Mission Creep: The Expanding Role Of The Debt Modification Regulations

By Mark Leeds and Donny McGraw1

The 2014 Burning Man Festival was an incredible experience, in part, because it forced one of your authors completely out of his comfort zone and to re-think his approach to things from simple daily interactions to those involving world issues. When I returned, I advocated that we send all of our prospective leaders to the 2015 Festival because one of the key to successful business leadership is being able to succeed in a hostile environment (the Festival takes place on corrosive dust) with unforeseeable challenges. Somehow though, I don't think that the Burning Man community would find an extension of the Festival to a "partner boot camp" as being fully consistent with their underlying values. The debt modification regulations in Treasury Regulation § 1.1001-3, however, have been undergoing an analogous expansion of mission.

While these regulations were originally promulgated to address only the federal income tax consequences to limited changes to debt instruments, in numerous instances as of late, the Internal Revenue Service (the "IRS") has used these regulations beyond their original scope. This article explores the recent mission creep of the debt modification regulations and whether such expansion is consistent with the values of such regulations.

A Brief Background

As a general rule, a taxpayer must recognize gain or loss realized from an exchange of property where the property exchanged differs "materially either in kind or in extent" from the property received.2 This rule is not limited to actual exchanges. For example, a modification to a bilateral arrangement may be so substantial as to amount to a deemed exchange of the "old" property for "new" property.3 Although contractual changes resulting in deemed exchanges is a not a novel concept, significant uncertainty remains with respect to the determination of whether such changes result in a deemed exchange. As a result of this uncertainty, various rules have been developed through judicial decisions, IRS rulings and pronouncements, and regulations. While these rules have been effective at fostering certainty with respect to the tax impact of changes to debt instruments, there continues to be a dearth of authority with respect to many non-debt financial instruments.

Prior to the issuance of Treasury Regulation § 1.1001-3 in 1992, interpretation of the "material difference" principle of Treasury Regulation § 1.1001-1(a) was most notably addressed by the IRS in Revenue Ruling 90-1094 and by the Supreme Court in Cottage Savings Assn. v. Comm'r.5

Revenue Ruling 90-109 dealt with a taxpayer that purchased a key person insurance policy on the life of an employee, listing the taxpayer as the sole beneficiary under the policy. The policy provided the taxpayer with the right to change the insured, which the taxpayer eventually exercised. The only change effected by the exercise of the right was changing the employee insured under the policy; the benefits and premiums under the policy were not changed.

In its analysis, the IRS articulated the "fundamental change" concept that provides, in relevant part, that "[a] change in contractual terms ... is treated as an exchange under [S]ection 1001 if there is a sufficiently fundamental or material change [such] that the substance of the original contract is altered." Looking at the exercise of the right by the taxpayer, the IRS determined that the essence of a life insurance contract is the life that is insured under the contract, and therefore viewed the exercise of the right as substantively the same as an actual exchange of contracts. As a result, the IRS held that the exercise of the option by the taxpayer resulted in a taxable sale or disposition of the policy under Section 1001 of the Internal Revenue Code of 1986, as amended (the "Code").

In the year following the issuance of Revenue Ruling 90-109, the Supreme Court addressed Code § 1001 exchange principles in Cottage Savings. This case involved a strategy by a savings and loan association to trigger losses for federal income tax purposes without impairing net worth for regulatory purposes. Specifically, the taxpayer entered into "reciprocal sale" transactions. The strategy arose from a rule change adopted by the Federal Home Loan Bank Board ("FHLBB"), which permitted savings and loan associations to exchange pools of residential mortgages without recognition of accounting losses where the mortgage pools are "substantially identical."6 In a transaction structured to qualify for the rule change, the taxpayer sold 90 percent participation interests in mortgage pools to four savings and loan associations while simultaneously purchasing 90 percent participation interests in mortgage pools held by the same savings and loan associations. All of the loans involved in the transaction qualified as "substantially identical," as defined in the FHLBB rule.

The taxpayer claimed a loss deduction from the exchange on its tax return for the year of the transaction. The loss was disallowed by the IRS but was ultimately held to be deductible by the Supreme Court. The Supreme Court determined that the realization principle in Code § 1001(a) incorporates a "material difference" requirement and provided guidance on what the requirement amounts to and how it applies.7 The Court focused on the fact that the mortgages were recourse obligations and the obligors on the mortgages were different. An exchange of a mortgage issued by individual X was held to be fundamentally different than a mortgage issued by individual Y.

While the Supreme Court's decision in Cottage Savings provided some guidance on how to evaluate the "material difference" requirement, the Supreme Court's "legally distinct entitlements" standard did not provide a high degree of certainty with respect to the types of changes to financial products or contracts that could result in a deemed exchange and the recognition of gain or loss.8 Of particular concern was the focus on differences in legal rights whether or not such rights were economically material. As a result, a number of questions remained as to whether very slight modifications in the terms of a financial product or contract could result in a recognition event.

Treasury Regulation § 1.1001-3 (the "Modification Regulations")

The IRS issued the Modification Regulations in 1992, which were finalized in 1996, to address when changes to the terms of a debt instrument causes the debt instrument to be considered to be re-issued.9 The Modification Regulations clarified the instances in which a change in a debt instrument will be treated as an exchange by limiting the application of Code § 1001 to instances where (i) the change results in a "modification" of the debt instrument and (ii) such modification is "significant."10

The Modification Regulations define a "modification" as "any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise."11 In general, an alteration that occurs by operation of the terms of a debt instrument is not a modification; however, certain fundamental changes (e.g., change in obligor of a recourse debt instrument, nature of debt and tax classification of debt) are treated as modifications even if permitted by the terms of the debt instrument.12

Once it is determined that a change in the terms of a debt instrument constitutes a "modification," a deemed exchange will result only where such modification is "significant." In general, and except as otherwise provided in the detailed rules discussed below, a modification is significant "only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant."13 In determining whether changes to legal rights or obligations are economically significant, all modifications to a debt instrument are considered collectively. Outside of the general significance rule, the Modification Regulations provide that the following changes will result in a deemed exchange:

Change in Yield. A modification to the yield of a debt instrument if the modification varies the yield on the unmodified debt instrument by the greater of one-quarter of one percent (.0025) or 5 percent of its original yield.14 This rule, however, does not apply to contingent payment debt instruments.15 Change in Timing of Payments. A modification to the timing of payments if the modification results in the material deferral of scheduled payments.16 The materiality of the deferral depends on all the facts and circumstances, including the length of the deferral, the original term of the instrument, the amounts of the payments that are deferred, and the time period between the modification and the actual deferral of payments.17 A safe harbor is provided (i.e., a deemed exchange will not result) where deferred payments are unconditionally payable no later than the lesser of five years or 50 percent of the original term for the instrument.18 Change in Obligor. Subject to limited exceptions, the substitution of a new obligor on recourse debt instruments is a significant modification.19 The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification and thus does not result in a deemed exchange.20 Change in Security. A modification to the collateral for, a guarantee on, or other form of credit enhancement for a recourse debt instrument that results in a change in payment expectations is a significant modification.21 A change in payment expectations results where: (i) there is a substantial enhancement of the obligor's capacity to meet payment obligations and that capacity was primarily speculative prior to the modification and is adequate after...