ABA Members Submit Report On Section 1001 Reg Relating To Modifications Of Debt Instruments.

A Task Force comprised of members of the American Bar Association Section of Taxation's Sales, Exchanges, and Basis, Tax- Exempt Financing, Real Estate, and Partnerships Committees, writing under the auspices of the Committee on Sales, Exchanges, and Basis, has submitted a report to the Internal Revenue Service on Prop. Treas. reg. section 1.1001-3 relating to the tax treatment of modifications of debt instruments as realization events under section 1001. The report contains the individual views of the members who prepared it and does not represent the position of the ABA or the Section of Taxation as a whole.

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April 26, 1994

Ms. Margaret M. Richardson

Re: Comments on Proposed Treasury Regulation -- Section 1.1001-3

Dear Ms. Richardson:

I am enclosing comments on the above noted report as prepared by members of the Committee on Sales, Exchanges and Basis. This report was reviewed by members of our Committee on Government Submissions.

This report represents the individual views of the members who prepared it and do not represent the position of the American Bar Association or of the Section of Taxation.

Sincerely,

M. Carr Ferguson, Jr.

Enclosure

cc: Leslie Samuels,

Victor Zonana,

April 26, 1994

COMMENTS ON PROPOSED TREASURY REGULATION SECTION 1.1001-3

This Report comments on Proposed Regulation section 1.1001-3 (FI-31-92), relating to the tax treatment of modifications of debt instruments as realization events under section 1001 of the Internal Revenue Code. The Proposed Regulation was published in the Federal Register on December 2, 1992.

This Report contains the individual views of members of the Section of Taxation who prepared it and does not represent the position of the American Bar Association or of the Section of Taxation as a whole.

The report was prepared under the auspices of the Committee on Sales, Exchanges and Basis (the "Committee"), which has primary responsibility for tax issues involving realization and recognition concepts of the Code generally, and section 1001 in particular. This report was written by a Task Force that included members of several other committees of the Section of Taxation having a significant interest in the issues raised by the Proposed Regulation. Principal responsibility was exercised by Richard L. Bacon, Chair of the Realization Subcommittee of the Committee. The principal co-authors are Harold L. Adrion and Glenn N. Eichen. Other co-authors are Kenneth W. Heick, Patrick Crawford and Alfred C. Groff of the Committee on Sales, Exchanges and Basis; Frederic L. Ballard, Jr., of the Committee on Tax-Exempt Financing; David L. Dubrow of the Real Estate Committee; and C. Ronald Kalteyer of the Partnership Committee. Helpful comments were provided by Joanne D. Ames, James C. Diana, James E. Donovan, Eric M. Elfman, Kristin H.R. Franceschi, David C. Garlock, Paul D. Jacokes, Richard L. Kornblith and William M. Loafman.

This report was reviewed by Patricia Ann Metzer, Ronald Blasi and Peter J. Connors of the Committee on Government Submissions and by Laurence Reich, Council Director for the Committee.

Although many of the members of the Section of Taxation who participated in preparing this Report have clients who would be affected by the federal tax principles addressed by this Report or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of the Report.

April 26, 1994

Contact Persons:

TABLE OF CONTENTS

I. INTRODUCTION AND EXECUTIVE SUMMARY OF

II. OVERVIEW OF THE PROPOSED REGULATION

A. General Content

II. GENERAL EVALUATION OF THE PROPOSED REGULATION

A. Goals of the Proposed Rules

IV. AN ALTERNATIVE APPROACH UNDER CURRENT LAW

A. Treatment of Obligors

V. LEGISLATIVE SOLUTIONS

A. In General

VI. SPECIFIC COMMENTS ON THE PROPOSED REGULATION

VII. SPECIAL TRANSACTIONS

I. INTRODUCTION AND EXECUTIVE SUMMARY OF

On December 2, 1992, the Internal Revenue Service (the Service) and the U.S. Department of the Treasury published Proposed Regulation section 1.1001-3 under section 1001 of the Internal Revenue Code of 1986 as amended (the "Code"). /1/ Section 1001 provides general rules for determining the amount of, and recognition of, gain or loss from the sale or other disposition of property. The Proposed Regulation sets forth rules for determining when a modification of a debt instrument between the holder and issuer of the obligation will be deemed to result in an exchange of property for other property "differing materially either in kind or in extent" within the meaning of existing Reg. section 1.1001-1(a). /2/

Section I of this Report provides an Introduction and Executive Summary of the Task Force's comments and recommendations. Section II describes the structure and general approach of the Proposed Regulation and notes the Service's invitation for comment on a variety of specific subjects. Section III discusses the goals of the proposed rules and describes the extent to which we share those goals while, at the same time, expressing basic policy problems we find with the Proposed Regulation. Section III generally evaluates the Proposed Regulation against what we understand to be "present law" affecting debt modifications as realization events in light of section 1001 and other Code provisions, common law, and the United States Supreme Court's decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991) ("Cottage Savings"). /3/

Section IV describes alternative provisions in existing law where legislative policy can be found for regulations dealing with debt modifications as realization events for both debtors and creditors.

Section V recommends legislative solutions to the realization issues raised by the Proposed Regulation and discusses ABA Section of Taxation Legislative Recommendation No. 1993-2.

Sections VI and VII provide specific comments on individual rules in the Proposed Regulation and their impact on special transactions.

A. OBJECTIVES OF THIS PROJECT

1. We share with the Service two basic goals:

o More certainty about the tax rules defining when a debt

o The development of rules which allow the parties to a debt

We agree that a flexible approach to defining whether, and when, a

2. We have concerns about the suitability of section 1001(a) as the source of regulations determining whether, and when, a debt modification is a realization event for a debtor and for a creditor. Because of this concern, and the fact that Cottage Savings has been interpreted by at least some observers to mean that any change in either party's legal rights or powers under a loan agreement creates a realization event, we believe that the Proposed Regulation may not accomplish the desired certainty.

3. We also believe that the desired goals can best be achieved under provisions of existing law other than section 1001, or preferably through a broad legislative solution.

B. ADDITIONAL PUBLIC HEARING

In light of the fundamental issues involved, we respectfully ask the Service to schedule another hearing on the Proposed Regulation.

C. DEBT MODIFICATIONS SHOULD NOT BE ADDRESSED IN REGULATIONS

1. We believe that section 1001 is not the applicable Code provision for regulations dealing with debt modifications as realization events for either debtors or creditors. Section 1001(a) deals only with computing the amount of gain or loss, not with defining when a sale or other disposition of property is a realization event at the threshold. Reference should be made, we believe, to other statutory provisions for defining factors that determine when a debt modification is a realization event, including section 61(a)(3) (relating to gains from dealings in property), section 165 (relating to deduction of losses sustained), section 1271(a)(1) (relating to exchange treatment of holders of "retired" debt instruments), and/or other Code provisions which apply more specifically to circumstances in which a debt modification occurs.

2. Section 1001(a) addresses only the realization of gain or loss from an exchange of PROPERTY. This provision does not apply to obligors on debt instruments, since debtors who agree to alter their liabilities do not sell or otherwise dispose of "property." With respect to creditors, section 1271(a)(1) applies more specifically than section 1001(a) to holders of debt instruments in determining when amounts received in retirement of existing debt claims create "exchange" treatment.

3. Even if section 1001(a) applies to modifications of obligations between debtors and creditors, the potential applicability of Cottage Savings to debt modifications raises the prospect that the governing tax rule is that any change in legal rights of a party to a contract, including a debt instrument, creates a realization event. Such a rule may leave no room for other criteria under section 1001(a); under the "material difference" language of Reg. section 1.1001-1(a); or under common law.

D. REGULATIONS SHOULD BE ADOPTED INSTEAD UNDER INDIVIDUAL

1. Under existing law, we recommend that the Service shift to an approach different from the general approach of the Proposed Regulation.

2. In lieu of a single set of "generic" rules defining whether and when a debt modification creates a realization event, a sounder and more flexible approach to the realization issues involved in debt modifications is available. We recommend defining realization events only in the context of individual Code provisions which apply to debtors, or creditors, or both, and applying those provisions in light of the language and legislative policies underlying those specific provisions.

The determination of whether a DEBTOR has "issued" new debt can only be determined, we believe, under individual Code provisions that apply to obligors on debt instruments. Section 108(e)(11), for example, can only be applied by determining whether a modified debt "satisfies" existing indebtedness under the language of that provision. Realization of gain or loss by CREDITORS is controlled specifically by section 1271(a)(1), which treats amounts received by holders of debt instruments in "retirement" of the existing debt as a statutory "exchange" and which applies for all purposes of the Code. Debt modifications are more closely within the purview of section 1271(a)(1) than section 1001.

3. This approach will produce different rules for different

4. The worst possible solution would be for the Service to withdraw the Proposed Regulation and simply adopt the "hair trigger" test suggested by Cottage Savings, so that any change in a party's legal rights or powers under a debt instrument would create a realization event. We agree with the Service's decision not to adopt such a flat rule in the Proposed Regulation. We recommend, however, that the Service consider this Report's suggested alternatives to the realization issues involved. The advantages of changing the overall approach to the regulations outweigh the disadvantages in our view. The result will, we think, better achieve certainty as to the governing tax rules.

E. AN OVERALL LEGISLATIVE SOLUTION IS NEEDED FOR REALIZATION

1. While section-by-section, or transaction-by-transaction, rules should work well for debtors, section 1271(a)(1) presents certain technical and definitional problems of its own. These problems may hinder its effectiveness in determining when a debt modification is a realization event for creditors. Section 1271(a)(1) does not apply, for example, to liabilities of natural persons. The provision also applies for all purposes of the Code, and may contravene policies underlying certain Code provisions where Congress has not specifically addressed the treatment of debt modifications. It may also not be possible to avoid the "Cottage Savings problem" under section 1271(a)(1).

2. On balance, we believe that a legislative solution is the best way to resolve the differences of views -- with resulting uncertainty -- about the scope and meaning of Cottage Savings and its relation to section 1001 and other Code provisions that apply to debt modifications. We recommend legislation establishing an overall policy for dealing with realization issues in debt modifications. This policy should include a determination of whether the tax treatment should depend on changes in specific terms of a loan agreement or should focus more broadly on the purpose of the transaction itself and its social and economic importance.

3. As a policy matter, we believe it is not necessary or desirable for tax rules to "micro-manage" debtor-creditor relationships by focusing on specific changes in loan terms, except as specific Code provisions may require otherwise. A general term- based approach is too mechanical, we think, and will interfere unnecessarily with the realities of complex and delicately-balanced tradeoffs which are a normal part of "working out" a debtor's liabilities. The better approach is to focus on the purpose of a workout transaction itself and its economic and social importance. Congress has used this broad approach in several existing legislative provisions.

4. A framework for Congress to begin considering legislative solutions is already in place. ABA Legislative Recommendation No. 1993-2 proposes conditions under which debt restructurings would, in general, not give rise to cancellation of indebtedness income for debtors, gain or loss recognition by creditors, or original issue discount for either party. This proposal can be expanded to deal with other potential tax consequences of debt workouts.

F. TECHNICAL COMMENTS

Sections VI and VII of the Report set forth technical comments on the Proposed Regulation. The Task Force's specific comments are summarized below.

1. SPECIFIC ISSUES. The regulations should define specifically and in more detail the "debt instruments" covered. For example, do the proposed rules include oral contracts, open account indebtedness, life insurance contracts and guarantees and agreements for services? A "deemed exchange" under the Proposed Regulation should not require automatic testing of the deemed "new" debt for debt/equity status under section 385. The regulation should not treat reduction of the principal amount of a debt as a modification of the entire obligation. Contingent modifications of debt should not be considered realization events unless and until the contingency occurs. The proposed rules relating to extensions of maturity and changes in timing and amount of payments should be revised so as to be addressed by a specific anti-abuse rule, or failing that, a bright-line safe harbor.

The regulation should not apply to assignments of notional principal contracts (and other executory contracts); rather, the creation of realization events in the case of such contracts should be addressed under the tax policies which govern such contracts specifically. Assumptions of liabilities in transactions governed by sections 351, 368 and 721 should not be considered deemed reissuances.

Filing a bankruptcy petition should not be considered a deemed exchange of old debt for new debt. A change in the currency of payment of a debt should not be considered a deemed exchange if the change occurs pursuant to terms provided in the instrument itself. A safe harbor for changes in interest rates is a welcome rule, but other tests are preferable -- for example, a test based on a percentage change in the overall return on the instrument (e.g. the greater of 25 basis points or 5 percent of the total return). Aggregation/disaggregation rules for multiple instruments should be provided.

In-substance defeasance transactions, like true defeasance transactions, should not be considered deemed exchanges of debt obligations. Conversion of a portion of a debt from recourse to nonrecourse or vice versa should be considered a modification of only a portion of the debt. Losses on deemed debt exchanges should not be disallowed under the wash sale rules. The proposed rule for variable rate instruments should be reconsidered, and if retained, should be clarified.

2. SPECIAL TRANSACTIONS. Deemed exchanges of debt instruments should not cause a fixed investment trust to be classified as an association, nor should such realization events jeopardize an entity's status as a REMIC or a REIT. Investors or other creditors holding debt claims having a tax basis less than face value should not be dealt with under broad general rules specified in section 1001(a); rather, the specific policies that address specific types of creditors holders should govern the timing of realization events when debt is restructured or refinanced; such creditors include, for example, shareholder-creditors of S Corporations, purchasers of loans of Government-Managed lenders, holders of loans with OID or market discount, and banks and thrifts claiming bad debt expense under section 166, section 585 or section 593). Transaction-specific realization tests should also be provided for tax-exempt bonds to address workouts, sales of bond-financed facilities, and tender bonds, consistent with the specific statutory policy that governs those transactions.

II. OVERVIEW OF THE PROPOSED REGULATION

A. GENERAL CONTENT

The Explanation of Provisions ("Explanation") accompanying the Proposed Regulation states that the proposal is being issued in "an effort to provide certainty" regarding when debt restructuring agreements have tax consequences for the debtor or creditor, and "in response to the issues raised by" a 1991 decision of the United States Supreme Court in Cottage Savings. The Explanation notes that "uncertainty" on this subject has resulted in "a great deal of controversy" between taxpayers and the Service and produced a substantial body of rulings and case law.

In Cottage Savings the Supreme Court held that the taxpayer, a savings and loan association, realized a deductible loss in 1980 when it exchanged a 90 percent participation interest in a group of residential mortgage loans for an unrelated thrift's similar interest in a group of its residential mortgage loans. /4/ The Explanation states that the Court determined that because the exchanged participation interests each involved different obligors and collateral, they embodied "legally distinct entitlements" and therefore were materially different for purposes of Reg. section 1.1001-1(a). Thus, the Explanation says, the transaction resulted in a sale or disposition under section 1001 of the Code.

The Explanation notes that the transaction before the Supreme Court in Cottage Savings involved actual sales and purchases of participation interests in mortgage loans by the taxpayer (which were treated for tax purposes as exchanges of interests). Nevertheless:

"Questions have arisen . . . concerning the Court's

OPERATION AND SOURCE OF THE PROPOSED RULES. The Proposed Regulation would be issued under Code section 1001. Under the proposed rules, a "significant modification" of a debt instrument is deemed to create an exchange of the original instrument for a modified instrument that differs materially from the original instrument within the meaning of Reg. section 1.1001-1(a). Since the Explanation observes that Cottage Savings did not deal directly with a debt modification, it is not clear whether the proposed rules purport to reflect, in whole or in part, the "distinct legal entitlements" test set forth by the Supreme Court. The Summary portion of the Notice of Proposed Rulemaking describes the proposed rules as relating broadly to

"the treatment of modifications of debt instruments as

SCOPE. The Proposed Regulation applies only to the federal

The Proposed Regulation applies only to "instruments." That term is not defined, leaving unclear whether the rules apply to revolving credit arrangements, open account debts, and other indebtedness not evidenced by a formal written instrument.

The Explanation provides that the proposed rules do not apply to certain tax-exempt bonds covered by Notice 88-130, 1988-2 C.B. 543, or to defining "dispositions" of installment obligations within the meaning of section 453.

Final regulations would apply to modifications occurring on or after 30 days following publication of the final rules in the Federal Register. The Explanation states that the Service will then declare obsolete existing revenue rulings that no longer represent the Service's position on when a debt modification results in a deemed exchange.

B. STRUCTURE

The Proposed Regulation's general approach is to list a variety

"is deemed to result in an exchange of the original

The deemed exchange would apparently be treated as occurring for both

In general, a "modification" is defined as an alteration in any legal right of the issuer or holder. An addition or deletion of an existing right or obligation counts as an alteration for this purpose. Several changes in terms which would otherwise be treated as a "modification" are excepted from the definition of a modification. These exceptions include:

(1) Alteration by operation of the original terms,

(2) A temporary failure to perform. Prop. Reg.

A modification must in turn be tested for whether it is "significant" or not significant. Modifications expressly classified as significant include:

(1) Changes in yield by more than 25 basis points. Prop.

(2) Changes in the timing or amount of payments under the

(3) Changes in obligor. Prop. Reg. section 1.1001-3(e)(3).

(4) Change in collateral and security. Prop. Reg. section

(5) Changes in the "nature" of the obligation, including

C. REQUESTS FOR SPECIFIC COMMENTS

The Service makes an unusual request for comment on the basic "desirability" of issuing regulations dealing with the question of when debt modifications give rise to realization events. There have been few, if any, requests for this kind of comment on other proposed regulations. /6/

The Service also invites comments on several specific subjects:

(1) the extent to which a "deemed exchange" of debt instruments

(2) the extent to which the Proposed Regulation should control

(3) additional rules covering "other types" of modifications,

(4) the extent to which alterations occurring as a result of

(5) the rules dealing with changes in obligors on a debt

(6) the treatment of recourse and nonrecourse debt under the

(7) adoption of additional "bright-line" tests.

III. GENERAL EVALUATION OF THE PROPOSED

This section of the Report addresses the Service's invitation for comments on the basic "desirability" of writing rules determining when debt modifications give rise to realization events.

Most of the thinking to date on the subject of debt modifications as realization events, reflected in Tax Court and appellate court decisions stretching back many years, has tended to assume that the provisions of section 1001(a) and (b) and their predecessors are the appropriate sources for defining whether or when a realization event occurs. This Report suggests that the tax community reexamine this assumption. The Service's invitation for comments on the basic effort to write regulations in this area calls for a discussion of fundamentals in the tax law. Consistent with the unusual nature of the Service's invitation, this Report attempts to analyze fundamental issues and offer constructive suggestions.

We recognize that regulations have played an increasingly important role in recent years. Because of the scope and basic nature of the realization issues which the Proposed Regulation addresses, however, we have not hesitated to discuss a broader landscape that includes alternative sources of regulations under existing law and legislative solutions. In that regard, we have attempted to take a new look at a longstanding but perhaps overlooked Code provision, section 1271(a)(1). Section V of the Report also lists broad policy issues that may lead to reconsidering the "term-based" approach to rules for debt modifications that has characterized many cases and rulings to date. This wider perspective is justified, we believe, by the need to examine carefully the Supreme Court's decision in Cottage Savings and by the general approach recommended by the Section of Taxation in ABA Legislative Recommendation No. 1993-2.

A. GOALS OF THE PROPOSED RULES

We and the Service share several basic objectives. One is greater certainty concerning the tax rules applying to the treatment of debt modifications as realization events.

Another goal is implementing a policy that not every change in terms of a debt instrument should create a realization event. /7/ By requiring a debt modification to be "significant," the Proposed Regulation seeks to provide an alternative to an over-inclusive test found by some observers in the Cottage Savings decision, which some have interpreted to mean that any change in either party's legal rights or powers under a contract creates a realization event.

However, we believe the Service may not have the necessary support to approach this subject through the concept of a "realization event" under judicial interpretations of the law, or through a set of generic rules under section 1001, for either debtors or creditors. This is a particularly strong concern where the potential tax consequences of a "realization event" involve something other than realization or gain or loss from the deemed exchange itself.

We think that section 1001 cannot be applied to debtors in the first instance, and thus cannot be used to trigger "issuances" of debt instruments independently of the policies underlying individual Code provisions that separately apply to newly-issued debt instruments. We also believe that the treatment of creditors is properly determined under Code provisions other than section 1001. A general rule for holders of debt instruments who participate in a workout of existing claims exists in section 1271(a)(1).

To the extent that legitimate concerns exist about the appropriateness of "realization" concepts to deal with the details of debt modification transactions, and about the appropriateness and adequacy of section 1001(a) as the source of the Proposed Regulation, the state of the law is likely to remain uncertain. Any difference between the holding of Cottage Savings and positions in the Proposed Regulation is likely to give at least some taxpayers an opportunity to take advantage of different tax consequences that may be available under the Proposed Regulation and under Cottage Savings. We believe the result is likely to increase taxpayer "selectivity" and control over the realization of gains, losses and other tax consequences and general uncertainty about what "the law" is.

This Report discusses an alternative approach for regulations under existing law that promises, we believe, a better way to achieve the goals of this project: sound, flexible and certain tax rules which minimize the "selectivity" of tax consequences. The Report also recommends legislative solutions to the issues discussed.

B. STATUTORY PROVISIONS

1. GENERAL ANALYSIS

CURRENT LAW. Under current law, Congress has not adopted any broad policy toward debt modifications generally, in terms of either REALIZATION or RECOGNITION policy. Section 354, relating to exchanges of securities in a corporate reorganization (including recapitalizations), is the only Code provision dealing expressly with nonrecognition of gain or loss from exchanges of debt instruments. Section 354, however, is limited to creditors holding corporate securities and only when those securities are exchanged as part of a corporate reorganization. /8/ The nonrecognition rules in section 1031, relating to "like kind" exchanges of property, expressly except exchanges of bonds, notes, other securities, other evidences of indebtedness or interest and choses in action. No Code provision (with the possible exception of section 1271(a)(1), discussed later in this Report) deals affirmatively and expressly with the question of whether, or when, amendments to loan agreements or changes in the identity of the debtor or creditor are generally treated as realization events for either the debtor or the creditor.

The Proposed Regulation seeks to develop such rules for a broadly-described category of "debt modifications" by relying on the concept of a "realization event" and placing the proposed rules under Code section 1001.

The occurrence of a "realization event" traditionally marks the point at which some act with respect to property -- usually a sale or exchange of the property -- requires the owner to report accrued gain or loss in the property's value while it was held by the owner. Given the substantial benefit to taxpayers of deferring annual realization on accrued appreciation, the courts have developed a common law rule that, in effect, requires "realization" of income at the most administratively convenient point evidenced by an easily-detected event such as a sale or exchange. /9/ Cottage Savings constitutes the most recent statement of this rationale for a realization event. The Supreme Court clearly endorsed this rationale in its Cottage Savings opinion. /10/

Nonrecognition provisions of the Code, by contrast, are legislative determinations that even though a sale or other disposition of property is a "realization event," reporting of the gain or loss should be deferred for policy reasons to a later date. (The "like kind" exchange rules of section 1031 and the corporate reorganization provisions of sections 354, 361 and 368 are examples of nonrecognition provisions). If a nonrecognition provision applies, it is usually academic whether the exchange is a realization event. Nonrecognition provisions deal with reporting gain or loss from the sale or exchange itself. These, and similar policy-based provisions dealing with tax consequences other than gain or loss -- for example, section 163(e)(5) limits interest deductions on certain "high yield" debt obligations issued by a corporation -- are the place where Congress sets forth major policy decisions overriding the normal consequences of a "realization event." These policy-based provisions are the place where the tax law purports to reflect, or not reflect, "economic reality," changes in a taxpayer's "economic position," or changes in "economic risk" as the result of a sale or exchange. /11/

AVOIDING A "HAIR TRIGGER" TEST. Many practitioners are concerned about the possibility that Cottage Savings stands for a excessively low standard that creates a realization event merely because a property transaction, including a debt modification, changes in some minimal way the legal rights or powers of one or both parties. While a debt modification may escape tax consequences under the terms of Code provisions other than section 1001, /12/ many practitioners believe that debt restructurings should not create even numerous "testing points" for possible imposition of tax consequences on either or both parties. This belief is prompted, in part, by a concern that a delicate business negotiation may be upset unnecessarily if a workout agreement is treated as a general realization event, which in turn forces the parties to introduce tax issues into their already complex business problem and then to try to rearrange the business deal by planning around the array of potential tax consequences across the entire tax Code.

We agree that a sound and practical tax policy should avoid a flat rule treating any change in the legal rights or powers of one or both parties to a loan agreement as a realization event for either the lender or the borrower. /13/ To this end, the Proposed Regulation appears to seek flexible rules in the "realization" area while avoiding a flat "hair trigger" that Cottage Savings may stand for. /14/

TECHNICAL CONCERNS ABOUT THE PROPOSED REGULATION. The special difficulty in dealing with debt modifications lies in the fact that these transactions are among a variety of "ambiguous transactions" which have no self-evident points that clearly indicate when, or whether, the holder has "sold or exchanged" the unmodified debt instrument. /15/ There are many different possible points to choose from in deciding when a "realization event" occurs. The litigation over savings and loan mortgage swaps culminating in the Cottage Savings decision illustrates the difficulty in identifying a realization event even when an actual, physical exchange of properties takes place. The difficulties are greater where no actual exchange occurs -- as in debt modifications -- because there is no point along the continuum of possible changes in the terms of a debt obligation that are clearly objective, indisputable points when the creditor can be said to have EXCHANGED his claim for a new and different claim, or when the obligor can be said to have ISSUED a new liability to the lender.

Unless we follow the broad holding found by many observers in Cottage Savings that a realization event occurs for all tax purposes whenever a contract changes the legal rights or powers of either party to any degree, the decision when to test amended debt requires difficult line-drawing. Selecting the testing points entails, we believe, the same type of policy judgments involved in determining the tax consequences of a realization event. /16/

The Proposed Regulation contains many distinctions which reflect judgments about what types of specific changes in the terms of a debt instrument should become points for testing a debt "workout" or refinancing for potential tax consequences. /17/ One premise appears to be that Cottage Savings does not apply to modifications of debt instruments, at least with regard to the proposed concept of a "significant" modification. Another premise appears to be that generally -- and unless the Service determines otherwise -- the proposed rules under section 1001 will be used to determine when a debtor will be treated as having "issued" a new debt instrument. The Explanation suggests that this determination will apply at least for purposes of triggering section 108(e)(11) (relating to discharge of debt income where a debt instrument is issued in satisfaction of existing indebtedness) and sections 1274-1275 (relating to original issue discount where a debt instrument is issued for property). /18/ These and similar provisions outside section 1001(a) create potential tax consequences other than gain or loss from an exchange of property as such, and for obligors as well as for creditors. On the other hand, the Explanation states that the proposed rules would not apply to determine when the holder of an installment obligation has "disposed of" the obligation within the meaning of section 453B -- presumably, different legislative policies apply in that area. /19/

The question we raise is whether flexible rules can be achieved through the concept of a "realization event" under existing law. The main difficulty, we think, is that many of the proposed distinctions in the Proposed Regulation are the kind that cannot be derived from existing section 1001 or from any judicial definition of when a sale or exchange is a "realization event." Our specific concerns are that:

(1) The language and legislative history of section 1001(a)

(2) The "legal entitlements" test of Cottage Savings may

(3) Many basic legislative decisions should be made about

In addition, section 1001(a) and (b) and the common law realization event concept are limited to determining gain or loss for an owner of property. Neither section 1001 nor the traditional realization event concept was developed as a source of general tests for triggering realization for

a) other types of tax consequences, or for

b) obligors (debtors) whose liability to the creditor is not

The difficulties in writing regulations under current law are made more complex by uncertainty and disagreement within the tax community as a whole over the meaning and scope of the Cottage Savings decision. Major issues are whether the so-called "distinct legal entitlements" test set forth by the Court is part of the Court's holding, and, if so, whether that criterion applies to debt modifications (so-called holder-issuer transactions) as well as to "holder-holder" exchanges by creditors of debt obligations of third parties.

Some commentators on the Proposed Regulation have suggested that the proposed rules might also be challenged to the extent they conflict with existing court decisions on bond refundings and other debt modifications. /20/

The uncertainties and controversy about the state of present law aggravate the uncertainty as to what basic tax policy affects the determination of whether, and when, a debt modification should be treated as a realization event. The fact that such uncertainty exists in and of itself opens the door to potential opportunities for financially healthy lenders and borrowers to select which rule or rules to claim as reflecting present law and thereby to create gains, losses, and other tax consequences at points of their own choosing. At the extreme are opportunities for some taxpayers to rely on the Proposed Regulation where it permits a modification to be treated as not significant, but to attempt to repudiate the proposed rules and rely on an alleged "hair trigger" test under Cottage Savings to realize losses (for example) or other benefits dependent on when a realization event occurs. /21/ A major casualty of this situation would be effective tax administration and certainty concerning the governing tax tests for debt modifications. /22/

RECOMMENDATION. As we analyze current law, debt modifications are special transactions not governed by section 1001 at all for either the debtor or the creditor. Under existing law, realization rules for DEBTORS who agree to alter or amend their loan agreements are not within the scope of section 1001(a) and (b) and can be determined only under policies that apply under individual Code provisions that apply to obligors who "issue" new debt. On the other hand, we believe that CREDITORS -- so-called holders of debt instruments -- are governed not by section 1001 with respect to modified claims, but instead by the provisions of section 1271(a)(1) and/or other specific common law or statutory rules.

We believe that the Service should not undertake at this point to write realization regulations under section 1001 in light of the alternatives we believe are available. If the Service wishes to write regulations under existing law defining whether, and when, a debt modification is a realization event, we recommend that consideration be given to the alternative approaches discussed in this Report. On balance, we recommend that Congress adopt and enact a fundamental tax policy for the economically crucial and pervasive subject of debt modification transactions before regulations addressing these transactions are promulgated. /23/

2. SECTION 1001

Our analysis is that section 1001(a) contains no legislative policy for the development of regulations defining when a debt modification is a realization event for either a holder or an obligor. As indicated above, we believe that section 1001(a) does not apply to obligors on debt instruments because debtors who merely agree to alter their liability do not sell or dispose of "property." With respect to creditors, section 1271(a)(1) and other Code provisions apply more specifically than section 1001(a) to determine when a debt modification should be treated as a constructive exchange of old debt for new debt.

Even if section 1001(a) were construed more broadly, however, and

LANGUAGE AND PURPOSE OF SECTION 1001. On their face sections 1001(a) and (b) deal only with computing the amount of gain or loss realized from a sale or other disposition of property. /24/ Subsection (c) indicates that the amount of gain or loss "determined" -- the word realized is not used -- under subsections (a) and (b) must be "recognized" except as otherwise provided elsewhere in the Code. We believe that the reference to "amount realized" in section 1001(a) and (b) was not intended to serve the function of defining when a sale or other disposition of property is a REALIZATION EVENT at the threshold. /25/ The language of section 1001(a) and (b) suggests that realization must occur elsewhere before entering section 1001. /26/

Based on the legislative history of section 1001 and on the role of former section 1002, some members of the Task Force have elsewhere questioned the legal soundness of using section 1001(a) as authority for defining the concept of a "realization event" generally. /27/ The argument is that the point when a property transaction -- including a debt modification -- is a realization event is determined generally by section 61(a)(3) (which includes in gross income "gains derived from dealings in property"); section 165(a) (which allows a deduction for any loss "sustained" during the taxable year and which the regulations say requires only an "identifiable event"); and/or other Code provisions applying more specifically to debt modifications. (One such other provision, section 1271(a)(1), is discussed in Section IV of this Report.) Section 61(a)(3) and section 165(a) each combine in one statutory provision the need for gain or loss, i.e., "income" or "loss," and the requirement for a point, i.e., "dealings" and "sustaining," when such gain or loss must be reported to the tax collector. /28/ In our view, regulations dealing with realization events generally belong under those sections rather than under section 1001(a).

Professor Stanley Surrey also viewed section 1001(a) as providing computation rules only after gain or loss has been realized under section 61 or section 165, and as using the phrase "amount realized" in a sense different from the concept of a "realization event":

"Section 1001(a) . . . does not determine the inclusion of gains

* * *

"The term 'amount realized' [in section 1001(a)] does not

Another reason to question section 1001 as the proper place for regulations defining when debt modifications are realization events is the fact that section 1001 does not deal with tax consequences other than measuring gain or loss from a sale or exchange of property. The courts have rejected analogous attempts by the Service to apply "exchange" treatment determined under a Code provision dealing only with gain or loss to other provisions imposing different tax consequences. /30/

DEBT MODIFICATIONS. Section 1001(a) speaks in terms of a "sale or other disposition of property." In our view it therefore applies only to those in whose hands a debt instrument is "property" and who "sell" or "dispose of" the property -- that is, only the owner of property or property rights. As we discuss in more detail below, section 1001 thus does not apply to a borrower's liability to repay the lender, because a liability is not "property" for purposes of section 1001 and a borrower does not realize gain or loss by modifying his liability to repay a debt. Therefore, a DEBTOR cannot be treated by virtue of section 1001(a) as participating in an "exchange," as selling or disposing of property, or as "issuing" a new debt instrument. We also find no principle of symmetry in section 1001 indicating that a debtor "issues" a new debt instrument whenever a creditor is treated (under section 1001 or elsewhere) as having "exchanged" his claim with the debtor for a modified claim.

With regard to holders of debt claims, i.e., creditors, a Code provision other than section 1001 applies more specifically to owners of contract rights in the form of claims under debt instruments. We believe that whether holders of debt instruments receive "exchange" treatment when a debt is modified is governed by section 1271(a)(1) rather than section 1001(a). On its face and by application, section 1271(a)(1) sets forth a test that has in fact been applied to determine when a debt modification transaction creates an exchange for tax purposes. If section 1271(a)(1) can be fairly applied to a debt modification under existing law, there is a statutory criterion in existing law that can guide regulations dealing with the creditor's side of debt modifications and an arguable basis for making it unnecessary to determine the scope of Cottage Savings, at least with respect to the creditor's side of debt modification transactions.

In sum, then, we believe that the authority for developing realization tests for both debtors and creditors who modify their loan agreements lies outside section 1001(a).

3. THE COMMON LAW CONCEPT OF A "REALIZATION EVENT"

The Summary portion of the Notice of Proposed Rulemaking states that the proposed rules relate to the treatment of modifications of debt instruments "as realization events under section 1001" of the Code. The technical question in this regard is whether the concept of a realization event exists independently of the statutory provisions of section 1001(a) and (b) or, even if it does not exist independently of that provision, whether the Supreme Court's discussion of the test of a "realization event" leaves leeway for the kinds of distinctions set forth in the Proposed Regulation.

As noted earlier in this Report, the concept of a realization event was developed by the courts to serve the limited function of ending deferral of tax on annual appreciation in the market value of a property owner's asset, and to do so under a test lending itself more to easy administration of tax law than to views about changes in an owner's real "economic position." In effect, the tax law makes a tradeoff: a property owner is not taxed annually on unrealized appreciation in market value, but there is a short fuse on "events" that can be used to end the period of deferral and require the owner to report "paper" gains or losses to the tax collector. The Supreme Court in Cottage Savings reaffirmed this rationale for the function of a "realization event." /31/

The concept of a realization event does not appear in the Code itself. It is part of the judicial interpretation of tax law, /32/ and is relevant, we believe, in interpreting and applying not section 1001(a), but rather section 61(a)(3), section 165 and similar more specific statutory provisions. /33/ The threshold question is whether income or loss arises by reason of an increase or decrease in the market value of property. /34/ If the answer to this question is yes, the next question is whether the transaction -- a sale, exchange or other change in legal or other rights associated with the property -- is one which should be treated as a "realization event." /35/ This Report focuses specifically on when the tax-reporting event should occur in the case of debt modifications.

This Report also addresses whether the general concept of a "realization event" applies to tax consequences other than the timing of a property owner's reporting of gain or loss from appreciation or depreciation in the property's fair market value.

a. LIMITED PURPOSE OF THE PRINCIPLE

The general concept of a "realization event" serves a highly limited function in the tax law: determining an easy administrative time for requiring a property owner to report increases or decreases in the market value of his asset.

The main point about the judicial notion of a realization event is that the test is not intended to be "economically sound" or otherwise to reflect "economic reality." The tax law on this point is arbitrary; it merely seizes on an objective point which is "easy to detect" by administrators and taxpayers. Consistent with the traditional reason for defining when a "realization event" occurs, scholars have noted that throughout the tax law almost "any definite event" resembling a disposition, or any "recognizable variation" in ownership rights, may be treated as a realization event for an owner of property. /36/

This rationale does not lend itself, we believe, to complex and sophisticated distinctions as to what types of debt modifications, for example, are "significant," or reflect ECONOMIC REALITY or changes in a taxpayer's ECONOMIC position. In Cottage Savings the Supreme Court in fact rejected as too complex and possibly not workable the Commissioner's stress on analyzing economically the mortgage exchange transaction before the Court to determine whether it created a "realization event." /37/ There are other limitations on use of the realization event concept. The traditional rationale is still largely associated with defining when a gain or loss in property value must be reported. The same rationale does not necessarily apply where tax consequences other than gain or loss are at issue, or for purposes of determining when an obligor on a debt instrument has "issued" a new liability. Therefore, the criteria that determine when the owner of a property interest, including a lender's claim against a borrower for repayment of a loan, realizes gain or loss when the loan's terms are modified need not necessarily be the same criteria that apply in deciding whether to test the modification for other potential tax consequences.

Another aspect of the realization principle is that the definition of a realization event has been chiefly a judicial function, except to the extent Congress has written a specific rule in the statute. /38/ Congress has on numerous occasions overridden case law and declared in the Code when a particular transaction is to be treated as a "sale or exchange" for tax purposes. /39/ Often Congress has acted after a period of prolonged litigation. /40/ Deemed-exchange treatment has served not only to characterize gain or loss for purposes of capital gain or loss treatment; it has also served to mark the point when a realization event occurs.

b. THE COTTAGE SAVINGS DECISION

In the Task Force's view, the Cottage Savings decision is open to a reasonable interpretation that the Supreme Court's holding is that, absent a contrary statutory provision, an exchange of property or property rights is a realization event whenever any change occurs in either or both party's legal rights regardless of degree. This principle, we believe, applies equally to debt modifications. To the extent the decision may be so interpreted by lower courts, such a holding would reaffirm an extremely low threshold for determining when a sale or exchange of property, or some other change in property or contract rights, creates a "realization event." This low threshold would exist whether or not the "distinct legal entitlements" test discussed in Cottage Savings represents an interpretation of tax common law or represents an interpretation of section 1001(a) of the statute.

At the other end of the spectrum of views about Cottage Savings is a view that the Supreme Court's discussion of "distinct legal entitlements" as the test of when an exchange is a realization event was "dictum." This view sees the Court's "holding" as limited to a statement that the specific mortgage exchange before the Court was a realization event because all of the mortgages carried different debtors and collateral. Anything else the Court said was unnecessary to that narrow holding. /41/

The Service appears to read the decision narrowly. The Explanation notes that the transaction before the Court involved two creditors holding mortgage receivables of third parties and "did not involve the modification of an instrument * * *." The Explanation also appears to suggest that the Service considers the "material difference" standard in Reg. section 1.1001-1(a) as having survived as a governing standard which is broader than a legal test based on changes in legal rights alone.

THE COURT'S REASONING. The issue before the Supreme Court was

In defining the issue before the Court, Justice Marshall saw two connected issues:

"We must therefore determine whether the realization

The Supreme Court thus addressed two subjects, not merely the

The Court said that the Commissioner's "material difference" test in Reg. section 1.1001-1(a) was a reasonable interpretation of the holdings of several earlier Supreme Court decisions involving corporate reorganizations under common law. However, Justice Marshall went on to reject the Commissioner's interpretation of his own regulation. The Commissioner had argued that the mortgage loans were not materially different from each other because of the alleged fungibility of home mortgages in the secondary mortgage market; the fact that the thrifts did not appear to care about differences in the collateral or borrowers on the mortgage interests they were trading; and the fact that regulatory accounting rules permitted the losses not to be recorded for book purposes. Those suggested tests, the Court said, raised questions of "workability" and "ill [serve] the goal of administrative convenience that underlies the realization requirement." (499 U.S. at 565-566)

As against the Commissioner's suggested criteria, Justice Marshall found that "section 1001(a) embodies a much less demanding and less complex test." He then set forth a "test" based on changes in one or both party's legal rights and powers as a result of an exchange:

"Under our interpretation of section 1001(a), an exchange of

"No more demanding a standard than this," Justice Marshall said, "is

Against that general standard for a realization event, the Court said that Cottage Savings' exchanges involving different obligors and homeowners "easily satisfy this test" (499 U.S. at 566).

The opinion refers repeatedly to "this test" as part of the Court's basic analysis. The opinion illustrates its general test by saying that separate groups of stock are not materially different if they confer "the same proportional interest of the same character in the same corporation." 499 U.S. at 565. They are materially different, however, if they "confer 'different rights and powers' in the same corporation ***." Id.

In light of these examples, we believe it is not unreasonable to read the Supreme Court's holding as consisting of two parts: (1) a clarification of the general common law "test" for determining when an exchange of contract or property rights is a "realization event," and (2) an application of that general test to a specific transaction before the Court.

The change in legal rights test seems clearly part of the Court's holding as a test of potentially wider application than the specific transaction before the Court. The examples listed in the opinion indicate that the Court was including in its analysis changes in legal rights and powers between the same issuer and holder, and not only exchanges between creditors holding obligations of third parties. The Court appears to have been reaffirming, and clarifying, a general tax standard for determining when many different kinds of transactions are realization events at least for purposes of realizing gain or loss, if not other tax consequences as well. Leading commentators appear to have construed Cottage Savings in this direction as "reaffirming" a general low threshold for defining when a realization event occurs. /43/

The fact that the Court might have resolved the specific loan swaps before it in Cottage Savings on narrower grounds does not in our view make the general rationale chosen by the Court "dictum." /44/

Although the opinion also appears on the surface to uphold Reg. section 1.1001-1(a) as a "reasonable" interpretation of section 1001(a), Justice Marshall actually discusses no legislative policy underlying section 1001(a) which the regulation purports to reflect. The opinion refers repeatedly to the realization event concept as underlying or implicit in section 1001(a). /45/ The Court also says that it "may presume" that Congress intended to codify realization principles in section 1001(a) (499 U.S. at 562). However, the opinion does not discuss the legislative history that indicated that Congress did not intend to use section 1001(a) to define a realization event. /46/ Cottage Savings seems properly viewed, we believe, as an interpretation of basic common law which is reflected in -- but is not original to or limited to -- section 1001(a) alone.

The Supreme Court does not say that the concept of a realization event exists solely under section 1001(a) or that the Court's test of a realization event cannot be applied under other Code provisions that may apply more specifically to the transaction at issue. /47/

We also think it is not unreasonable to read the opinion as limiting the meaning of the materiality standard to changes in legal rights or powers alone. /48/

IMPACT OF THE DECISION ON THIS PROJECT. Because of the Court's stress on an "easily detected" standard in order to achieve the goal of administrative convenience underlying the realization requirement, the change in legal rights test probably cannot leave room for other legal tests not approved by the Supreme Court. /49/ We cannot say it is likely that lower courts will not apply the "test" set forth by the Supreme Court to both holder-issuer debt modifications and holder-holder exchanges of third-party obligations. Nor can we say it is likely that lower courts will not equate the "distinct legal entitlements" test with material difference as the sole test for deciding when changes in the terms of debt instruments in a "workout" or other refinancing transaction, or when changes in obligors or collateral in other contexts, generally create a realization event -- at least for purposes of reporting gain or loss. Some leading commentators have also construed Cottage Savings as applying to debt- for-debt exchanges and potentially triggering tax effects other than gain or loss as such. /50/ Under such broad readings, there may be limited leeway for regulations containing rules different from such a test.

The fact that no actual exchange of "old" and "new" debt occurs should not prevent application of the distinct legal entitlements test, even though a lender and borrower change their agreement by amending its terms rather than executing entirely new instruments. There is no real difference between saying that an actual exchange is (or is not) a realization event and that specific amendments to a loan agreement create (or do not create) a constructive exchange which is treated as a realization event. There is a verbal difference between these two formulations, but not a substantive difference. /51/

Some practitioners have asked the Supreme Court not to write

On the other hand, there are arguable limits to Cottage Savings. Although the distinct legal entitlements test appears to cover more than exchanges of mortgage loans between or among holders of those loans, the rationale invoked by the Court arguably confines it to tax effects involving realization of gain or loss as distinct from OTHER TYPES of tax consequences. Further, since the administrative convenience rationale for realization discussed by the Court relates to owners of property or property rights, the decision is arguably also limited to holders of property rights (creditors, in the case of debt modifications) and may not be applicable to determine, for example, when an obligor on a debt instrument who renegotiates his liabilities has "issued" a new debt instrument. These potential limits on Cottage Savings may open the door to other alternatives for regulations under existing law dealing with debt modifications, as discussed in Section IV of this Report.

Because we agree that realization rules for debt modifications should not turn on changes in the legal rights of one or both parties alone, we believe that the strongest possible foundation should exist for avoiding the potential ramifications of the Cottage Savings decision. /54/ For that reason, we recommend that the Service consider the alternative sources of authority for realization rules suggested in this Report and, ultimately, a legislative solution as the best way to develop sound and certain rules for debt modifications.

4. POLICY DECISIONS TO RECONSIDER

Earlier portions of this Report have expressed the view that there is no social or economic policy underlying section 1001 and that the traditional rationale for a "realization event" under common law is inflexible. These factors hinder the development of an organizing principle around which determinations of a "significant" modification can be made. From the standpoint of ultimate economic and social policy toward debt modifications broadly, we recommend that many of the proposed distinctions should be reconsidered. Several examples are discussed below.

(a) SIGNIFICANT MODIFICATION. The source of the concept of a "significant" modification is not clear, nor is it clear what "facts and circumstances" are relevant, or not relevant, where the particular situation is not dealt with specifically in the regulation. /55/ For example, can facts and circumstances be considered which are not changes in legal rights and hence are not within the definition of a "modification"? Although multiple non- significant changes cannot be treated as significant when viewed together (Prop. Reg. section 1.1001-3(f) (3)(i)), can a single significant modification be offset, under the facts and circumstances test, by other tradeoffs in a larger package of workout agreements? Suppose that a debtor allows the creditor to place a representative on the debtor's board of directors, or the debtor agrees to cooperate in persuading other partner/debtors to agree to a multi-party workout. Are those types of agreements relevant to determining whether changes in a party's legal rights are "significant"? Can changes in "risk" caused by loan revisions be considered in weighing whether one or more changes to a loan agreement are significant? The Proposed Regulation offers no yardstick for knowing whether such factors are even relevant to the existence of a realization event.

(b) CHANGES UNDER UNILATERAL ACTION OR ORIGINAL TERMS. In defining a "modification" of a debt instrument, a party's exercise or waiver of a right provided for in the instrument is treated more favorably if the party's action is "unilateral" rather than mutually negotiated (Prop. Reg. section 1.1001-3(c) (2)(i)(B)). We do not believe that this distinction finds support in the traditional common law rationale for defining a realization event; it is also likely to give taxpayers a way to create a taxable event at a point of their own choosing. Since debt workouts rarely involve actions taken by a party without receipt of some benefit in return, the proposed distinction is also likely to encourage efforts to make negotiated agreements appear to have happened solely by action of one party where the objective is to avoid a modification. /56/

Under a related rule, an alteration of a legal right or obligation is not a modification if it occurs under the instrument's original terms (Prop. Reg. section 1.1001-3(c)(2)(i)). The rationale for the original-terms rule appears to be that if a potential change in terms was included in the original terms of a contract, the change is inchoate and its taking effect in a later year does not "change" the parties' legal rights. /57/ Moving from an inchoate to a choate condition works, in reality, a change in a party's legal rights. Arguably, there is a difference between the fact that a change occurred and the reason it occurred. /58/

As a policy matter, a negotiated agreement between the debtor and creditor, involving "tradeoffs" and multiple factors on both sides, should arguably not be a taxable event where many complex factors on both sides are delicately balanced and the debtor might be fairly viewed as having only rearranged his total burden. A concession made "unilaterally" by the creditor conferring a benefit on the debtor, by contrast, might in fact be a better candidate for creating taxable income than a complex mixture of tradeoffs which leaves the borrower more restricted than before the workout or similarly restricted but in different ways.

The larger policy question is whether there is any reason to treat a change in a debt instrument differently depending on whether the change was anticipated in the original agreement or whether the change happened by "unilateral" action or by hard bargaining between the parties. It is highly unlikely that some lenders will tolerate detailed provisions in an original loan agreement suggesting that the loan might not be repaid in full. Some draftsmen may think of possible future trouble spots in the loan, while others may be less astute or "negative" in their anticipation of trouble. Favoring original terms in the tax rules for debt modifications thus draws a line that will favor those who draft as many options as possible into the original agreement and penalize those who do not. /59/ We might also ask why only the "original" terms are favored; if a waiver or extension provision is added as an amendment in year 2 of a 15-year loan agreement, the same logic justifies treating later exercise of that waiver as favorably as one the parties thought of on day one.

Tax planners are likely to exploit the opportunities in the original-terms rule, while other taxpayers are likely to consider it unfair. What is needed is a guiding social or economic policy that is served by differentiating between unilateral and bilateral actions or between original terms and later amendments.

(c) A PARTY'S SUBJECTIVE ATTITUDE. The proposed rule that a change of obligor on a nonrecourse loan (Prop. Reg. section 1.1001-3 (e)(3)(B)) is not a significant modification is likely founded on the view that the holder looks only to the collateral and does not "care" that the obligor has changed. However, in Cottage Savings the Supreme Court rejected the Commissioner's argument that the thrifts' indifference to differences or similarities in the mortgages they exchanged showed that the swapped properties were not materially different. Even though the Court treated as irrelevant whether the taxpayer subjectively cares about the significance of the change in his economic position, the Proposed Regulation in effect applies such a test.

(d) NARROW DISTINCTIONS. A number of distinctions required by the Proposed Regulation are narrow and may be susceptible to adverse taxpayer use. A "change" in collateral on a nonrecourse note is a significant modification but if the collateral is "improved" rather than "replaced," the change is considered not significant. Prop. Reg. section 1.1001-3(e)(3)(iv). Although there may appear to be a difference between putting a new roof on a hotel securing a mortgage loan and substituting farmland for the hotel as collateral, both changes may increase the total value of the collateral to give the lender equal comfort levels. Distinguishing between these two situations not only interferes unnecessarily with the business decisions of the parties but also may require a distinction that is difficult to make and/or easily manipulated. The same comments apply to the proposed distinction between changing obligors (significant) and adding an obligor (not significant). Prop. Reg. section 1.1001- 3(e)(3).

(e) RECOURSE INSTRUMENTS. Adding security to a recourse instrument is generally not a significant modification. Prop. Reg. section 1.1001-3(e)(3)(iv). But if a lender is able to look to a second mortgage on a newly-completed, high value building or other property which the borrower agrees to add to the collateral, the practical effect may be to enhance the lender's rights to a highly significant degree.

(f) INTENTION TESTS. Several rules in the Proposed Regulation are "intention" tests based on one or both parties' subjective intention. For example, a deferral of payments designed to avoid OID rules is a significant modification (Prop. Reg. section 1.1001- 3(e)(2)(i)), as is adding a co-obligor if intended to effectively change obligors (Prop. Reg. section 1.1001-3(e)(3)(ii)). Such intention tests appear to fall outside the objective test under common law for defining a "realization event." The common law applies a wholly objective test in the interest of easy detection and general administrative convenience.

(g) LENDERS' WAIVERS. If a real estate lender waives indefinitely a right to declare default against a financially troubled borrower, or allows missed payments of principal or interest to be made up from future cash flow, a significant modification may occur. But the lender's only other alternative may be to foreclose, and he may feel he cannot manage the project better than the borrower or that the value of the collateral may decline even further if the parties' financial troubles were publicized. We do not support a tax rule that may put the property in different hands without a clear business advantage. /60/

(h) INAPPROPRIATE TIME FOR REALIZING INCOME. In a variety of circumstances we believe a creditor should not become taxable (perhaps realizing gain) merely by agreeing to change the loan agreement, when the creditor will realize more cash as and when the relieved debtor is enabled to complete his payments. Assume, for example, that an investor or original lender who purchased debt and warrants in a venture capital company and allocated part of the purchase price to the warrants so that OID exists in the debt finds that the business has stopped making scheduled debt payments. The reason may be genuine financial difficulty or less serious cash flow problems. If the default cannot be shown to be "temporary" under Prop. Reg. section 1.1001-3(c)(2)(ii) and the delay continues beyond the safe harbor for payment deferrals under Prop. Reg. section 1.1001-3(e)(2), the lender may realize income (and accelerate the OID element) in circumstances where the borrower has fallen into deeper difficulty and failed to pay anything to the lender. We believe the lender should not incur a realization event in these circumstances.

There are many circumstances where a familiar restructuring technique is proposed but, because of the tax consequences under the Proposed Regulation, one or both parties may refuse to agree to the restructuring, with adverse business results. For example, the Proposed Regulation considers a conversion of debt from recourse to nonrecourse liability a significant modification. However, a creditor will usually not release the borrower from personal liability unless the loan is otherwise adequately secured or under local law it is difficult for the lender to enforce the personal liability. Or, the collateral may have appreciated in value so that the lender may be willing to look only to the collateral for repayment. To take a different situation, a debtor may propose increasing the interest rate as an inducement to the creditor not to invoke an acceleration clause.

In general, in these situations, we see no clear policy (apart from a technical change in legal rights test) why the "workout" itself should generally be a point to impose (or to test for imposing) tax consequences on the debtor or the creditor. If the lender is concerned about realizing taxable gain, or if the debtor is concerned about being deemed to have "issued" a new debt instrument, either party may refuse to agree to a compromise. The debtor may then be forced into default or into filing formal bankruptcy. In either case the lender may end up not being repaid at all or receiving less than if he had agreed to a compromise. /61/ We believe that tax policy should not discourage a creditor from agreeing to refinance the claim (because of adverse tax results) when the result of placing more pressure on the borrower may be to increase the likelihood that the lender will not be repaid at all.

IV. AN ALTERNATIVE APPROACH UNDER CURRENT LAW

Under existing law we believe that the sounder approach to determining when a creditor "exchanges" his claim, and when a debtor "issues" new debt, in a refinancing or renegotiation of loan terms is to address these subjects only under individual Code provisions applying to specific transactions, and in light of the statutory policies that apply under those individual provisions.

For example, regulations dealing with debt modifications should not determine, under section 1001, when a debtor has "issued" a new debt instrument for purposes of triggering the application of substantive provisions in section 108(e)(11) (relating to income from discharge of indebtedness) or in section 1273 or section 1274 (relating to original issue discount). Nor does a determination under section 1001 mean that new debt has been "issued" for purposes of a variety of other Code provisions, including grandfather provisions in effective date rules for new statutory provisions. With regard to holders of debt instruments, we believe that section 1271(a)(1) applies specifically to creditors and is broad enough to cover debt modification transactions. As such, section 1271(a)(1) supersedes section 1001(a) in the area of debt modifications.

This analysis has the potential advantage of making it unnecessary to determine whether Cottage Savings creates a low common law "trigger" on realization events generally. Despite the potentially broad meaning of the Court's holding in Cottage Savings, there are still, we believe, important limitations on the decision's impact. First, the Supreme Court's rationale for a low threshold on a "realization event" appears to apply at most to the reporting of gain or loss from a rise or fall in property (such as mortgage) values and does not necessarily determine when a debt modification causes a tax effect OTHER THAN realization of gain or loss from the exchange itself. Therefore, regardless of whether Cottage Savings interprets common law or section 1001 of the Code, the Supreme Court's "test" would not apply if tax consequences other than gain or loss from the transaction itself are at issue.

Second, the Supreme Court described its own opinion in Cottage Savings as dealing with exchanges of "property." /62/ Since an obligor on a modified debt instrument does not exchange or transfer "property," we believe that Cottage Savings -- even if read broadly to create a realization event by any change in a property owner's legal rights -- does not affect the obligor's tax consequences. Thus, we think Cottage Savings does not apply to determine whether an obligor realizes discharge of indebtedness income under section 108(e)(11) because the issue in that transaction does not involve ending a period of tax deferral on appreciation in an asset's value or ending a bar to deducting a loss in value.

Third, with regard to CREDITORS whose claims usually constitute property, if a more specific statutory provision applies to a transaction, Cottage Savings, read as an interpretation of tax common law, arguably does not apply. Therefore, if a Code provision such as section 1271(a)(1)) applies specifically to creditors who hold debt instruments and agree to revise their claims, a possible "hair trigger" test under Cottage Savings arguably does not apply if a more specific statutory policy applies and the Service can satisfactorily apply the statutory concept of debt "retirement" to debt modification transactions.

The alternative approach discussed in this Section does not, however, eliminate all concerns over the potential meaning of Cottage Savings and its application to debt modifications. It may not solve all of the technical and potential policy questions that may arise even if holders of debt instruments receive "deemed exchange" treatment under section 1271(a)(1). To achieve the highest level of certainty that the tax "triggers" for testing debt modifications as realization events reflect legislative policy, and to achieve symmetrical treatment of debtors and creditors who amend a loan agreement -- if that is the desired tax policy -- we believe that the Service needs -- and should seek -- more legislative support than it presently has.

A. TREATMENT OF OBLIGORS

1. SECTION 1001 DOES NOT APPLY TO OBLIGORS

Obligors owe liabilities. It is difficult to conceive how an obligor on a debt instrument can be viewed as transferring a "property" interest or as participating in an "exchange" within the terms of section 1001(a) if his only action is to agree to alter his liability to the lender. As a general proposition, the U.S. Supreme Court has treated a debtor's liability to a creditor as not "property" with respect to the debtor himself. /63/ The Service itself has also treated a debtor who realizes income from discharge of part or all of his debt as not having participated in a "sale or exchange." /64/

A different theory appears to underlie the Proposed Regulation: if the creditor can be treated as having made an exchange for purposes of section 1001, the debtor can be treated as having "issued" a new liability as a byproduct or corollary of the creditor's treatment. It is difficult to find such symmetry within the language of section 1001(a), however. The fact that a creditor might be required to report gain or loss from amending his claim against a borrower does not mean that the borrower should ipso facto realize cancellation of debt income within the meaning of section 108(e)(11), or should lose an interest deduction on newly-issued debt which can be classified as a "high yield" obligation within the meaning of section 163(e)(5), or should be treated as "issuing" new debt for purposes of carrying out the legislative policies underlying sections 1273-1274 (relating to original issue discount). We find no court decision construing section 1001 to determine:

o When a debtor "issues" a new liability for purposes of

o When a debtor "issues" a new debt instrument for computing the

o Whether a debtor has "issued" a new liability for purposes of

o Whether a debtor has "issued" a new debt instrument for

The committee reports on section 108(e)(11), enacted in 1990, state that in determining whether a debtor has "issued" a debt instrument in satisfaction of existing indebtedness, the tests used to determine when a debt modification "qualifies as a realization event under section 1001 for the holder" are to apply. /65/ This comment, we think, does not take into account the general lack of symmetry in current law between the tax treatment of the debtor and the creditor as parties to a debt instrument, and the fact that different tax policies may apply to determining when a debtor "issues" a new liability and to determining when a creditor "exchanges" his claim. We do not think Congress or its staff fully considered the question of "crossover" between section 1001 and section 108. In any event, the statute does not support the statement made in the committee report. We recommend that the issue be revisited broadly. See Section IV of this Report.

Where the issue is whether a debtor has "issued" new debt in

2. SPECIFIC TRANSACTIONS

a. SPECIFIC STATUTORY PROVISIONS

In several instances Congress has legislated specifically on the treatment of debt modifications as they affect obligors. One important context involves "grandfather" provisions under effective date rules in newly-enacted tax statutes, where Congress has applied a new substantive rule to debt "issued" after a specified date but excepted debt issued originally before that date even though in some cases the debt was renegotiated after the effective date. Examples include the following:

o Section 267. When Congress amended section 267 in 1984 to add

"(B) Treatment of Renegotiations, Extensions, Etc. -- If

o SECTION 163(e)(5) limits interest deductions on certain "high

o WITHHOLDING. In 1984, when Congress repealed the 30%

o SECTION 163(j). Under the earnings stripping rules of section

o QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS. New section

o LOANS FROM QUALIFIED PROFIT-SHARING PLANS. Code section

o SECTIONS 72, 101(f), 264(a)(4), 7702, 7702A specify a variety

In dealing with modifications of contracts other than conventional debt instruments, Congress has in several instances also used its committee reports to provide guidance to the Service concerning the definition of a "material" modification. /72/

b. NO EXPLICIT POLICY

Where Congress has not adopted a specific policy toward debt modifications in specific areas, it may be possible to obtain some policy guidance from the general policy underlying the statutory provision as a whole. For example:

o SECTION 108(e)(11) computes a debtor's income from discharge

o SECTION 108(e)(4) treats an acquisition of debt by a party

o SECTION 108(e)(8), as amended by the Revenue Reconciliation

Where the legislative purpose underlying the specific Code provision or rule is not apparent from the language or from the committee reports, we believe that definitive regulations cannot be developed.

c. ORIGINAL ISSUE DISCOUNT; SECTION 108(e)(11)

The Section of Taxation's Section 108 Task Force has expressed the view that the legislative intent behind section 1274 was to focus on sales of nontraded property for nontraded debt as part of a seller financing transaction, and that the abuse potential in such transactions might also be present in modifications of the purchase money debt, but that the same abuse potential does not exist when bank loans and other non-purchase money debts are refinanced. /74/ However, regardless of whether the original issue discount rules in sections 1271-78 are limited to transactions where a borrower "issues" new debt in a refinancing of seller-financed debt, or whether these Code provisions can be applied to modifications of debt generally, /75/ we have been unable to find legislative policy authorizing criteria outside the original issue discount provisions themselves defining when an obligor has "issued" new debt to the same creditor for purposes of triggering the original issue discount rules. /76/

If the OID rules do not apply to debt modifications for this reason, we believe that the cancellation of debt rules of section 108 (e)(11) cannot be triggered by regulations under section 1001. /77/

B. TREATMENT OF CREDITORS

From the standpoint of holders of debt instruments, this Report suggests that section 1001 does not apply to creditors in debt modifications because a more specific Code provision, section 1271(a)(1), creates a statutory "exchange" for the creditor when he receives "amounts" in "retirement" of a debt instrument. This provision, we think, can be reasonably interpreted to treat modified claims held by creditors as amounts received in "retirement" of the creditor's unmodified claim.

Nevertheless, we recognize that, at the same time, there are problems with applying section 1271(a)(1) with complete certainty to debt modifications. We believe that several of these problems cannot be solved without further legislation and that therefore, while section 1271(a)(1) provides a specific rule applying to holders of debt instruments, the best resolution of the debt modification issue lies with a broad legislative solution.

1. SECTION 1271(a)(1)

Section 1271(a)(1) has received little or no attention in connection with the Proposed Regulation. Section 1271(a)(1) provides that amounts received by the holder on "retirement" of any debt instrument are considered amounts received in "exchange" therefor. This rule applies expressly to the "holder" of "any debt instrument." It covers all holders, and all debtors except natural persons. section 1271(b)(1). Exchange treatment applies for all purposes of the Internal Revenue Code. /78/

If section 1271(a)(1) can be fairly applied to the creditor's side of a debt modification, this provision, as a specific statutory provision applying to holders of debt instruments, overrides the more general provisions of section 1001(a). From the standpoint of holders of debt instruments, the Service should look to this specifically- directed provision for authority under existing law to define the details under which a creditor's agreement to change the terms of a loan agreement is a constructive exchange by the creditor.

Section 1271(a)(1) has been greatly expanded since its original enactment in 1934. Today, this provision sets forth a broad statutory standard for determining, for all tax purposes, when a creditor is considered to have "exchanged" his claim when he receives consideration from the debtor that "retires" his claim. This provision is not limited to characterizing an amount received by a creditor as capital gain or loss; since 1984 the creditor's claim does not have to be held as a capital asset.

Section 1271(a)(1) is broad enough, we believe, to include debt modifications and to treat a revised loan agreement, in appropriate circumstances, as replacing (retiring) the existing agreement. Commentators have also called attention to the possibility of applying section 1271(a)(1) to the creditor's side of debt modifications. /79/

In a particular case, if it is found that the amended debt claim has not been "retired," the creditor would not be tested separately under either section 1001 or Cottage Savings. The conclusion would be that the creditor has not exchanged his claim against the borrower; this treatment would apply for all tax purposes unless a more specific Code provision directs otherwise.

Section 1001(a) plays only a computational role in connection with section 1271(a)(1), supplying rules for computing the "amount" received in order to calculate precisely the amount of gain or loss reportable by the creditor from the section 1271 "deemed" exchange. /80/

a. BACKGROUND

The original predecessor of section 1271(a)(1) was first enacted in 1934 and has been gradually expanded to its current broad scope. /81/

Before Congress enacted the statutory exchange rule in 1934, the common law rule was that a creditor who receives a payment in settlement or compromise of his claim, or who purchased his claim at a discount and then receives part or full payment from the debtor, does not sell or "exchange" his claim, but receives payments in "satisfaction" or "extinguishment" of the claim. /82/ Hence, any gain or loss (to the extent collections exceed or fall short of the claim amount) is ordinary income or loss. Under this judicial rule, several court cases treated a new obligation of the debtor issued to the creditor as a payment in "satisfaction" of the existing claim, not as received in an exchange by the creditor. /83/ A debtor's payment to his creditor in bonds of a third party was also held part of a satisfaction of the claim. /84/

The committee reports on the Revenue Act of 1934 do not list specific reasons for enacting the constructive exchange rule. Congress may have intended to prevent revenue losses from creditors' ordinary loss deductions or to give creditors the same capital gain or loss treatment they would have received if they had sold their claim to a third party. /85/ Whatever the origin, however, section 1271(a)(1) has been broadened by Congress and the courts far beyond its original scope, as shown below.

b. "RETIREMENT" THEORY

The retirement rule is not limited to situations where the creditor receives payment in full, where the debtor is solvent, or where the creditor might have easily sold the claim to a third party. Under recent final regulations under sections 1271-75, the Service also defines the term "debt instrument" broadly enough to cover open account indebtedness and other debt arrangements even if not evidenced by a conventional debt instrument. /86/

The provision has been applied where a creditor is the original lender who receives less than his principal and where the creditor acquired the claim from the original lender and then receives full or partial payment of the claim. /87/ The retirement rule has also been applied in the context of workout arrangements between creditors and financially troubled debtors. The courts have construed the concept of "retirement" of a debt obligation broadly, /88/ and have applied the provision where the creditor receives a settlement payment from a financially troubled debtor. /89/ The courts and the Service have applied section 1271(a)(1) and its predecessors where the creditor receives property other than cash, such as real estate serving as collateral for defaulted debt or stock in another company. /90/ Even where the creditor actually surrendered outstanding bonds for real property acquired in foreclosure on the loan, the courts have treated the property as received in "retirement" of the bonds. /91/

The logic of section 1271(a)(1) makes it applicable, we think, to situations where a creditor can fairly be viewed as "receiving" a different, or changed, claim against the debtor in replacement of the creditor's existing claim. If bonds of a third party, for example, are received in satisfaction of the existing claim, the Service has already held that the fair market value of such bonds is received by the creditor under the predecessor of section 1271(a)(1). /92/ Such bonds of a third party are equivalent to changes in the obligor on a debt instrument which are clearly within the scope of the Proposed Regulation. The retirement rule has in fact been applied to a creditor's receipt of debt obligations of third parties and to "new" debt obligations of the debtor. The courts have considered these issues in the context of "workouts" between the creditor and a financially troubled debtor. /93/ There are a number of other decisions in which, in the context of deciding whether the 1939 Code or the 1954 Code version of the retirement rule applied to cash payments on modified debt, the courts considered in effect whether modified debt instruments issued in a negotiated workout of nonperforming debt were a continuation of the original debt obligation or an issuance of new debt. /94/

Section 1271(a)(1) is, in a real sense, a specialized realization rule in the statute. It also dovetails with the debtor's treatment under section 108(e)(11) and can be used to provide some structural support for symmetrical treatment of debtors and creditors where a workout agreement is otherwise treated as a realization event. Section 108(e)(11) creates income from discharge of indebtedness where the debtor "issues a debt instrument in satisfaction of indebtedness..." The debtor is treated "as having satisfied the indebtedness with an amount of money equal to the issue price of such debt instrument." If section 108(e)(11) treats a borrower whose liability is altered as having "satisfied" his existing liability, the lender can be considered to have received his modified claim in satisfaction of, i.e., in "retirement" of, the original indebtedness. The lender's side is thus a mirror image of the debtor's satisfaction of his outstanding liability via the modified agreement. /95/

It is not illogical or strained to conceive that a creditor who agrees to modify the terms of his loan to the borrower has "retired" his existing claim. This may, in fact, be a more accurate way to view a renegotiated loan agreement -- i.e., not treating it as an exchange -- since the unmodified debt does not survive as an asset in the debtor's hands, but in fact disappears. /96/

There is also a statutory basis in section 1271(a)(1) for using a flexible definition based on facts and circumstances to determine when a debt modification "retires" the outstanding debt. Under a statutory criterion which the Supreme Court has said can be construed in flexible fashion, the Service would be better able, we think, to justify standards for debt modifications which might not have to be limited to formal changes in either party's legal rights alone. /97/ Where Code provisions other than section 1271(a)(1) apply more specifically to holders of debt instruments, the policies of those other provisions could also be allowed to prevail without interference from the judicial rule defining a realization event established by Cottage Savings. Thus, Cottage Savings would arguably not apply under section 1271 in considering whether a creditor's existing claim has been "retired" and replaced by a new claim against the debtor. Under a "retirement" standard, for example, no one change in terms would necessarily determine that the workout is a realization event; on the other hand, a combination of changes in terms might be considered to have revamped the loan agreement so drastically that after all separate changes are netted, it might be accurate to view the parties as having "retired" one agreement and replaced it with an entirely new agreement. By contrast, Prop. Reg. section 1.1001-3(f)(3)(i) provides that multiple changes, none of which would be significant alone, do not collectively cause a realization event.

c. INDIVIDUAL BORROWERS

Section 1271(a)(1) does not apply where the debtor is an individual. section 1271(b)(1). That fact does not mean that section 1001 applies to the creditor of an individual borrower. The creditor's treatment of amounts he "receives" from an individual debtor -- including a modified debt obligation -- is determined under case law rather than under the Code. This is still the general rule for debt retirements not covered by section 1271(a)(1), including payments made by debtors who are individuals. /98/ The question in these situations is whether a modified agreement between the debtor and creditor "satisfies" or "extinguishes" the existing liability. If so, the creditor realizes ordinary income or loss at that point under section 61(a)(3) (gain from dealings in property), section 165 (loss sustained during the taxable year) or section 166 (bad debt deductions). /99/ If the answer is no, the workout would not be a realization event for the creditor.

We foresee a potential for litigation in this area if the

d. EVALUATION OF SECTION 1271(a)(1)

Despite the foregoing discussion, section 1271(a)(1) in its present form is probably not a cure-all for the problems raised by the Proposed Regulation under section 1001. The problems and drawbacks in using section 1271(a)(1), even if it can otherwise reasonably be applied to debt modifications, include the following:

o "RETIREMENT" STANDARD MAY BE TOO AMBIGUOUS. Several members of the Task Force believe that even a "retirement" standard is not likely to produce realistic, practical rules that reflect the realities of debt modification transactions. There is no guarantee that even a "retirement" standard offers case-specific guidance in deciding how to deal with financially troubled debtors, "temporary" failures to pay, extensions of payment schedules or maturity dates, or changes in interest rates.

o STILL A TERM-BASED TEST. So long as we continue to search for individual "factors" that have more or less "significance" in isolation in treating a loan workout as a realization event, we may not be able to escape completely a "realization event" analysis under common law. We may not be able to escape the risk that Cottage Savings may require treating a creditor's existing claim as "retired" by the slightest change in either party's legal rights after a workout agreement. In short, even a "retirement" analysis probably needs further reinforcement to deal satisfactorily with the continuum of possibilities when debtors and creditors amend their loan agreements.

A retirement standard is also probably not flexible enough to permit the important and basic kinds of policy decisions which ought to made for debt modifications. It may seem logical, for example, that changes occurring pursuant to a loan's original terms should not be viewed as "retiring" the existing liability. Yet many comments on the Proposed Regulation raise a broader policy issue whether such a rule would unfairly penalize draftsmen who do not (or are not permitted to) write into the original loan document every conceivable change the parties may later want to make. Moreover, unlike under the Proposed Regulation, multiple changes in terms might be viewed as adding up, in toto, to a new loan arrangement. These basic policy questions are discussed in Section V of this Report.

o SECTION 1271(a)(1)'s SCOPE ACROSS THE TAX LAW MAY STILL BE OPEN TO QUESTION. Section 1271(a)(1), as it currently reads, mandates exchange treatment for holders of debt instruments for all purposes of the tax Code. This fact raises a possibility that "exchange" treatment is mandated everywhere a more specific rule does not apply and regardless of the tax consequence involved. So, for example, a REIT that buys a nonperforming real estate mortgage and then renegotiates its terms with the borrower might risk losing its basic REIT status in light of section 856(c)(4), which limits a REIT's gross income to less than 30 percent derived from sales or other dispositions of mortgages held for less than 4 years. Unless a special rule is in place for that particular provision, a creditor's exchange treatment under section 1271(a)(1) might automatically require the same treatment under section 856(c)(4), although we believe that would not be sound REIT policy. /101/ On the other hand, at least one court has refused to extend exchange treatment under section 1271(a)(1) to find exchange treatment under other Code provisions involving a tax effect other than gain or loss from the exchange itself. The U.S. Claims Court rejected an argument by the Commissioner that a debtor's payments to a corporate creditor which was a Subchapter S corporation were "passive investment income" (under Subchapter S) from an exchange because the creditor hypothetically would have received exchange treatment under former section 1232(a)(1). /102/ The court viewed the retirement rule as dealing only with the creditor's tax treatment of the collection proceeds themselves and not with other tax effects turning on the existence of a sale or exchange; it called former section 1232(a)(1) "only a characterization provision, intended to provide one of several requirements necessary in order to confer capital gain status" on a redemption or retirement of debt instruments. Since 1984, however, section 1271(a)(1) applies for purposes of the entire Internal Revenue Code and its language is not limited to computing or characterizing gain or loss; therefore, despite the Court of Claims decision, a deemed exchange under section 1271 might apply throughout the Code. /103/ In our opinion, sections 1271(a)(1) and 1001 both raise the same broad policy issue -- whether one should put in place a single uniform set of realization rules for debt modifications that determines when a creditor (or a debtor) realizes gain or loss and incurs other tax consequences as a result of modifying a loan agreement.

o THE PROVISION DOES NOT APPLY TO DEBTORS WHO ARE NATURAL PERSONS. If the Service is willing to consider the possible use of section 1271(a)(1) as the source of realization rules for creditors who participate in debt workouts, we believe that Congress should be asked to consider whether any reason exists not to cover creditors of individual debtors under section 1271(a)(1).

On balance, although section 1271(a)(1) should be further explored by the Service as a more appropriate vehicle for regulations than section 1001, the questions arising under section 1271(a)(1) lead us to prefer an overall broad-brush legislative solution to the issue of debt modifications as realization events.

2. SPECIFIC CODE PROVISIONS

Even if section 1271(a)(1) can be reasonably applied to the creditor's side of debt modifications, this provision can itself be superseded by more specific Code provisions containing policies that can help the Service decide in a particular context whether, or when, a debt modification should be a realization event. The Service itself has deferred to special legislative policies in the following circumstances:

o REMIC PROVISIONS. Under the REMIC provisions, the regulations

o SECTION 382. For purposes of the special relief for creditors

o SECTION 453. The Proposed Regulation's tests do not apply to

o ORIGINAL ISSUE DISCOUNT. section 1274(c)(4) excepts from

The lack of more such specific Code provisions which preclude inequitable results that can occur if and when a general provision (such as section 1271(a)(1)) applies by default to a particular debt restructuring is a matter which we believe Congress should consider in connection with the entire subject of debt modifications. It is desirable, we believe, for the tax rules defining when a debt modification is a realization event to reflect the particular policies underlying the transaction where the realization issue arises. The existence of section 1271(a)(1) as a statutory general rule creating an "exchange" for holders of debt instruments may produce inequitable results if this provision applies by default to a particular debt restructuring and no more specific Code provision applies. This potential impact of section 1271(a)(1) is one of the major policy issues which we recommend should be part of Congressional attention to the entire subject of debt modifications.

V. LEGISLATIVE SOLUTIONS

A. IN GENERAL

The Proposed Regulation represents the first attempt by the Service to deal comprehensively with basic realization issues by regulation. The Service's welcome attempt to write flexible rules for debt modifications and to place those rules under section 1001 is affected, as we have indicated earlier in this Report, by the inflexible and low threshold associated with the common law concept of a "realization event," on one hand, and, on the other hand, by the lack of statutory policy guidance under section 1001(a) facilitating distinctions keyed to "economic reality" and "changes in economic position" of a debtor or creditor. In this area concerns with economic reality and changes in economic position are both within Congress's jurisdiction under the nonrecognition provisions of the statute. Cottage Savings even pulls in the opposite direction by reinforcing a common law "hair trigger" test for at least some kinds of exchanges, and raising reasonable concerns that the same tax test applies to debt modifications.

There are compelling reasons for favoring a legislative solution to the realization issues in debt modification transactions in lieu of regulations dealing with the subject under existing law. The tax treatment of debt modifications is of paramount importance to the national economy from the standpoint of ultimate tax consequences that will or will not result from efforts by lenders and borrowers to convert a nonperforming loan to performing status. Defining the events that trigger the basic process of "testing" a modified loan agreement for possible tax consequences is an important part of that issue. Both aspects of workout transactions involve important tax policy decisions.

At this point, we recommend that the tax community step back from an overly-technical absorption with highly detailed changes in specific terms of a loan agreement and with (in numerous circumstances) unrealistic distinctions keyed to changes in payment schedules, "unilateral" versus negotiated agreements, and changes in collateral and other types of "credit enhancement." As suggested in Section III of this Report, if we are looking for a policy permitting something other than a rigid "hair trigger" for creating realization events, we think there is no neutral or objective way administratively to select points along the nearly seamless continuum of possibilities as the "proper" points for treating (or merely testing) changes in a debt instrument as "realization events." That process -- or the adoption of a broader approach keyed to the purpose of a debt restructuring agreement -- is inherently a policy matter along with deciding what tax consequences should result from a debt modification which has been classified as a realization event. The threshold policy decisions on both subjects should be made by Congress. /108/

This basic policy guidance, we have suggested, will benefit both tax advisers and the Service in terms of achieving certainty about the governing tax rules, agreement on fundamental tax policy, and prevention of whipsaw of the Treasury -- objectives which are common to difficult tax issues other than debt modifications. /109/

One threshold policy issue is whether the law should treat debt modifications as realization events as often as possible, or should at least test changes in debt terms as often as possible for potential tax consequences, or whether there should be fewer realization points as debtors and creditors revise terms frequently in order to anticipate and prevent difficulties with their loan relationship.

In terms of basic realization policy, we also question a "term- based" approach which parses debt modifications into changes in individual terms of a debt instrument and creates realization events around changes in such terms as collateral, interest rates, payment schedules, and maturity dates. Except for changes in terms that clearly carry out a specific statutory policy (such as reductions in principal amount giving rise to discharge of indebtedness), it is hard -- in our view -- to find in current law a general realization policy that requires micromanaging a debt modification. /110/

Throughout this Report we have also questioned the need for a single set of all-purpose realization rules that define generically when revisions of a loan agreement are tested for possible tax consequences.

In discussing the basis for alternatives to the Proposed Regulation, we emphasize that we are not recommending that the Service should revise the Proposed Regulation to take the position that it has no leeway to apply anything but a low threshold for debt modifications based on changes in legal rights alone. In that event, any change in the debtor's or creditor's legal rights of any kind, regardless of degree, would presumably trigger a realization event for both parties, with resulting disruption of many delicate and nontax-motivated business negotiations.

It is important at this point for the tax community and the Treasury to work with Congress to develop basic policies for debt modifications, starting with the numerous policy issues involved in these transactions. Congress should consider whether tax rules should play a role in encouraging or discouraging such transactions and whether the same or different tax policies should be adopted for the wide variety of "debt modifications." This effort involves deciding not only the tax consequences of a debt modification for the borrower and lender, but also the basic approach, including (if Congress chooses to use a "term-based" approach) selection of specific types of changes in terms that should be considered realization marks. Congress might also consider whether it wishes to focus primarily on the threshold question of whether a debt modification gives rise to "income" or "loss" at all rather than on defining when income or loss is reportable via a realization event. After the basic policy decisions are made, the Service can then fill in the necessary details through regulations.

1. LIMITED SOLUTIONS UNDER CURRENT LAW

a. If the Service decides to adopt a single set of generic rules for debt modifications, while "carving out" special rules to carry out special policies for certain transactions, the Service will have to be continually concerned with assuring that the special rules are in place and that the generic rules do not inadvertently override the special rules.

b. If the Service should decide to continue developing regulations for debt modifications under section 1001 or by reference to the common law concept of a "realization event," we believe the Service needs more legislative support than it presently has for placing the rules under section 1001; for using rules under that provision to trigger tax consequences other than gain or loss as such from the workout; and for treating an obligor as having "issued" new debt for purposes of other provisions throughout the Code.

c. If the Service should wish to try to develop an alternative approach to debt modifications under existing law through section 1271(a)(1) and individual Code provisions dealing with debtors and creditors, we recommend that Congress should be asked to clarify that a revised loan agreement can be treated as "retiring" the existing agreement for purposes of section 1271(a)(1), and to expand section 1271(a)(1) to cover creditors of natural persons. d. Short of a broad legislative solution, the cause of certainty would be helped if Congress were to deal specifically, each time it amends the Code, with the question of whether to subject modified debt to a new statutory rule or specifically except a modified debt from that particular rule.

2. BROAD-BRUSH LEGISLATIVE RULES

a. SUGGESTED ALTERNATIVES

If Congress were to consider a broad legislative approach to debt modification transactions, the general choices would probably include the following:

1) Creation of general rules in the Code dealing expressly with

2) Enactment of general rules prescribing NONRECOGNITION

3) A general delegation of authority to the Treasury for

4) A policy of no general rules for debt modifications and

Any of these broad approaches would have the advantage of eliminating

b. POLICY ISSUES

Whichever general approach Congress might choose to adopt, we offer below several considerations which we believe should be part of a sound policy toward debt modification transactions.

(1) GENERAL NONRECOGNITION TREATMENT. The advantages and disadvantages of an approach similar to the corporate reorganization provisions in current law should be considered -- including a general rule providing nonrecognition of gain or loss (even if debt modifications are considered realization events under a low threshold test) with appropriate exceptions and safeguards against abuse.

In 1923, Congress removed from "like kind" exchange treatment under the predecessor of section 1031 exchanges of stocks, bonds, notes, other securities or evidences of indebtedness, and certain other intangibles. These exchanges had been given nonrecognition treatment in the original like-kind rule, but Congress concluded that it had "gone too far" in permitting taxpayers to realize exchange gains in cash without tax. /111/ The 1923 amendment left open the possibility that exchanges of debt generally produce realized gains and (as Cottage Savings later showed) deductible losses. Arguably, the pendulum should now swing back toward nonrecognition treatment for debt modifications between the debtor and the creditor on the same obligation, at least as to most types of changes in terms. Section 354 already provides general nonrecognition for modifications of debt securities in corporate reorganizations.

Exceptions might be suitable for reductions in principal amount and for changes in obligor (though such changes among related parties should probably remain nontaxable events).

(2) TAILORING REALIZATION RULES TO POLICIES OF INDIVIDUAL CODE PROVISIONS. The unsuccessful attempt in the early 1980s to write regulations, even under legislative authority, setting forth detailed factors for distinguishing debt and equity under section 385 and applying uniformly across the Code is instructive in this project. /112/ The primary reason for the lack of success may have been that where there is an almost seamless continuum of possible points for saying that "debt" ends and "equity" begins, it is not possible, without a clear economic or social policy, to select particular "factors" in the abstract and treat them as definitive. About the section 385 regulations project, one leading commentator has observed:

"There is nothing more complex than trying to draw

According to the same commentator:

"I submit that the heart of the debt-equity dilemma that has

* * *

"It is my conviction . . . that if a fraction of the time and

These observations apply equally to efforts to draw detailed lines

As experience has already shown in the debt-equity area, we believe the Service should move away from "a single definitional approach to widely varying tax issues" and look instead to "the purposes of each of the several statutory provisions affected." As in the debt-equity area, different statutory policies for debt modifications may apply in different contexts. For example, the traditional common law rationale for capturing a property owner's accrued gain or loss does not necessarily apply where the tax consequence is something other than gain or loss from a debt modification. It is difficult to conclude that any one "trigger" suits lenders and borrowers equally, or suits different policies and different tax effects under different Code provisions.

(3) TERM-BASED TESTS. We doubt that it will ultimately be possible -- or desirable -- to write term-based rules that (with some exceptions) will not be arbitrary in treating some types of changes in loan agreements as creating taxable events and some as not creating taxable events. There are no inherently obvious policy reasons, for example, why changes in interest rate, changes in collateral or obligors, extensions of maturity, or changes in put or call rights should in themselves make a workout a realization event. There is also no clear reason why some kinds of changes in degree among these and other factors are more indicative than others of a suitable point for testing the changed terms for possible tax effects. Term-based tests, we think, interfere unreasonably with the dynamics of debtor-creditor negotiations, particularly in complex cases, and unnecessarily "micro-manage" business relationships. In dealing with debt modifications in the Code to date, Congress has generally written the governing rules in broad form. /115/

(4) DRAWBACKS OF CREATING FREQUENT REALIZATION EVENTS. Generally, we believe it is not good tax policy to create "realization events" too frequently in the course of a debt restructuring transaction. Because of the function of realization events throughout the tax law in creating at least testing points for potential tax consequences that turn on "issuances" or "exchanges" of debt instruments, we believe that creating numerous testing points for debt modifications is likely to increase unnecessarily the role of the tax adviser in otherwise nontax-motivated business negotiations to restructure or refinance loan transactions.

From the standpoint of overall policy concerns, the delicacy of negotiations over debt compromises calls for a conservative tax policy against both surprise tax consequences -- arising from the wide assortment of tax provisions that might be triggered by a "realization event" throughout the tax law -- and overly harsh tax consequences arising from primarily business-motivated changes in the terms of a loan, particularly where the parties are attempting to improve the likelihood of payment of a financially-troubled loan. Tax policy should also not have the perverse effect of making it easier for financially healthy companies to create "deemed exchanges" in order to avoid Code limitations and otherwise "game" the tax system, while making it more difficult for financially troubled companies to restructure their debt burdens. /116/ Because of the absence of a general nonrecognition rule for debt modifications for both creditors and debtors, one commentator on the Proposed Regulation has properly pointed out that an extremely short fuse on turning debt restructurings into taxable events is also likely to mean that "cautious lenders will refuse to renegotiate debts and unwary but economically reasonable creditors may be hit with an unanticipated tax burden." /117/

We recommend an overall policy, consistent with prevention of abuse, expressed by another ABA Section of Taxation Task Force dealing with tax issues in debt restructurings and bankruptcies:

"[A] debt reduction/restructuring does not occur in an economic

Other broad goals of a legislative solution should include the

o To prevent manipulations of the tax system and increased

o To increase parallel treatment of debtors and creditors in the

o To avoid uncertainty concerning the tax treatment of debt

In developing a new legislative solution to debt modifications, some of the specific policy issues which should be addressed are the following:

o Should different realization rules apply to holder-holder

o Should modifications of short-term debt generally be allowed

o Should the rules that apply to debt instruments apply equally

o Should debtors and creditors be treated symmetrically in all

o Should greater relief from "realization" be available to

o Should all changes in obligor on a debt instrument be

o Should some buyers of discount loans be favored over others?

o Should any line be drawn between small versus large debt

One place to begin a policy review of the entire subject is with ABA Legislative Recommendation No. 1993-2.

B. TAX SECTION LEGISLATIVE RECOMMENDATION NO. 1993-2.

The American Bar Association Section of Taxation has proposed reinstating and broadening former section 1275(a)(4) as a legislative resolution of certain policy consequences of debt modifications in the areas of original issue discount, debt discharge income for the obligor and creditor recognition of gain or loss. Legislative Recommendation No. 1993-2 was approved by the Section of Taxation on August 7, 1993. /120/

For obligors, this legislative proposal would provide, in effect, a nonrecognition rule through a computational approach: EVEN IF a borrower were treated as having "issued" a new liability in a loan workout arrangement, original issue discount and cancellation of debt would be computed by assuming that the new debt's issue price equals the old debt's adjusted issue price, provided the interest rate on the new debt is at or above the then-applicable federal rate. As a result, no OID would be created for the debtor or the creditor, and no debt discharge would arise for the debtor, unless the old debt's principal amount is reduced or the new interest rate is below the applicable federal rate. For the creditor, even if the debt modification is a realization event, it would not be a recognition event for tax purposes. /121/

This legislative proposal has several fundamental policy objectives. One is to reflect the "economic reality" that a troubled debtor cannot be presumed to have borrowed fresh funds in the open market and used the proceeds to redeem the unmodified obligation. Another objective is to reduce the disincentive for solvent issuers of publicly-traded debt to agree to workouts that may create COD income, or for creditors who have previously written off their claims to agree to workouts that otherwise would effectively require recapture of the prior deductions merely because of the workout. (The national interest in enabling private-sector investors to buy troubled bank or thrift loans from the Resolution Trust Corporation or the Federal Deposit Insurance Corporation illustrates this policy objective).

The Section of Taxation's proposal also aims at reducing the incentive for troubled debtors to file formal bankruptcy in order to avoid current COD income if a restructuring of debts will trigger COD and OID rules. Still another objective is to reduce taxpayer "selectivity" by using minor debt modifications to trigger COD income and OID deductions where doing so is tax-beneficial. Another is to achieve greater consistency between debtors and creditors in workout transactions. A specific objective is to reduce the potential impact of a hair trigger test for realization under various interpretations of the Cottage Savings decision on both the incentives and disincentives to debt modifications under existing law. The Report on the Legislative Recommendation states, in relevant part:

"The reenactment of section 1275(a)(4) would eliminate the

Legislative Recommendation No. 1993-2 does not cover more than debt discharge and original issue discount tax consequences of a debt modification. If enacted, this proposal would replace section 108(e)(11) for borrowers. Creditors might still be treated as participating in an "exchange" pursuant to section 1271(a)(1), but any gain or loss realized from that exchange would be nonrecognized and deferred, in effect, until the "new" claim is disposed of in a taxable disposition.

This ABA Proposal might serve as the basis for a broader legislative amendment relating to debt modifications generally.

VI. SPECIFIC COMMENTS ON THE PROPOSED REGULATION

A. "DEBT INSTRUMENTS"

The Proposed Regulation applies by its terms to "debt instruments." This fundamental term is not defined. It is not clear, for purposes of applying the proposed rules, what the term "debt" means and whether a debt obligation must be evidenced by a formal written instrument or whether the proposed rules apply to obligations not put in formal written form.

The Proposed Regulation does not incorporate any definition similar to the broad definition of "debt instrument" in the original issue discount regulations. /122/ There is no explicit exception for debts of natural persons, whose obligations are expressly excepted from section 1271(a)(1).

It is not clear whether the proposed rules apply to open account indebtedness, revolving credit arrangements, lines of credit, or oral debts not put in writing. It is also not clear whether the proposed rules apply to debt instruments which constitute "property" in the holder's hands as well as to debt instruments which evidence a debt claim but which are not themselves the indebtedness itself. If the proposed rules do not apply to modifications of these kinds of "debts," it is unclear why they do not apply.

A basic definition of "debt instrument" is also important in connection with life insurance contracts and guarantees that might arguably be viewed as "contingent" debt obligations. Is a life insurance contract a debt instrument for purposes of the Proposed Regulation? /123/ The Proposed Regulation treats a material alteration of a guarantee on a nonrecourse debt as a significant modification. Prop. Reg. section 1.1001-3(e)(3)(iii). This rule apparently triggers a deemed exchange for both the debtor and the creditor. Is the guarantee itself a "debt instrument"? Is the guarantor a debtor who might be viewed as "issuing" a new debt instrument if the guaranty terms are changed materially? None of these questions is answered clearly by the terms of the proposal.

Still another problem area concerns debt instruments issued to providers of services. If these service contracts are changed or amended after they are originally entered into, are those contracts "debt instruments" subject to the debt modification regulations? Although there may not be gain or loss realized in many of these situations, other types of tax consequences may be affected depending, for example, on such questions as whether the "debt instrument" was issued before or after the effective date of a new statutory rule. Possibly, regulations authorized by section 467(g) can deal with this issue. We believe this matter should not go unclarified. /124/

B. RETESTING DEBT AS EQUITY

A major concern raised by the Proposed Regulation is the apparent requirement that outstanding debt be retested for possible equity or "stock" status each time the debt is "altered," even if pursuant to the terms of the instrument itself.

The Proposed Regulation deals with potential debt-equity retesting in two places, once under the definition of a "modification" and again under the rules for "significant" modifications. Under the modification rules, an alteration of the terms of a debt instrument, even pursuant to the original terms, is a modification if the alteration results in an instrument or property right that is not debt for federal income tax purposes. Prop. Reg. section 1.1001-3(c)(3). A modification is considered significant "if it changes the instrument to an instrument or property that is not debt for Federal tax purposes." Prop. Reg. section 1.1001-3(e)(4)(i). This language seems to require that if the debtor and creditor alter their agreement, even in a minor way that would not otherwise create a "modification," the altered instrument must be retested at that point to determine whether it is still debt for tax purposes or whether the debt should be reclassified as equity. Further, if such retesting causes the debt to be recharacterized as equity at that point, the old debt is considered to have been significantly modified, and hence exchanged, for new equity.

We believe there should not be a requirement, in effect, to retest a debt instrument any time the instrument is altered in any way, especially if the alteration would not otherwise constitute a "significant modification." If, as we understand, the Service did not intend to require retesting under debt/equity concepts at any time debt terms are altered, the Proposed Regulation should be clarified to remove this ambiguity.

We would not effectively require that modified debt be retested

At a minimum, we believe the Service should not bring the debt/equity distinction into the realization area and apply debt/equity rules as part of a determination as to whether a modification in terms should be treated for tax purposes as an exchange of debt for new equity in the first instance. In effect, that is tantamount to mandating testing of every debt modification specifically to determine whether the existing indebtedness continues to be indebtedness at that particular point.

The better rule is to leave existing IRS administrative practice in place, so that debt is generally tested only upon its initial issuance, i.e., after a determination has been made that the new debt has been issued. /125/

C. REDUCTION IN PRINCIPAL AMOUNT

The Proposed Regulation appears to provide that a reduction in a debt's principal amount can properly be treated as an exchange by the creditor of the entire obligation and as an "issue" of new debt by the obligor even if the only event that occurs is a reduction in part of the obligation's principal amount. /126/ The Proposed Regulation does not clearly indicate any change in the Service's position on this point. See Prop. Reg. section 1.1001-3(g), Example 3 (exchange if yield changes on remaining portion of original debt).

Treating a discharge of part of a debt as an exchange of the old obligation in toto for a new reduced obligation means that the debtor not only will realize income from discharge of indebtedness but also will be considered to have "issued" a new debt instrument. As a result, the debtor might realize a larger amount of debt discharge income if he must refer to the issue price of the entirely "new" debt instrument than if he computed COD income by reference merely to the reduction in the debt's principal amount. /127/ The creditor, for his part, will realize gain or loss based on offsetting his basis in the entire claim against the "new" obligation's issue price or fair market value. The creditor might therefore realize more gain or loss than if he referred only to the reduction in the debt's principal amount. Under an "exchange" theory, too, any gain or loss realized by the creditor might be subject to nonrecognition treatment (via section 354) if the deemed "exchange" constitutes a recapitalization under section 368(a)(1)(E). /128/

If the partial discharge were NOT treated as an exchange of the entire debt, as we believe should be the rule, the debtor would realize income from debt discharge by reference only to the reduction in principal amount but would not be treated as issuing an entirely new obligation. The creditor could deduct the forgiven portion of his claim as a bad debt or ordinary loss but would not be treated as having exchanged the balance of his claim for any new claim (except to the extent the remaining debt is modified so as to trigger a taxable event as to that portion of the debt). /129/

Consistent with the treatment we believe is appropriate for a reduction in principal amount, sections 108(e)(11) and 1271(a)(1) can be properly interpreted so that a discharge of part of a debt need not be treated as an exchange of the balance of the debt by the creditor or as an issuance of new debt by the obligor. We believe it is not appropriate to focus on abstract notions of exchange or issuance; the full inquiry under these Code sections is whether an amount has been paid or received to SATISFY or RETIRE the existing liability. When a creditor holding a $1,000 claim, for example, agrees to forgive $200 of that claim, the debtor pays nothing as to that portion of the liability (and issues no new liability in its place); the creditor receives nothing on that portion of his claim (and $800 of the original claim remains unchanged). Therefore, as we interpret the law, neither section 108(e)(11) nor section 1271(a)(1) applies to a partial reduction of debt. /130/

A final point is that a rule that a partial reduction of debt ipso facto creates an exchange of the entire debt invites "tax planning" by parties who, if they did not originally issue two separate debt instruments (so that a cancellation of one clearly does not affect the other), might divide the existing note into two separate notes and merely cancel one. /131/

D. CONTINGENT MODIFICATIONS

A lender may sometimes agree to forgive debt in the future provided the debtor satisfies specified conditions. The issue in such transactions is whether the debt should be deemed forgiven at the point when the parties enter into the agreement rather waiting to see whether the conditions occur. Practitioners have generally divided on this question.

Prop. Reg. section 1.1001-3(f)(1) appears to provide that a modification is tested at the time the parties agree to a modification even though the changes may not be immediately effective. It is not clear whether the contingency as such is taken into account as a possible change in legal rights or whether the rule requires an assumption that the contingency has already occurred. The apparent intent is the latter. /132/

One difficulty with this apparent rule is that many contingencies are framed in the alternative -- for example, in terms of different possible levels of future income which in turn affect the type of change in terms of the debt instrument. The Proposed Regulation does not explain which possible version of the future contingency will be assumed to occur at the time the parties create the contingency itself. Many debt restructurings, particularly those involving financially troubled debtors, condition a future discharge or rescheduling of debt on the debtor's future income or acts to be performed by the debtor (such as reorganizing his business operations, for example). In these difficult circumstances, the Service's proposed rule would confront the debtor and creditor with a potential realization event -- a result the parties are trying to avoid by conditioning the renegotiation or discharge of debt on future events. This would undoubtedly discourage debtors and creditors from entering into agreements which allow debtors some degree of "breathing room" to recover from economic downturns and make needed business changes before either party's tax planners need to be mobilized. The Explanation does not explain why it is necessary or desirable to accelerate realization in the case of contingent workouts or what policy supports the proposed rule.

As a policy matter, we think that contingent modifications should not be treated as realization events until the contingency occurs. This is the case where the issue is gain or loss realization under section 1001. It is, a fortiori, the preferred rule where the tax stakes may involve loss of grandfather status under a statutory effective date rule or some substantive tax effect other than the reporting of gain or loss. /133/

E. EXTENSIONS OF MATURITY

Under the Proposed Regulation, an extension of a debt's final

If the material-deferral-of-periodic-payments rule or the extension-of-final-maturity rule were applied in this situation, the settlement agreement would be a realization event upon its execution -- even if the Service agrees with our suggestion that a contingent modification should be tested only when one knows whether the condition occurs. We believe that would not be a sound result. Although the Proposed Regulation provides that a deemed exchange will occur if the modification is significant "under any rule" (Prop. Reg. section 1.1001-3(f)(1)), a wait-and-see rule would be defeated by an inherent feature of the wait-and-see rule, namely, delaying the original payment schedule until the waiting period expires. The Service should consider qualifying the extension of maturity rules to apply only if and when no other changes in terms are made in the settlement which, by their terms, effectively change the timing of payments.

We find other problems with the rule that a change in the timing and/or amount of payments is a significant modification if it materially defers payments due under the debt instrument. Prop. Reg. sectionl.l00l-3(e)(2)(i). This provision is troubling for several reasons. First, the Proposed Regulation in our view changes case law. /134/ Second, the concept of "material" deferral is both subjective and highly uncertain. Materiality is not defined in the Proposed Regulation; nor is it rationalized under Cottage Savings or under any other Code provision. However, we believe that the example given to illustrate this rule suggests a "hair trigger" definition of materiality.

Example 4 in Prop. Reg. sectionl.l00l-3(g) involves a deferral of interest payments but no deferral of principal payments. In the context of a 20-year debt originating in 1990, the Service finds a significant modification where, in 1993, the interest payments due at the end of l994 through l997 are deferred until l998. Interest was compounded so there was no change in the yield on the debt instrument. It is difficult to understand how this modification could be perceived as material where there is no change in yield, no extension of final maturity, no deferral of principal payments, and a deferral of five of the 20 interest payments by an average of three years.

One suggested justification for the material deferral approach is to protect the integrity of the original issue discount rules. For example, the concern seems to be that a debt instrument not originally governed by the OID rules could otherwise be modified in a manner that would have been subject to the OID rules if originally issued with, for example, an interest deferral. So long as the yield is not changed and the maturity date is not extended, this modification will not be significant without the material deferral rule.

Instead of a test keyed to materiality, we believe the Service's concerns regarding original issue discount should be dealt with by a specific "anti-abuse" rule. There appears to be no evidence of abuse in Example 4, cited above, where the change to the terms was made three years after the debt instrument originated.

However, if the material-deferral test is retained, it should be revised to establish a bright-line test with safe harbors. The safe harbors should be similar to the extension-of- final-maturity-date rule. For example, we suggest that a deferral should not be material if the deferral period does not exceed 5 years or an average of 5 years.

F. ASSIGNMENTS OF ONE SIDE OF AN OBLIGATION

1. NOTIONAL PRINCIPAL CONTRACTS

The Proposed Regulation specifically invites comment on whether

On June 10, 1992, Section of Taxation members submitted detailed comments on the apparent application of Cottage Savings to notional principal contracts contained in the proposed regulations relating to notional principal contracts. In those comments, the following statement was made:

"The Service is under no compulsion to mechanically apply the

We believe that the tax rules the Service writes for notional principal contracts should be determined under principles relating to the unique features of such contracts and not derived from "principles" of realization found in section 1001. In the financial markets, assignments of one leg of a notional principal contract are generally viewed as nonevents by the nonassigning party. In our view, the relationships among the parties to an interest rate swap and an assignee of the interest of one of the parties is different from the traditional relationship in which we commonly look for a "realization event." As explained earlier in this Report, the traditional rationale for a realization event -- which Cottage Savings reinforces -- involves defining a point when the owner of an asset should end the deferral of tax on annual appreciation in the value of the property and report accumulated gain (or loss) to the tax collector. This rationale, and the rationale for rules defining "realization events" under section 1001 or any other Code provision, do not apply to persons in the position of an obligor on a debt instrument, and do not apply to persons in the position of a creditor to the extent the common law rationale for a realization event does not justify creating a realization event.

Notional principal contracts, in which a party is both a debtor and a creditor simultaneously, are fundamentally different from debt agreements, in which a party is either a debtor or a creditor but not both. If there is to be a realization event for the nonassigning party, it should be determined under the principles of section 446, rather than section 1001. Whether guidance for modification of debt instruments is finalized under section 1001 or under other existing code provisions, that guidance should not automatically be imposed in the area of notional principal contracts.

A notional principal contract, in the broadest sense, is a contract in which one party agrees to pay the other party an amount measured by an index (such as a fixed rate of interest) times a notional amount (such as a fixed dollar amount). The other party agrees to pay the one party an amount measured by a different index (such as a floating rate of interest) times a notional amount (typically the same fixed dollar amount). On measurement dates, the obligations of the respective parties will typically be netted against each other, and a net settlement payment will be made. Typically a party cannot assign its position in such a contract without the consent of the counter- party (although such consent is routinely given in practice). This type of contract is a bilateral executory contract. Each party is both debtor and creditor of its counterparty at the same time; each party has both unripened rights and undischarged obligations to perform under the contract. A conventional debt obligation, by contrast, involves completed performance by one party (the lender) and an obligation to pay by the other party (the borrower).

Where both parties to an interest rate swap have continuing rights and obligations with respect to each other, a mere assignment by one party of his position to a third party does not bring into play the basic rationale for finding a realization event in the first place, namely, that the event in question (assignment) is an appropriate time to end the deferral of tax on the previously-untaxed appreciation in value of the property owner's asset. If the nonassigning party continues to have obligations to the assignee before he will receive payments from the assignee under the contract, the nonassigning party has not earned any income or achieved any value which can suitably be taxed when the assignment occurs under the basic common law rationale for finding a "realization event." In the financial markets, such assignments are generally viewed as nonevents by the nonassigning party, so long as they are made within certain broad parameters (i.e. consent is automatically given so long as the assignee is of credit standing equal to or better than that of the assignor).

There is no established rule we can find which justifies taxing a nonassigning consenting party in the assignment of a contract right under a bilateral executory contract. We believe the Service has not previously attempted to develop such a theory in the tax law primarily because income has not been earned on the contract in the all events/economic performance sense. Consider the situation in which a litigant is represented by a journeyman trial lawyer, and during the course of the litigation, the lawyer brings in to substitute for himself the most successful and renowned trial lawyer in practice. The litigant has theoretically received an economic benefit at that point. Yet the litigant would not be taxed on this theoretical benefit until it ripened, that is, until the new lawyer wins the case and the litigant becomes entitled to a benefit.

Similarly, if a landlord leases space to a tenant of A credit standing and, part way through the lease term, the tenant moves out and substitutes for itself as obligor on the lease a tenant of AAA credit quality (or a tenant of B credit quality), the landlord would not have a realization event. The landlord's realization of income occurs as the new tenant pays the rent. In order to be entitled to the rent, however, the landlord must fulfill certain responsibilities to the tenant over the future term (e.g., he cannot deny the tenant quiet enjoyment of the premises, he may be required to supply customary tenant services, etc.)

A notional principal contract resembles these situations, not a one-sided debt obligation. If, for example, Customer agrees to pay Bank 6% and Bank agrees to pay Customer LIBOR on a notional principal amount of $10,000,000, then, on the settlement dates, the two amounts will be netted and the net obligor will pay over the balance. The expected value of each party's obligation may be almost as predictable as the payments on a lease, but that does not justify creating a realization event for either party. As with a lease, those expected amounts have not yet been earned. Consequently, they should not be taxed merely because the party from whom they will be earned has been replaced.

The Revenue Reconciliation Act of 1993 enacted a new statutory rule requiring certain taxpayers to mark securities positions to current market values (section 475). This rule essentially taxes unrealized gains. This new realization rule applies to those taxpayers who are dealers in securities and does not apply generally to all taxpayers. The treatment of assignments of notional principal contracts as realization events would effectively tax unrealized gains in areas not addressed by Congress. Where section 475 does not apply, we believe the Service lacks authority to take such a policy position for notional principal contracts under the rubric of "realization" principles.

2. ASSUMPTIONS OF LIABILITIES

A change in obligor has generally been considered a material change by the Service and courts. Prop. Reg. section1.1001-3(e)(3) provides that generally the substitution of an obligor is a significant modification, but not in the case of a change in obligor resulting from a transaction to which section 381(a) applies if the new obligor is the acquiring corporation within the meaning of that section or in the case of a change in the obligor of a nonrecourse debt.

The rule which provides that a change in obligor resulting from a transaction to which section 381(a) applies is not a significant modification is helpful and reflects the overall tax treatment accorded tax-free reorganizations. However, the relief rule does not cover a significant number of other transactions which warrant similar treatment. For example, if assets and liabilities are transferred to a partnership or corporation in a transaction treated as tax free pursuant to section 721 or section 351, the transfer of liabilities results in a change of obligor and is treated as a realization event. Furthermore, if a parent's obligation is assumed by a subsidiary or vice versa, these transactions will result in a change in obligor which will be treated as a realization event under the proposed regulation.

Although these types of assumptions would be tax free to the debtor (e.g., treated as a contribution to capital or intercompany dividend, depending on which entity assumed the debt), the fact that a realization event has occurred can trigger other adverse tax consequences. A realization event may cause loss of "grandfather" status, debt-equity testing, and triggering of debt discharge income if debt is publicly traded or constitutes a potentially abusive transaction. The effect of triggering COD income hinders those companies which do not have sufficient NOLs to consume the income and benefits those companies with expiring NOLs or NOLs which will become subject to limitation on usage. These tax effects raise the general issue we discussed at the outset of this Report: whether the Service can, without legislative clarification, prevent regulations ostensibly limited to section 1001 from applying automatically wherever the existence of a realization event must be determined.

In the context of assumptions of debt between related corporations (particularly in the context of affiliated groups) or transfers to partnerships and trusts, the assumption of debt should not create realization events as a matter of policy. The same principle and policy in sections 368, 721 and 351 should also apply to debt transferred pursuant to transactions governed by these sections.

G. FILING A BANKRUPTCY PETITION

There is little authority on the question of whether, on filing for bankruptcy, the debtor's obligations are deemed to be exchanged for new obligations for tax purposes. Section 502(b)(2) of the Bankruptcy Code provides in essence that interest stops accruing at the date of filing of the petition. In addition, claims are prioritized and are subject to the Bankruptcy Court's determination. The policy perspective of rejuvenating the debtor and the administrative aspects of determining the amount of debt canceled imply that an exchange should not occur until either a binding agreement is reached by the debtor and creditor or upon the debtor's discharge by the Bankruptcy Court. /136/

The Proposed Regulation does not directly address this issue. We recommend that the proper policy should be that the filing of a petition in formal bankruptcy does not itself constitute a realization event for the debtor and the creditor.

H. CHANGE IN CURRENCY OF PAYMENT

In American Air Filter Co. v. Commissioner, /137/ the Tax Court held that where a loan agreement provided that a liability payable in a foreign currency could be converted to one payable in another currency, the conversion from a foreign currency liability to a U.S. dollar liability was a realization event. Consequently, there is judicial authority for the rule in the Proposed Regulation that a change in currency for payment of debt results in a material modification. Prop. Reg. section 1.1001-3(e)(4)(ii)(D) specifically provides that a modification is significant if it changes the currency in which payment under the debt instrument is made.

We recommend, however, that this rule should be amended to specify that when a currency adjustment mechanism is provided for in the debt instrument (which maintains the value of debt relative to the original currency), such a provision will prevent the change in currency from being a modification. /138/

I. CHANGES IN INTEREST RATE

Prop. Reg. section 1.1001-3(e)(1) provides that a change in the

SAFE HARBOR. A safe harbor for minimal changes in the rate of interest on a debt instrument is a welcome idea. We believe, however, that a bright-line test -- whether 25 basis points or some other threshold -- will necessarily produce inconsistent results when applied across a wide spectrum of debt instruments. Twenty-five basis points represents a smaller alteration in the overall return on a troubled country loan or a highly-leveraged transaction loan or a good quality real estate loan than it does on a good quality general obligation bond. Similarly, 25 basis points represents a smaller alteration in the overall return on a short-term U.S. Treasury obligation than it does on a 30-year U.S. Treasury obligation. Thus, using this single benchmark uniformly to classify some changes in interest rates as minimal will protect some cases but fail properly to characterize others as de minimis changes. We recommend that this safe harbor be expressed alternatively, as a percentage change in the overall return on the instrument (e.g., the greater of 25 basis points or 5 percent of the total return).

SEPARATE OBLIGATIONS. Where an debtor has two debt instruments outstanding to the same creditor, are the debt instruments viewed separately for purposes of applying the above safe harbor, or can the two debt instruments be merged when analyzing a reduction in the interest rate of one of the debt instruments? The Proposed Regulation should clarify that this provision is applied separately to each debt instrument.

J. DEFEASANCE TRANSACTIONS

One class of transactions involving changes of security with respect to debt instruments are "defeasance" transactions. In such transactions characterized by their accounting (but not legal) treatment as early extinguishments of debt, /139/ the issuer of debt instruments (assumed for purposes of this discussion to be in the form of bonds) typically deposits into an escrow or grantor trust account a pool of Treasury obligations, the anticipated receipts of principal and interest on which will be sufficient to meet the payment obligations of the issuer on all or a portion of the bonds. In such a transaction neither legal nor beneficial ownership of the Treasury obligations is transferred to the bondholders; nevertheless, the transaction is treated for accounting purposes as an extinguishment of debt in which, for reporting purposes, the issuer removes both the debt and the Treasury obligations from its balance sheet. /140/ The funds to acquire the Treasury obligations used in a defeasance transaction may be generated through a borrowing (including in the tax-exempt finance area "advance refundings"); an offering of equity securities; or application of accumulated monies of the issuer. /141/ During 1993 billions of dollars of municipal obligations were defeased through advance refunding defeasance transactions.

There are two common types of "defeasance." The first is an actual or "true" defeasance, in which all liens on assets or revenues of the issuer securing the repayment of the debt, and/or various covenants (other than payment covenants) of the issuer, are released (or "defeased"). The second format is an "in-substance" defeasance, in which the issuer establishes the pool of Treasuries which it dedicates as a segregated source of payment (enabling it to take debt extinguishment accounting treatment), but which it does not pledge, or grant any security interest in, to the bondholder, and in which no covenants or security interests are released.

In a true defeasance, generally, all covenants and security interests created under the bond indenture or other agreement pursuant to which the debt instrument is issued are released. However, the debt instrument itself is not retired or satisfied. Generally the issuer retains the beneficial economic interest in the Treasuries (which it may enjoy if, for example, an inverted yield curve or other market opportunity develops during which the issuer can liquidate and substitute other Treasury obligations at a profit). In most cases, the issuer remains primarily liable under the debt instrument to make additional contributions of Treasury obligations or otherwise to supplement the available cash flow if the pool of securities proves insufficient to provide for the payment obligations under the debt instrument. /142/

A true defeasance transaction typically is undertaken pursuant to optional defeasance provisions in the original bond indenture or bond resolution. As such it would comprise the unilateral exercise of an option on the part of the issuer and thus, under the Proposed Regulation, would not be a significant modification. Prop. Reg. section 1.1001-3(c)(2)(i). That this is the correct result follows from the observation that, in most cases, the right of and terms under which the issuer may effect an optional defeasance are important "deal points" in the course of the negotiations in respect of the original issuance of the debt, in which the issuer strives for maximum flexibility in its future ability to rid itself of burdensome covenants or liens on its property or revenues. Thus, although a true defeasance results in a substitution of collateral (i.e., the Treasury obligations) for the liens and/or covenants originally securing the debt instrument, such a substitution generally should not result in a deemed exchange of instruments.

An in-substance defeasance also is a unilateral transaction in which the issuer establishes the pool of Treasury obligations which it dedicates as a segregated source of payment (enabling it to take debt extinguishment accounting treatment), but which it does not pledge to, or grant any security interest in, to the bondholder. Unlike the case of a true defeasance, an in-substance defeasance generally does not result in the bondholder enjoying any lien or other interest in the segregated securities, or the issuer being freed of any covenants or burdens on its property. Such a transaction should not raise any issue under section 1001 since it does not involve any modification of the relationship between issuer and creditor.

Because of the importance of defeasance transactions, in both private and municipal finance, we recommend that, if finalized, the regulation include examples demonstrating that such transactions (when undertaken either as true defeasance in accordance with the terms of the indenture or other financing agreement, or as in- substance defeasance) do not constitute significant modifications of the debt instruments.

K. CONVERSION FROM RECOURSE TO NONRECOURSE AND VICE VERSA

We find little authority in the statute or in case law concerning

L. WASH SALE RULES

Under the Proposed Regulation, could a debt modification involving a "security" which is treated as a deemed exchange of one security for another under section 1001 still be subject to disallowance of a realized loss under section 1091, on grounds that the obligations were "substantially identical" for purposes of section 1091? /143/ We recommend that the Service should amend the regulations under section 1091 to clarify that loss realized from a deemed exchange of securities under section 1001 will not be disallowed under the wash sale rule.

Technically, the fact that an exchange is a realization event may not mean that a loss cannot be subjected to nonrecognition under the wash sale rule. /144/ However, many of the same kinds of term- based differences which indicate whether securities are substantially identical under a nonrecognition provision of the statute have been applied in the Proposed Regulation to determine whether a debt modification is a "realization event."

This great difficulty in reconciling the realization tests for debt modifications with the loss disallowance rule of section 1091 would be eliminated under ABA Legislative Recommendation No. 1993-2, since that proposal would provide nonrecognition treatment for holders of debt instruments in the context of debt workout transactions. See Section V, B, of this Report.

M. CHANGES IN FORMULA FOR VARIABLE RATE INSTRUMENTS

Prop. Reg. section 1.1001-3(e)(iii) provides that in the case of a variable rate instrument, a change in the index, formula, or other mechanism that is used to determine the interest rate for each period is a significant modification if the change can reasonably be expected to affect the annual yield on the instrument by more than 1/4 of one percent (25 basis points). It is not clear how this can be determined in advance.

VII. SPECIAL TRANSACTIONS

If the Service decides to issue realization event rules for both debtors and creditors under section 1001, we recommend that the Service make clear that any regulations it writes defining when a debt modification is a "realization event" (or a "deemed exchange") for the holder of a claim against the obligor --

(1) do not apply to determine tax consequences other than realization of gain or loss by the holder, and

(2) are superseded by a contrary statutory policy that may apply under individual Code provisions. /145/

Several special types of transactions illustrate this suggestion. Examples include REMICs; the "tacking" rule under section 382(l)(5) (relating to the effect of debt workouts on a corporate debtor's net operating loss carryovers) /146/; fixed investment trusts; restructurings by banks and investors of loans purchased at a discount; and tax-exempt bonds. These special situations are discussed more specifically below.

A. FIXED INVESTMENT TRUSTS

Without clarification, the deemed receipt of modified debt for old debt triggered as a result of the Proposed Regulation might cause a fixed investment trust no longer to qualify as a trust for federal income tax purposes.

Reg. section 301.7701-4(c) ("Fixed Investment Trust Regulations") addresses the federal income tax classification of entities that are commonly referred to as "investment trusts." Trusts issuing mortgage pass-through certificates, certain auto-receivables trusts, and both privately-placed investment trusts and publicly- offered unit investment trusts are often structured to qualify as trusts under the Fixed Investment Trust Regulations (and therefore qualify as grantor trusts) in order to avoid entity-level taxation.

A central tax requirement is that the trustee must not have "power to vary the trust's investments." If the trustee held a power to dispose of trust assets and reinvest the proceeds in new assets to be retained by the trust, the power would be considered an impermissible "power to vary" and would prevent the trust from qualifying as a grantor trust. A power to vary the investments of the trust is one that enables the trustee to take advantage of market variations to improve the investment for the benefit of all beneficiaries. However, a trustee also has a fiduciary duty to protect and conserve the trust property. In this latter vein, the Service has permitted a trustee to modify a loan consistent with that fiduciary duty. See Rev. Rul. 90-63, 1990-2 C.B. 270 (trustee permitted to consent to changes in credit support of an obligation if trustee reasonably believes the change is advisable to maintain value of trust's assets); Rev. Rul. 73-460, 1973-2 C.B. 424 (trustee permitted to accept loan modifications in event of default or probable default in foreseeable future).

We believe that a bona fide debt restructuring should not be equated with the kind of sale and reinvestment that has been thought to disqualify the trust from grantor trust status. We recommend that Reg. section 301.7701-4(c) be clarified to indicate that if the terms of a loan receivable held by a fixed investment trust are modified consistent with the trustee's duty to protect and conserve trust assets, the modification will not cause the trust to be classified as an association.

B. REMICs

At the end of 1992, the Service issued a series of final regulations relating to mortgage investment pools known as Real Estate Mortgage Investment Conduits ("REMIC"). The REMIC regulations under sections 860A-860G generally incorporate by reference the rules for debt modifications under section 1001. /147/ Under the REMIC provisions, however, the tax effect at issue is not to determine whether the REMIC realizes gain or loss from a restructuring of problem loans. It is to determine whether the REMIC has received new mortgages in exchange for the renegotiated mortgages, which may mean that the REMIC may have engaged in a prohibited transaction or may even have lost its REMIC status entirely by owning new loans which are not "qualified mortgages." /148/ The REMIC regulation thus illustrates the potentially serious spillover effect of the income or loss rules to determine other tax consequences.

We do not understand that Congress' policies in the REMIC area warrant applying to REMICs general rules the Service might adopt under section 1001 for determining whether a creditor realizes gain or loss when he agrees to amend a loan agreement. The common law rationale for gain or loss realization is not appropriate to determine whether the REMIC should suffer a 100 percent penalty tax on dispositions of mortgages from the pool, or should possibly lose its basic REMIC status entirely. We do not find any Congressional policies that suggest Congress may have intended such harsh tax results when the REMIC agrees to restructure problem loans. /149/

The REMIC regulations provide an appropriate measure of relief. Under a series of "exceptions" to the treatment of significant modifications as deemed exchanges of old mortgages for new mortgages, certain changes in terms are not considered significant modifications for REMIC purposes: (1) changes in the terms of the mortgage occasioned by default or a reasonably foreseeable default; (2) assumption of the obligation; (3) waiver of a due-on-sale clause or a due on encumbrance clause; and (4) conversion of an interest rate by a mortgagor pursuant to the terms of a convertible mortgage. If one of these exceptions applies, the apparent intent is that the restructuring will not threaten the REMIC with a prohibited transaction or with loss of the mortgage's status as a qualified mortgage. /150/

Part of the policy for these exceptions in the REMIC regulations stems from the statute. A qualified replacement mortgage includes a new mortgage received for a "defective" obligation, which Congress considered to be a qualified mortgage loan on which the obligor has defaulted or threatened to default. /151/ The REMIC regulations pick up this definition and add to it. /152/ Similarly, the prohibited transaction rules expressly allow a REMIC to dispose of its creditor position in a mortgage "incident to the foreclosure, default, or imminent default of the mortgage" or to substitute a qualified replacement mortgage for a defective loan. /153/ It is clear that Congress intended a REMIC to have the flexibility, as indicated earlier, to "accommodate ... legitimate business concerns" by working out problem loans or culling out and completely replacing problem loans with sounder loans.

In that light, we believe that general rules for debt modifications under section 1001 should not have relevance in connection with REMIC policies. The general rules for realizing gain or loss from debt modifications should not apply potentially to disqualify a REMIC entirely from passthrough status, or to produce other harsh effects from bona fide efforts by the pool to improve the performance of its mortgage assets. The fact that the REMIC regulations soften the otherwise harsh impact of "generic" rules that might be issued under section 1001 cast doubt on the soundness of incorporating section 1001 rules in the first place. The potential existence of general realization rules for debt modifications under section 1001 also create ambiguities under the REMIC regulations. /154/

C. PURCHASE OR WRITEOFF OF TROUBLED LOANS

Another group of special situations for holders of debt instruments arises where the creditor's tax basis in his claim is less than the unpaid balance of the debt. This situation may arise in a variety of ways. The creditor may be an investor who purchased a nonperforming loan at a discount from face, or a bank or thrift institution which originated the loan but has already charged the loan off, in whole or in part, before a workout agreement occurs. The creditor may be a shareholder-creditor of a Subchapter S corporation whose basis in his claim has been reduced by operation of the regular Subchapter S rules reducing the shareholder's basis in his stock and debt of the corporation to reflect operating losses at the corporate level. If the creditor agrees to reschedule his claim because of the debtor's financial difficulty, cash flow problems or other nontax reasons, a realization event on account of the workout will trigger gain or loss and possibly other tax consequences for the creditor.

Depending on the circumstances, these kinds of situations raise important policy issues that cannot be resolved satisfactorily through all-purpose, generic rules under section 1001. Some of the special considerations which are involved are discussed briefly below.

PURCHASE OF LOANS OF GOVERNMENT-MANAGED BANKS AND THRIFTS. Without special rules, investors who buy a portfolio of troubled or nonperforming loans from the Resolution Trust Corporation or from the Federal Deposit Insurance Corporation acting as conservators or receivers for an insolvent thrift or bank, knowing that the loans may or must be renegotiated, may find themselves in receipt of immediate income from the workout, even though Congress' policy is to move such loans back into the private sector. An immediate tax on a constructive taxable gain may discourage that process. /155/ Where investors buy troubled loans from RTC or FDIC, an important question of Congressional policy under the Financial Institutions Reform Recovery and Enforcement Act of 1989 is whether Congress, had it addressed the issue, would have wanted investor-buyers to face potential tax liabilities from the act of trying to make purchased loans more creditworthy. /156/

An even more serious question is whether Congress would have wanted a REIT that buys troubled loans from the government, or even from an original lender, to risk losing its basic passthrough status by agreeing to modify terms to help the borrower maintain the loan. /157/

The potential application of section 1271(a)(1) to the investors, mandating "exchange" treatment if modified debt is considered received in retirement of the original claim, only makes these policy questions more difficult. It may be possible to find a basic policy in the REIT provisions that might preempt section 1271(a)(1) and justify not treating a REIT that restructures a troubled loan as "selling or disposing of" the loans for purposes of section 856(c)(4). /158/ The Revenue Reconciliation Act of 1993 also contains an expression of Congressional policy in this general area through provisions that relax some of the restrictions under the unrelated business income tax so that tax-exempt pension funds and similar investors can buy RTC or FDIC-managed real estate free of UBIT tax. /159/

This area -- investor purchases of FDIC or RTC-managed loans and real estate -- illustrates clearly why there may be no need for "general rules" under section 1001 for realization issues and why we believe the better approach is to determine whether or when a debt modification is a realization event in light of the particular policies applying to the specific transaction at issue. The strong Congressional policy to encourage the transfer of government- controlled assets back to the private sector is one clear source of policy guidance for the Service in dealing with realization issues in this area.

ORIGINAL ISSUE DISCOUNT AND MARKET DISCOUNT. If an investor buys a unit of debt and warrants and allocates part of the purchase price to the warrants, so that the debt is considered to have original issue discount, a later negotiation to restructure the debt may have the effect of

(1) accelerating original issue discount income into the

(2) converting market discount, where the investor

We believe that whether either of these tax consequences should

SPECIAL ISSUES INVOLVING COMMERCIAL BANKS. Most loans held by banks and which are restructured and "significantly modified" within the meaning of the Proposed Regulation will have earlier been partially or completely deducted as bad debts pursuant to section 166. Small banks and thrift institutions claim bad debt expense using a reserve method (under sections 585 and 593) in lieu of any deduction under section 166. Other comments on the Proposed Regulation have argued that requiring a bank to "recapture," in effect, a prior bad debt deduction when the same loan is revised with the borrower (through treating the modification as a deemed exchange of old debt for new debt taken into account at the new debt's issue price) does not reflect the circumstances in which a "recapture" should be required. Other comments have also proposed an alternative solution for this problem by proposing that the Service either (a) allow the bank a bad debt deduction with respect to the deemed "new" loan, which economically is no better than the unmodified loan, or (b) allow the bank to compute its amount realized on the modified loan by reference to the "new" loan's fair market value rather than its issue price under the original issue discount rules.

Our view is that whether the bank should be considered to realize gain or loss in the first instance from renegotiating a loan for which the bank previously claimed a bad debt deduction should be determined by the tax policies that apply to recoveries of previous deductions. We believe there is no need to determine whether the loan modification in these circumstances is generically a realization event.

D. TAX-EXEMPT BONDS

The following comments discuss the application of the Proposed

(1) Workouts.

(2) Sales of bond-financed facilities.

(3) "Tender bonds."

In each context the broad issue is whether the activity in question

Both the Federal government and private practitioners in municipal finance have customarily analyzed reissuance questions by analogy to precedents under section 1001 (see, e.g., the analysis in Rev. Rul. 87-19 concerning the interest deduction of financial institutions). However, section 1001 is relevant only by analogy and not directly. That fact, we think, supports the creation of special rules for tax-exempt bonds consistent with our broader comments on section 1001 in this Report.

The following comments suggest various amendments to the Proposed Regulation to deal with special problems related to tax- exempt bonds.

OVERVIEW. Generally stated, tax-exempt bonds are debt instruments issued by a state or municipal government to provide funds for public purpose projects. The "tax exemption" is a statutory exclusion of the interest on the bonds from the gross income of the bondholders, under section 103 as limited by sections 141 through 150. Depending on the type of issue, the interest may also be exempt from alternative minimum tax under section 57(a)(5).

Tax-exempt bonds are generally issued either to provide financing for facilities to be owned and used by the issuer or to provide "conduit" financing for facilities to be owned and used by some other entity or person. If the user entity in a conduit financing is a business corporation, the bonds are known generally as industrial development bonds and must finance an "exempt facility" described in section 142 or comply with the $10,000,000 "small issue" limit of section 144(a). If the user entity in a conduit financing is a charitable organization such as a hospital, the bonds must comply with the rules for qualified section 501(c)(3) bonds in section 145. Other Code sections provide limitations on tax-exempt bond financings for home mortgages (section 143) or student loans (section144(b)). Bonds described and regulated in sections 142 through 145, referred to as "private activity bonds," are subject to various additional restrictions under section 146, imposing a state volume ceiling on private activity bonds, and section 147, imposing a requirement of a preliminary public hearing and other general restrictions. All tax- exempt bonds are subject to limits on "arbitrage" investment of bond proceeds under section 148.

1. WORKOUTS

A "workout" of the debt represented by an issue of tax-exempt bonds presents the unique tax problem of determining whether the workout modifications will jeopardize the tax exemption of the bonds. The potential loss in value if the modifications cause the debt to lose its exemption is so great that it can become a predominant consideration in structuring the workout. The predominant effect of the rules in the Proposed Regulation, we think, is that a workout of tax-exempt debt would generally be treated as a reissuance transaction.

Since 1982 Congress has restricted the ability of states and municipalities to use tax-exempt bond financing. Congress did so through the 1982, 1984, and 1986 tax laws. As a general matter, these restrictions took effect for bonds "issued" after a date specified in the legislation. In some cases, the effective date provisions create an exemption for "refundings," defined generally as an issuance of bonds to provide funds for payment of other outstanding bonds. A refunding exemption, if present, would normally apply to the deemed exchange of modified debt for original debt in a workout reissuance. However, some tax law changes have not added specific exemptions for refundings. For example, assume that industrial development bonds ("IDBs") were issued to finance a restaurant prior to the 1982 amendments preventing use of IDB proceeds for restaurants. See section 144(a)(8). Assume that the bond issue requires a workout at the present time. The effective date provision of the 1982 legislation applies to bonds issued after 1982, with no exemption for refundings. Therefore, if the workout is deemed to include a significant modification, the modified obligations will be treated as a new issue that is not tax-exempt.

As another example, assume that bonds for general governmental purposes were issued in 1985 and that the entire issue was sold to a local bank. At that time, banks were not subject to disallowance of interest expense under section 265 unless the bank had outstanding debt that related specifically to tax-exempt bonds. In 1986 Congress amended section 265 so that it now applies to banks on an allocation basis, in the case of bonds acquired after 1986. The effective date provisions of this amendment do not contain an exemption for refundings. Therefore, if the issuer experiences financial difficulties requiring a workout of the bonds with significant modifications, the modified bonds will be subject to the 1986 version of section 265, which may deny the bank a deduction for the portion of its overall interest expense allocable to carrying the bonds. (This example, based on Rev. Rul. 87-19, assumes that the exemption for qualified small issues under section 265(b)(3) is not available.)

Similar problems arise under the 1984 legislation preventing a use of tax-exempt bond financing for acquisitions of land or existing facilities (see section 147(c) and (d)). Bonds that would violate these rules if issued today could not be "significantly modified" under the proposed regulations even though the bonds were tax-exempt when originally issued.

The problems with workouts could be solved by adding a general rule that modifications in a workout of tax-exempt debt are not significant if the workout does not significantly extend the maturity of the debt (i.e., does not extend the maturity by 5 years, or 50 percent if less). This solution would allow "significant" interest rate changes (i.e., more than 25 basis points) provided there was not a significant maturity extension.

This recommendation would recognize the fact that a workout that does not significantly extend the life of the transaction does not confer on the parties a benefit that is sufficiently substantial to justify depriving them of the benefit of tax exemption. The modifications in a workout in this circumstance, therefore, should not be regarded as "significant."

The suggested solution generally resembles a pattern founded in certain existing statutory exemptions for refundings. For example, a tax-exempt industrial development bond issued in 1985 under the $10 million limit to finance the construction of a commercial facility may be refunded despite a provision in the 1986 tax legislation generally preventing new financings for commercial facilities, provided the refunding bonds do not have a later average maturity than the refunded bonds. See section 144(a) (12)(A)(ii).

2. SALE OF BOND-FINANCED FACILITIES

In a typical financing using industrial development bonds ("IDBs"), the governmental issuer issues IDBs to the public and uses the proceeds to make a loan to a business corporation (the "conduit borrower"), secured by a facility constructed with the borrowed funds. If a bond-financed facility is sold, several different provisions of the Proposed Regulation may come into play.

The Proposed Regulation generally treats a change in the obligor on a recourse obligation as a significant modification, and treats a change in collateral on a nonrecourse obligation as a significant modification if a substantial portion of the collateral is released or replaced. Thus, a recourse obligation will not be treated as reissued merely because there is a change in the collateral, provided there is no change in the obligor.

The Proposed Regulation provides that in the case of tax-exempt bonds, the "issuer" or "obligor" is the governmental issuer and not a conduit borrower. Prop. Reg. section 1.1001-3(h). If a bond-financed facility is sold to a purchaser who assumes the loan, this rule was apparently intended to allow the transaction to be analyzed as presenting no significant modification on the ground that there is no change in "obligor," that is, the governmental issuer. (This rule conforms with Rev. Rul. 79-262, which approved a purchase and remarketing of bonds simultaneously with a sale of a bond-financed plant.)

IDBs are normally nonrecourse to the governmental issuer. Therefore, an assumption of the loan by a purchaser of the bond- financed facility will constitute a change in collateral for a nonrecourse obligation (the bond issue), i.e., a significant modification, if the debt of the initial conduit borrower is released. Thus, in most cases, a "reissuance" will occur if a bond- financed facility is sold, apparently contrary to the intended result.

This problem can be easily cured by an amendment providing that a loan securing an issue of governmental obligations would not be treated as collateral for purposes of creating a significant modification. This change would allow facility sales to occur without reissuance treatment.

In addition, the amendment should provide that the bonds may be defeased without reissuance treatment in the context of a sale of a facility without an assumption of the loan obligation by the purchaser.

RELEVANCE OF SECTION 150 REGULATIONS. Reg. section 1.150- 1(d)(2)(v) provides that if a debt is refinanced within 6 months before or after an acquisition of assets financed by the debt, the refinancing will be treated as financing the acquisition rather than as a refunding. Treatment as financing the acquisition of the facilities is adverse because it means the debt will lose the benefit of a refunding exemption from a tax law change, if the change has a refunding exemption. Similarly, treatment as an acquisition can cost the issuer its opportunity to use a refunding exemption from the state volume ceiling on private activity bonds under section 146.

RELEVANCE OF REV. PROC. 93-17. Rev. Proc. 93-17, I.R.B. 1993-10, 41, provides for various remedial actions an issuer may take to preserve the tax exemption of bonds after a "change in use" of facilities financed by the bonds, including certain facility sales. Under Rev. Proc. 93-17, the only facility sales that give rise to a "change in use" are those where the sale is to a nonqualified purchaser (e.g., a business corporation purchasing facilities financed by qualified section 501(c)(3) bonds under section 145, which requires the financed facilities to be owned by a section 501(c)(3) organization). Rev. Proc. 93-17 sets out the mechanisms for insuring that the bonds remain tax-exempt, one of which involves a unilateral in-substance defeasance of all or a portion of the bonds by the issuer and/or the beneficiary of the financing. As discussed above (Section VI, J), a defeasance of an obligation should not result in a modification or "reissuance" of the obligations. Accordingly, an exercise of the defeasance option of Rev. Proc. 93-17 in the context of a "change in use" should not trigger a reissuance, permitting Rev. Proc. 93-17 to assure continued tax exemption of the bonds.

3. TENDER BONDS

"Tender bonds" are, generally, variable rate bonds which the issuer periodically repurchases and remarkets at a new rate of interest reflecting current market rates.

Notice 88-130, 1988-2 C.B. 543, allows tax-exempt tender bonds to undergo rate changes, and rate period changes, without treatment as a reissuance. The preamble to Prop. Reg. section 1.1001-3 says the rules of Notice 88-130 will be preserved in the final regulation. This exception is needed because of the general rule that a modification occurs if a party exercises a right that creates a "counter right." See Prop. Reg. section 1.1001-3(d), Example 8. Without a special rule preserving the non-reissuance treatment of tender bond operations under Notice 88-130, tender bond operations would produce reissuances under the doctrine of the counter right, as illustrated by Example 8.

An exemption for transactions covered by Notice 88-130 will solve most of the problem. Notice 88-130 does not, however, permit amendments to interest rate formulas (except for "corrections"). This prevents the parties from implementing interest rate modifications that could save interest cost (and reduce revenue loss from tax- exempt interest). The problems with tender bonds could be fully solved by making clear that an amendment to the documents for tender bonds will not cause a reissuance if the amendment either (a) meets the standards of Notice 88-130, or (b) does not affect interest rates by more than 25 basis points (thus allowing tender bonds under Notice 88-130 to use the 25 basis point rule).

FOOTNOTES

/1/ Notice of Proposed Rulemaking, 57 Fed. Reg. 57034 (Dec. 2, 1992).

/2/ This regulation provides, in relevant part:

"Except as otherwise provided in subtitle A of the Code, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained."

/3/ On the same day it decided Cottage Savings, the Supreme Court also decided a companion decision, United States v. Centennial Savings Bank FSB, 499 U.S. 573 (1991). The latter decision ("Centennial") involved two issues, one of which was the same loss deduction issue presented in Cottage Savings. Centennial directly exchanged 90 percent participation interests in a pool of its own residential mortgage loans with similar participation interests in loans owned by the Federal National Mortgage Association. The other issue in Centennial was whether the thrift realized income from discharge of indebtedness when time deposit customers forfeited portions of principal as penalties for early withdrawal of certificate accounts.

/4/ The mortgages in each pool had similar financial features (interest rates, terms to maturity, etc.) and were secured by homes located within the same state. The majority, in an opinion by Justice Thurgood Marshall, held the loss deductible under section 1001. Dissents were filed by Justices Blackmun and White.

/5/ Prop. Reg. section 1.1001-3(b) states:

"This section, however, does not apply to exchanges of

/6/ The Explanation asks for comments "with respect to the desirability of providing rules for the modification of debt instruments, as well as comments with respect to what those rules might be."

/7/ After noting the potential application of the "distinct legal entitlements" standard of the Cottage Savings decision to debt modifications, the Explanation states:

"It has been suggested that the parties to a debt

/8/ The Service did not always construe section 354 and its predecessors as applying to debt-for-debt exchanges. At one time, the Service argued that this provision is limited to capital stock; that a bondholder's exchange with the issuing corporation for new bonds having different terms is only a "refinancing" and that the holder's realized gain is therefore not covered by nonrecognition under the predecessor of section 354. The courts rejected this argument in 1941. The Service then accepted restructurings of corporate debt securities as Type E recapitalizations. See Commissioner v. Neustadt's Trust, 131 F.2d 528 (2d Cir. 1942), affg. 43 B.T.A. 848 (1941), nonacq., 1941-1 C.B. 17, nonacq. withdrawn, acq., 1951-1 C.B. 2; Rev. Rul. 77-415, 1977-2 C.B. 311.

/9/ In this Report, we refer to the "common law" principle of realization events, and to the "common law rationale" for realization events, in the traditional sense that the common law is reflected in court decisions decided in the absence of specific legislative provisions or policies. Black's Law Dictionary defines the common law as "a body of law that develops and derives through judicial decisions, as distinguished from legislative enactments." Black's Law Dictionary (6th ed. 1990).

/10/ 499 U.S. at 559. The Supreme Court's discussion of realization is noted further in Section III of this Report. The concept of "realization" has two related but separate aspects. The term realization is sometimes used to refer to a determination as to whether "income" has arisen as distinct from underlying "capital." After income has arisen, the determination of the point when income (or loss) must actually be reported to the tax collector is commonly referred to as defining the realization event. For discussion of this distinction, see the opinion of District Judge Walter S. Smith in First Federal Savings and Loan Association of Temple v. U.S., 694 F.Supp. 230, 240-241 (W.D. Tex. 1988), aff'd, 887 F.2d 593 (5th Cir. 1989). See also Bacon & Adrion, note 16 infra, at 1241-43, summarizing other relevant authorities. This project involves the second, or timing, aspect of realization. Several Code provisions dispense with the event requirement and require reporting based on "unrealized" appreciation or depreciation. See, e.g,, sections 475, 951, 1256.

/11/ See Bittker & Lokken, Federal Taxation of Income, Estates And Gifts, p. 44-4 (2d ed. 1990); Reg. section 1.1002-1(c) (nonrecognition provisions describe specific exchanges of property having particular differences but "such differences are more formal than substantial").

/12/ In the original issue discount area, the rules soften the potential impact of treating a debt workout as an issue of new debt. For debt that is not publicly traded, the issue price of new debt is deemed equal to the stated principal amount if the interest rate on the modified debt is at or above the current Applicable Federal Rate of interest. section 1274(a). Keying the OID rules for privately-held debt largely on the interest rate thus reduces the types of debt modification that will give rise to original issue discount. For other collateral effects of treating a debt modification as a taxable event, see Letter from Arthur J. Liberman (May 20, 1993), 93 TNT 108- 88; Bacon, "S&L Loan Swaps At the Supreme Court: Ripple Effects," 49 Tax Notes 1121 (1990).

/13/ See note 118 infra.

/14/ But see Lipton, "IRS Issues Proposed Regulations on Debt Modifications," 71 Taxes 67, 76-77 (1993).

/15/ See Bittker & Lokken, note 11 supra, section 40.2. The phrase "ambiguous transactions" was used by the Supreme Court in Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247, 251 (1941). Other transactions in the hard-to-classify category include divisions and partitions of property rights, casualties and involuntary conversions, abandonments, payments which extinguish or release contract rights, commodity straddles, collections on debt claims, royalty agreements, and lapses of unexercised options. See also Stoller v. Commissioner, 994 F.2d 855 (D.C. Cir. 1993), aff'g and rev'g 60 T.C.M. 1554 (1990) (straddle losses from cancellation of contracts classified as ordinary because no sale or exchange; section 1234A enacted in 1981).

/16/ See generally Bacon & Adrion, "Taxable Events: The Aftermath of Cottage Savings (Part I), 59 Tax Notes 1227 (1993); Part II, 59 Tax Notes 1385 (1993).

/17/ These include:

o Classifying some changes in debt terms as "significant"

o Giving more favorable treatment to "unilateral" waivers or

o Distinguishing between "temporary" and non-temporary

o Defining "benefits" received from a settlement.

o Differentiating between a change in obligor on

o Treating "material" deferrals of interim payments under

o Treating changes occurring pursuant to the original terms of

o Differentiating between "fungible" and non-fungible

o Treating credit enhancements on nonrecourse debt as a

o Deciding which "facts and circumstances" make a

o Determining when adding a co-obligor or a guarantor is

o Determining when a change in terms is "designed to avoid"

/18/ The Explanation says:

"Even if a modification results in a deemed exchange under the

/19/ See note 106 infra. The Service has also deferred to individual statutory policies in some other areas. See, e.g., Reg. section 1.382-9(d)(5)(iv), allowing tacking of holding period of unmodified debt to modified debt for purposes of 18-month creditor holding period rule under section 381(l)(5)(note 105 supra); and Reg. section 1.860G-2(b)(3) (special rules for mortgage modifications under REMIC rules), discussed in Section VII, B, of this Report.

/20/ Letter from Gordon D. Henderson (Mar. 31, 1993), 93 TNT 80- 90.

/21/ The most frequently cited example arises under section 108(e)(11). By making relatively minor changes in an outstanding debt obligation, a debtor can arguably create a constructive "issuance" of new debt for existing debt and, by operation of the original issue discount rules, effectively create cancellation of indebtedness income to absorb expiring net operating loss carryovers and, through the new debt instrument, create future OID deductions.

Some insolvent debtors might also consider converting some liabilities from nonrecourse to recourse if the collateral's value has fallen below the principal amount of the debt, since the resulting ordinary income under section 108 can be excluded if the debtor is insolvent. See Prop. Reg. section 1.1001-3(e)(4)(iv).

/22/ The case law developed in lower courts over many years dealing with municipal bond refundings and other debt modifications between lenders and borrowers has also not produced any clearly- rationalized general rules. The Explanation acknowledges that a state of "uncertainty exists ... with respect to whether particular types of modifications result in deemed exchanges of debt instruments."

/23/ In many respects the debate over the scope and meaning of Cottage Savings, and questions about the potential invalidity of regulations departing from the decision, parallel the ongoing debate over the U.S. Supreme Court's decision in Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988). That decision dealt with "common law" tests for characterizing gains and losses as capital or ordinary in nature and the application of those tests to hedging transactions. Some commentators have suggested that recent proposed regulations dealing with this question under Code section 1221, despite their generosity in many respects, may still be open to challenge as inconsistent with Arkansas Best. See Bureau of National Affairs, Inc., "Ways and Means members exploring legislative fix to 'Arkansas Best," Daily Tax Rept. No. 63, Apr. 4, 1994, p. G2; Scherer & Magee, "Marching Toward Clarification: The New Hedging Regulations," 93 TNT 256-28 (1993) (comments on Temp. Reg. section 1.1221-2T and Prop. Reg. section 1.1221-2(c) (Oct. 18, 1993)).

/24/ Section 1001 is entitled, "Determination Of Amount Of and Recognition of Gain or Loss." Subsection (a) reads as follows:

"(a) Computation of Gain or Loss. -- The gain from the sale

Subsection (b) defines the phrase "amount realized from the sale or

/25/ In its Supreme Court brief on behalf of the Commissioner in Cottage Savings, the Department of Justice argued that the reference to amount realized in section 1001(b) implies that the Commissioner has authority to define realization events by regulation. Brief for the Respondent, Cottage Savings Association v. Commissioner, No. 89- 1965 (U.S. Supreme Court), pp. 16-19.

/26/ Section 1001(a) refers to the gain or loss from the sale or other disposition of property as the difference between basis and the amount realized "therefrom." This language implies that a sale or other disposition of property has already been found to have occurred and section 1001(a) deals only with the amount of gain or loss "therefrom." Subsection (b) in fact specifically defines the phrase "amount realized" by reference to amounts "received." That language further suggests that the threshold determination that gain or loss has been realized has been made elsewhere. For the Supreme Court's discussion of section 1001(a) and the realization principle, see notes 45-47 infra.

/27/ See Bacon & Adrion, note 16 supra, at 1243-45. The argument is that the legislative history of section 1001(a) and (b) indicates that this provision was intended to be computational only. Statutory rules defining when an exchange of property creates a realization event were contained in the predecessors of former section 1002. The Revenue Act of 1918 contained an explicit realization rule which treated an exchanging party as receiving money in the amount of the received property's fair market value. In 1921, this explicit realization rule was converted to a general nonrecognition rule that gain or loss from an exchange of property is recognized only if the property received had a "readily realizable market value." In 1924 Congress broadened the general nonrecognition rule for exchanges of property. This rule, section 203 of the 1924 Revenue Act, continued as a separate Code provision (section 1002 of the 1954 Code) until 1976 when it became section 1001(c) as part of a simplification title in the Tax Reform Act of 1976.

In 1924 Congress also separately created the predecessor of current section 1001(a) -- section 202 of the Revenue Act of 1924 -- apparently only in order to codify certain computation rules previously contained only in regulations at the time. See Reg. 45, art. 1564, 1565; Bacon & Adrion, id. at 1248.

/28/ See Reg. section 1.165-1(b). The Sixth Circuit in Cottage Savings took this position and would have tested the taxpayer's loss for deductibility under section 165. See 890 F.2d 848 (6th Cir. 1989). See also PLR 9403010 (Oct. 20, 1993) (applying "identifiable event" test to conversion of foreign corporation to foreign partnership). For the Supreme Court's discussion of section 165 in connection with Cottage Savings' transaction, see note 47 infra.

/29/ Surrey, Warren, McDaniel & Ault, Federal Income Taxation: Cases and Materials 818-819 (1972 ed.) See also Reg. section 1.61-6: "The specific rules for computing the amount of gain or loss are contained in section 1001 and the regulations thereunder."

/30/ See Bradshaw v. United States, 683 F.2d 365 (Ct. Cl. 1982) (rejecting Commissioner's argument that Subchapter S corporation's receipt of payments on debtor's note would have constituted an exchange under the predecessor of section 1271(a)(1) and, as an exchange, the payments were disqualifying passive investment income under former section 1372(e)(5)); attempt to apply exchange treatment under one provision to a different Code provision is "an improper application of the statute"). See also note 102 infra.

/31/ See note 42 infra.

/32/ See note 9 supra.

/33/ See text accompanying notes 28-29 supra.

/34/ See First Federal of Temple, note 10 supra, at 239-241.

/35/ There are exceptions in the tax law which require income or loss to be reported even the absence of a sale or other disposition of property. See note 10 supra.

/36/ Bittker & Lokken, note 11 supra, at p. 5-10 (any definite event); Surrey, "The Supreme Court and the Federal Income Tax: Some Implications of the Recent Decisions," 35 Ill. L. Rev. 779, 784 (1941). See Citron v. Commissioner, 97 T.C. 200 (1991) (test for whether partner abandons partnership interest, and thus qualifies for ordinary loss rather than capital loss from sale or exchange of his interest, is whether partner received any consideration, even de minimis, for his interest). Rev. Rul. 93-80, I.R.B. 1993-38, 5, accepts this standard. See also PLR 9402008 (Sept. 30, 1993).

/37/ See page 48 of this Report infra.

/38/ See Surrey, "The Supreme Court and the Federal Income Tax: Some Implications of the Recent Decisions," 35 Ill. L. Rev. 779, 784 (1941).

/39/ See section 1398(f): transfer of an asset (other than by sale or exchange) from an individual debtor and his estate in bankruptcy, or vice versa, "shall not be treated as a disposition for purposes of any provision of this title assigning tax consequences to a disposition, and the debtor [or estate] shall be treated as the debtor [or estate] would be treated with respect to such asset."

For more conventional provisions defining when a sale or exchange is deemed to occur, see section 165(g) (worthless securities); section 582(c) (sales or exchanges of debt held by financial institutions); section 631(a) (timber cutting treated as sale or exchange): section 1234A (capital asset treatment for termination of certain futures and currency contracts); section 1253 (transfers of franchises, trademarks or trade names with significant retained rights not treated as sale or exchange of capital asset).

/40/ See, e.g., Helvering v. Bruun, 309 U.S. 461 (1940) (lessor realized income when lessee defaulted and lessor received back his land with a building constructed by the tenant); United States v. Davis, 370 U.S. 65 (1962) (exchange of marital rights in divorce settlement). Both transactions involved in these court decisions were later covered by specific statutory provisions: section 109 (lessor of real property does not realize income at termination of lease on receipt of improvements made by lessee); and section 1041 (no gain or loss recognized by transferor on transfer of property to spouse, or to former spouse incident to divorce).

The Supreme Court's opinion in Bruun summarizes numerous lower court decisions which had rendered different decisions on the question of when a lessor realizes income from lessee improvements. The history of the Bruun issue includes a lower court holding that a Service regulation on the subject was invalid. This lower court history is summarized at 309 U.S. at 465-466. For more on the tax policy aspects of Bruun, see note 108 infra.

/41/ Henderson & Goldring, Failed and Failing Businesses section 404 (1993 ed.) (CCH).

/42/ "As this Court has recognized," Justice Marshall wrote, "the concept of realization is 'founded on administrative convenience.'" 499 U.S. at 559. Quoting Professor Roswell Magill's leading tax text, Taxable Income (1945 ed.), Justice Marshall pointed out that in lieu of valuing assets annually, "'a change in the form or extent of an investment is easily detected by a taxpayer or an administrative officer.'" Id. Justice Marshall's opinion says that the change in obligors and collateral on the mortgage interests exchanged in Cottage Savings fell within this rationale because those changes in legal entitlements

"put both Cottage Savings and the Commissioner in a position to

Id. at 567.

/43/ Bittker & Eustice read Cottage Savings as applying broadly to debt modifications and as "reaffirming" the generally low trigger on gain or loss realization from property transactions:

"The Supreme Court's decision in Cottage Savings Association

Bittker & Eustice, Federal Income Taxation of Corporations and

/44/ The Seventh Circuit has defined dictum as "a statement in a judicial opinion that could have been deleted without seriously impairing the analytical foundations of the holding * * *." Sarnoff v. American Home Products Corp., 798 F.2d 1075, 1084 (7th Cir. 1986). It is hard not to read the two steps used by Justice Marshall -- defining a general standard and then applying that general standard to the transaction before the Court -- as part of the decision's "analytical foundation." Black's Law Dictionary defines dicta as "opinions of a judge which do not embody the resolution or determination of the specific case before the court." Black's Law Dictionary 454 (6th ed. 1990).

/45/ The opinion contains such statements as: "The realization requirement is implicit in section 1001(a) of the Code * * * " (499 U.S. at 559) and "We must therefore determine whether the realization principle in section 1001(a) incorporates a 'material difference' requirement" (499 U.S. at 560).

/46/ The legislative history of section 1001 and its predecessors is discussed at note 27 supra.

/47/ Although Justice Marshall begins his opinion by appearing to focus on defining the statutory term "disposition" in section 1001(a), the Court's statement of its ultimate holding is framed in terms of the definition of a "realization event." 499 U.S. at 566. The opinion also states that since 1934 the tax regulations have construed the statutory term "disposition" to include a "material difference" requirement. 499 U.S. at 561. However, Reg. section 1.1001-1(a) and its predecessors do not profess to interpret any language of section 1001(a). See note 2 supra. The substantive definition of a realization event was historically dealt with in the predecessors of former section 1002 and in section 61(a)(3) rather than in section 1001(a); see note 27 supra. It is unfortunate, we believe, that the Court focused on section 1001(a) in deciding Cottage Savings. That fact may reflect more the way the Government emphasized section 1001 to the Court. The Court seemed puzzled that the Government mentioned section 165 only in a footnote in its brief. 499 U.S. at 567-568. The Government declined to press the reliance on section 165 by the Sixth Circuit in holding for the Commissioner in its consideration of Cottage Savings' transaction. See note 28 supra.

/48/ Justice Marshall's opinion says:

"Taken together, Phellis, Marr, and Weiss stand for the

This passage suggests that the Court was using "materiality" to mean

See Prescott, note 43 supra (materiality "apparently plays no role" in applying the distinct legal entitlements test); Bacon & Adrion, note 16 supra, at 1238-1246, arguing that the notion of material difference relates to defining whether income or loss has come into existence at all rather than to the tests for determining when income or loss must be reported to the tax collector. See generally note 10 supra.

/49/ Some scholars read footnote 7 in the Court's opinion as suggesting that the Court, even after Cottage Savings, would defer to Treasury regulations prescribing standards different from the "distinct legal entitlements" test. This thought stems from Justice Marshall's suggestion that if the Treasury had issued a regulation before the loan swap litigation applying the material difference language in section 1.1001-1(a) to S&L loan swaps, the Supreme Court might have deferred to such a regulation. While Justice Marshall's footnote is not easy to explain, it is difficult to believe that, going forward, the Court, having enunciated its own definition of what constitutes material difference, and focusing that test on easy detection, would allow its test to be modified by a different administrative regulation.

/50/ Bittker & Eustice, note 43 supra, say:

"[D]eemed exchanges by security holders can cause OID and COD

/51/ The Proposed Regulation properly applies to amendments of the terms of existing debt instruments and to actual exchanges of a new instrument for an existing instrument. Prop. Reg. section 1.1001- 3(b).

/52/ See Amicus Curiae Brief submitted individually by Frederic W. Hickman, K. Martin Worthy, and Bradford L. Ferguson in Newark Morning Ledger Co. v. United States, 113 S.Ct. 1670 (1993). Because the Internal Revenue Code "is the lengthiest, most complex, and most internally interrelated statute on the books today," the writers say, and a tax case before the Supreme Court is often "one thread in an extensive web,"

"there is in the tax area a larger than usual danger that a

/53/ See Evans, "The Realization Doctrine After Cottage Savings," 70 Taxes 897, 904 (1992): "[A]lthough the language may be dicta, it is Supreme Court dicta, and in tax decisions such dicta frequently plays a major role in the interpretation of the law by lower courts." See also Bacon & Adrion, note 16 supra, at 1249-50, and ABA Section of Taxation, "Proposal For a Procedure For Developing Better Responses to Problems Created by Complex Supreme Court Tax Opinions" (individual comments of members of Committee on Special Projects) (Dec. 10, 1993).

/54/ Even those who do not give Cottage Savings an expansive reading have expressed concern that many of the rules in the Proposed Regulation depart from the body of rulings and case law pre-dating Cottage Savings below the Supreme Court level and dealing with tax effects of changes in terms between a debtor and creditor. See Henderson letter, note 20 supra.

/55/ Thus, for example, the Proposed Regulation says that substituting collateral is generally significant under a nonrecourse note but not under a recourse note. Prop. Reg. section 1.1001- 3(e)(3)(iv). If a loan is part recourse and part nonrecourse, is the loan fragmented under this rule if new collateral is substituted for the existing collateral?

/56/ It is not completely clear whether "unilateral" bars any negotiation between the debtor and creditor or merely bars giving some benefit in return to the waiving party. Apparently, if the parties negotiate at all over the exercise or waiver, the change may not be considered unilateral.

/57/ This concept of deferring to original terms has a long history for the Service. See Reg. 45, Art. 1563 (1919) (exercise of conversion right in bond not a realization event); Rev. Rul. 57-535, 1957-2 C.B. 515.

/58/ Several commentators on the Proposed Regulation have suggested that under Cottage Savings even a change occurring pursuant to the original terms of a debt instrument changes the parties' legal rights regardless of how the change was caused. Evans, "The Realization Doctrine After Cottage Savings," 70 Taxes 897, 906 (1992); Willens, "Contingent Interest Rules and the Potential Role of Section 354(a)(2)(B)," 9 J. Tax. of Inv. 323, 324 (1992); Prescott, note 43 supra, at 469.

/59/ The effective date of the Proposed Regulation -- modifications made after 30 days following publication in the Federal Register -- will create inequities between new loans made after the effective date, when draftsmen can anticipate all possible future changes, and pre-existing loans whose instruments did not contain the necessary original terms.

/60/ See Letter from Stephen A. Goldberg (Feb. 4, 1993), 93 TNT 26-88.

/61/ Letter from Kenneth High and Michael Shaff (Feb. 10, 1993), 93 TNT 32-43.

/62/ In its opinion in the Centennial case, note 3 supra, the Supreme Court summarized its Cottage Savings holding as follows:

"In Cottage Savings we recognized that a property exchange gives

/63/ Case of the State Tax on Foreign-Held Bonds; Railroad Company v. Pennsylvania, 82 U.S. 300, 320 (1872); Farmers Loan & Trust Company, Executor v. Minnesota, 280 U.S. 204, 212-213 (1930); Texas v. New Jersey, 379 U.S. 674, 680 (1964). See also Bingham v. Commissioner, 105 F.2d 971, 972 (2d Cir. 1939) (creditor's receipt of property to extinguish his claim is not received in a sale or exchange because the creditor did not transfer "property" to the obligor; maker's own notes "could not, as assets, survive the transaction").

/64/ Rev. Rul. 69-613, 1969-2 C.B. 163 ("the gain realized by the corporation from the retirement of its bonds does not constitute gain from a sale or exchange but is treated as ordinary income").

/65/ Conference Report, Omnibus Budget Reconciliation Act of 1990, 136 Cong. Rec. H12607, H12729 (Oct. 26, 1990).

/66/ The fact that there are court decisions dealing with debt modifications does not mean that the obligor is governed by section 1001. Commentators have noted that the common law cases dealing with actual bond refundings and debt modifications under section 1001 have dealt only with the tax treatment of the creditor, not the debtor. Kalteyer, "Real Estate Workouts -- Original Issue Discount Implications of Troubled Debt Restructurings," 43 Tax Law. 579, 582, 589 (1990).

/67/ Deficit Reduction Act of 1984 (P.L. 98-369), section 174(c)(3). See also Reg. section 1.267(a)-3(d).

/68/ The transition, or "grandfather," rule appears in section 7202(c)(2)(C) of the Omnibus Budget Reconciliation Act of 1989. See PLR 9122082 (Mar. 6, 1991) (refinancing bonds carrying reduced principal amount and earlier maturity qualifies under transition rule).

/69/ Revenue Reconciliation Act of 1993, Pub. L. No. 103-66, section 13228(d).

/70/ Id. section 13150.

/71/ As to whether insurance contracts are subject to the Proposed Regulation, see Section VI, A, of this Report. See, e.g. Rev. Proc. 92-57, I.R.B. 1992-28, 8 (Service will provide "relief" via ruling letters that changes in policy terms in a state proceeding for rehabilitation of a financially troubled insurance company will not be considered a new contract for purposes of grandfather rules cited in the text). PLR 9412023 (Dec. 22, 1993) calls attention to specific committee reports and Code provisions affecting whether certain policy modifications cause "material change" in original policy or create new policy "issued," "entered into," or "purchased" after effective date of new Code provision. See also PLR 9407019 (Nov. 19, 1993) (change of primary obligor in reinsurance transaction not "issue" of new contracts).

/72/ The recently-enacted limitation on deductions for "excessive" employee compensation contains an effective date rule in which "material" modification appears to carry its own specific legislative intent. Section 162(m)(4)(D) grandfathers payments under contracts in effect on February 17, 1993, except if the contract was "materially" modified after that date and before the remuneration is paid. The committee report spells out specific circumstances which will be considered material modification. H. Rept. 103-213, 103d Cong. lst Sess. 589 (1993). Prop. Reg. section 1.162-27(h)(iii) applies the material modification rule to accelerations and deferrals of compensation, supplemental contracts, automatic extensions, cost- of-living increases, and restricted stock grants. This proposed regulation thus deals with a form of realization rule in light of the specific statutory provision and the objectives of the particular provision.

In the gift and estate tax area, see section 11602(e)(1) of Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, and Reg. section 25.2703-1(c) (defining "substantial modification" of options and agreements for purposes of Oct. 8, 1990, effective date).

The final section 752 regulations in the partnership area generally apply to liabilities incurred or assumed after December 28, 1991, and to preexisting liabilities that are "materially modified" after that date. T.D. 8380 (Dec. 23, 1991). There are some reports that the Service may apply its position in regulations under section 1001 to determine when liabilities are materially modified for this purpose.

/73/ See note 65 supra.

/74/ ABA Section of Taxation, "Report of the Section 108 Real Estate and Partnership Task Force (Part II)," 46 Tax Law. 397, 440- 442 (1993).

/75/ See Cook, Kalteyer & Beckett, Federal Tax Aspects of Cancellation of Indebtedness and Foreclosure 3-16 (Shepard's McGraw- Hill 1993):

"There is no indication in the legislative history that Congress

/76/ Final regulations under sections 1271-1275 were adopted in T.D. 8517, 59 Fed. Reg. 4799 (Feb. 2, 1994). Unlike the 1986 proposed regulations under sections 1271-78, the final rules contain no cross reference to section 1001 regulations for determining when the OID rules are triggered by a debt modification. Cf. Prop. Reg. section 1.1274-1(c)(1) (1986). The final rules refer to exchange treatment as determined under section 1001(a), however, in Reg. section 1.1274- 5(b) (effect of debt modifications on the assumption of, or taking subject to, existing debt in connection with a sale or exchange of property); and section 1.1274A-1(c)(3) (modified debt eligible for cash method treatment under certain conditions). But see Reg. section 1.1272-1(c)(6) (yield and maturity of debt instrument subject to contingencies must be recomputed on date on which outcome of contingencies becomes known; debt deemed reissued "solely for purposes of the accrual of OID").

/77/ Unlike section 1001, section 1274(c) requires that the debtor give a debt instrument in return for the transfer of "property" to the debtor. In order to make this language apply to debt modifications, the Service views the debtor's unmodified liability as "property." Reg. section 1.1274-1(a) (1994). There is case law, however, holding that a debtor's own liability is not "property" as to the debtor himself; see note 63 supra. If sections 1273-1274 do not apply to a debt-for-debt agreement, it may not be possible to determine the issue price of the modified debt for purposes of section 108(e)(11), since the latter rule incorporates sections 1273-1274 by reference.

/78/ Section 1271(a)(1) is entitled, "Treatment of Amounts Received on Retirement or Sale or Exchange of Debt Instruments." The provision reads as follows:

"(a) General Rule. -- For purposes of this title --

"(1) Retirement. -- Amounts received by the holder on

/79/ See Harllee & McCoy, Bad Debts (Tax Management Portfolio No. 19-8th), p. A-20 (1991).

/80/ Treating section 1271(a)(1) as covering the treatment of a debt modification as an "exchange" by the creditor does not resolve the unsettled question under section 1001 whether a new claim received by the creditor should be taken into account at the new claim's fair market value (as specified by section 1001(b)) or at the new obligation's issue price determined under the original issue discount rules. Reg. section 1.1001-1(g) (1994) requires computing amount realized by reference to the new (modified) debt's issue price under OID rules. It is unclear whether this regulation prevails over the statutory provision in section 1001(b) that the amount realized from the sale or other disposition of property is the sum of any money received "plus the fair market value of the property (other than money) received." Nothing in Prop. Reg. section 1.1001-3 would resolve this computation issue.

/81/ First enacted as section 117(f) of the Revenue Act of 1934, this provision treated amounts received by the holder upon the "retirement" of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including governmental units), with interest coupons or in registered form, as received "in exchange therefor."

The 1954 Code eliminated the registration and interest coupon restrictions, and broadened the general rule to cover all bonds and other evidences of indebtedness which are capital assets (former section 1232(a)(1)).

The Deficit Reduction Act of 1984 renumbered the retirement rule as section 1271(a)(1), eliminated the requirement that the obligation must be a capital asset, and broadened its application beyond subtitle A (income taxes) to title 26 generally. The 1984 Act also extended the provision's coverage to any debt instrument, and added the exception that the retirement rule does not apply if the obligor is a natural person.

/82/ Fairbanks v. United States, 306 U.S. 436 (1939); Hale v. Helvering, 85 F.2d 819 (D.C. Cir. 1936); Commissioner v. Spreckels, 120 F.2d 517 (9th Cir. 1941) (mortgaged property transferred to mortgagee); and Bingham v. Commissioner, 105 F.2d 971 (2d Cir. 1939). See generally Chirelstein, Federal Income Taxation 330-31 (6th ed. 1991). See also Hudson v. Commissioner, 20 T.C. 734 (1953), aff'd per curiam sub nom. Ogilvie v. Commissioner, 216 F.2d 748 (6th Cir. 1954) (discount buyer of claim taxable on collections as ordinary income).

/83/ Timken v. Commissioner, 6 T.C. 483 (1946) (insolvent bank depositor's receipt of "creditors note" of reorganized bank, containing modified payment terms, treated in effect as recovery of prior bad debt deductions and collection on original claim as deposit creditor); Carlson v. Commissioner, 39 B.T.A. 185 (1939) (insolvent bank depositor received cash for 40% of claim and negotiable subordinated note for 60% balance; note represented "satisfaction of his deposit"); Denniston v. Commissioner, 37 B.T.A. 834 (1938) (creditor allowed bad debt deduction when borrower defaulted on new modified note given to creditor as part payment on defaulted first mortgage note; court viewed new note as "representing the unpaid portion of the old indebtedness").

/84/ See Denniston v. Commissioner, id.

/85/ See discussion of the legislative history in Bradshaw v. United States, 683 F.2d 365, 380 (Cl. Ct. 1982).

/86/ Reg. section 1.1275-1(d) defines the term "debt instrument" to mean "any instrument or contractual arrangement that constitutes indebtedness under federal income tax law (including, for example, a certificate of deposit or a loan)." Open account indebtedness appears to be included by this language. Under former section 1232(a)(1), compare Gurda v. Commissioner, 54 T.C.M. 104 (1987).

/87/ Shaw v. Commissioner, 117 F.2d 587 (7th Cir. 1941) (water district bondholders accepted 49.8% cash settlement from insolvent water district); Monroe Estate v. Commissioner, 45 BTA 1060 (1941), aff'd sub nom. Pinnell v. Commissioner, 132 F.2d 126 (3d Cir. 1942) (claim satisfied by liquidating corporate debtor's cash payment of 7.42 percent of principal); Atlas v. Comm-issioner, 4 T.C.M. 111 (1945) ($61,000 face bonds purchased for $23,000; later collections capital gain).

/88/ McClain v. Commissioner, 311 U.S. 527, 530 (1941) ("retirement" not limited to voluntary call or redemption of a bond; term should be given "its accepted meaning in common speech"). See also Rev. Rul. 80-57, 1980-1 C.B. 157 (citing McClain to the effect that retirement in former section 1232(a)(1) is construed broadly and in accord with its ordinary meaning); Shaw v. Commissioner, id. (retirement occurred where water district bonds were surrendered to insolvent district and not cancelled but assigned to RFC as security for loan to water district).

/89/ The lead decision on point is McClain v. Commissioner, id. (cash payment of 49.9 percent of principal on a financially troubled water district's bonds, and cash payment of $5 on each $1,000 debenture by receiver for insolvent hotel company's bonds, held, received by holders in "retirement" within section 117(f) of 1934 Revenue Act).

/90/ Commissioner v. Spreckels, 120 F.2d 517 (9th Cir. 1941)(farm collateral); Bingham v. Commissioner, 105 F.2d 971 (2d Cir. 1939) (real estate collateral); Rev. Rul. 87-124, 1987-2 C.B. 205 (stock). For general discussion of the treatment of creditors both under and outside section 1271(a)(1) in a real estate context, see Handler, "Tax Consequences of Mortgage Foreclosures and Transfers of Real Property to the Mortgagee," 31 Tax L. Rev. 193 (1976).

/91/ See, e,g., Atlas v. Commissioner, note 87 supra ("We think that the surrender of the $61,000 bonds, Series M-1184, for the Fort Hubbard Apartments was the equivalent of the retirement of the bonds by the Bankers Trust Co").

/92/ See G.C.M. 15766, XV-1 C.B. 128 (1936).

/93/ Stoddard v. Commissioner, 141 F.2d 76 (2d Cir. 1944), rev'g and remanding 47 B.T.A. 584 (1942) (retirement rule applied to modified mortgage bonds issued to creditors containing reduced principal amounts, reduced interest rates, extended maturity dates and new stock; creditors' gains and losses held capital as result of exchange treatment; losses not deductible as bad debts). Of the surrendered mortgage bonds the court said:

"Under subdivision (f) of [section 117 of the 1936 Revenue Act]

/94/ Call v. United States, 66-2 USTC section 9705 (E.D. Tenn. 1966) (workout agreement considered a new contract under the 1954 Code version of retirement rule); Riddell v. Scales, 406 F.2d 210 (9th Cir. 1969), rev'g 66-1 USTC par. 9325 (S.D. Cal. 1966) (1956 debt modification of original 1953 notes treated as not replacement of original debt, hence 1954 Code version of retirement rule not applicable). See also Driscoll v. Commissioner, 306 F.2d 35 (7th Cir. 1962), rev'g 37 T.C. 52 (1961) (post-1954 division of debtor's note into 3 separate notes viewed as not retirement of original pre-1954 single note, but as new "evidence of" the debt after 1954, so 1954 Code version of retirement rule applied).

/95/ See Adrion & Blasi, "Renegotiated Debt: The Search for Standards," 44 Tax Law. 967, 1033 (1991) (modified debt received in exchange for existing debt "constitutes payment (or repayment) of a debt * * *).

/96/ See note 63 supra. The traditional case law on bond refundings made little reference to determining the tax treatment of bond holders under the predecessor of section 1271(a)(1). The omission is probably explainable by the fact that the original retirement rule applied only to debt instruments in registered form with interest coupons attached. This limitation was not eliminated from the retirement rule until 1954. During the period of the 1930s and 1940s, when most of the bond refunding cases on debt modifications were decided, municipal bonds were generally issued in bearer form and thus could not have qualified under the retirement rule. Thus, section 117(f) would not have been relevant to determining the creditor's gain or loss realization from bond refundings in the case law before the 1954 Code. For an example of section 117(f) and the predecessor of current section 1001(a) passing in the night in the same case, see Newberry v. Commissioner, 4 T.C.M. 576 (1945).

/97/ See Stoller v. Commissioner, 994 F.2d 855 (D.C. Cir. 1993) (on facts, cancellation of contracts in straddle transactions produced ordinary losses under pre-1981 law; possible distinction between a cancellation and offset of a contract might turn on whether "the essentials of the [existing] transaction lived on because the replacement contract was in most respects identical to the cancelled contract").

/98/ See cases cited at note 82 supra. See also Chirelstein, Federal Income Taxation 330 (6th ed. 1991); Surrey, McDaniel, Ault & Koppleman, Federal Income Taxation: Cases and Materials 925 (Successor ed. 1986). Under this theory, where the borrower is an individual, the creditor recovers his basis in the loan as repayment of the loan rather than as part of an "exchange." See also Rev. Rul. 68-523, 1968-2 C.B. 82 (creditor entitled to bad debt deduction to extent collection was less than creditor's basis in some claims, and realized ordinary section 61 income to extent collection exceeded basis in other claims).

/99/ Compare Commissioner v. Sisto Financial Corporation, 139 F.2d 253 (2d Cir. 1943); Elverson Corp. v. Helvering, 122 F.2d 295 (2d Cir. 1941), where stock of the debtor received by a creditor in "satisfaction" of notes held by the creditor was realization event under predecessor of section 61(a)(3) (income includes gain from "dealings" in property); and Herbert's Estate v. Commissioner, 139 F.2d 756 (3d Cir. 1943). See also Rev. Rul. 80-57, 1980-1 C.B. 157 (former section 1232(a)(1) inapplicable to real estate accepted in lieu of creditor's foreclosure since mortgage note not held as capital asset; creditor realized ordinary income under section 61(a)(3)).

/100/ The regulations make an effort to narrow the scope of the natural person exception in section 1271. See Reg. section 1.1275- 1(g) (debt instrument not issued by natural person even if such person is co-maker and jointly liable with an entity, or even if a partnership of natural persons issued the instrument).

/101/ For further discussion of section 856(c)(4), see Section VII, C, of this Report.

/102/ Bradshaw v. United States, 683 F.2d 365 (Cl. Ct. 1982). The Commissioner argued in this case that the creditor's collections would have qualified for exchange treatment under section 1232(a)(1), and thus were also gross receipts derived from "sales or exchanges of stock or securities" within the definition of passive investment income in former section 1372(e)(5)(A). See also note 30 supra.

/103/ Current regulations under Subchapter S expressly exclude from the definition of passive investment income "amounts received .. as a repayment of a loan." Reg. section 1.1362-2(c) (4)(iii)(B)).

/104/ Reg. section 1.860G-2(b)(3). This rule reflects the statutory provision that a disposition of a mortgage incident to foreclosure, default or imminent default of the mortgage is not a prohibited transaction for the REMIC. section 860F(a)(2)(A)(ii). The special policy considerations operating in the REMIC area are discussed in Section VII, B, of this Report infra.

/105/ Reg. section 1.382-9(d)(5)(iv) (allows tacking for purposes of section 382(l)(5)). This regulation applies even if a workout of debt between the creditor and the corporate debtor results in a deemed exchange of old debt for new debt. The effect of the regulation is equivalent to a rule that a debt modification will not be treated as a realization event for purposes of section 382(l)(5).

/106/ The Explanation says that a deemed disposition under section 1001 does not "conclusively" determine that an installment obligation has been "disposed of" for purposes of section 453. The Service has issued numerous rulings reflecting the same position. See, e.g., PLR 9412013 (Dec. 21, 1993). The Service thus appears to acknowledge that section 1001 may not be a suitable vehicle for rules triggering tax consequences under specific Code provisions that have their own legislative policies.

If the terms of an installment note are changed to make the note payable on demand or readily tradable, the original note would not have qualified for installment method treatment. Section 453(f)(4). Presumably, a modified note containing these terms would end installment method treatment as of the date of modification.

It appears unclear how section 1271(a)(1) affects a modified debt for the creditor. If the modified obligation "retires" the existing debt instrument held by the creditor, within the meaning of section 1271(a)(1), and the creditor is deemed to have "exchanged" the existing debt claim, has the installment obligation been disposed of for purposes of section 453B?

/107/ H. Rept. 90-87, 90th Cong. lst Sess. 16 (1985); S. Rept. 90-83, 90th Cong. lst Sess. 20-21 (1985).

/108/ The litigation leading to the Supreme Court's decision in Helvering v. Bruun, note 40 supra, illustrates the enormous time and expense involved in litigating different possible answers to a question of when a realization event occurs. Professor Michael Graetz has suggested that a lessor might plausibly be taxable when the tenant constructed the building or when the lessor sells the building after he regains possession.

"[I]ssues of timing are enormously important in terms of the

Graetz, Federal Income Taxation: Principles and Policies 207

/109/ See note 23 supra

/110/ Reference to a "term-based" test for defining when a debt modification is a realization event is borrowed from Adrion & Blasi, note 95 supra, at 969-971. The same criticism also applies to alternatives which some commentators have built around single-focus criteria -- changes in the yield on old and new debt agreements, changes in present values, and before and after changes in risk inherent in the debt instrument. See Lipton, "IRS Issues Proposed Regulations on Debt Modifications," 71 Taxes 67, 68 (1993) (yield test); Adrion & Blasi, id. 967 (net present value); Evans, "The Realization Doctrine After Cottage Savings," 70 Taxes 897, 901 (1992) (risk analysis).

Each of these seemingly objective standards professes to reflect "economic reality" and "changes in economic position" of a party to the obligation. The alternatives, we believe, would be either too complex to administer or represent the kind of policies that normally belong to statutory nonrecognition provisions.

/111/ Statement of Cong. W.R. Green, Acting Chairman, House Ways and Means Committee, on Act of Mar. 4, 1923, quoted in Seidman's Legislative History of Federal Income Tax Laws 1938-1861, pp. 797-99.

/112/ Proposed regulations were originally issued on March 24, 1980 (45 Fed. Reg. 18957 et seq.). Final regulations were adopted on December 31, 1980 (T.D. 7747, 1981-1 C.B. 141). However, the effective date of the final rules was postponed several times. The regulations were ultimately withdrawn on November 3, 1983. T.D. 7920, 1983-2 C.B. 89.

/113/ Plumb, "The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal," 26 Tax L. Rev. 369, 619 (1971) (quoting Professor Geoffrey Lanning).

/114/ Id. 590, 639-40.

/115/ Congress has generally taken a broad generic approach in writing various statutory "grandfather" rules involving debt refinancings. See the specific statutory provisions noted in Section IV, A, 2, a, of this Report. Section 354 provides nonrecognition of gain or loss for holders of corporate securities who exchange their instruments for new corporate securities without regard to changes in terms of the old and new securities, except where the principal amount of the new security exceeds the principal amount of the old security and except where accrued interest is being paid. See also section 56(e)(1) (deduction for qualified housing interest under minimum tax includes "refinancing" of debt incurred to acquire, construct or improve a residence).

/116/ Adrion & Blasi, note 95 supra, at 1034.

/117/ High & Shaff, note 61 supra.

/118/ ABA Section of Taxation, "Report of the Section 108 Real Estate and Partnership Task Force (Part I)," 46 Tax Law. 209, 214 (1992).

/119/ See the discussion of buyers of discount loans at Section VII, C, of this Report. See also Sheppard, "IRS Joins the Vultures Circling Defunct Tax-Shelter Promoter," 61 Tax Notes 1294 (1993).

/120/ This legislative proposal was officially approved on August 11, 1993, by the House of Delegates of the American Bar Association. The report accompanying this Legislative Recommendation has been designated Report No. 112. For the text of the Report, see ABA Section of Taxation, "The Case For Reinstatement and Expansion of Section 1275(a)(4)," 62 Tax Notes 217 (1994).

/121/ The Section of Taxation proposal would amend section 1001 to provide, in effect, that even if a creditor is considered as receiving a "new" debt instrument in exchange for his existing claim, his realized gain or loss is not recognized at the time of the actual or deemed exchange. Thus, even if section 1271(a)(1) applies to the creditor and treats modified (new) debt as received in exchange for his existing claim, the creditor's gain or loss realized would not be recognized.

If the debtor is a natural person so that section 1271 does not apply to the creditor, the common law rule (as noted earlier in our discussion of section 1271(a)(1)), is that the creditor does not participate in an "exchange" with the debtor who pays consideration to the creditor on the claim. Legislative Recommendation No. 1993-2 should be clarified to indicate whether a creditor who renegotiates his claim with a debtor who is an individual will recognize gain or be permitted to deduct loss realized in those situations.

/122/ For purposes of sections 1271-78, the term "debt instrument" is defined as meaning "a bond, debenture, note, or certificate or other evidence of indebtedness," except for certain annuity contracts covered by section 72. Code section 1275(a)(1). Reg. section 1.1275-l(d) (1994) broadens the statutory definition of debt instrument to include:

"any instrument or contractual arrangement that constitutes

/123/ For the tax stakes involved in this issue, see note 71 supra, and Letter from Anthony Manzanares to James Malloy, 92 TNT 145-36 (July 16, 1992).

/124/ Original issue discount can arise where new debt is issued for services, if the new debt is publicly traded. section 1273(b). But if "new" debt is not publicly traded and is issued for services, the OID rules of section 1274 do not come into play. The Service might consider whether section 467 (relating to deferred payments for services and for use of property) is an appropriate Code provision for writing rules dealing with providers of services who renegotiate their claims with their customers. See section 467(g) (regulations authority).

/125/ See Reg. section 1.269-5(b)(1), second sentence (creditors of bankrupt or insolvent corporation not treated as shareholders before they actually receive stock or at least before bankruptcy court confirms plan of reorganization).

But see Plumb, "The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal," 26 Tax L. Rev. 369, 496 (1971), citing several common law court decisions holding that initial debt may be transformed into equity in light of changed circumstances. See, e.g., Hollenbeck v. Commissioner, 50 T.C. 740,748 (1968); Cuyuna Realty Co. v. U.S., 382 F.2d 298, 301 (Ct.Cl. 1967). See also Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders 4-14 (6th ed. 1994). Section 385(c) binds an issuer of an instrument to initial characterization as debt or equity, but does not bind the Commissioner).

/126/ See Rev. Rul. 89-122, 1989-2 C.B. 200 (Situation (2)).

/127/ If the existing debt is publicly traded, the issue price of the "new" debt would be determined by the "old" debt's current fair market value. If the existing debt is not publicly traded, the issue price of the "new" debt depends on whether the existing interest rate is above or below the then-Applicable Federal Rate.

/128/ The creditor's gain or loss might be capital depending on the claim's status as a capital asset or on whether the holder is a bank or thrift. The deductibility of the creditor's loss under either section 165 (loss) or section 166 (bad debt) turns, according to the Service, on whether the debt reduction was negotiated "bilaterally"; if so, the loss is deductible under section 165. Rev. Rul. 89-122, 1989-2 C.B. 200, held that a debt modification between a U.S. commercial bank and a foreign government created an "exchange" for the creditor which resulted in a loss deductible under section 165 rather than section 166. The realized loss was ordinary in character via section 582(c). The loss did not qualify for nonrecognition under section 354 because, as a foreign government, the debtor was considered not a corporation as required by section 354. Section 165 treatment enabled the bank to carry its loss forward 15 years. section 172(b)(1)(A). If the loss had arisen from a bad debt in a taxable year beginning before January 1, 1994, it would have been required to be carried back 10 years and then forward 5 years. section 172(b)(1)(D).

/129/ Where the creditor accepts less than full repayment in settlement of the entire claim -- assuming the creditor is not treated as exchanging his claim -- the rules concerning a creditor's entitlement to a bad debt deduction under section 166, an ordinary loss deduction under section 165, or a business expense deduction under section 162 are unsettled. Court decisions do not apply the bilateral - unilateral distinction favored by the Service, but turn largely on the debtor's solvency or insolvency and on the creditor's motive in agreeing to reduce the principal amount. See, e.g., Gleason v. Commissioner, 62 T.C.M. 600 (1991); West Coast Securities Co. v. Commissioner, 14 T.C. 947 (1950). See generally Surrey, McDaniel, Ault & Koppleman, Federal Income Taxation: Cases and Materials 463 (1986); Handler, "Tax Consequences of Mortgage Foreclosures and Transfers of Real Property to the Mortgagee," 31 Tax L. Rev. 193, 199-201, 212-215 (1976).

The sections 165-166 rules should apply pro tanto to a partial reduction of the debt.

/130/ Where section 1271(a)(1) does not apply, the common law cases viewed a creditor's claim as having been "extinguished" by a settlement with the debtor. The same theory can be applied to a settlement of part of the holder's claim, where he agrees to accept nothing and extinguish only a portion of the claim. See note 81 supra.

/131/ This strategy would undoubtedly lead the Service to try to invoke the aggregation rule in Reg. section 1.1275-2(c). This rule applies, however, only to debt instruments which are "issued." Arguably, a division of an existing note into two separate notes, with no other changes, would not amount to an issuance of new notes even under a broad "hair trigger" reading of Cottage Savings, since arguably neither party's legal rights are changed by the division. Cf. PLR 9327069 (Feb. 12, 1993) (partition of real property not a section 1001 realization event).

/132/ Proposed regulations under section 1274 relating to contingent payment debt instruments were issued on January 19, 1993 (FI-59-91), but were later withdrawn by the Treasury. The withdrawn proposals retreated from the "wait and see" approach of earlier proposed regulations on this subject and opted instead for an approach based on estimating yields and estimating the performance of contingencies year by year.

In the tax-exempt bond area, the Service has ruled in the context of section 103 that a "change" will occur on the date the terms of the bond are altered, even though the effect of that alteration may occur later. Notice 88-130, 1988-2 C.B. 543. See also Rev. Rul. 87-19, 1987-1 C.B. 249.

/133/ A "wait and see" approach in the section1001 regulations is not necessarily inconsistent with using an estimate and adjustment approach in the contingent debt regulations. The contingent debt regulations provide measurement rules. They do not determine that a recognition event requiring measurement has occurred. It would be sound tax policy to make recognition occur at the time the new contingency becomes fixed, while valuing newly issued debt instruments which contain contingencies by an estimation and adjustment approach.

/134/ The courts have held on several occasions that the payment of interest in bonds instead of cash does not constitute a material modification. See, e.g., City Bank Farmers Trust Co. v. Hoey, 52 F. Supp. 665 (S.D.N.Y. l942), aff'd per curiam, l38 F.2d l023 (2d Cir. l943). The Service has also issued several recent private letter rulings concluding that a revision of the timing of certain payments will not trigger a taxable exchange. See PLR 8935007 (May l5, l989).

/135/ T.D. 8491 (Oct. 8, 1993), adopting Reg. section 1.446-3. See section 1.446-3(h).

/136/ The ABA Section of Taxation Section 108 Real Estate and Partnership Task Force concluded that realization should occur when the debtor is formally discharged by the Bankruptcy Court or, if earlier, when the debtor and creditor reach a binding agreement for reducing the debt. See note 118 supra at 227-229.

/137/ 81 T.C. 709 (1983). While this case predates enactment of section 988 (relating to the character of gain or loss from certain foreign currency transactions), the definition of a realization event is in some circumstances still relevant in applying section 988.

/138/ Prop. Reg. section 1.1274-4(g)(2)(ii)(B) (1986) provided that a sale in which the purchase price or the interest thereon is denominated in a currency other than the U.S. dollar is a potentially abusive situation. Thus, if a U.S.-denominated debt is converted into foreign currency debt the potential for gain or loss and possible COD income pursuant to sections 108(e)(11) and 1274(b)(3) was great. Final Reg. section 1.1274-3 (1994) does not include as a potentially abusive situation a sale in which the purchase price or the interest thereon is denominated in a currency other than the U.S. dollar. Consequently, potential problems relating to converting the currency of debt are significantly reduced.

/139/ It is important to distinguish defeasance transactions from transactions in which issuer's liability is satisfied through the delivery of securities. In a true defeasance, the primary liability if the issuer continues: if the securities set aside provide insufficient to cover the debt service, the issuer remains liable to make up the shortfall. Conversely, if the securities set aside prove to be in excess of that required to cover the debt service, the issuer enjoys that excess. See generally Reg. section 1.61-13(b) and Rev. Rul. 77-416 (withdrawn for unrelated reasons by Rev. Proc. 93-17). The fact that the realization of any such risk, or benefit, by the issuer is remote does not affect this conclusion.

/140/ See generally FASB Statement of Financial Accounting Standards No. 76 ("Extinguishment of Debt", November 1983), and FASB Technical Bulletin No. 84-4 ("In-Substance Defeasance of Debt", Oct. 17, 1984). These rules, as well as guidance under federal securities laws, have established the framework within which most corporate and municipal defeasance is undertaken.

/141/ In the context of the defeasance of a facility financing, the source of monies may be the proceeds of sale of the facility. The consequences of a sale/defeasance transaction under a particular statutory provision should depend upon policy considerations underlying that particular provision. As an example, sale/defeasance transactions in the context of tax-exempt facility financings raise particular considerations. See the discussion in Section VII, D, 2, of this Report infra.

/142/ In the municipal finance area, the laws of a few states provide that upon a complete advance refunding of general obligation bonds, the issuer is not obligated to make up losses or insufficiencies in the pledged Treasuries. Although set forth as a fact in Rev. Rul. 77-416 that the issuer would be obligated to make- up such losses, we do not believe this should be a deciding factor. Rather, since the defeasance occurs through the unilateral exercise of an option included (through incorporation by statute) in the original terms of the debt instrument, it cannot be a significant modification of the debt instrument. Rather, the ultimate question in such transactions is whether, through the provision of the Treasuries, the issuer has delivered payment in satisfaction of the debt instrument. That the answer to this is negative is manifest in the continuing ownership by the issuer of the Treasuries and the issuer's continuing right to exploit any benefit which subsequent restructuring of the Treasury portfolio might offer.

/143/ The statutory wash sale rule provides in general that no deduction will be allowed under section 165 for a loss realized from the sale or other disposition of stock or securities if, within the 61-day period spanning the sale or disposition, the taxpayer acquires "substantially identical" stock or securities.

/144/ See G.C.M. 38285 (Feb. 22, 1980).

/145/ It may be less easy to impose this limitation if the Service accepts our recommendation that holders of debt instruments are governed by section 1271(a)(1). Since that provision treats the holder as participating in an "exchange" for all purposes of the Internal Revenue Code, it may be difficult to avoid triggering tax consequences that turn on the occurrence of an "exchange" even if the tax effect is something other than gain or loss for the holder.

/146/ See note 105 supra.

/147/ Reg. section 1.860G-2(b)(1) and (2).

/148/ A REMIC's assets are generally limited to certain kinds of "qualified mortgages" and other permitted investments. Section 860D(a)(4). A qualified mortgage must generally be acquired when the REMIC is formed or within 3 months afterward. The term includes a "qualified replacement mortgage" which is received for another obligation within 3 months after the pool's startup date or for a "defective" obligation within 2 years after the startup day. section 860G(a)(3), (4).

A qualified mortgage must also be principally secured by an interest in real property. section 860G(a)(3)(A). The REMIC regulations permit this test to be satisfied if the fair market value of the real estate collateral was at least 80 percent of the issue price of the mortgage when the loan was "originated." Reg. section 1.860G-2(a)((i). If the REMIC agrees to renegotiate a problem loan which the Service would treat as a constructive new loan under the Proposed Regulation, the new loan would be considered "originated" on the modification date and if the collateral's value had dropped below the 80 percent level at that date, the modified loan would no longer be a qualified mortgage.

Under the prohibited transaction rule, a REMIC's disposition of a qualified mortgage is generally subject to a 100 percent tax on net income from the disposition. section 860F(a).

/149/ When Congress created the REMIC regime it expressed an intent that "the new vehicle provided by the [1986 Tax Reform] Act, since it is intended to be the exclusive one for the issuance of multiple class securities backed by real property mortgages, should be flexible enough to accommodate most legitimate business concerns while preserving the desired certainty of income tax treatment." Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 ("1986 Bluebook") 411 (1987).

/150/ PLR 9414014 (Dec. 30, 1993) holds that a mortgage loan refinancing is not a disposition of the loan by the REMIC holder (and thus not a prohibited transaction by the REMIC) if the REMIC assigns the receivable to a new lender who then agrees with the borrower to modify the loan's principal amount, maturity date, interest rate, prepayment terms, and other terms and conditions. See also PLR 9418021 (Feb. 4, 1994).

/151/ 1986 Bluebook 413 n. 68.

/152/ Reg. section 1.860G-2(f)(1) defines a defective obligation as including a mortgage which "is in default, or a default with respect to the mortgage is reasonably foreseeable." The regulation also lists a variety of other defects which permit the REMIC to replace the loan.

/153/ See section 860F(a)(2)(A)(ii).

/154/ The special exceptions in Reg. section 1.860G-2(b)(3) treat a modified obligation as one that was not newly issued, or originated, on the date the modification took place. But this relief applies, apparently, only for purposes of the general rule in the REMIC regulations themselves. Reg. section 1.860G-2(b)(1)). It may be that if changes in terms create a realization event for purposes of section 1001, even if default has occurred or is foreseeable, the "new" mortgage might not be a qualified replacement mortgage if the workout occurs more than 2 years after the startup day. It may be advisable for the Service to clarify whether it intends such a result to occur. The existence of this issue shows the kind of uncertainties that can arise where the concept of realization events pervades the Code and "generic" rules are adopted under section 1001(a).

It is also unclear whether a debt workout which satisfies the special exceptions in the REMIC regulation causes the REMIC to realize gain or loss which is passed through to investors. If a modification is not considered a significant modification under the REMIC regulation, the modified obligation is not treated as newly- issued in exchange for the unmodified obligation. Does this mean that REMIC investors do not realize gain or loss from the workout of a defaulted loan? Or do the section 1001 regulations take precedence for that purpose?

/155/ For discussion of the computational question of whether the amount realized by the creditor is the face amount or current fair market value of the modified debt, see note 80 supra. Section 475 may also ameliorate the taxable gain effect if the creditor holds the claim for sale to customers, since that provision could allow the creditor to write down the modified debt to its current market value and currently deduct the amount of the writedown.

/156/ Sections 512(b)(16) and 514(c)(9)(H), enacted in 1993, loosen certain restrictions on sales of real estate from a governmental receiver for a failed bank or thrift institution to certain tax-exempt buyers and later improvements to the property by the buyers. These provisions are intended to encourage investors to "provide a valuable source of capital for the purchase of these bundled properties." House Ways & Means Committee Print No. 103-11, 103d Cong. lst Sess. 181 (May 18, 1993).

/157/ If the purchaser of troubled loans from RTC, FDIC, or any other holder of such loans is a REIT or RIC, a restructuring of the loans between the entity and the borrowers following the purchase could potentially threaten the entity's basic tax qualification as a REIT or RIC. This issue arises under the 30 percent gross income test in section 851(b)(3) for RICs and section 856(c)(4) for REITs, under which the entity cannot receive 30 percent or more of its gross income from the "sale or other disposition" of (among other things) securities held for less than 3 months (in the case of a RIC) or interests in real property or mortgages on real property held for less than 4 years (in the case of REITs). A REIT that buys troubled debt at a discount and within 4 years agrees to modify the loan with the borrower may find that if enough of these workouts occur in a particular year, the REIT has lost its basic qualification as a passthrough entity.

/158/ Section 856(c)(4) was broadly intended to limit a REIT to investment, rather than "trading," in real property. H. Rept. 2020, 86th Cong. 2d Sess., 1960-2 C.B. 819, 822 (1960). The restriction excepts involuntary conversions and sales of "foreclosure property" (including real property acquired in anticipation of imminent default on a mortgage). Within the spirit of these exceptions, a REIT should arguably be able to buy nonperforming real estate mortgages at a discount and then restructure the loans with the borrowers in an effort to improve their creditworthiness and prevent default for the potential benefit of all investors in the REIT. Under such a policy, a REIT should be allowed to make a broad range of specific changes in the loan's terms without having the changes treated as a "disposition" of the original loan, thereby risking loss of the REIT's tax qualification.

/159/ See note 156 supra.

END OF FOOTNOTES