Bar Association Recommends Changes To Debt Modification Regs.

The Committee on Taxation of Corporations of the Association of the Bar of the City of New York has recommended several changes to proposed regulations under section 1001 concerning modifications of debt instruments.

Most of the changes relate to the definition of a modification and how to determine whether a modification is significant. One area of particular concern to the committee is legal defeasance. It believes the Service should provide an example illustrating that a defeasance resulting in the conversion of old debt into nonrecourse debt or into a debt obligation of a defeasance trust is not a recognition event.

The committee also believes that routine modifications to operating and financial covenants should not, standing alone, constitute "significant modifications" -- nor should changes in the timing of payments that do not affect yields (unless designed to avoid application of the original issue discount rules) or a reduction in principal.

On a more basic level, the committee recommends the Service clarify several of the terms used in determining whether a modification is significant, including "materially," "significant," and "substantial."

The committee goes on to examine the impact of the proposed regs on other sections of the code, in particular sections 453, 382(l)(5), and 305.

====== FULL TEXT ======

April 14, l993

COMMENTS ON PROPOSED REGULATION SECTION 1.1001-3

Dear Commissioner Dolan:

Enclosed are comments of the Committee on Taxation of Corporations on the Proposed Regulations relating to modifications of debt instruments that were published in the Federal Register on December 2, 1992.

If you have any questions regarding the enclosed comments, please contact the undersigned (telephone: 212-474-1706) or Seth L. Rosen (telephone: 212-909-6373).

Very truly yours,

Herbert L. Camp

Michael P. Dolan, Esq.

Encl.

Copy w/ encl. to:

Harry L. Gutman, Esq.

David L. Jordon, Esq.

Thomas R. Hood, Esq.

Charles S. Triplett, Esq.

Stuart L. Brown, Esq.

James F. Malloy, Esq.

Gayle G. Morin, Esq.

Robert Rozen, Esq.

Mr. Mark Weinberger

Report on

by the Association of the Bar

Committee on Taxation of Corporations

April 13, 1993

This report sets forth the comments of the Committee on Taxation of Corporations of the Association of the Bar of the City of New York (the "Committee") on Proposed Regulations section 1.1001-3, governing the circumstances under which modifications to debt instruments should result in "deemed exchanges" for purposes of section 1001 of the Internal Revenue Code of 1986, as amended (the "Code"). The Committee generally approves of the approach taken by the proposed regulations and believes that the drafters should be commended for making significant progress in giving useful guidance to practitioners.

In a letter to the Commissioner of the Internal Revenue Service, dated June 1, 1992, the Committee commented on issues that might be included in regulations or other guidance on the application of the Supreme Court's decision in Cottage Savings Association v. Commissioner /1/ to the question of when modifications of debt instruments should be treated as resulting in deemed exchanges. A number of those suggestions are reflected in the proposed regulations. This report will address those areas in which the proposed regulations do not adopt the approaches suggested by our prior letter, and new issues raised by the proposed regulations.

SUMMARY

As discussed in more detail below, our principal recommendations are as follows:

A. DEFINITION OF A MODIFICATION

1. DEFEASANCE OCCURRING BY OPERATION OF THE ORIGINAL TERMS OF AN INSTRUMENT. The proposed regulations raise the question of whether a legal defeasance that is provided for under the original terms of a debt instrument would result in a deemed exchange. Additional guidance on that issue should be provided by the Service.

2. "TEMPORARY" WAIVER. Guidance is needed on when a waiver of a right is "temporary." Example 8 to subsection (d) of the proposed regulations suggests that a waiver of three months will not be deemed to result in a modification. That period is too short. It should be made clear that a longer waiver period also could be within the "temporary" definition. In addition, it should be made clear that a lender's voluntary forbearance from enforcing operating and financial covenants would never result in a deemed exchange.

3. MODIFIED INSTRUMENT IS NOT DEBT. The proposed regulations state that an alteration in terms results in a modification if the alteration results in the instrument becoming something that is not debt for federal income tax purposes, even if the modification is provided for under the terms of the original debt instrument. The Committee requests additional guidance on whether there are other modifications that may be provided for under the original debt instrument and implemented unilaterally by the issuer that should be treated as significant modifications. Moreover, additional guidance is needed on the application of debt/equity analysis to the modified instrument. In particular, the regulations should confirm that it is not necessary to conduct a de novo economic analysis of the relationship between the creditor and debtor at the time of the deemed exchange. It should also be made clear that changed financial circumstances of the debtor, rather than changes to the terms of the instrument itself, would not be considered in determining whether there should be a recharacterization of the investment resulting in a deemed exchange.

4. CHANGES TO COVENANTS. The proposed regulations should provide explicit guidance on when amendments to covenants, and in particular to covenants that do not alter the timing and amount of payments, result in a deemed exchange. We recommend a bright-line test be adopted that would prevent routine changes in operating and financial covenants from resulting in deemed exchanges.

B. DETERMINATION OF WHETHER A MODIFICATION IS SIGNIFICANT

1. DEFERRAL OF PAYMENTS. Except in abusive cases involving changes designed to avoid the application of the original issue discount rules, changes in the timing of payments that do not affect yields should not be deemed "significant modifications."

2. IMPRECISION. A number of terms used in the regulations governing the question of whether a modification is "significant" need to be clarified. In particular, examples or other additional guidance should be provided to define the terms "materially," in subsection (e)(2)(i), "significant" in subsections (e)(2)(iv) and (e)(4)(iii) and "substantial" in subsection (e)(3)(iv).

3. SUBSTITUTION OF COLLATERAL. The regulations should provide that "fungible" collateral includes any commercially reasonable substitute collateral of equivalent value, provided that, in the case of collateral that is tangible property, the substitution of collateral would qualify as a like-kind exchange under section 1031.

4. MULTIPLE CHANCES OVER PERIODS OF TIME. Changes to a debt instrument should be aggregated only if they occur within a 36-month period, unless the changes can be shown to have been part of a single plan.

5. REDUCTIONS IN PRINCIPAL AMOUNT. A reduction in the principal amount of a debt instrument should not result in a deemed exchange of the remaining obligation.

C. EFFECT ON OTHER AREAS OF THE CODE

1. SECTION 453. Significant modifications to a debt instrument created in an installment sale should result in a deemed exchange for purposes of section 1001. However, as long as a "disposition" of the underlying debt does not occur under the existing law under section 453B, gain on the original sale should continue to be deferred.

2. SECTION 382(l)(5). New debt created in a deemed exchange under the regulations should not be treated as newly issued for purposes of section 382(l)(5). Even after a "significant modification," the creditor remains the holder of an historic interest in the loss corporation and should be recognized as such for purposes of determining whether the debtor should have the benefit of the special bankruptcy protections built into section 382.

3. SECTION 305. Modifications to conversion ratios resulting in deemed exchanges under the proposed regulations should not be deemed to result in deemed dividends under section 305.

4. SECTION 103. The proposed regulations should not apply to obligations governed by sections 103 and 140 through 150. The special considerations applicable to those obligations are reflected in a large body of specific law that should not be overturned by rules of general application.

5. SECTION 446. Proposed Regulation section 1.446-3(e)(6) should be amended to provide that the assignment by one party of a notional principal contract pursuant to the terms of the contract does not result in any tax consequences to the non-assigning party.

DETAILED DISCUSSION

A. DEFINITION OF A MODIFICATION

1. DEFEASANCE.

An important area in which the proposed regulations could usefully provide further guidance is legal defeasance. Issuers have provided for the possibility of legal defeasances for a variety of reasons. For example, insurance regulators, who do not follow GAAP accounting principles, may not permit economically defeased debt (and the associated escrowed assets) to be eliminated from an insurer's balance sheet. Thus, debt instruments are commonly issued with a provision in the indenture that the issuer may legally defease the debt obligation if it provides an opinion of counsel that (i) such defeasance will not result in a taxable exchange under section 1001 and (ii) the holders will continue to be taxed as if there had been no defeasance.

A typical legal defeasance clause enables an issuer of debt to place in a trust a portfolio of noncallable U.S. government securities, which produce cash from interest and principal payments sufficient in amount and timing to make the scheduled principal and interest payments on the debt the issuer proposes to defease. In return, the issuer of the debt is freed from all the covenants of the debt (the payment covenants being satisfied under the terms of the trust containing the government securities). As a legal matter, the debt is changed from being recourse to the issuer to being recourse only to the assets in the trust. Under current law, it is unclear whether such a legal defeasance would constitute an exchange of the debt instrument under section 1001. /2/

The proper characterization of a legal defeasance of a taxable obligation for tax purposes under current law is unclear. Legal defeasance might be characterized as a conversion of the outstanding debt into (i) non-recourse debt of the issuer secured by the government securities in the trust, (ii) a debt obligation of the defeasance trust established to hold the government securities, (iii) an equity interest in the trust or (iv) a direct interest in the government securities held by the trustee. In any transaction, the correct characterization may turn on the facts and circumstances, including the terms of the trust document and whether the trust is adequately or excessively capitalized to meet the remaining payments under the original debt instrument. /3/ Under current law and regulations the question of which analysis is correct does not necessarily need to be resolved, since under any characterization a deemed exchange of the old debt for a new instrument is likely to occur. As a result, legal defeasances of taxable obligations have generally not occurred under the opinion of counsel standard described above. /4/

Under the proposed regulations, if (i) a provision permitting legal defeasance is contained in a debt instrument and (ii) such provision may be invoked unilaterally by the issuer, the resulting legal defeasance would occur by operation of the original terms of the instrument. Under subsection (c)(2)(i), such legal defeasance would not constitute a modification of the debt instrument if the legal defeasance resulted in conversion of the old debt into (x) nonrecourse debt of the issuer, or (y) a debt obligation of the defeasance trust. With respect to the latter, that result appears to have been made clear by example 6 of subsection (d), which states that the assumption of an "assumable" home mortgage by a new obligor (presumably with a release of the old obligor) under the terms of the original loan does not result in a deemed exchange.

If the correct analysis is that the legal defeasance results in a conversion of the debt instrument into an equity interest in the defeasance trust, the legal defeasance would presumably be considered a substantial modification under subsections (c)(3) and (e)(4), because it changes the debt instrument into a property that is not debt for federal tax purposes. Under the proposed regulations, that is true regardless of whether the legal defeasance is provided for under the terms of the original instrument and regardless of whether it may be invoked unilaterally by the issuer.

Although the result is not clear under the proposed regulations, if the correct analysis is that the legal defeasance results in a conversion of the debt instrument into a direct interest in the assets held by the defeasance trust (even though those assets may themselves be debt instruments), then the legal defeasance should result in a taxable exchange.

Given the commercial significance of legal defeasance, it would be very helpful if the Service provided additional guidance with respect to this issue. An example should be provided in the final regulations illustrating that a legal defeasance that is properly characterized as (x) a change from recourse debt to nonrecourse debt or (y) the substitution of the defeasance trust as a new obligor (by the same logic that applies to assumable home mortgages) does not result in sale or exchange treatment for the holders.

2. TEMPORARY STAYS OF COLLECTION OR ACCELERATION.

Subsection (c)(2)(ii) of the proposed regulations provides that an agreement by the holder to stay collection temporarily or to waive an acceleration clause or similar default right temporarily is not a modification. The only guidance as to what is meant by "temporary" is found in example 9 of subsection (d), which indicates that three months would be considered temporary. The Committee believes that in the commercial marketplace a 3-month waiver of a demand for acceleration of payment in the case of a troubled lender is unrealistically short. To the extent that example 9 of subsection (d) could be viewed as defining a maximum "temporary" period it actually adds to the uncertainty of whether the majority of waivers of demands for acceleration (which will invariably be longer than three months) will meet the "temporary" requirement of the proposed regulations.

The Committee believes the final regulations should provide that waiver of an acceleration clause or similar right exercisable in the event of default with respect to covenants that do not relate to the amount or timing of payment terms should never constitute a modification. Lenders frequently "waive" breaches of covenants governing business or financial terms ("operating and financial covenants") as long as all obligations under the debt instrument are timely paid in accordance with their terms. Such forbearance should not result in a deemed exchange.

With respect to a waiver of acceleration or default rights in the case of payment defaults, we believe that example 9 of subsection (d) should be modified to illustrate that a stay of collection or waiver of acceleration is "temporary" if it continues for not more than one year, and that a waiver of more than one year is "temporary" as long as the parties are engaged in active negotiations after the expiration of the one-year period.

3. MODIFICATIONS THAT CHANGE DEBT INTO EQUITY.

The proposed regulations provide in subsections (c)(3) and (e)(4) that a significant modification occurs if an alteration "changes the instrument to an instrument or property that is not debt for Federal tax purposes." That is true even if the alteration "occurs by operation of the original terms of the instrument."

The Committee suggests that more specific guidance be provided on the question whether there are other changes to an instrument pursuant to its terms that would result in a deemed exchange. For instance, if a corporate issuer of debt has the right to cause its subsidiary to assume the indebtedness, with release of the issuer, is the assumption and release a non-taxable event under Section 1001 even if the assumption is not made in connection with a transfer to the subsidiary of property securing the indebtedness? /5/ By invoking its rights under the instrument, the issuer would choose one option available to it under the contract that is embodied in the debt instrument and the indenture and would not modify the terms of the contract or change the rights and obligations that the holder agreed to when it made its original investment. Under those circumstances, the holder still holds what it bargained for when it made its original investment, but what it holds may be so different that the change may be viewed as a taxable exchange under existing law and rulings. /6/ What the holder ends up with may be neither debt of the issuer (or a permitted replacement obligor) nor debt secured by the original collateral (or a permitted substitute). /7/

The proposed regulations contain no guidance regarding the mechanics of the debt/equity determination. Subsections (c)(3) and (e)(4) leave open the possibility that the debt/equity determination may turn on the financial condition of the issuer at the time of modification. Since that interpretation would disproportionately burden financially troubled issuers by impeding debt workouts, the final regulations should clarify that, for purposes of subsection (e)(4), a modification is "significant" only if the modification itself, without regard to the financial condition of the borrower, changes debt into equity. In addition, the final regulations should provide specific and realistic examples of modifications that would be deemed to change debt into equity and thus trigger a deemed exchange.

a. MECHANICS OF THE DEBT-EQUITY DETERMINATION. As mentioned, the proposed regulations provide no guidance regarding the method by which the debt/equity determination of subsections (c)(3) and (e)(4) should be made. In the absence of such guidance, the proposed regulation may be read to require a de novo debt/equity determination -- the modified instrument would be tested for debt/equity purposes as if the creditor had made a new investment at the time of modification. The debt/equity test itself is a judicially developed test that looks to the facts and circumstances surrounding each case. /8/ In the situation where insiders advance funds to the corporation, the debt/Equity test depends, inter alia, on the "economic reality" of the transaction -- the parties' objective intention to create debt. /9/ Factors which evidence such an intention include: the absence of a reasonable expectation of repayment from corporate cash flow, rather than profits, /10/ and to a lesser extent an excessively thin capital cushion. /11/

In the case of an issuer on the brink of insolvency, the danger inherent in the de novo determination lies in the possibility that a court might consider the debt holders "insiders" because the shareholders' equity in the issuer has effectively disappeared. A court applying the de novo standard would look for a reasonable expectation of repayment and an adequate capital cushion at the time of the modification in order to determine whether the parties objectively intended to create debt. In the case of a financially troubled issuer the result of such determination would likely be that the modified instrument is treated as equity and, therefore, that a "significant" modification has occurred. In fact, the modification itself may have no bearing on that outcome: once the issuer's financial condition is sufficiently precarious, even a de minimis modification may be "significant" if it results in a de novo debt/equity determination.

The final regulations should clarify that subsection (e)(4) does not contemplate a de novo economic determination and that a modification would be "significant" under subsection (e)(4) only if the modification, without more, changes the instrument from debt into equity. That clarification would be consistent with case law holding that the mere exhaustion of the net worth of the issuer through adversity does not change debt into equity. /12/ A modification that is not otherwise "significant" by operation of the proposed regulations should not become so merely by reason of the issuer's financial difficulties. To interpose a deemed exchange in those circumstances imposes an additional hurdle in the path of a successful workout. /13/

b. BRIGHT-LINE RULES IDENTIFYING CHANGES FROM DEBT TO EQUITY. The final regulations should also, to the extent practicable, provide concrete guidelines specifying which modifications, without more, change debt into equity. Presumably, modifications that are specifically identified in the proposed regulations as not being "significant" modifications will not be deemed to transform debt into equity. For example, under the case law unreasonable or repeated extensions of the maturity date of an instrument evidence the presence of equity. /14/ Subsection (e)(2)(i) specifies that an extension which does not exceed the lesser of five years or one-half the original term of the instrument is not a significant modification. However, repeated extensions that are not individually "significant" under subsection (e)(2)(i) may be "significant" in the aggregate, by application of subsection (f)(3)(ii). Furthermore, under case law, a holder that subordinates a note to other creditors may transform its interest into an equity investment in the issuer. /15/ Again, subsection (e) addresses this situation in a bright-line manner, providing in subsection (e)(3)(v) that such modifications are not "significant." Other case law factors already addressed in subsection (e) include participation in the issuer's gains and participation in control. /16/ The proposed regulations address those factors in subsections (e)(2)(iv) and (e)(4)(iii) (addressing puts and calls, and conversion rights, respectively).

To the extent that the Service is concerned that other modifications, without more, change debt into equity and are thus "significant," the final regulations should include bright-line rules to address any such modifications.

4. MODIFICATIONS OF COVENANTS.

Under current law, the conventional wisdom is that modifications of operating and financial covenants, which do not alter the timing or amount of payments under the debt instrument, do not result in a deemed exchange of the instrument for purposes of section 1001. Furthermore, as discussed in our Cottage Savings Letter to the Commissioner, the Committee believes that routine modifications in operating and financial covenants to accommodate changes in circumstances of a borrower or changes in business conditions or business practices should generally not be treated as significant modifications for purposes of the proposed regulations. Since lenders and borrowers must frequently amend operating and financial covenants in debt instruments in order to respond flexibly to changes in circumstances, the final regulations should address directly whether modifications to operating and financial covenants are "significant modifications." As currently drafted, the proposed regulations are silent as to modifications of operating and financial covenants, leaving the analysis of such modifications to fall under the facts and circumstances test of subsection (e).

The Committee suggests that a bright-line rule be added to subsection (e) of the proposed regulations to provide that any modification of an operating or financial covenant would not of itself constitute a significant modification. Under subsection (e)(1)(ii), if a modification is made in return for a payment of additional consideration, the payment may result in a significant modification if the instrument's yield over the remaining life of the instrument would change by more than 0.25% if the additional consideration were treated as a payment made in consideration for the modification. /17/ The payment rule is appropriate, but modifications to operating or financial covenants that are made without additional consideration, or are made for so little consideration that the payment itself does not result in a change in yield covered by subsection (e)(1), should be deemed not to be significant modifications. The final regulations should clarify that result.

B. DETERMINATION OF WHETHER A MODIFICATION IS SIGNIFICANT

1. CHANGES IN TIMING OF PAYMENTS.

Subsection (e)(2)(i) of the proposed regulations provides that a significant modification occurs if the time and/or amounts of payments are changed in a way that "materially defers" payments, without regard to whether the deferral affects the yield of the instrument. That provision is a departure from the Service's consistent ruling position with regard to the rescheduling of payments, particularly in "troubled debtor" situations. /18/ The Committee believes that if the economic consequences of a transaction (the yield and return to lenders) are not significantly affected by the mere deferral of payments, it is not appropriate to find a significant modification. The Committee acknowledges that in some circumstances, involving accrual basis borrowers, cash-basis lenders and loans with adequate stated interest under section 1274, a deferral of payments may conceivably result in an avoidance of the original issue discount rules. However, the special rule contained in subsection (e)(2)(i) is adequate to address that extraordinary circumstance.

If the material deferral rule is retained, the final

2. IMPRECISION OF CERTAIN TERMS.

The Committee recommends that certain terms used in the proposed regulations be clarified, by the use of more exact wording, additional explanation or the use of examples. Specifically, the following terms in the proposed regulations are unduly vague: "temporary" in subsection (c)(2)(ii) (discussed in Section A. 2 above), "materially" in subsection (e)(2)(i), "significant" in subsections (e)(2)(iv) and (e)(4)(iii), and "substantial" in subsection (e)(3)(iv).

With regard to the term "substantial" in subsection (e)(3)(iv), the Committee recognizes that this term appears in various places in the Code /19/ but notes that such use is often followed by a more explicit definition in the Code or regulations /20/ or has sparked significant litigation. /21/ The Committee urges more precise language.

With regard to the term "significant" in subsections (e)(2)(iv) and (e)(4)(iii), the fact that the whole of subsection (e) is devoted to define under what circumstances a modification will be deemed to be "significant" stands as sufficient evidence of the need for further clarification -- as drafted, subsections (e)(2)(iv) and (e)(4)(iii) state that a modification is "significant" if its effect on value is "significant." The Committee believes that subsections (e)(2)(iv) and (e)(4)(iii) should provide that a modification covered by those subsection will be "significant" if it increases or decreases the value of an instrument by a specified percentage amount determined by reference to the value of the instrument immediately prior to the modification.

3. SUBSTITUTION OF COLLATERAL.

Subsection (e)(3)(iv) of the proposed regulations provides that a significant modification to a nonrecourse debt includes a substitution of collateral, unless the collateral is "fungible or otherwise of a type where the particular units pledged as security are unimportant." The proposed regulations mention "government securities or securities of a particular type and rating" as examples of fungible collateral.

The final regulations should clarify that fungible collateral for that purpose should include any commercially reasonable substitute collateral, provided that the substitute collateral is of equivalent value at the time of the substitution, and, in the case of collateral which is tangible property, the substitution of collateral would qualify as a like-kind exchange under section 1031. For example, a significant modification should not occur when credit card receivables with a similar maturity and credit profile are substituted for other credit card receivables securing a nonrecourse obligation. /22/ Another example is suggested by nonrecourse leveraged lease financings. Commercially typical nonrecourse leveraged lease financings permit a lessee to substitute equipment with a value and remaining useful life at least equal to the original equipment if an event of loss occurs with respect to the original equipment. Such substitutions should not be treated as significant modifications, whether or not contemplated by the original terms of the obligations.

4. CUMULATIVE CHANGES.

Subsection (f)(3)(ii) of the proposed regulations provides that multiple changes over ANY period of time will be aggregated to determine if there has been a significant modification. While that rule may be appropriate in abusive situations, at some point federal income tax law should treat non-abusive transactions as old and cold. The Committee recommends that, in that instance, changes to a debt instrument should be aggregated only if they occur within a 36-month period, /23/ unless the changes can be shown to have been part of a plan.

5. TREATMENT OF REDUCTIONS IN PRINCIPAL AMOUNT.

The proposed regulations provide that if the parties agree to reduce the principal amount of a debt obligation, but do not change any of its other terms, the transaction will be analyzed under other rules provided in the proposed regulations (most significantly, change of yield in subsection (e)(1)) to determine whether this modification constitutes a significant modification of the entire debt obligation. The Committee believes that that method of analysis is inappropriate. If a $100,000 debt obligation is modified to reduce the amount payable at maturity to $80,000 and no other changes are made, the transaction should be analyzed as a cancellation of $20,000 of indebtedness. In contrast, example 3 to subsection (g) appears to enable parties to elect whether to treat the transaction as a modification of the entire debt instrument, or, alternatively to split the debt instrument into multiple notes, and then modify or cancel only certain of those notes. The final regulations should provide that a reduction of the principal amount of the debt without more should be analyzed as a cancellation of indebtedness and not an exchange of the remaining obligation.

C. EFFECT ON OTHER AREAS OF THE CODE

1. SECTION 453.

The Committee recommends that the proposed regulations be made applicable to determine when dispositions of installment sales obligations occur, but that a section 1001 determination should not by itself govern when gain is recognized by the holder of such an obligation.

The installment sales provisions of section 453 et seq. allow taxpayers to defer the recognition of gain on the sale of certain property until they actually receive cash payments. That benefit helps minimize the incidence of significant tax liability at a time when no cash is available to fund its payment. However, gain must be recognized by the holder if an installment sales obligation is sold or is pledged to secure indebtedness, or if cash or other property is received by the holder.

The recognition of gain upon disposition of an installment sales obligation is governed by section 453B, and not, apparently, by section 1001. Under current law it is not clear when changes to the terms of an installment obligation will be deemed to constitute a disposition of the installment obligation. However, the Service has stated that a disposition of an installment obligation occurs "when the rights of the seller under [an] installment sale either disappear or are materially changed so that the need for postponing gain recognition ceases." /24/ That standard is higher than the standards set out in the proposed regulations. For example, there is authority that a taxpayer may substitute obligors, change interest rates, defer principal payments or reduce the principal amount without triggering a disposition of the obligation under section 453B. /25/

The rationale for that higher standard is not expressly explained. It appears to be based on an unwillingness to require a taxpayer, once granted the boon of avoiding gain recognition until payment is actually received, to recognize all or part of that gain until payment actually materializes, even if the installment sales obligation is significantly modified.

Although that unwillingness is appropriate, the dichotomy between the significant modification rules of section 1001 and the disposition rules of section 453B results in the anomaly that the issuer of an installment sales obligation that is modified may be treated as having exchanged the old debt for new debt under the proposed regulations (with resulting changes to accruals of original issue discount deductions), while the holder would be unaffected because the modifications do not result in treatment as a disposition under section 453B.

The Committee believes that a modification, if "significant" under the proposed regulations, should constitute an exchange for both the issuer and the holder. From the holder's standpoint, however, gain on the sale should continue to be deferred. The new debt's issue price should be treated as a new "evidence of indebtedness of the person acquiring the property" which, under section 453(f)(3), is not treated as a payment with respect to which gain must be recognized. Accordingly, such a modification may require an adjustment to the accrual of original issue discount income by the holder of the new debt, or a write-off (for financial reporting purposes) of a portion of the principal and a correlative adjustment to the gross profit percentage pursuant to which gain is recognized by the holder while the issuer realizes cancellation of indebtedness income. The basic deferral of gain under the installment sales provisions will be preserved while the symmetry in treatment of the issuer and holder is achieved. However, gain should be recognized when the modification is such that, had the modified debt been received by the holder in the first instance in exchange for the property sold, the installment method of accounting would not have been available and receipt of the debt by the holder would have been considered to be a payment under section 453(f)(3).

2. SECTION 382(l)(5).

The Committee recommends that the proposed regulations not be applied to impute an exchange of debt instruments for purposes of determining whether a loss corporation has issued its stock to "qualified creditors" as described in section 382(l)(5). The policy underlying section 382(l)(5) is concerned with issues that differ radically from those underlying section 1001.

Under section 382, a loss corporation's use of its net operating loss carryovers after the occurrence of an "ownership change" (as such term is defined in section 382) is subject to a limitation. Under section 382(l)(5), such limitation does not apply, however, if (i) the loss corporation is under the jurisdiction of a court in a title 11 case /26/ immediately before the ownership change and (ii) as a result of the transactions resulting in an ownership change, qualifying creditors and old shareholders hold 50 percent or more of the voting power and value of the stock of the loss corporation. Qualifying creditors are those who hold debt instruments that (i) were held for at least 18 months before the filing of the title 11 case or (ii) arose in the ordinary course of the loss corporation's business and were always held by such creditor. The policy underlying that exception to the general limitation is that historic creditors of the failing business in effect should not be penalized for the undesired "conversion" of their debt into equity through the failure of the business and, instead, historic losses should be deducted and utilized by the parties who funded them.

It is possible that a debtor that eventually restructures its debts in a title 11 case will have resorted to negotiated restructurings of individual borrowings before resorting to the protection of the bankruptcy court proceedings. Thus, the debtor may well have modified the terms of its indebtedness during the 18-month period before filing in a way which results in a deemed exchange under section 1001 and the proposed regulations. Arguably, such holder cannot be a qualifying creditor under the rules of section 382(l)(5) because the creditor did not hold the debt for 18 months. /27/

Although a person who acquires a new debt issued within 18 months of a title 11 case filing might be fishing for the opportunity to acquire equity in the company in the impending workout, an historic creditor of the debtor who restructures debt in an attempt to recover some of his investment is not in the same boat. While that restructuring may result in the recognition of gain or loss under section 1001, it should not disqualify the creditor for purposes of section 382(l)(5). The creditor is still the holder of an historic interest in the loss corporation and the loss corporation should not be penalized for having attempted to restructure its debts outside of the bankruptcy courts. Certainly it his implausible to argue that the creditor modified its indebtedness in order later to acquire an equity interest in the loss corporation.

Accordingly, the Committee recommends that, although the significant modification rules of section 1001 apply even to creditors who modify their debts within 18 months of the debtor's filing a title 11 case, the final regulations should clarify that such application does not extend to the treatment of the creditors as nonqualifying creditors under section 382(l)(5).

The Committee's recommendation is consistent with its approach to the application of the significant modification rules under section 453. In the case of section 453, the issue at hand is the proper recognition of gain or loss by the holder and the accrual of original issue discount deductions and income by both the issuer and holder with respect to the modified debt. The proper analysis results in the application of the proposed regulations in such a case, but the continued deferral of gain by the holder under a special "payment" provision of section 453. In the case of section 382(l)(5), to the extent of accounting with respect to the modified debt and the old debt, the significant modification rules are applicable. In determining the historic relationship of the holder of the modified debt as a creditor of the loss corporation, however, it is appropriate to tack, in effect, the creditor's holding period prior to the modification.

3. SECTION 305.

The final regulations should clarify that a deemed exchange of debt instruments under the proposed regulations should control the tax treatment of a transaction which might otherwise be deemed to give rise to a dividend or other distribution under section 305(c). For example, if there is a change in conversion ratio with respect to debentures which are convertible into common stock, the debenture holders may be treated as receiving a taxable distribution under section 301 (as if they were shareholders) to the extent that the debenture holders are deemed to have an increase in their interest in the earnings and profits of the corporation. /28/ The final regulations should clarify that with respect to modifications to a debt instrument which are sufficient to result in an exchange under the proposed regulations, section 305(c) should not be applicable to produce a deemed distribution if the change in conversion ratio is one of the modifications that causes the deemed exchange.

4. SECTION 103.

The preamble to the proposed regulations states that: "Although Section 1001 of the Code applies generally to tax-exempt obligations, Notice 88-130, 1988-2 C.B. 543, governs the treatment of certain obligations for purposes of sections 103 and 140 through 150 of the Code."

Whether a change in the terms of an obligation constitutes a deemed exchange frequently is of greater importance for tax-exempt obligations than for taxable obligations. If the modification of a tax-exempt obligation causes a deemed exchange, the obligation will be deemed to have been reissued on the date of the exchange. In addition to recognition of gain or loss, such reissuance could result in loss of tax-exempt status, if the obligation does not meet all requirements for tax exemption under the rules in effect on the date of the exchange. Frequently, it will not be possible for obligations issued before the effective date of the greatly tightened restrictions in the Tax Reform Act of 1986 to so qualify.

While it is true, as the preamble to the proposed regulations points out, that the rules of section 1001 in theory apply to tax- exempt obligations, there have been a number of rulings and other authorities specifically dealing with the issue of "reissuance" of tax exempt obligations on which issuers of tax-exempt obligations and their counsel have relied. For example, in addition to Notice 88-130 cited in the preamble, /29/ Rev. Rul. 79-262 /30/ holds that the substitution of a new obligor on an industrial development bond would not cause a reissuance of the bond for purposes of section 103. That result appears to be contrary to subsection (e)(3) of the proposed regulations, which provides that a change in obligor will result in a significant modification.

Analyzing those rulings, and the potentially severe consequences of reissuance, commentators have suggested that in determining whether a modification was material enough to constitute a deemed exchange that would constitute a reissuance causing a loss of tax exemption, "considerations peculiar to Section 103 may have a role to play." /31/ In light of those special considerations that apply to tax-exempt obligations, the Committee believes the regulations should specifically provide that obligations exempt from tax under section 103 are not subject to the proposed regulations. Until the Service issues rules specifically applicable to such obligations, pre- existing law and rulings should apply unless an issuer specifically elects to apply the proposed regulations.

5. NOTIONAL PRINCIPAL CONTRACTS.

Under Proposed Treasury Regulations section 1.446-3(e)(6), where one party to a notional principal contract assigns its rights and obligations under the contract to a third party, the notional principal contract is deemed to be terminated. As a result, the non- assigning party recognizes income or gain (or loss) in an amount equal to the amount which the assigning party pays to (or receives from) the assignee; that amount is then amortized by the non- assigning party over the remaining life of the contract, thus offsetting the original inclusion or loss.

The only change in the non-assigning party's economic position is the substitution of a new obligor with the attendant change in credit risk. The only apparent justification for the result described above is that the substitution of the new obligor results in a deemed exchange by the non-assigning party of the original notional principal contract for a new contract. If the contract by its terms permits assignments by one party without the other party's consent (or subject to such consent which may not be unreasonably withheld), that result is inconsistent with subsection (c)(2)(i) of the proposed regulations, which as discussed above, provides that an alteration of a debt instrument pursuant to its original terms does not constitute a modification.

The Committee recommends that Proposed Regulation section 1.446- 3(e)(6) be amended to provide that an assignment by one party of a notional principal contract pursuant to the terms of the contract does not result in any tax consequences to the non-assigning party.

Members of the Committee on

Andrew H. Braiterman Michael Nissan

FOOTNOTES TO TABLE

/*/ Members of the subcommittee that prepared this report.

/**/ Chair of the subcommittee that prepared this report.

END OF FOOTNOTES

The Committee thanks Peter F.G. Schuur for his assistance in the

Dated: April 13, 1993

FOOTNOTES

/1/ ___ U.S. ___, 111 S. Ct. 1503 (1991).

/2/ To be contrasted with legal defeasances are "in substance defeasances," which can be either of two types. In the case of unsecured general obligation debt, an economic defeasance does not affect the debtor's payment obligation; but, under FASB Statement No. 76, both the debt and the assets in the defeasance escrow are eliminated from the debtor's balance sheet. In the case of secured debt, such as tax-exempt revenue bonds, an economic defeasance eliminates the pledges and covenants in the indenture and leaves only the payment obligations and certain administrative provisions (such as exchanges of large denominations for smaller denominations). Cf. Rev. Rul. 85-42, 1985-1 C.B. 36 (holding that "in-substance defeasance" will not result in discharge of the debt for tax purposes); Priv. Ltr. Rul. 90-46-027 (Aug. 17, 1990) (holding that, upon the facts therein, legal defeasance would not cause tax exempt bonds to become arbitrage bonds within the meaning of section 103(c) of the 1954 Code).

/3/ See Peaslee and Nirenberg, Federal Income Taxation of Mortgage Backed Securities, 158-162 (1989).

/4/ Significant amounts of municipal bonds have been legally defeased. However, different rules may apply to defeasances of tax- exempt debt. Id. at 161, n. 102.

/5/ Cf. Priv. Ltr. Rul. 79-25-065 ((March 22, 1979) (issuance of bonds by subsidiary to replace bonds of parent is a taxable event under Section 1001).

/6/ Cf Rev. Rul. 69-135, 1969-1 C.B. 198 (bonds of X corporation converted into common stock of Y corporation); Estate of Timken, 47 B.T.A. 494 (1942) (bonds of Chesapeake Corporation converted into stock of Chesapeake & Ohio Railway Co.)

/7/ The Committee recognizes that difficult questions could be presented if a modification pursuant to the terms of the document would predictably result in a change in the investors in the debt obligations. For example, certain variable rate obligations are eligible for investment by money market mutual funds if accompanied by a "demand" feature (such as a put to a letter of credit bank). However, if the obligation is converted at the option of the issuer to a fixed rate pursuant to the terms of the obligation, the "demand" feature generally is extinguished; and the obligation is no longer eligible for investment by money market mutual funds. In such a case, the terms of the obligation will generally anticipate the remarketing of the debt to new long-term investors; and it can be questioned whether the conversion to a fixed rate is part of the original investor's agreement or is instead part of a mechanism for reaching an agreement with new investors. For that reason, commentators have sometimes drawn a distinction between changes effected at the option of the holder, see Revenue Ruling 57-535, 1957-2 C. B. 513, and changes effected at the option of the issuer. With respect to tax exempt obligations, Notice 88-130 provides guidelines for determining when changes at the option of the issuer will not be considered a sale or exchange even though such changes will predictably result in the obligations being acquired by new investors.

/8/ See Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders, paragraph 4.02 (1987) (hereinafter "Bittker").

/9/ Id. For an extensive discussion regarding the classification of advances by insiders, see William T. Plumb, Jr., The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369 (1971) (hereinafter "Plumb").

/10/ See Wagner Electric Corp. v. United States, 75-1 U.S.T.C. paragraph 9471 at 87,238 (Ct. Cl. Trial Div. 1975), aff'd, 76-1 U.S.T.C. paragraph 9209 (Ct. Cl. 1976); Gilbert v. Comm'r, 248 F.2d 399 (2d Cir. 1957).

/11/ See Development Corp. of America, T.C. Memo. 1988-126; In re Uneco, 532 F.2d 1204 (8th Cir. 1976). But see Bradshaw v. United States, 82-2 U.S.T.C. section 9454 (Ct. Cl. 1982) (high debt-equity ratio not determinative of presence of equity).

/12/ See Plumb, supra, at 499 (cited in note 4).

/13/ A deemed exchange under section 1001 generally forces the issuer, to the extent of solvency, to recognize cancellation of debt income and forces the holder to recognize a loss currently, regardless of the holder's ability to offset the loss against current gains. Those additional costs marginally increase the cost of engaging in a workout. Accordingly, a workout is less likely to succeed and the likelihood of bankruptcy, with its attendant costs, increases.

/14/ See Bittker, supra, paragraph 4.03 at 4-16 (cited in note 3).

/15/ See id., paragraph 4.03 at 4.17.

/16/ See id paragraph 4.03 at 4-18, 19.

/17/ Cf. Prop. Treas. Reg. section 1.1273-2(j) (payments from borrower to lender incident to lending transactions generally reduce the principal amount).

/18/ See, e.g., Rev. Rul. 73-160, 1973-1 C.B. 365; Priv. Ltr. Rul. 90-37-009 (June 12, 1990).

/19/ See, e.g., I.R.C. section 83(a) (substantial risk of forfeiture); I.R.C. section 368(a)(1)(C) (substantially all); former I.R.C. section 341(b)(1)(A) (substantial part).

/20/ See I.R.C. section 83(c)(1); Treas. Reg. section 1.83-3(c).

/21/ See, e.g., Comm'r v. First Nat'l Bank of Altoona, 104 F.2d 865 (3rd Cir. l939), cert. dismissed, 306 U.S. 691 (1940); James Armour, Inc. v. Commissioner, 43 T.C. 295 (1964) ; Rev. Rul. 72-48, 1972-1 C.B. 102, and cases cited therein.

/22/ We assume that such a substitution that was provided for under the terms of the original instrument, if unilateral, would not be a "modification". An example clarifying that result would be helpful.

/23/ Cf. I.R.C. section 6501(a) (statute of limitations for assessment of taxes); Treas. Reg. section 1.305-3(b)(4) (36-month period for testing disproportionate distributions under section 305).

/24/ Rev. Rul. 82-122, 1982-1 C.B. 80. See also, Rev. Rul. 75- 457, 1975-2 C.B. 196; Cunningham v. Commissioner, 44 T.C. 103 (1965), acq. 1966-2 C.B. 4.

/25/ See, e.g., Rev. Rul. 82-122, 1982-1 C.B. 80 (increased interest rate to reflect higher interest rates and substitution of obligor did not result in a disposition); Rev. Rul. 72-570, 1972-2 C.B. 241 (reduction of principal is not a disposition); Rev. Rul. 68- 419, 1968-2 C.B. 196 (deferral of repayments and increase in interest is not a disposition); Rev. Rul. 55-429, 1955-2 C.B. 252 (reduction of principal and term of a note was not a disposition because the modifications better reflected sales and profits related to articles manufactured under the patent sold in exchange for the note); Cunningham v. Commissioner, 44 T.C. 103 (1965) (substituting of one obligor for another and one year later reducing principal and waiving interest thereon was not a disposition); see generally, Winterer, "Reissuance and Deemed Exchanges Generally," 37 Tax Lawyer 509, 519- 522 (1984).

/26/ A title 11 case is one under title 11 of the United States Code, or a receivership, foreclosure or similar proceeding in a federal or state court.

/27/ The issue clearly arises with respect to the 18-month rule and possibly also with respect to the ordinary course of business rule. If the modification of the debt can be said to have been made in the ordinary course, it is clear that the holder of such debt can continue to be a qualified creditor. If, however, the modification was extraordinary, even if the debt was issued in the ordinary course, it might be argued that the modified debt is not held by a qualified creditor even if the original creditor still holds the outstanding debt.

/28/ Treas. Reg. section 1.305-3(b)(5) and section 1.305-3(d). See Rev. Rul. 75-513, 1975-2 C.B. 114 (debenture holders deemed to receive taxable distribution on change in conversion ratio of convertible debentures).

/29/ Notice 88-130 provides that bonds will be considered reissued if they are modified and the modification constitutes a sale or exchange under section 1001. Thus, further action may be required to implement the stated intent not to affect the application of Notice 88-130.

/30/ 1949-2 C.B. 33.

/31/ See, e.g., Winterer, supra, 37 Tax Lawyer at 525 (cited in note 19).

END OF FOOTNOTES