Final actively traded debt regulations: implications for debt modifications and exchanges.

• Author: Pomierski, William R.

Overview

If an outstanding debt instrument is modified, or is exchanged for a new debt obligation of the issuer, a taxable exchange will occur if the terms of the outstanding instrument (hereinafter, the "old debt") are significantly modified within the meaning of Treas. Reg. [section] 1.1001-3. (1) In a taxable exchange, the amount deemed paid by the issuer to holders of the old debt will be based on the issue price of the modified or newly issued instrument (hereinafter, the "new debt"). (2)

The tax consequences, if any, to an issuer and holders resulting from a taxable debt-for-debt exchange can vary significantly depending on whether the issue price of the new debt is based on fair market value, or is determined based on the new debt's stated redemption price at maturity. (3) A fair market value issue price will apply if either of the new debt or the old debt is "traded on an established market" (hereinafter referred to as "publicly traded") as defined in Treas. Reg. [section] 1.1273-2(f).

Final regulations revising--and expanding--the definition of publicly traded property for purposes of the issue price determination took effect on November 13, 2012 (the "Final Regulations"). As described below, the Final Regulations generally make it easier to classify debt or property as publicly traded for federal income tax purposes, increasing the risk that an issuer in a distressed debt situation may realize phantom cancellation of indebtedness income in a taxable debt-for-debt exchange. On the positive side, classifying debt as publicly traded in a debt-for-debt exchange where a redemption premium is paid allows issuers to immediately deduct the resulting redemption premium, rather than amortizing the deduction over the life of the new debt.

This article focuses on the consequences to an issuer resulting from the application of the Final Regulations in the context of a taxable debt-for-debt exchange. Before discussing the Final Regulations and the resulting issue price considerations, a brief summary of the debt-for-debt exchange principles of Treas. Reg. [section] 1.1001-3 is in order.

Taxable Debt-for-Debt Exchanges

Under Treas. Reg. [section] 1.1001-1(a), gain or loss is generally realized from the exchange of property for other property "differing materially either in kind or in extent." Treas. Reg. [section] 1.1001-3(b) provides that if an outstanding instrument is modified, or is actually exchanged for a new debt instrument, the modification or exchange is not a taxable exchange for purposes of Treas. Reg. [section] 1.1001-1(a) unless the terms of the resulting instrument (the new debt) are sufficiently different from the terms of outstanding instrument (the old debt) to result in a "significant modification."

Treas. Reg. [section] 1.1001-3 establishes a two-step analysis for determining whether a taxable debt-for-debt exchange occurred as a result of a modification or an exchange of debt instruments. The first step is to determine whether there has been a modification to the terms of the old debt. The second step is to determine whether a modification is significant.

1. Modifications

   A modification of a debt instrument is defined broadly as any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder, whether evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. (4) Subject to limited exceptions, alterations that occur automatically by operation of the terms of an instrument are considered modifications. (5)

   Alterations resulting from the exercise by the issuer or a holder of a right (option) set out in the terms of an instrument are considered modifications under the regulations unless the option is unilateral and in the case of a holder option, exercise does not result in (or, in the case of a variable or contingent payment, is not reasonably expected to result in) a deferral of, or a reduction in, any scheduled payment of interest or principal. (6) An option is unilateral only if the following conditions are met: (1) there does not exist at the time the option is exercised, or as a result of the exercise, a right of the other party to alter, terminate or put the instrument to a person who is related to the issuer (within the meaning of Section 267(b) or Section 707(b)(1)); (2) exercise of the option does not require the consent or approval of the other party, a person related to the other party (within the meaning of Section 267(b) or Section 707(b)(1)), whether or not that person is a party to the instrument, or a court or arbitrator; and (3) exercise of the option does not require consideration (other than incidental costs and expenses) unless, on the issue date, the consideration is de minimis, a specified amount, or an amount based on a formula that uses objective financial information (as defined in Treas. Reg. [section] 1.446-3(c)(4)(ii)). (7)

2. Significant Modifications

   If the terms of an instrument are modified pursuant to an alteration or an exchange, step two in the analysis is to determine whether the modification is significant. Except as otherwise provided in a specific rule or a safe harbor, as described below, the general rule is that a modification is significant if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are "economically significant."(8) In making this determination under the general rule, all modifications (other than modifications described in a specific rule or safe harbor) are considered collectively. (9)

   Beyond the general rule, Treas. Reg. [section][section] 1.1001-3(e)(2) through (6) provide specific rules (and safe harbors) for determining whether certain types of modifications are significant. The specific rules include (1) changes in yield (which are significant only if the change is more than the 25 basis points or 5% of the annual yield on the unmodified instrument); (2) changes (deferral) in the timing of payments (which are not significant if the deferral is the lesser of 5 years or 50% of the original term); (10) (3) changes in the obligor or security; (4) changes in the nature of the instrument (i.e., changes into property that is not debt (e.g., equity) or changes in the recourse nature of the debt); or (5) changes in accounting or financial covenants. If any of these specific rules is violated, the modification will be considered significant...