Debt Exchanges

1. INTRODUCTION

   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.

2. DEEMED EXCHANGES OF DEBT

   1. 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...