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Times are tough, and many troubled companies are facing the need to modify debts that were issued when times were better (and the companies were financially much stronger). For companies that wish to modify their debts, and for investors that hold those debts, federal tax law imposes an unfortunate limitation. An outstanding debt that undergoes a “significant modification” is treated as having been exchanged for a new instrument with the modified terms. See Treas. Reg. § 1.1001-3. As a result, holders of the debt will generally be required to recognize gain or loss on the deemed exchange of the debt and, in some instances, the issuer may be forced to recognize income as well. Thus, the question of whether a modification will result in a deemed exchange of the debt for federal income tax purposes has the potential to complicate, or even derail, potentially beneficial debt modifications.
One way in which the modification of a debt instrument can result in a deemed exchange is if the instrument is modified to such an extent that it is no longer characterized as debt for federal tax purposes. Treas. Reg. § 1.1001-3(e)(5)(i). As most practitioners know, the characterization of an instrument as debt or equity for federal tax purposes is a complex, and somewhat imprecise, determination that takes into account a wide variety of factors. To quote Bittker and Eustice’s legendary treatise:
The crux of the classification problem is that “debt” and “equity” are labels for the two edges of a spectrum, between which lie an infinite number of investment instruments, each differing from its nearest neighbors in barely perceptible ways.
Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations & Shareholders ¶ 4.02. The factors that can influence the classification of an instrument as debt or equity include: the obligor’s debt-to-equity ratio, the instrument’s priority of payment, the presence (or absence) of a fixed maturity date, and the rate of return (or “yield”) payable on the instrument.
When the Treasury Department first issued regulations governing the effect of modifications of debt instruments, commentators expressed concern that a deterioration in the financial condition of the obligor between the debt’s issuance and the date of a modification could lead to a determination that the modified instrument is not debt for tax purposes. To alleviate this concern, the final regulations provided that any deterioration in the financial condition of the obligor between the issue date and the date of the modification is not taken into account for purposes of classifying a modified instrument as debt or equity for federal tax purposes.
Notwithstanding this limitation in the regulations, taxpayers expressed concern that the regulations could be interpreted so that a decline in the creditworthiness of an obligor might be taken into account for purposes of the debt modification rule. This ambiguity, it was thought, could inhibit the restructuring of debt of a company whose financial condition had deteriorated since the issuance of the debt.
On June 3rd, the Treasury Department issued proposed regulations intended to remedy this uncertainty. (You can find the regulations here.) The proposed regulations insert a new § 1.1001-3(f)(7), which clarifies that the determination of whether an instrument is debt or equity for purposes of this rule is made without regard to any deterioration in the financial condition of the obligor (as it relates to the obligor’s ability to repay the debt instrument). Thus, the preamble provides that a decrease in the value of a debt instrument between the issue date and the date of any prospective modification is not taken into account to the extent the decrease is attributable to the deterioration in the obligor’s financial condition and not to a modification of the terms of the instrument.
Further, though not reflected in the text of the proposed regulations, the preamble suggests that a special rule applies in the case of a modification of publicly traded debt. According to the preamble, if the issue price of a modified instrument is determined under the rules of Treas. Reg. § 1.1273-2(b) or (c) (relating to the issue price for publicly traded debt), any increased yield on the modified instrument is not taken into account to characterize the modified instrument as debt or equity to the extent the increased yield is attributable to a deterioration in the financial condition of the obligor. In contrast, a change in market interest rates generally would be taken into account in characterizing the modified instrument.
Unfortunately, the regulations and the preamble leave unanswered the nagging, and ultimately central, question: how are taxpayers to apportion changes in the value of a pre-modification debt instrument among (i) changes in market interest rates, (ii) the modification of the instrument, and (iii) the deterioration in the obligor’s financial condition? For example, some portion of any decline in an instrument’s pre-modification value could very well be due to investors’ anticipation of the modifications themselves. Likewise, to the extent that the obligor’s deteriorating financial condition coincides with the deterioration of other companies in the same industry, identifying the change that is due to any particular issuer’s deterioration will be, at best, an expensive challenge that will have no certainty of being respected by the IRS.
I don’t dismiss the possibility that, in issuing the regulations, the Treasury Department may have intended to give troubled obligors a wide berth that will enable them to restructure debt with minimal interference from the government. Nevertheless, if that is the Treasury Department’s intent, they have not done a particularly good job communicating that intent to taxpayers.