Modifying the terms of indebtedness, as opposed to cancelling or discharging the indebtedness, leaves the indebtedness outstanding but revises the terms governing the obligation. For example, the lender and borrower of a debt instrument may adjust the interest rate, change the collateral underlying the obligation, or defer or otherwise adjust the schedule of payments made on the debt instrument. Whether such a change in terms results in tax consequences is dependent on the terms of the original, unmodified indebtedness instrument, as well as the nature and extent of the changes made.
Parts I and II of this series discussed the tax consequences of the cancellation of indebtedness and various statutory and congressionally-enacted exceptions to the general rule that cancellation of indebtedness results in taxable gross income to the debtor (“COD Income”), and Part III defined indebtedness. This installment will focus on the modification, rather than cancellation, of indebtedness instruments and the potential tax consequences that may result from such modifications.
Why it Matters – the Tax Impact of Modifications
Section 1001 of the Internal Revenue Code (the “Code”) and Treasury Regulation § 1.1001-3 provide that if an alteration to a debt instrument is considered a “significant modification,” it may be treated as if a new debt instrument has been issued in exchange for the original debt instrument, resulting in a taxable exchange, despite the fact that no exchange has actually occurred. Although tax consequences are not generally the primary concern when restructuring debt, parties negotiating modifications to the terms of existing debt obligations should be aware of this potential consequence—it is precisely the times when debt restructurings are needed that an unexpected tax bill could cause large financial strain.
If a modification of a debt instrument is significant, the holder (the creditor of the obligation) may be treated as having sold the original instrument and receiving an amount realized equal to the difference between the issue price of the new, modified obligation and the adjusted basis in the original obligation, for which gain or loss must be recognized, and the issuer (the borrower) may have COD Income to the extent the adjusted issue price of the original debt exceeds the issue price of the new, modified obligation. It is also possible that the modification could result in original issue discount (“OID”) includible in the holder’s income.
An in-depth discussion of the nuances of adjusted basis, issue price, adjusted issue price, and OID is beyond the scope of this post, but basic definitions are helpful to understanding the concepts discussed throughout this post. The adjusted basis in the original obligation is generally the purchase price of the instrument, increased by any OID that has been included in the holder’s income for each year they held the instrument. The issue price of the new debt instrument is the fair market value of the debt instrument if either the new or original instrument (or both) are considered publicly traded under Treasury Regulation § 1.1273-2(f); If the instrument is not publicly traded but bears adequate stated interest, the issue price is equal to the principal amount of the debt instrument. The adjusted issue price of the original debt instrument is generally the principal amount if the debt was not issued at a discount and the instrument provided for current payment of interest. OID, a form of interest, is the excess of the stated redemption price at maturity over the issue price.
Determining Whether There Has Been a Significant Modification
In order to ascertain whether alterations to the terms of a debt instrument will result in taxable income, the original terms of the instrument and the altered terms must be examined. An alteration must be analyzed first to determine whether it is considered a “modification,” and, if deemed a modification, it must then be analyzed to determine whether the modification was a “significant modification.”
What Constitutes a Modification
Treasury Regulation § 1.1001-3 defines 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.” Alterations of legal obligations or rights that occur by operation of the terms of a debt instrument, however, whether automatically or through the exercise of a unilateral option, are generally not considered modifications (this exception, the “Terms of the Instrument Rule”).
Certain alterations are excluded from the Terms of the Instrument Rule, though. For example, alterations that result in the substitution of a new obligor, the addition or deletion of a co-obligor, a change in whole or in part in the recourse nature of the instrument, or an instrument or property right that is not debt for income tax purposes are considered modifications regardless of whether the alteration is pursuant to the terms of the instrument. Alterations resulting from the exercise of options, even if pursuant to the terms of the instrument, are also deemed modifications unless the option is unilateral or a holder-exercisable option that does not result in a deferral of, or reduction in, any scheduled payment of interest or principal.
Neither the failure of an issuer to perform its obligations under a debt instrument or the failure to exercise an option to change a term of a debt instrument is generally considered a modification. Notwithstanding this, though, if there is no written or oral agreement to alter other terms of the debt instrument and the forbearance does not remain in effect for more than two years, an agreement by the holder to stay collection or temporarily waive an acceleration clause is not a modification. If the forbearance remains in effect more than two years (and any additional period during which the issuer is in bankruptcy) from the issuer’s initial failure to perform, though, it can be considered a modification.
If an alteration to the legal rights or obligations of the issuer or holder of a debt instrument does not fall within a specifically stated exception, the alteration is a modification which must be evaluated for significance in order to determine whether the modification will result in tax consequences to the issuer and holder.
If a change in terms is a modification, it is deemed to be effective at the time the holder and issuer enter in the modification agreement, regardless of whether or not the change in terms is immediately effective.
When a Modification is a Significant Modification
Not all modifications will result in a taxable event—only those modifications considered significant modifications will be subject to possible tax consequences.
The Treasury Regulations provide five specific rules addressing certain types of modifications to determine whether such modifications are significant. These specific rules address changes in yield, changes in timing of payments, changes in obligor or security, changes in the nature of a debt instrument, and changes affecting accounting or financial covenants. If a modification does not fall within one of these five specific rules, the general rule discussed below will govern.
The general rule provides that “a modification is a significant modification 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.” When determining whether a modification is significant under the general rule, all modifications falling under the general rule are considered collectively, with the result that the collective modifications may be considered significant even if each modification would not independently be a significant modification.
Changes in Yield
A modification that results in the change in the yield of a debt instrument is a significant modification if the yield of the modified instrument varies from the annual yield on the unmodified instrument by more than the greater of ¼ of one percent (25 basis points) or 5% of the annual yield of the unmodified debt instrument.
Changes in Timing of Payment
The Treasury Regulations provide that a modification that changes the timing of payments due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments. Whether a deferral is material is a facts and circumstances analysis determined based on a number of items, 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.
The Treasury Regulations contain a safe-harbor period, which begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the instrument. Under the safe harbor, a deferral of one or more scheduled payments within the safe-harbor period is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the safe-harbor period. If the period during which payments are deferred is less than the full safe-harbor period, the unused portion of the period remains a safe-harbor period for any subsequent deferral of payments on the instrument.
Changes in Obligor or Security
Generally, the substitution of a new obligor on a recourse debt instrument is a significant modification, although the Treasury Regulations do provide exceptions for instances such as certain corporate acquisitions and bankruptcy proceedings. The substitution of a new obligor on a nonrecourse debt instrument is not, however, a significant modification. These differing results are consistent with the principles of recourse and nonrecourse indebtedness—a taxpayer is personally liable for recourse indebtedness and the substitution of a new obligor would economically change the taxpayer’s position by releasing him from his liability, whereas a taxpayer is not personally liable for nonrecourse debt and therefore is not economically impacted by the substitution of a new obligor.
An addition or deletion of a co-obligor on a debt instrument or a change in the priority of a debt instrument relative to other debt of the issuer is a significant modification if the addition, deletion, or change results in a change in payment expectation. Modifications that release, substitute, add or otherwise alter the collateral or other form of credit enhancement may also be considered significant modifications.
Changes in the Nature of a Debt Instrument
A modification of a debt instrument resulting in an instrument or property right that is not considered debt for federal income tax purposes is a significant modification; Examples of such modifications include reducing creditors’ rights or subordinating the modified debt. To determine whether the modified obligation should be classified as debt, traditional debt and equity factors, which were discussed in Part III of this series, are evaluated. However, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor, the Regulations provide that deterioration of the financial condition of the issuer will not be considered as a factor in determining the classification. Additionally, a change in the nature of a debt instrument from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), or vice versa, is a significant modification.
The Treasury Regulations do provide exceptions to this rule, though, for defeasance of tax-exempt bonds and modifications resulting in an instrument changing from recourse to nonrecourse where the obligation continues to be secured only by the original collateral, with no change in payment expectations.
It is also important to note that if the issuer is a partnership, a failure of the obligation to continue to be characterized as debt or a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, could result in deemed contributions or distributions of cash by or to the partners of the partnership under § 752 of the Code, impacting the partners’ capital accounts, outside basis, and potentially requiring gain recognition.
Accounting or Financial Covenants
The Treasury Regulations provide that a modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.
Modifications of Non-Debt Obligations
While the primary focus of this post is the modification of debt instruments, it is important to note that even if an obligation does not constitute indebtedness (for a discussion of the definition of indebtedness, see Part III of this series), there may still be tax implications as a result of the modification of the obligation.
For example, modifications of commercial leases may cause a lease to become subject to § 467, a provision in the Code intended to prevent certain perceived timing abuses regarding the income and deductions associated with certain leases. Leases may be subject to § 467 when initially entered into or may become subject to § 467 as a result of modifications which cause the lease to be deemed a new lease falling within the scope of § 467. A discussion of the precise modifications that may cause a lease to be subject to § 467 is beyond the scope of this post, but the § 467 Regulations provide a framework similar to that under Regulation § 1.1001-3, discussed above, which analyzes the type and substantiality of the modification in comparison to the pre-modification lease.
Section 467 applies to leases for tangible property under which (i) all rent due under the lease exceeds $250,000 and (ii) the lease provides for deferred or prepaid rent in relation to when the rent is accrued or provides that the amount of accrued rent within a rental period changes throughout the lease. If § 467 applies, the lessor and lessee are required to report income and deductions under the accrual method of accounting, regardless of their traditional method of accounting, and the parties may be required to recognize or recharacterize prepaid or deferred rents as imputed interest. If unexpected, these results could be costly.
Taxpayers should be aware of the potential tax consequences that may result from the modification, restructuring or renegotiation of both debt instruments and non-debt obligations. If a taxpayer-debtor enters into a modification of a debt instrument that is considered significant and the taxpayer has COD Income as a result of the significant modification, the taxpayer should consult with a tax advisor to determine whether there are any exceptions available to exclude the COD Income from gross income. Exceptions to COD Income inclusion were discussed in Parts I and II of this series, and further installments will discuss the exceptions in more detail.
For any questions on this or any other tax-related matter, please feel free to contact Charles Pulman at firstname.lastname@example.org or by phone at (214) 749-2447 and Annie McGinnis at email@example.com or by phone at (214) 749-2412. This blog was written based on the law as in effect on June 23, 2020.