United States: Debt Exchanges

Last Updated: August 5 2013
Article by Linda Z. Swartz

Most Read Contributor in United States, October 2018


This article focuses on one of the crucial issues in any debt restructuring—whether changes to the terms of outstanding debt typically sought by lenders would constitute a deemed exchange of the debt pursuant to section 10011 and the corresponding Treasury regulations.2 The first part of the article discusses the regulations. The second part of the article discusses the adverse tax consequences to debt holders of a deemed debt exchange under the regulations, including the collateral effects of a possible recharacterization of the modified debt as equity. The third part of the article discusses the tax consequences if modified debt is subject to the original issue discount ("OID") rules. Finally, the article discusses strategies to avoid the pitfalls commonly associated with debt exchanges.


A. Regulations

Many of the modifications commonly sought by lenders to the terms of troubled debt would cause a deemed exchange of the debt; in many cases, a single modification would be sufficient to cause a deemed exchange. However, several provisions in the regulations represent a significant extension of case law and rulings insofar as the regulations would trigger a deemed exchange of debt where no exchange would otherwise occur.3 Proposed regulations were issued on December 2, 1992, in response to the Supreme Court's decision in Cottage Savings Association v. Commissioner4 that a deemed exchange of property occurs if the "legal entitlements" of the exchanged properties are not identical, which decision significantly lowered the threshold for deemed exchanges.5 The proposed regulations, with certain changes, were finalized on June 26, 1996, effective for any alteration of the terms of a debt instrument on or after September 24, 1996.6

1. Modifications

The regulations employ a two-part test to determine whether a deemed exchange occurs when debt is modified. Under this test a specific change to a debt instrument triggers a deemed exchange if the change constitutes a "modification," and the modification is "significant."7 As a threshold matter, it is important to note that although the modifications made to debt in a workout context where debt is in default often address unique issues, the Internal Revenue Service (the "IRS") has generally treated the context in which modifications are made as irrelevant.8 This past practice is continued in the regulations, which provide that a deemed exchange may not be avoided simply because the borrower is insolvent or bankrupt.9 The regulations broadly define a modification as any change in a legal right or obligation of the issuer or holder of the debt instrument, with some exceptions.10

A change that occurs pursuant to the original terms of a debt instrument is not a modification.11 An alteration that occurs by operation of the terms may occur automatically (for example, an annual resetting of the interest rate based on the value of an index or a specified increase in the interest rate if the value of the collateral declines from a specified level) or may occur as a result of the exercise of an option provided to an issuer or a holder to change a term of a debt instrument. The following alterations, however, are modifications even if the alterations occur by operation of the terms of a debt instrument:

  • An alteration that results in the substitution of a new obligor,12 the addition or deletion of a coobligor, or a change (in whole or in part) in the recourse nature of the instrument (from recourse to nonrecourse or from nonrecourse to recourse);13
  • An alteration that results in an instrument or property right that is not debt for federal income tax purposes 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;14 and
  • An alteration that results from the exercise of an option provided to an issuer or a holder to change a term of a debt instrument, unless:
    • The option is unilateral; and
    • In the case of an option exercisable by a holder, the exercise of the option 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.15

An option is unilateral only if, under the terms of the instrument or under local law, (i) at the time the option is exercised, or as a result of the exercise, there is no right of the other party to alter or terminate the instrument or put the instrument to a person related to the issuer;16 (ii) the exercise of the option does not require the consent or approval of the other party, a person related to the other party or a court or arbitrator; and (iii) the exercise of the option does not require consideration (other than incidental costs and expenses relating to the exercise of the option), unless, on the issue date of the instrument, the consideration is a de minimis amount, a specified amount, or an amount that is based on a formula that uses objective financial information.17

An issuer's failure to perform its obligations under a debt instrument is also not a modification.18 An agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds two years following the issuer's initial failure to perform, and any additional period during which the parties conduct good faith negotiations or during which the issuer is in a Title 11 or similar case.19

Although a change in the currency denomination of a debt instrument is generally considered a modification, Treasury regulations provide an exception for a change in denomination to the euro.20 The advent of the euro, on January 1, 1999, as the single currency of participating members of the European Union21 initially raised concerns that the conversion of the national currencies of those members ("legacy currencies") to the euro would be a taxable exchange.22 Responding to those concerns, the IRS issued temporary, and then final regulations providing nonrealization treatment for the conversion of a legacy currency to the euro.23 The regulations apply broadly to a change in rights and obligations denominated in a legacy currency if the change results solely from the conversion of the legacy currency to the euro.24

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* The author would like to thank Hoon Lee, Aliza R. Levine, Jean M. Bertrand, John T. Thomas, Gary T. Silverstein and Christopher Slimm for their invaluable assistance in updating this article.

1 All section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and to the Treasury Regulations promulgated thereunder.

2 Treas. Reg. § 1.1001-3, added by T.D. 8675, 1996-2 C.B. 60 (June 26, 1996).

3 See generally New York State Bar Association, Tax Section, Report of Ad Hoc Committee on Provisions of the Revenue Reconciliation Act of 1990 Affecting Debt-for-Debt Exchanges, 51 TAX NOTES 79 (Apr. 8, 1991).

4 499 U.S. 554 (1991).

5 Prop. Treas. Reg. § 1.1001-3, 57 Fed. Reg. 57,034 (Dec. 2, 1992); Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). For background on the proposed regulations, see Lawrence H. Brenman, Tax-Oriented Investments: Proposed Regulations Regarding Debt Modification Issued in Response to Cottage Savings Decision, 10 J. Partnership Tax'n 175 (1993); Richard M. Lipton, IRS Issues Proposed Regulations on Debt Modifications, 71 Taxes 67 (1993); Linda Z. Swartz, Troubled Real Estate Partnerships: What Options Are Available to Foreign Lenders?, 12 J. Partnership Tax'n 196 (1995).

6 Treas. Reg. § 1.1001-3, added by T.D. 8675, 1996-2 C.B. 60 (June 26, 1996).

7 Treas. Reg. § 1.1001-3; see also Priv. Ltr. Rul. 1999-50-022 (Sept. 16, 1999) (holding that an investor that exchanges a pool of securities matching in number and type the securities represented by a specified number of units in an investment trust is not considered to have materially altered its ownership position in the securities, and is not required to recognize gain or loss with respect to the securities for purposes of section 1001).

8 Priv. Ltr. Rul. 84-51-012 (Aug. 23, 1984) (constructive sale of notes under section 1001 where maturity date and interest rate of notes were materially and involuntarily altered by the New York State Emergency Moratorium Act); supplementing Priv. Ltr. Rul. 80-52- 023 (Sept. 25, 1980). By contrast, some courts have treated troubled debt restructurings more liberally than they have restructurings in the absence of economic distress. See, e.g., Mutual Loan & Savings Co. v. Commissioner, 184 F.2d 161 (5th Cir. 1950); Newberry v. Commissioner, 4 T.C.M. (CCH) 576 (1945). Moreover, the IRS Chief Counsel stated in 1977 that "as a matter of policy" the IRS will not litigate the issue of whether a deemed debt exchange has occurred when involuntary changes are made to a debt instrument that is in default, unless the bonds were acquired "in contemplation of realizing a gain from the change in terms." G.C.M. 37,002 (Feb. 10, 1977). Although the IRS has not retracted this General Counsel Memorandum, it is doubtful whether it continues to represent the IRS' position in light of the regulations.

9 See Treas. Reg. § 1.1001-3(c)(6)(iii) (providing that a "modification" occurs upon the effective date of a plan of reorganization in a Title 11 or similar case if a change in a term of a debt instrument occurs pursuant to such plan); see also Treas. Reg. § 1.1001-3(c)(4), (d), Ex. 13.

10 Treas. Reg. § 1.1001-3(c)(1)(i); see also Priv. Ltr. Rul. 2011-39-003 (Sept. 30, 2011) (subsidy payments made by loan servicer on behalf of borrower who was a member of the armed services were not a modification because subsidy payments were an arrangement between the borrower and the loan servicer that did not change the mortgage owners' legal relationship with the borrower).

11 Treas. Reg. § 1.1001-3(c)(1)(ii).

12 Under temporary and proposed regulations issued under section 1001, an exchange or assignment of derivatives (including notional principal contracts) by a dealer or clearing organization to another dealer or clearing organization is not a taxable event, even if a third party's consent is required. Temp. Reg. § 1.1001-4T(a)(1)-(2). If, however, the terms of the derivative instrument are otherwise modified, the assignment may result in a taxable exchange under section 1001. Temp. Reg. § 1.1001-4T(a)(3); see also Marie Sapirie, Proposed Regs Address Derivative Contract Assignments, TAX NOTES (July 25, 2011).

13 Treas. Reg. § 1.1001-3(c)(2)(i). Note that the obligor of a taxexempt bond is the entity that actually issues the bond and not a conduit borrower of bond proceeds. Treas. Reg. § 1.1001-3(f)(6)(i); see also Priv. Ltr. Rul. 2000-47-046 (Aug. 30, 2000) (parent obligor's removal of subsidiary as co-obligor on conduit loans securing industrial revenue bonds ("IRBs") was a modification occurring by operation of the terms of the IRBs where the loan terms allowed the removal of the subsidiary as co-obligor without the consent of the holders of the IRBs; change-in-obligor exception did not apply because neither the parent nor the subsidiary were considered obligors with respect to the IRBs, which are obligations of the issuing state or local governments or agencies).

14 Treas. Reg. § 1.1001-3(c)(2)(ii).

15 Treas. Reg. § 1.1001-3(c)(2)(iii).

16 It should be noted that this is an absolute test—even an economically insignificant right of the other party to alter the instrument may prevent the option from being unilateral. Obviously, a de minimis exception in this regard would be welcome. See also Priv. Ltr. Rul. 2011-49-017 (Dec. 9, 2011) (no significant modification after unilateral option resulting in mandatory tender by holders; in accordance with bond terms because the mandatory tender was not equivalent to a holder's right to alter or terminate the bonds).

17 Treas. Reg. § 1.1001-3(c)(3).

18 Treas. Reg. § 1.1001-3(c)(4)(i).

19 Treas. Reg. § 1.1001-3(c)(4)(ii).

20 Treas. Reg. § 1.1001-5.

21 Only eleven members of the European Union initially participated in the conversion of their national currencies to the euro. The eleven members were: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal and Spain. Today, sixteen of the twenty-seven member states of the European Union have adopted the euro as their official currency.

22 See, e.g., Deloitte & Touche Joins Microsoft and Others in Seeing Euro Conversion as "Non-Event," 98 TNT 93-35 (Apr. 30, 1998).

23 Treas. Reg. § 1.1001-5(a); T.D. 8776, 1998-2 C.B. 6 (July 29, 1998) (temporary regulations); T.D. 8927, 2001-1 C.B. 807 (Jan. 10, 2001) (final regulations).

24 Treas. Reg. § 1.1001-5(b) (effective for tax years ending after July 29, 1998).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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