The IRS ruled in a private letter ruling that a consent fee a debtor paid its creditors was a modification of the underlying debt and must be tested as a significant modification under Treas. Reg. Sec. 1.1001-3.
In PLR 201431003, the taxpayer, a publicly traded and widely held C corporation, had issued certain outstanding exchangeable debentures, which constituted contingent payment debt instruments as defined in Treas. Reg. Sec. 1.1275-4 (notes).
The taxpayer was planning a spin-off transaction. However, prior to an earlier transaction that was similar to the spinoff, the taxpayer and the holders of the notes engaged in a dispute regarding whether the earlier transaction violated a term of the notes. The taxpayer prevailed in litigation, but the process delayed the earlier spinoff and was costly to the taxpayer, who was also required to pay the note holders' legal fees.
In light of the litigation related to the earlier transaction, the taxpayer wanted to negotiate a one-time payment with the noteholders in exchange for their consent to the spinoff.
Under Treas. Reg. Sec. 1.1001-3, a modification of a debt generally means any alterations, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of debt with certain exceptions. While a debt modification that is not a "significant modification" doesn't result in an exchange, Treas. Reg. Sec. 1.1001-3(b) provides that a significant modification results in a deemed exchange of the existing debt for a new debt.
Whether a debt modification constitutes a significant modification is based on the facts and circumstances. However, Treas. Reg. Sec. 1.1001-3(e) provides a bright-line test that a significant modification occurs when a debt modification changes the yield of a debt by more than the greater of one-fourth of 1% or 5% of the annual yield of the unmodified debt.
Because the one-time consent payment would result in the noteholders' receiving more money than they otherwise would have under the terms of the notes, the payment would change the yield on the notes. Therefore, the IRS ruled that the consent payment would constitute a debt modification of the notes that must be tested to be treated as a significant modification under Treas. Reg. Sec. 1.1001-3.
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