Proposed regulations on debt modifications - are grandfathered earnings stripping obligations in jeopardy?

• Author: Burke, Michael S.

The so-called earnings stripping rules of Sec. 163(j), enacted in 1989, generally limit the deductibility of interest paid to a foreign related person by a domestic corporation. Interest paid on certain financial instruments issued before July 10, 1989 is generally exempt from these limitations. However, certain debt modifications may now subject these instruments to the vagaries of Sec. 163(j). Considering the multitude of debt workouts in recent months, companies with "grandfathered" debt obligations are well-advised to pay special attention to any modifications that may jeopardize their preferred status.

Prop. Regs. Sec. 1.163(j)-10(b)(1)(i) provides that "[i]nterest paid or accrued with respect to a fixed-term debt obligation outstanding on July 10, 1989, shall not be treated as disallowed interest expense, even though such interest is paid or accrued in a taxable year of the payor corporation beginning after July 10, 1989." Further exceptions are provided for certain obligations issued pursuant to written contracts binding on July 10, 1989.

Prop. Regs. Sec. 1.163(j)-10(b)(1)(iii) denies this so-called grandfather treatment for qualified obligations that are modified after July 10, 1989. A modification is defined as a revision (whether by renegotiation, assumption, reissuance or otherwise) in a manner that would be treated as a deemed exchange of debt instruments by the obligee under Sec. 1001.

Under Regs. Sec. 1.1001-1(a), gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as a taxable exchange. This definition however is very vague. Various IRS pronouncements and court opinions have generally attempted to cure this uncertainty, but unfortunately they have taken the position that even seemingly innocuous changes in an obligation will result in a taxable exchange.

Rev. Rul. 89-122 held that a reduction in the principal amount of a debt obligation would result in a material modification and consequently a taxable exchange. This ruling has been strongly criticized. It appears that, in substance, a reduction in the principal amount of a debt obligation by debt cancellation is not materially different from a prepayment of the debt by the obligor. Therefore, one should expect symmetry in their treatment.

In December 1992, the Service proposed new Regs. Sec. 1.1001-3 offering guidance on when a debt modification will result in a taxable exchange. Generally, these...