Debt Exchanges (Debt Restructuring)

Article by Linda Z. Swartz *

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 co-obligor, 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

         For example, a change in the currency denomination of a bond from French francs to euros as a result of the conversion of the franc to the euro is not a "modification" under the section 1001 regulations.25

         If a party to a debt instrument has an option to change a term of an instrument, the failure of the party to exercise that option is not a modification.26

         A modification is tested when the parties agree to a change, even if the change is not immediately effective.27 The regulations provide exceptions for a change in a term that is agreed to by the parties but is subject to reasonable closing conditions or that occurs as a result of bankruptcy proceedings.28 In these cases, a modification occurs on the date the change in the term becomes effective.29 Thus, if the conditions do not occur (and the change in the term does not become effective), a modification does not occur.

      2. Significant Modifications

         As stated above, a modification must be "significant" to trigger a deemed exchange. The regulations describe categories of modifications that generally would be considered significant and add a general rule for types of modifications for which specific rules are not provided.30 Under this general rule (the "general significance rule"), a modification is significant if, based on all the facts and circumstances, the legal rights or obligations being changed and the degree to which they are being changed are economically significant.31

         When testing a modification under the general significance rule, all modifications made to the instrument (other than those for which specific bright-line rules are provided) are considered collectively. Thus, a series of related modifications, each of which independently is not significant under the general significance rule, may together constitute a significant modification.32 The general significance rule also applies to a type of modification for which specific rules are provided if the modification is effective upon the occurrence of a substantial contingency.33 Moreover, the general significance rule will apply to certain types of modifications that are effective on a substantially deferred basis.34

         1. Changes in Yield

            The regulations provide that a change in yield is significant if the change exceeds the greater of 25 basis points or 5% of the original yield on the instrument. This bright-line rule is limited to fixed rate and variable rate debt instruments. Because of the difficulties in developing appropriate mechanisms for measuring changes in the yield of other debt instruments (for example, contingent payment debt instruments), the regulations provide that the significance of changes in the yield of those other instruments is determined under the general significance rule, described above.35 A commercially reasonable prepayment penalty generally is not taken into account in determining the yield of the modified instrument.36

            Example 1: ABC Corp. issues to L a debt instrument bearing a 10% annual interest rate at par. ABC Corp. and L agree to a modification of the debt instrument that reduces the yield to 9.25%. The 75 basis point reduction in yield is a significant modification because it exceeds 50 basis points (i.e., the greater of 25 basis points or the product of 5% and the original yield of 10%). To avoid a significant modification from a change in yield, the yield should not be reduced below 9.5%.

         2. Changes in Timing and Amount of...