[Federal Register Volume 75, Number 107 (Friday, June 4, 2010)]
[Proposed Rules]
[Pages 31736-31738]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-13492]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106750-10]
RIN 1545-BJ30


Modifications of Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
modification of debt instruments. The regulations clarify the extent to 
which the deterioration in the financial condition of the issuer is 
taken into account to determine whether a modified debt instrument will 
be recharacterized as an instrument or property right that is not debt. 
The regulations provide needed guidance to issuers and holders of debt 
instruments. This document also provides notice of a public hearing on 
these proposed regulations.

DATES: Written or electronic comments must be received by August 3, 
2010. Outlines of topics to be discussed at the public hearing 
scheduled for Wednesday, September 8, 2010, at 10 a.m. must be received 
by Wednesday, August 11, 2010.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106750-10), room 
5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
106750-10), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS and REG-106750-
10).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Diana Imholtz, at (202) 622-3930; concerning submission of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, [email protected], at (202) 622-7180 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 1.1001-3 provides rules for determining when a modification 
of a debt instrument results in an exchange for purposes of Sec.  
1.1001-1(a). In general, Sec.  1.1001-3 defines a modification and 
provides that a modification that is significant results in a deemed 
exchange of the original debt instrument for a modified debt 
instrument. Section 1.1001-3 also addresses alterations to the terms of 
a debt instrument that result in a modified instrument that is not 
debt. Section 1.1001-3(c)(2)(ii) generally provides that a modification 
to a debt instrument occurs if an alteration changes the instrument to 
an instrument or property right that is not debt for Federal income tax 
purposes, even if the alteration occurs by operation of the original 
terms of the debt instrument. Section 1.1001-3(e)(5)(i) generally 
provides that a modification of a debt instrument that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a significant modification. For purposes of making the 
determination prescribed by Sec.  1.1001-3(e)(5)(i), the regulations 
state that any deterioration in the financial condition of the issuer 
between the issue date of the unmodified debt instrument and the date 
of modification (as it relates to the issuer's obligation to repay the 
debt instrument) is not taken into account, unless there is a 
substitution of a new obligor or the addition or deletion of a co-
obligor.
    In response to the proposed regulations published on December 2, 
1992 (57 FR 57034), taxpayers were concerned that taking into account 
the creditworthiness of a financially troubled issuer when a debt 
instrument is modified would impose a significant barrier to 
restructuring distressed debt instruments. The rule in Sec.  1.1001-
3(e)(5)(i) to disregard the financial condition of the issuer was 
intended to address this concern. The preamble to the existing 
regulations published on

[[Page 31737]]

September 24, 1996 (TD 8675; 61 FR 32926) explains that ``for purposes 
of this regulation, unless there is a substitution of a new obligor, 
any deterioration in the financial condition of the issuer is not 
considered in determining whether the modified instrument is properly 
characterized as debt.''
    The language in the preamble to the existing regulations suggests 
that for all purposes of Sec.  1.1001-3 the financial deterioration of 
the issuer is generally not taken into account. Issuers and holders, 
however, are concerned that, as the existing regulations are currently 
drafted, a decline in the creditworthiness of the issuer, under certain 
circumstances, may be taken into account under Sec.  1.1001-3. The 
uncertainty about the proper interpretation of the existing regulations 
has led taxpayers to request clarification on the circumstances in 
which the credit quality of the issuer should be considered in 
determining the nature of the instrument resulting from an alteration 
or modification of a debt instrument. Accordingly, the IRS and the 
Treasury Department believe it is appropriate to propose amendments to 
Sec.  1.1001-3 to clarify this issue.

Explanation of Provisions

    In general, the proposed regulations require an analysis of all of 
the factors relevant to a debt determination of the modified instrument 
at the time of an alteration or modification. However, in making this 
determination for purposes of the regulation, any deterioration in the 
financial condition of the issuer between the issue date of the debt 
instrument and the date of the alteration or modification (as it 
relates to the issuer's ability to repay the debt instrument) is not 
taken into account, unless there is a substitution of a new obligor or 
the addition or deletion of a co-obligor.
    As noted in this preamble, the proposed regulations clarify that 
any deterioration in the financial condition of the issuer is generally 
not taken into account to determine if the modified instrument is debt. 
For example, under the proposed regulations, any decrease in the fair 
market value of a debt instrument (whether or not publicly traded) 
between the issue date of the debt instrument and the date of the 
alteration or modification is not taken into account to the extent that 
the decrease in fair market value is attributable to the deterioration 
in the financial condition of the issuer and not to a modification of 
the terms of the instrument. Consistent with this rule in the proposed 
regulations, if a debt instrument is significantly modified and the 
issue price of the modified debt instrument is determined under Sec.  
1.1273-2(b) or (c) (relating to a fair market value issue price for 
publicly traded debt), then any increased yield on the modified debt 
instrument attributable to this issue price generally is not taken into 
account to determine whether the modified debt instrument is debt or 
some other property right for Federal income tax purposes. However, any 
portion of the increased yield that is not attributable to a 
deterioration in the financial condition of the issuer, such as a 
change in market interest rates, is taken into account.

Proposed Effective Date

    The regulations, as proposed, apply to alterations of the terms of 
a debt instrument on or after the date of publication of the Treasury 
decision adopting these rules as final regulation in the Federal 
Register. A taxpayer, however, may rely on these amendments for 
alterations of the terms of a debt instrument occurring before that 
date.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking has been submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and the Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for Wednesday, September 8, 
2010, beginning at 10 a.m. in Auditorium, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by Wednesday, August 11, 2010. A period of 10 minutes will be allotted 
to each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal author of these regulations is Diana Imholtz, Office 
of Associate Chief Counsel (Financial Institutions & Products). 
However, other personnel from the IRS and the Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1001-3 is amended by revising paragraphs 
(c)(2)(ii), (e)(5)(i) and (h) and adding paragraph (f)(7) to read as 
follows:


Sec.  1.1001-3  Modifications of debt instruments.

* * * * *
    (c) * * *
    (2) * * *
    (ii) Property that is not debt. An alteration that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a

[[Page 31738]]

modification unless the alteration occurs pursuant to a holder's option 
under the terms of the instrument to convert the instrument into equity 
of the issuer (notwithstanding paragraph (c)(2)(iii) of this section). 
The rules of paragraph (f)(7) of this section apply to determine 
whether an alteration or modification results in an instrument or 
property right that is not debt.
* * * * *
    (e) * * *
    (5) Changes in the nature of a debt instrument--(i) Property that 
is not debt. A modification of a debt instrument that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a significant modification. The rules of paragraph (f)(7) 
of this section apply to determine whether a modification results in an 
instrument or property right that is not debt.
* * * * *
    (f) * * *
    (7) Rules for determining whether an alteration or modification 
results in an instrument or property right that is not debt--(i) In 
general. Except as provided in paragraph (f)(7)(ii) of this section, 
the determination of whether an instrument resulting from an alteration 
or modification of a debt instrument will be recharacterized as an 
instrument or property right that is not debt for Federal income tax 
purposes shall take into account all of the factors relevant to such a 
determination.
    (ii) Financial condition of the obligor--(A) Deterioration in 
financial condition of the obligor generally disregarded. Except as 
provided in paragraph (f)(7)(ii)(B) of this section, in making a 
determination as to whether an instrument resulting from an alteration 
or modification of a debt instrument will be recharacterized as an 
instrument or property right that is not debt under this section, any 
deterioration in the financial condition of the obligor between the 
issue date of the debt instrument and the date of the alteration or 
modification (as it relates to the obligor's ability to repay the debt 
instrument) is not taken into account. For example, any decrease in the 
fair market value of a debt instrument (whether or not the debt 
instrument is publicly traded) between the issue date of the debt 
instrument and the date of the alteration or modification is not taken 
into account to the extent that the decrease in fair market value is 
attributable to the deterioration in the financial condition of the 
obligor and not to a modification of the terms of the instrument.
    (B) Substitution of a new obligor; addition or deletion of co-
obligor. If there is a substitution of a new obligor or the addition or 
deletion of a co-obligor, the rules in paragraph (f)(7)(ii)(A) of this 
section do not apply.
* * * * *
    (h) Effective/applicability date--(1) In general. Except as 
otherwise provided in paragraph (h)(2) of this section, this section 
applies to alterations of the terms of a debt instrument on or after 
September 24, 1996. Taxpayers, however, may rely on this section for 
alterations of the terms of a debt instrument after December 2, 1992, 
and before September 24, 1996.
    (2) Exception. Paragraph (f)(7) of this section applies to an 
alteration of the terms of a debt instrument on or after the date of 
publication of the Treasury decision adopting these rules as final 
regulation in the Federal Register. A taxpayer, however, may rely on 
paragraph (f)(7) of this section for alterations of the terms of a debt 
instrument occurring before that date.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. 2010-13492 Filed 6-3-10; 8:45 am]
BILLING CODE 4830-01-P