Background 

In the current economic climate, borrowers are attempting to work with their lenders to change specific terms of their debt obligations. A common concern is whether the changes are to such a degree that for federal income tax purposes, the modification is considered an exchange of old debt for a modified debt instrument. If treated as an exchange, the borrower could recognize cancellation of debt income and the holder of the debt instrument could recognize gain or loss. In addition, if an exchange is treated as occurring, under existing rules the modified instrument may be characterized as equity for federal income tax purposes, which would deny interest deductions with respect to the modified instrument.   For example, if the value of the collateral has declined to less than the modified debt obligation, the Service could challenge a mortgage note as debt rather than equity. 

On June 4, 2010, the Internal Revenue Service issued proposed regulations to clarify that, in general, the deterioration in the financial condition of the issuer will not be considered in determining whether a debt has been significantly modified and whether the modified instrument is treated as debt or equity. The effect of the proposed regulation, if enacted, is to allow borrowers and lenders to be less concerned with: (i) a potential deemed exchange of a debt instrument resulting from the financial condition of the borrower and (ii) the treatment of the modified debt instrument as equity due to the financial condition of the borrower. 

Current Law

Treasury Regulation Section 1.1001-3 provides a set of rules to determine whether the terms of a debt instrument have been modified to the degree that the debt instrument will be treated as exchanged for the modified debt instrument for federal income tax purposes. Treasury Regulation Section 1.1001-3(e)(5) provides that the deterioration in the financial condition of the borrower occurring between the issue date and the date of modification is not in general taken into account for purposes of determining whether the modification results in an exchange of the old debt for the modified debt (with the exception of the substitution of a new obligor or the addition of a co-obligor). Treasury Regulation Section 1.1001-3, as currently enacted, does not address whether the deterioration of the financial condition of the borrower is considered in determining whether the modified debt instrument is debt or equity.

Proposed Regulation 

Proposed Treasury Regulation Section 1.1001-3(e)(5) provides that deterioration in the financial condition of the borrower occurring between the issue date and the date of the modification would not in general be taken into account in determining whether a debt exchange is treated as occurring (with the exception of the substitution of a new obligor or the addition of a co-obligor). Proposed Treasury Regulation Section 1.1001-3(f)(7)(ii) would add that in determining whether the modified instrument is debt or equity, any deterioration in the financial condition of the borrower occurring between the issue date and the date of the modification is not taken into account (with the exception of the substitution of a new obligor or the addition of a co-obligor). 

The proposed regulation, if enacted, would apply to alterations of instruments occurring on or after the publication of the final regulation in the Federal Register. 

Conclusion

The promulgation of the proposed Treasury Regulation would be a welcome clarification for clients seeking to modify the terms of their debt obligations. We will follow up on the development of the proposed regulation. 

CIRCULAR 230 NOTICE. Any advice expressed above as to tax matters was neither written nor intended by the sender or Klehr Harrison Harvey Branzburg LLP to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. If this document is delivered to any person or party other than to our client to whom the advice is directed, the recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient's particular circumstances from an independent tax advisor.

If you wish to discuss these matters further, please call Larry Arem at 215.569.4142 or Ben Kwon at 215.569.1496.