's 1991 decision in Cottage Savings Ass'n v. Commissioner, 111 S. Ct. 1503 (1991), particularly with respect to the Court's "MATERIAL DIFFERENCE" standard and its possible application to modifications of debt instruments by issuers and holders. Indeed, Cottage Savings has triggered increased concern on the part of both issuers and holders of debt instruments about what adjustments they may make to the terms of a debt instrument before a deemed exchange will result. In response to this need for clarification, the Internal Revenue Service (the "Service") has issued the Proposed Regulation in an effort to provide a framework for evaluating the effects of adjustments to debt instruments. Our comments are intended to address both the impact of the Proposed Regulation on tax-exempt debt instruments (although we have noted the statement in the preamble indicating that existing guidance issued by the Service controls whether a change made with respect to a tax-exempt bond results in a newly issued bond which remains tax-exempt) /1/ as well as its more general application to any debt instrument.

GENERAL COMMENTS

While we believe that the theory underlying the rules set forth in the Proposed Regulation provides a valuable structure for analyzing the impact of adjustments to debt instruments, as practitioners involved in transactions with complex and ever-changing factual scenarios, we are concerned that the application of the Proposed Regulation in certain contexts may be unduly complex and somewhat difficult. Moreover, we question whether in a variety of circumstances, because of the complexity of the Proposed Regulation and the routine occurrence of events that would constitute "significant modifications," many taxpayers (other than those intentionally using the rules to trigger realization events) will even be aware that a realization event has occurred.

"Alteration" Undefined and Determining Appropriate Limits

Under the Proposed Regulation, whether a deemed exchange of a debt instrument has resulted hinges upon whether a "SIGNIFICANT MODIFICATION" has occurred. /2/ "MODIFICATION" is defined under Prop. Treas. Reg. Section 1.1001-3(c)(1) as "any alteration in any legal right or obligation. . . ." Although understanding what constitutes an alteration is a necessary first step in fully comprehencing and applying the Proposed Regulation, nowhere in the Proposed Regulation is the term "ALTERATION" defined. Our efforts to evaluate the concept of an "alteration" have led us to assume that a fairly broad scope is intended; construing the term too narrowly would raise concerns that the operating rules of Prop. Treas. Reg. Section 1.1001-3(c) and (e) would be rendered inapplicable in inappropriate cases. An "alteration," at least from a "plain English" standpoint, would appear to include ANY change in the relationship between the issuer and the holder of a debt instrument. Moreover, it would seem to encompass any change in the relationship between the issuer and the holder of the debt instrument, regardless of whether the change is contemplated and authorized by the original terms of the debt instrument (e.g., a conversion of the interest rate on a debt instrument from one interest rate mode to another).

Although we have assumed that an "alteration" should encompass a broad range of acts, the lack of a concise definition in the Proposed Regulation has raised concerns regarding the appropriate limits on the definition. In particular, in our attempts to discern the intended meaning of "alteration," we have focused on the appropriate outer boundaries of the definition in two different contexts: (1) changes in legal rights that have no direct economic significance and (2) events that have economic significance to the issuer and holder of a debt instrument but which are consistent with the existing legal rights of the parties.

To illustrate our concerns regarding "alterations" in legal rights without economic significance, consider the note agreement for a debt instrument that includes certain noneconomic issuer covenants or provides the holder of the debt instrument with rights to receive notice from the issuer of the occurrence of various events. Assume that the specified notice delivery dates are modified, the address to which such notice is delivered is changed by the parties or the holder waives its right to receive notice. Should these events, which do not directly impact the economic rights of the parties under the debt instrument, be treated as alterations? As a theoretical matter, we acknowledge that these changes could have an ultimate economic effect of one sort or another in certain cases. However, we believe that the treatment of each of these types of changes as an "alteration" simply forces both taxpayers and the Service to apply a tax analysis to events that, by themselves, are unlikely to result in realization events under the Proposed Regulation. /3/ Forcing this type of analysis in these situations appears an inappropriate use of Service and taxpayer resources.

Our concerns regarding the meaning of "alteration" in the context of changes in economic consequences to the parties under a debt instrument that are consistent with the existing legal rights of the parties can be seen in the context of ongoing interest rate adjustments ("RATE RESETS") with respect to an agreed interest rate formula that is periodically reset. As discussed below, the issue with respect to such rate resets is whether the rate reset is simply not an "alteration" or an alteration which, depending upon other factors, may not constitute a modification.

The first sentence of Prop. Treas. Reg. Section 1.1001- 3(c)(2)(i) states that an alteration that occurs automatically under the documents is not a modification. Depending upon how broadly the term "alteration" is interpreted, this sentence could be analyzed as meaning that any act, even if it happens automatically under the issuing documents, is nonetheless an alteration (but, which, pursuant to the "AUTOMATIC RULE" of Prop. Treas. Reg. Section 1.1001- 3(c)(2)(i), is not a modification).

Under such an expansive interpretation of the term "alteration," each rate reset of a variable rate debt instrument could be viewed as an alteration. In our view, such an interpretation appears overly broad. Moreover, Example 1 of Prop. Treas. Reg. Section 1.1001-3(d) does not appear consistent with this interpretation. Example 1 provides that the automatic resetting of an interest rate on a bond every 49 days by a remarketing agent based on an objective standard is not an alteration. Therefore, no modification results. However, note that the conclusion in Example 1 would not be affected (i.e., a modification would not be deemed to have occurred) even if the rate reset were not considered an alteration because the alteration would not constitute a modification under the AUTOMATIC RULE of Prop. Treas. Reg. Section 1.1001-3(c)(2)(i). Consider Example 3 of Prop. Treas. Reg. Section 1.1001-3(d), which describes a situation where, under the terms of a bond, its interest rate decreases if it is registered by the issuer. Example 3 concludes that the change in interest rate is an alteration, but not a modification because of the AUTOMATIC RULE of Prop. Treas. Reg. Section 1.1001-3(c)(2)(i). The distinction in many cases between an alteration and a modification in connection with changes that occur pursuant to the original terms of a debt instrument is not likely to be important because, as illustrated by Example 3, although an alteration may be determined to exist, no modification will have occurred. This is illustrated by Examples 1 and 3, only one of which concludes that an alteration has occurred but neither of which concludes that a modification has occurred. Nonetheless, clarification of the definition of "alteration" would be helpful in applying the final regulation to the many "real life" situations that will arise over the coming years. Moreover, consistent with the explicit language of Example l, we believe that rate resets pursuant to an existing rate formula should not be treated as "alterations" necessitating further analysis under the operating rules of the Proposed Regulation.

To clarify both the meaning of an "alteration" (and the term "modification") we recommend that in each example in Prop. Treas. Reg. Section 1.1001-3(d) it be stated very clearly that an alteration has or has not occurred (and a modification has or has not occurred). For instance, Example 2 does not indicate whether or not the substitution of collateral therein is an alteration or not. The conclusion in Example 2 could have been reached in one of two ways. First, it could have been concluded that there was no alteration and, therefore, no modification. Alternatively, it could have been concluded that although there was an alteration there was no modification. Understanding how the conclusion in Example 2 was reached would be useful in understanding the meaning of an alteration. (It would appear to us that the correct analytical approach to the conclusion in Example 2 is that there was no alteration and, therefore, no modification.)

Given the significance attached to the term "alteration," we recommend that (1) an explicit definition be provided in the final regulation, (2) changes in legal rights that do not have any real economic effect (such as changes with respect to notice provisions and various noneconomic covenants) be excluded from the definition of alteration, (3) rate resets under existing interest rate formulas be explicitly excluded from the definition of alteration (consistent with Example 1) and (4) each example in Prop. Treas. Reg. Section 1.1001-3(d) explicitly indicate whether an alteration has occurred and the nature of the alteration.

"Modification" -- Clarify Impact of Third Party Relationships

The definition of a "modification" set forth in Prop. Treas. Reg. Section 1.1001-3(c)(1) needs to be clarified with respect to the impact of third party transactions. Currently, the definition is phrased in terms of an alteration in any legal right or obligation of the issuer or holder of a debt instrument. The scope of this definition is unclear in the situation in which the issuer or holder enters into arrangements with third parties that impact the legal rights or obligations of the parties with respect to the debt instrument. For example, is it a modification to a debt instrument if the holder of a debt instrument obtains, for a fee, an agreement from a third party (unrelated in any manner to the issuer) to guarantee the payment of principal and interest on the holder's debt instrument? In addition, what is the impact of puts, calls and options relating to a debt instrument that are written or acquired by a holder of a debt instrument when the other party is a third party, rather than the issuer of the debt instrument? We believe that the answers to these questions are clearly that no modification has occurred as a result of any of these third party-related transactions. /4/ To clarify this result we suggest that the following language be added in Prop. Treas. Reg. Section 1.1001- 3(c)(1) after the words "debt instrument" and before the comma: "that occurs directly or indirectly (through a third party or otherwise) between the issuer and holder."

Recourse versus Nonrecourse: Appropriate Definition

The characterization of a particular debt instrument as either a recourse obligation or a nonrecourse obligation can be critical for purposes of determining whether a modification constitutes a SIGNIFICANT MODIFICATION that triggers a realization event under the Proposed Regulation in certain situations. For example, under Prop. Treas. Reg. Section 1.1001-3(e)(3)(i)(B), while the substitution of a new obligor on a recourse note is a "significant modification," it is not with respect to a nonrecourse note. Moreover, under Prop. Treas. Reg. Section 1.1001-3(e)(3)(iii), the addition or material alteration of credit enhancement on a nonrecourse obligation is a significant modification. In contrast, the addition or material alteration of credit enhancement on a recourse instrument is only a significant modification if the provider of the credit enhancement is, in substance, substituted as the obligor and the change is intended to circumvent the rules applying to a change in obligor. Accordingly, to apply the significant modification tests of Prop. Treas. Reg. Section 1.1001-3(e), it is critical to be able to ascertain whether the debt instrument under consideration is recourse or nonrecourse. While the "recourse" and "nonrecourse" distinction is set forth in other instances in the Code (i.e., Sections 49 /5/ and 465, /6/ and Treas. Reg. Sections 1.704-2 /7/ and 1.752-1 /8/), it is impossible to discern which, if any of these concepts is intended to be applied. Moreover, we question the appropriateness of applying the standards applied in determining whether partnership debt is "nonrecourse" with respect to the partners for purposes of determining whether debt issued by a corporation or a trust, for example, is nonrecourse.

Given the significance attached to the distinction between "nonrecourse" and "recourse" obligations, we recommend that explicit definitions of the terms be provided in the final regulation. In addition, with respect to tax-exempt debt instruments we have additional comments regarding this aspect of the Proposed Regulation, as discussed in a later section of this letter.

"Material Deferral" Standard Not Appropriate

Prop. Treas. Reg. Section 1.1001-3(e)(2)(i) provides that a change in timing and/or amounts of payments is a significant modification if it "materially defers" payments due under a debt instrument (the "MATERIAL DEFERRAL RULE"). We acknowledge that the deferral of payments with respect to a debt instrument may have economic significance, even in cases where the interest rate and principal amount are unaffected (and interest appropriately accrues with respect to the deferred amounts). /9/ However, it is important to note that the MATERIAL DEFERRAL approach of the Proposed Regulation is a significant departure from the existing law, and, more specifically, is inconsistent with a number of private letter rulings issued by the Service in which the rescheduling of principal payments as a result of certain unforeseen circumstances did not result in a taxable exchange. /10/ In light of the important public policy reasons relating to the "workout" of troubled debt and the fact that the deferral of payments under circumstances in which the principal amount and return to the holder are simply deferred but not modified is not treated as a realization event under existing law and private letter rulings, we believe that the MATERIAL DEFERRAL RULE of Prop. Treas. Reg. Section 1.1001-3(e)(2)(i) should be deleted.

In addition, the interrelationship between the MATERIAL DEFERRAL RULE of Prop. Treas. Reg. Section 1.1001-3(e)(2)(i) and the EXTENSION OF FINAL MATURITY RULE of Prop. Treas. Reg. Section 1.1001- 3(e)(2)(ii) is unclear. Neither the preamble nor the Proposed Regulation provides any guidance regarding the intended interrelationship of these two rules. We believe that one method of reconciling the interrelationship of these two rules, to the extent the MATERIAL DEFERRAL RULE is retained, would be to clarify Prop. Treas. Reg. Section 1.1001-3(e)(2)(i) to indicate that it applies only to payments of INTEREST. If the MATERIAL DEFERRAL RULE is treated as applying to principal payments, it could in many cases negate entirely the EXTENSION OF FINAL MATURITY RULE set forth in Prop. Treas. Reg. Section 1.1001-3(e)(2)(ii).

In addition, regardless of whether the MATERIAL DEFERRAL RULE applies to only interest, we believe that to the extent the MATERIAL DEFERRAL RULE is retained, Prop. Treas. Reg. Section 1.1001- 3(e)(2)(i) should be amended to provide a bright-line test or safe harbor as to what is material. The test should be phrased in terms of a period of time as is the case under the EXTENSION OF FINAL MATURITY RULE of Prop. Treas. Reg. Section 1.1001-3(e)(2)(ii) (a test based on the change in the yield on the instrument would be redundant in light of Prop. Treas. Reg. Section 1.1001-3(e)(1)(ii)). The addition of a bright-line test or safe harbor with respect to the determination of whether a material deferral of payments has occurred appears critical because of the likely deferral of payments in the workout of troubled debt. The failure to provide such a bright-line test or safe harbor will ultimately increase compliance costs for both the Service and taxpayers.

Accordingly, we recommend that the MATERIAL DEFERRAL RULE of Prop. Treas. Reg. Section 1.1001-3(e)(2)(i) be deleted. However, to the extent the rule is retained, we recommend that (1) the interrelationship of the MATERIAL DEFERRAL RULE to the EXTENSION OF FINAL MATURITY RULE of Prop. Treas. Reg. Section 1.1001-3(e)(2)(ii) be reconciled by providing that the MATERIAL DEFERRAL RULE only applies to payments of interest and (2) regardless of the scope of the rule, a bright-line test or safe harbor be provided for determining whether a material deferral has occurred.

Change in Credit Enhancement

Under Prop. Treas. Reg. Section 1.1001-3(e)(3)(iii), the addition or material alteration of a guarantee or other form of credit enhancement on a nonrecourse instrument results in a deemed exchange (the "CHANGE IN CREDIT ENHANCEMENT FOR NONRECOURSE DEBT RULE"). Given the state of today's marketplace and the frequency of transactions involving credit enhancement, we believe that changes in credit enhancement in and of themselves should not constitute a taxable exchange. Although we acknowledge the economic change relating to changes in credit enhancement, recent experience with bank-provided credit enhancement has forced issuers of credit- enhanced debt to replace or modify credit enhancement, either because the credit enhancing bank fails or is acquired, or because the rating agencies downgrade the rating of the credit enhancing bank. As a policy matter, it seems inappropriate to treat transactions that are principally intended to merely "shore-up" credit enhancement for a debt instrument as a result of these types of events (i.e., bring the credit enhancement for a debt instrument back to the level originally desired by the issuer and holder) as realization events. In previous authorities, the Service has not characterized changes in credit enhancement as constituting a realization event. /11/

We recommend that the CHANGE IN CREDIT ENHANCEMENT FOR NONRECOURSE DEBT RULE be omitted from the final regulation.

Changes in Security

Under Prop. Treas. Reg. Section 1.1001-3(e)(3)(iv), changes in the collateral securing a nonrecourse note are generally significant modifications if a "SUBSTANTIAL PORTION" of the collateral is released or replaced with other property. It is very common, particularly in transactions involving real estate, for collateral to be added, released, or exchanged on a regular basis. The "SUBSTANTIAL PORTION" approach taken in the Proposed Regulation is vague and fails to provide guidance to issuers and holders of debt who must on a regular basis assess the impact of events affecting collateral.

For example, consider a nonrecourse note issued by a small or medium sized manufacturing business that is secured by its existing manufacturing facility. Four years after the debt instrument is issued, the business decides to build or acquire a newer, state-of- the-art facility and sell the existing manufacturing facility. Accordingly, it contacts the holder of the note and asks that it consent to the release and replacement of the collateral securing the note (i.e., the release of the existing facility as security for the note in exchange for a security interest in the new facility). This type of transaction (i.e., the release and substitution of collateral) is common and its treatment as a realization event (by way of its characterization as a significant modification) is likely to result in realization events in many circumstances in which the parties are simply not aware of the potential tax treatment of the transaction under the Proposed Regulation (unless as indicated earlier, the rule is being intentionally used to trigger gain or loss recognition).

Although we acknowledge the economic theory underlying this rule of the Proposed Regulation, we believe that it should be deleted in light of its fundamental practical implications. However, to the extent that the rule is retained, the recurring release and substitution of collateral will simply place attention on whether a "SUBSTANTIAL PORTION" of the collateral is released. Accordingly, we recommend that, to the extent the rule is retained, the final regulation include a bright-line test or safe harbor regarding what is considered a "SUBSTANTIAL PORTION" that will trigger a taxable exchange. We have already been asked a number of questions regarding whether a specified release or substitution of collateral constitutes a "SUBSTANTIAL PORTION" for purposes of this rule. We believe that a bright-line test or safe harbor would provide needed certainty that will ultimately reduce compliance burdens on the Service and taxpayers if the rule is retained.

Puts and Calls

The Proposed Regulation should be amended to indicate that the provisions of Prop. Treas. Reg. Section 1.1001-3(e)(2)(iv) only apply to the addition or deletion of puts and calls that are not specifically permitted by the documents governing the issuance of the debt instruments. If the sale of a put or call by the issuer is authorized in the issuing documents it should not be viewed as a modification. To the extent that the Service views the consideration received for the addition or deletion of a put or call as affecting the yield on a debt instrument, if such addition or deletion is provided in the documents pursuant to which the debt instruments are issued the Service should not view the change in yield effected by such an addition or deletion any differently than a change in the interest rate mode on the same debt instrument where there is no right to put the debt instrument upon conversion (see Example 8 in Prop. Treas. Reg. Section 1.1001-3(d)).

Prop. Treas. Reg. Section 1.1001-3(e)(2)(iv) should be amended to provide a bright-line test as to what constitutes significant value. Without such a test, the certainty that the Service hopes to achieve in the Proposed Regulation will not be obtained.

TECHNICAL COMMENTS

In addition to the general comments raised above, we would also like to request clarification on several specific technical issues.

Scope -- Debt Instrument by Debt Instrument?

We recommend clarification as to whether the Proposed Regulation applies to a single debt instrument, to more than one debt instrument held by a single holder, or to an entire "issue" as defined under Prop. Treas. Reg. Section 1.1275-1(g). We believe that the final regulation should clearly state that it is to be applied on a debt instrument-by-debt instrument basis, regardless of whether a holder may own more than one debt instrument. There is no policy reason why a modification made by one holder of a debt instrument should cause an entire issue of debt instruments of which such debt instrument is a part to be deemed to have been exchanged for new debt instruments, or should cause another debt instrument held by the modifying holder to be deemed to have been exchanged. In our view, the final regulation should explicitly state that it is to be applied on a single debt instrument basis, regardless of whether the holder may own more than one debt instrument.

Unilateral Exercise -- The "Consent" Rule

Prop. Treas. Reg. Section 1.1001-3(c)(2)(i) provides that an alteration that occurs by the operation of the original terms of a debt instrument is not a modification. In addition, an alteration that occurs through one party's exercise or waiver of a right under the instrument is deemed to be by operation of the original terms of the debt instrument provided that it is "unilateral." Prop. Treas. Reg. Section 1.1001-3(c)(2)(i)(A)(2) provides that the exercise of a right is not unilateral if it requires the consent of the other party, unless that consent may not be unreasonably withheld (the "CONSENT RULE"). We recommend that the meaning of the term "consent" as used in Treas. Reg. Section 1.1001-3(c)(2)(i)(A)(2), be clarified, particularly with respect to whether it is a state law determination.

Unilateral Exercise -- The "Consideration" Rule

Under Prop. Treas. Reg. Section 1.1001-3(c)(2)(i)(A)(3), the exercise of a right is not unilateral if it requires consideration, unless the amount of consideration is fixed on the issue date (the "CONSIDERATION RULE"). The scope of this prong of the definition of unilateral is unclear. Does the required consideration refer only to moneys or other property the payment or receipt of which is a necessary precondition to the exercise of the right or does it refer to moneys or other property that may be received upon the disposition of a debt instrument immediately following the exercise of a right under the debt instrument? We believe that the more narrow interpretation is appropriate. Accordingly, we suggest that Example 5 of Prop. Treas. Reg. Section 1.1001-3(d) be expanded to include a statement to the effect that the conclusion reached therein would not be changed if the lender sold the mortgage for cash immediately upon conversion of the interest rate. This addition to Example 5 would clearly demonstrate that the cash received from the sale of the mortgage by the lender does not constitute the type of consideration referred to in the third prong of the definition of unilateral.

In addition, we are concerned that the requirement that the consideration be "fixed" on the issue date could be interpreted too narrowly. Note that Example 5 indicates that "[i]f the amount of the conversion fee varied depending on the market interest rates, however, the conversion would be a modification." This sentence raises concerns regarding conversion fees intended to cover then applicable processing costs (since the amounts would be based on an appropriate fee to cover costs as of the time of conversion rather than at the time the debt instrument was issued). We do not believe that such fees, even though not determinable as of the date the debt instrument was issued, should prevent a rate conversion from qualifying for the "unilateral modification" rule of Prop. Treas. Reg. Section 1.1001-3(c)(2)(i). Accordingly, we recommend that the scope of permissible consideration under Prop. Treas. Reg. Section 1.1001-3(c)(2)(i)(A)(3) be expanded to cover fees that commonly arise, such as "reasonable processing fees" that are incurred, for example, when a fixed rate obligation is converted to a floating rate obligation and that are not fixed on the date of issue.

"Corrective Changes"

There are certain types of modifications, such as "corrective changes" intended to correct the provisions of a debt instrument and the related documents to reflect the intent of the parties as of the date the debt instrument was issued or to correct the provisions of a debt instrument for changes in circumstance that prevent the debt instrument from functioning as the parties initially intended (for example, changes necessary to correct the provisions of a debt instrument that referenced the Manufacturers Hanover prime rate for purposes of computing its interest rate), for which neither the issuer nor holder should be penalized. In this regard, we believe that the final regulation should provide that in those situations described in Sections 7.1(b) and (c) of Notice 88-130 a modification does not occur.

Section 7.1(b) of Notice 88-130 deals with changes that correct a term of a debt instrument that could not reasonably have been intended on the date of issuance.

Section 7.1(c) of Notice 88-130 relates to changes that are necessary solely by reason of circumstances occurring after the date a debt instrument is issued. For example, such a provision would permit a change in the method for establishing a "back-up" interest rate on a variable rate obligation (i.e., the interest rate that would be used if the current interest rate setting mechanism was not appropriate for any reason) when the method used to establish the original back-up rate does not work under then existing market conditions.

Temporary Stay or Waiver

Prop. Treas. Reg. Section 1.1001-3(c)(2)(B)(ii) excepts from the definition of "modification" a temporary failure of the issuer to perform its obligations under a debt instrument. In addition, an agreement by the holder to temporarily stay collection or waive a default right is not a modification (the "TEMPORARY STAY OR WAIVER RULE"). We believe that the temperance of the general rule to accommodate troubled debt situations is appropriate. However, we recommend that the final regulation provide a safe harbor regarding the length of the permissible temporary stay or waiver period. The permitted period should be reflective of the actual period necessary to resolve troubled debt situations. Our experience is that this period often exceeds one or two years.

Waivers or Indirect Modifications

We recommend clarification regarding the statement in Prop. Treas. Reg. Section 1.1001-3(b) that the Proposed Regulation applies whether a modification is effected directly between a holder and an issuer or indirectly through one or more transactions with third parties. Rev. Rul. 87-19, 1987-1 C.B. 249 addressed the situation where a waiver by a bondholder of a right to receive additional interest resulted in a deemed exchange of the bonds. The preamble to the Proposed Regulation states that upon publication of the final regulation, the Service will declare inconsistent revenue rulings obsolete. /12/ Accordingly, we recommend clarification as to whether the situation described in Rev. Rul. 87-19 will constitute a deemed exchange under the final regulation.

Collateral-Nonrecourse Obligations

Prop. Treas. Reg. Section 1.1001-3(e)(4)(iv)(A) provides that a modification is significant if it changes a recourse debt instrument to a nonrecourse debt instrument. With respect to the provision set forth in Prop. Treas. Reg. Section 1.1001-3(e)(4)(iv), we recommend consideration by the Service of the effect of appreciation in value of collateral with respect to a recourse instrument. Arguably, once the collateral has reached a sufficient value, the parties may be willing to consent to the elimination of recourse with respect to the debt instrument (resulting in the transformation of the obligation into a nonrecourse debt instrument). We understand that this type of release occurs with respect to many real estate secured debt instruments. To the extent this type of release triggers a realization event under the Proposed Regulation, we are concerned regarding the practical application of this rule. We recommend that the Service consider the appropriateness of whether such a release should trigger a realization event and provide clarification in this regard.

Multiple Changes

We appreciate the clarification by the Service in Prop. Treas. Reg. Section 1.1001-3(f)(3)(i) that multiple changes to a debt instrument will not collectively constitute a significant modification if none of them individually would so constitute. However, we believe that the provision set forth in Prop. Treas. Reg. Section 1.1001-3(f)(3)(ii) stating that multiple changes to a debt instrument over "any period of time" will constitute a significant modification if a significant modification would have resulted had the changes been done simultaneously (the "CUMULATIVE CHANGE RULE") creates a potentially impractical rule for taxpayers and the Service in analyzing whether a specific change triggers a realization event. Accordingly, we believe that the CUMULATIVE CHANGE RULE should be modified in the final regulation to provide a rolling reasonable period or safe harbor (for example, one year ending on the date of a specific modification subject to analysis under Prop. Treas. Reg. Section 1.1001-3(e)) during which cumulative changes must be analyzed to determine if a significant modification has occurred.

Extensions of Maturity -- Mandatory Sinking Fund Payments

Prop. Treas. Reg. Section 1.1001-3(e)(2)(ii), which sets forth the EXTENSION OF FINAL MATURITY RULE, should be expanded to deal with extensions of mandatory sinking fund payment dates. A mandatory sinking fund date is NOT the final maturity of a debt instrument. We believe that with respect to extensions of mandatory sinking fund payment dates, it would be appropriate to recalculate the weighted average maturity of the debt instrument taking into account the extension and to apply the test contained in Prop. Treas. Reg. Section 1.1001-3(e)(2)(ii), to determine whether, when compared to the original weighted average maturity, there has been a significant modification.

EFFECT ON STATE AND LOCAL OBLIGATIONS

Interrelationship of the Proposed Regulation and Notice 88-130

We believe that the relationship between the Proposed Regulation and Notice 88-130 should be clearly stated in the final regulation, not the preamble to the final regulation (similar to the manner in which Prop. Treas. Reg. Section 301.7701(i)-4, dealing with taxable mortgage pools, provides specific guidance for states and municipalities). Stating the relationship between Notice 88-130 and the Proposed Regulation in the preamble merely creates uncertainty and the risk that taxpayers or Service field personnel will fail to review the referenced relationship.

We also believe that the final regulation should clearly state that the definition of a "change" for purposes of Notice 88-130 is not affected in any way by the provisions of the final regulation. In other words, the final regulation should specifically provide that, except when there is a specific cross-reference in Notice 88-130 to Section 1001, any conflict between Notice 88-130 and Section 1001 should be resolved by reference to Notice 88-130 in determining whether bonds have been "REISSUED" for purposes of Sections 103 and 141 through 150. /13/

The interplay between the Proposed Regulation and the effective date provisions of Notice 88-130 is a source of confusion. Some tax practitioners have raised questions as to whether "qualified tender bonds" issued prior to December 15, 1988 are treated less favorably than those issued after December 14, 1988. Without discussing this concern in detail, it is clear that the second sentence in Section C of Notice 88-130 is a relief provision, and it would be inappropriate to subject bonds that were accorded favorable treatment under Notice 88-130 to the more stringent rules of the Proposed Regulation. An unequivocal affirmative statement should be made in the final regulation that "qualified tender bonds" issued before December 15, 1988 are not to be treated any differently than those issued after December 14, 1988 for purposes of construing Section 1001 in the context of Notice 88-130.

Special Considerations Regarding Recourse and Nonrecourse Debt

Prop. Treas. Reg. Section 1.1001-3(h) specifically recognizes the inapplicability of the "true obligor" theory in the context of state and local obligations, whether taxable or tax-exempt. Although this concept works well with most of the provisions of the Proposed Regulation, it appears to create a serious problem under Prop. Treas. Reg. Section 1.1001-3(e)(3) relating to a change in obligor or security. We suggest that for purposes of Prop. Treas. Reg. Section 1.1001-3(e)(3) only, the final regulation specifically state that the determination of whether a debt instrument is recourse or nonrecourse is to be made by reference to the terms of the debt instrument from the conduit borrower to the municipal issuer.

Under the Proposed Regulation, ALL conduit financings would appear to be nonrecourse because a conduit issue agrees to pay debt service on the bonds it issues to the public only from payments received on the debt instrument executed by the conduit borrower. There is no policy reason why the addition of a guarantee or letter of credit to support a municipal obligation that is secured by a RECOURSE obligation from the conduit borrower should be a significant modification. The treatment of many state or local obligations as nonrecourse debt under the Proposed Regulation as drafted could significantly disrupt the municipal markets. For example, in a conduit financing, under Notice 88-130, obtaining a bond insurance policy upon the conversion of a variable rate obligation to a fixed rate obligation is not a reissuance if the bond insurance policy is required by the issuing documents. However, if the Proposed Regulation is not changed, obtaining bond insurance would appear to be a reissuance under Section 2.2(c) of Notice 88-130 even if it is required by the issuing documents (because 2.2(c) of the Notice provides that a qualified tender bond is treated as retired if there is a change in the terms of the bond that constitutes a Section 1001 event and a change in credit enhancement with respect to a nonrecourse debt instrument would constitute a significant modification under the Proposed Regulation). Surely this result was not intended. Accordingly, as set forth above we recommend that the final regulation specifically state that the determination of whether a debt instrument is recourse or nonrecourse (but not the determination of who the issuer of the debt instrument is) is to be made by reference to the terms of the debt instrument from the conduit borrower to the municipal issuer.

In addition to the questions raised by conduit financings, the concepts of recourse and nonrecourse are very difficult to apply to state and local obligations generally. For example, there are state and local obligations that are supported only by the revenues of a utility system (e.g., electric, water or sewer) or limited tax sources, not by the full faith and credit of the municipal issuer. If these obligations are nonrecourse obligations, current practices in the municipal market will be significantly disrupted as a result of the credit enhancement and substitution of collateral rules for determining whether a significant modification has occurred under the Proposed Regulation. Accordingly, we recommend that all types of nonconduit state and local obligations be specifically defined in the final regulation as recourse obligations.

REQUEST TO APPEAR

We ask that we be scheduled on the agenda to present oral comments at the public hearing on the Proposed Regulation scheduled for February 17, 1993. If you have any questions regarding these comments, please do not hesitate to contact any of the undersigned.

Very truly yours,

Vincent M. Aquilino

cc: Office of the Assistant Secretary of the Treasury, Tax Policy

FOOTNOTES

/1/ 57 Fed. Reg. 57,035 (December 2, 1992) (referencing Notice 88-130, 1988-2 C.B. 543).

/2/ Prop. Treas. Reg. Section 1.1001-3(a).

/3/ Regardless of the potential impact of Cottage Savings with respect to whether the modification of the terms of a debt instrument constitutes a realization event, we do not believe that such noneconomic covenant and notice changes should generally trigger a realization event under existing law.

/4/ Our comment and recommendation are not intended to encompass or alter the Proposed Regulation's inclusion of transactions BETWEEN a holder and an issuer that are effected "indirectly through one or more transactions with third parties." Prop. Treas. Reg. Section 1.1001-3(b).

/5/ Contains "at risk" rules and excludes certain nonrecourse financing from the credit base of certain property.

/6/ Limits deductions for losses attributable to certain activities to the amount with respect to which the taxpayer is "at risk." "Qualified nonrecourse financing" as defined in Section 465(b)(6) of the Code is treated as an amount at risk.

/7/ Contains rules applying to partnership allocations attributable to nonrecourse liabilities.

/8/ Definitions of "recourse liability" and "nonrecourse liability" are contained in Treas. Reg. Section 1.752-1(a)(1) and (2) for purposes of the treatment of partnership liabilities.

/9/ We also acknowledge that the deferral of payments on a debt instrument may also result in a "SIGNIFICANT MODIFICATION" under the "CHANGE IN YIELD RULE" of Prop. Treas. Reg. Section 1.1001-3(e)(1), although we have concerns regarding whether many taxpayers will take the potential implications of this rule into account in negotiating the deferral of payments with respect to a debt instrument.

/10/ See, e.g., Priv. Ltr. Ruls. 9037009 (June 12, 1990) (lack of funds); 9043060 (August 1, 1990) (cancellation of project before completion); 8935007 (May 15, 1989) (cash flow problems); 8920047 (February 17, 1989) (cash flow problems); 8907049 (November 23, 1988) (cash flow problems); 8753014 (October 2, 1987) (financial hardship).

/11/ See, e.g., Priv. Ltr. Rul. 8534064 (May 28,1985) (additional guarantor).

/12/ 57 Fed. Reg. 57,035.

/13/ "REISSUANCE" refers to a debt instrument that is treated as newly issued because a modification results in the deemed receipt of the debt instrument as (the "NEW" debt instrument) in exchange for the debt instnunent prior to modification (the "OLD" debt instrument).

END OF FOOTNOTES