Treasury Finalizes New Debt Modification Regulations

By Jonathan Prokup

On Friday, the Treasury Department issued final regulations under Code section 1001 relating to the modification of debt instruments.  In relevant part, the regulation provides that, following the modification of a debt instrument, the classification of the modified instrument as debt or equity for federal income tax purposes does not take into account any deterioration in the financial condition of the obligor.  Treas. Reg. § 1.1001-3(f)(7)(ii)(A).

The only public comment on the proposed regulations noted that the existing regulation does not contain rules for determining whether a modified debt instrument remains debt for federal tax purposes.  As a result, the comment expressed concern that the regulation could be read to suggest that it would apply only “to determine whether an exchange has occurred, and not the determination of the character of a new instrument resulting from a significant modification.”  The final regulations add language to the general rule of Treas. Reg. § 1001-3(b) to make clear that the new rules apply to determine whether (i) an exchange has occurred and (ii) retains its prior characterization as debt for federal tax purposes.

As we previously discussed, absent this rule, holders of the debt of troubled obligors might be less willing to restructure the debt because of the risk of the restructuring being treated as an exchange, and therefore a recognition event, for federal income tax purposes.  If any financial deterioration of the obligor were taken into account, that factor could increase the risk that the debt would be recharacterized as something else following the modification.  Thus, the proposed regulations were a welcome (if incomplete) step to facilitating modifications of the debts of troubled obligors.

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