[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1001-3]
[Page 17-26]
TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
PART 1--INCOME TAXES--Table of Contents
Sec. 1.1001-3 Modifications of debt instruments.
(a) Scope--(1) In general. This section provides rules for
determining whether a modification of the terms of a debt instrument
results in an exchange for purposes of Sec. 1.1001-1(a). This section
applies to any modification of a debt instrument, regardless of the form
of the modification. For example, this section applies to an exchange of
a new instrument for an existing debt instrument, or to an amendment of
an existing debt instrument. This section also applies to a modification
of a debt instrument that the issuer and holder accomplish indirectly
through one or more transactions with third parties. This section,
however, does not apply to exchanges of debt instruments between
holders.
(2) Qualified tender bonds. This section does not apply for purposes
of determining whether tax-exempt bonds that are qualified tender bonds
are reissued for purposes of sections 103 and 141 through 150.
(b) General rule. For purposes of Sec. 1.1001-1(a), a significant
modification of a debt instrument, within the meaning of this section,
results in an exchange of the original debt instrument for a modified
instrument that differs materially either in kind or in extent. A
modification that is not a significant modification is not an exchange
for purposes of Sec. 1.1001-1(a). Paragraphs (c) and (d) of this section
define the term modification and contain examples illustrating the
application of the rule. Paragraphs (e) and (f) of this section provide
rules for determining when a modification is a significant modification.
Paragraph (g) of this section contains examples illustrating the
application of the rules in paragraphs (e) and (f) of this section.
(c) Modification defined--(1) In general--(i) Alteration of terms. A
modification means 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.
(ii) Alterations occurring by operation of the terms of a debt
instrument. Except as provided in paragraph (c)(2) of this section, an
alteration of a legal right or obligation that occurs by operation of
the terms of a debt instrument is not a modification. 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.
(2) Exceptions. The alterations described in this paragraph (c)(2)
are modifications, even if the alterations occur by operation of the
terms of a debt instrument.
(i) Change in obligor or nature of instrument. An alteration that
results in the substitution of a new obligor, 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) is a modification.
(ii) Property that is not debt. An alteration that results in an
instrument or property right that is not debt for Federal income tax
purposes is a modification 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 (notwithstanding paragraph
(c)(2)(iii) of this section).
(iii) Certain alterations resulting from the exercise of an option.
An alteration that results from the exercise of an option provided to an
issuer or a holder
[[Page 18]]
to change a term of a debt instrument is a modification unless--
(A) The option is unilateral (as defined in paragraph (c)(3) of this
section); and
(B) 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.
(3) Unilateral option. For purposes of this section, an option is
unilateral only if, under the terms of an instrument or under applicable
law--
(i) There does not exist at the time the option is exercised, or as
a result of the exercise, a right of the other party to alter or
terminate the instrument or put the instrument to a person who is
related (within the meaning of section 267(b) or section 707(b)(1)) to
the issuer;
(ii) The exercise of the option does not require the consent or
approval of--
(A) The other party;
(B) A person who is related to that party (within the meaning of
section 267(b) or section 707(b)(1)), whether or not that person is a
party to the instrument; or
(C) 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 (as
defined in Sec. 1.446-3(c)(4)(ii)).
(4) Failure to perform--(i) In general. The failure of an issuer to
perform its obligations under a debt instrument is not itself an
alteration of a legal right or obligation and is not a modification.
(ii) Holder's temporary forbearance. Notwithstanding paragraph
(c)(1) of this section, absent a written or oral agreement to alter
other terms of the debt instrument, 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--
(A) Two years following the issuer's initial failure to perform; and
(B) Any additional period during which the parties conduct good
faith negotiations or during which the issuer is in a title 11 or
similar case (as defined in section 368(a)(3)(A)).
(5) Failure to exercise an option. 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.
(6) Time of modification--(i) In general. Except as provided in this
paragraph (c)(6), an agreement to change a term of a debt instrument is
a modification at the time the issuer and holder enter into the
agreement, even if the change in the term is not immediately effective.
(ii) Closing conditions. If the parties condition a change in a term
of a debt instrument on reasonable closing conditions (for example,
shareholder, regulatory, or senior creditor approval, or additional
financing), a modification occurs on the closing date of the agreement.
Thus, if the reasonable closing conditions do not occur so that the
change in the term does not become effective, a modification does not
occur.
(iii) Bankruptcy proceedings. If a change in a term of a debt
instrument occurs pursuant to a plan of reorganization in a title 11 or
similar case (within the meaning of section 368(a)(3)(A)), a
modification occurs upon the effective date of the plan. Thus, unless
the plan becomes effective, a modification does not occur.
(d) Examples. The following examples illustrate the provisions of
paragraph (c) of this section:
Example 1. Reset bond. A bond provides for the interest rate to be
reset every 49 days through an auction by a remarketing agent. The reset
of the interest rate occurs by operation of the terms of the bond and is
not an alteration described in paragraph (c)(2) of this section. Thus,
the reset of the interest rate is not a modification.
Example 2. Obligation to maintain collateral. The original terms of
a bond provide that the bond must be secured by a certain type of
collateral having a specified value. The terms also require the issuer
to substitute
[[Page 19]]
collateral if the value of the original collateral decreases. Any
substitution of collateral that is required to maintain the value of the
collateral occurs by operation of the terms of the bond and is not an
alteration described in paragraph (c)(2) of this section. Thus, such a
substitution of collateral is not a modification.
Example 3. Alteration contingent on an act of a party. The original
terms of a bond provide that the interest rate is 9 percent. The terms
also provide that, if the issuer files an effective registration
statement covering the bonds with the Securities and Exchange
Commission, the interest rate will decrease to 8 percent. If the issuer
registers the bond, the resulting decrease in the interest rate occurs
by operation of the terms of the bond and is not an alteration described
in paragraph (c)(2) of this section. Thus, such a decrease in the
interest rate is not a modification.
Example 4. Substitution of a new obligor occurring by operation of
the terms of the debt instrument. Under the original terms of a bond
issued by a corporation, an acquirer of substantially all of the
corporation's assets may assume the corporation's obligations under the
bond. Substantially all of the corporation's assets are acquired by
another corporation and the acquiring corporation becomes the new
obligor on the bond. Under paragraph (c)(2)(i) of this section, the
substitution of a new obligor, even though it occurs by operation of the
terms of the bond, is a modification.
Example 5. Defeasance with release of covenants. (i) A corporation
issues a 30-year, recourse bond. Under the terms of the bond, the
corporation may secure a release of the financial and restrictive
covenants by placing in trust government securities as collateral that
will provide interest and principal payments sufficient to satisfy all
scheduled payments on the bond. The corporation remains obligated for
all payments, including the contribution of additional securities to the
trust if necessary to provide sufficient amounts to satisfy the payment
obligations. Under paragraph (c)(3) of this section, the option to
defease the bond is a unilateral option.
(ii) The alterations occur by operation of the terms of the debt
instrument and are not described in paragraph (c)(2) of this section.
Thus, such a release of the covenants is not a modification.
Example 6. Legal defeasance. Under the terms of a recourse bond, the
issuer may secure a release of the financial and restrictive covenants
by placing in trust government securities that will provide interest and
principal payments sufficient to satisfy all scheduled payments on the
bond. Upon the creation of the trust, the issuer is released from any
recourse liability on the bond and has no obligation to contribute
additional securities to the trust if the trust funds are not sufficient
to satisfy the scheduled payments on the bond. The release of the issuer
is an alteration described in paragraph (c)(2)(i) of this section, and
thus is a modification.
Example 7. Exercise of an option by a holder that reduces amounts
payable. (i) A financial institution holds a residential mortgage. Under
the original terms of the mortgage, the financial institution has an
option to decrease the interest rate. The financial institution
anticipates that, if market interest rates decline, it may exercise this
option in lieu of the mortgagor refinancing with another lender.
(ii) The financial institution exercises the option to reduce the
interest rate. The exercise of the option results in a reduction in
scheduled payments and is an alteration described in paragraph
(c)(2)(iii) of this section. Thus, the change in interest rate is a
modification.
Example 8. Conversion of adjustable rate to fixed rate mortgage. (i)
The original terms of a mortgage provide for a variable interest rate,
reset annually based on the value of an objective index. Under the terms
of the mortgage, the mortgagor may, upon the payment of a fee equal to a
specified percentage of the outstanding principal amount of the
mortgage, convert to a fixed rate of interest as determined based on the
value of a second objective index. The exercise of the option does not
require the consent or approval of any person or create a right of the
holder to alter the terms of, or to put, the instrument.
(ii) Because the required consideration to exercise the option is a
specified amount fixed on the issue date, the exercise of the option is
unilateral as defined in paragraph (c)(3) of this section. The
conversion to a fixed rate of interest is not an alteration described in
paragraph (c)(2) of this section. Thus, the change in the type of
interest rate occurs by operation of the terms of the instrument and is
not a modification.
Example 9. Holder's option to increase interest rate. (i) A
corporation issues an 8-year note to a bank in exchange for cash. Under
the terms of the note, the bank has the option to increase the rate of
interest by a specified amount upon a certain decline in the
corporation's credit rating. The bank's right to increase the interest
rate is a unilateral option as described in paragraph (c)(3) of this
section.
(ii) The credit rating of the corporation declines below the
specified level. The bank exercises its option to increase the rate of
interest. The increase in the rate of interest occurs by operation of
the terms of the note and does not result in a deferral or a reduction
in the scheduled payments or any other alteration described in paragraph
(c)(2) of this section. Thus, the change in interest rate is not a
modification.
[[Page 20]]
Example 10. Issuer's right to defer payment of interest. A
corporation issues a 5-year note. Under the terms of the note, interest
is payable annually at the rate of 10 percent. The corporation, however,
has an option to defer any payment of interest until maturity. For any
payments that are deferred, interest will compound at a rate of 12
percent. The exercise of the option, which results in the deferral of
payments, does not result from the exercise of an option by the holder.
The exercise of the option occurs by operation of the terms of the debt
instrument and is not a modification.
Example 11. Holder's option to grant deferral of payment. (i) A
corporation issues a 10-year note to a bank in exchange for cash.
Interest on the note is payable semi-annually. Under the terms of the
note, the bank may grant the corporation the right to defer all or part
of the interest payments. For any payments that are deferred, interest
will compound at a rate 150 basis points greater than the stated rate of
interest.
(ii) The corporation encounters financial difficulty and is unable
to satisfy its obligations under the note. The bank exercises its option
under the note and grants the corporation the right to defer payments.
The exercise of the option results in a right of the corporation to
defer scheduled payments and, under paragraph (c)(3)(i) of this section,
is not a unilateral option. Thus, the alteration is described in
paragraph (c)(2)(iii) of this section and is a modification.
Example 12. Alteration requiring consent. The original terms of a
bond include a provision that the issuer may extend the maturity of the
bond with the consent of the holder. Because any extension pursuant to
this term requires the consent of both parties, such an extension does
not occur by the exercise of a unilateral option (as defined in
paragraph (c)(3) of this section) and is a modification.
Example 13. Waiver of an acceleration clause. Under the terms of a
bond, if the issuer fails to make a scheduled payment, the full
principal amount of the bond is due and payable immediately. Following
the issuer's failure to make a scheduled payment, the holder temporarily
waives its right to receive the full principal for a period ending one
year from the date of the issuer's default to allow the issuer to obtain
additional financial resources. Under paragraph (c)(4)(ii) of this
section, the temporary waiver in this situation is not a modification.
The result would be the same if the terms provided the holder with the
right to demand the full principal amount upon the failure of the issuer
to make a scheduled payment and, upon such a failure, the holder
exercised that right and then waived the right to receive the payment
for one year.
(e) Significant modifications. Whether the modification of a debt
instrument is a significant modification is determined under the rules
of this paragraph (e). Paragraph (e)(1) of this section provides a
general rule for determining the significance of modifications not
otherwise addressed in this paragraph (e). Paragraphs (e) (2) through
(6) of this section provide specific rules for determining the
significance of certain types of modifications. Paragraph (f) of this
section provides rules of application, including rules for modifications
that are effective on a deferred basis or upon the occurrence of a
contingency.
(1) General rule. Except as otherwise provided in paragraphs (e)(2)
through (e)(6) of this section, 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. In making a determination under
this paragraph (e)(1), all modifications to the debt instrument (other
than modifications subject to paragraphs (e) (2) through (6) of this
section) are considered collectively, so that a series of such
modifications may be significant when considered together although each
modification, if considered alone, would not be significant.
(2) Change in yield--(i) Scope of rule. This paragraph (e)(2)
applies to debt instruments that provide for only fixed payments, debt
instruments with alternative payment schedules subject to Sec. 1.1272-
1(c), debt instruments that provide for a fixed yield subject to
Sec. 1.1272-1(d) (such as certain demand loans), and variable rate debt
instruments. Whether a change in the yield of other debt instruments
(for example, a contingent payment debt instrument) is a significant
modification is determined under paragraph (e)(1) of this section.
(ii) In general. A change in the yield of a debt instrument is a
significant modification if the yield computed under paragraph
(e)(2)(iii) of this section varies from the annual yield on the
unmodified instrument (determined as of the date of the modification) by
more than the greater of--
(A) \1/4\ of one percent (25 basis points); or
[[Page 21]]
(B) 5 percent of the annual yield of the unmodified instrument (.05
x annual yield).
(iii) Yield of the modified instrument--(A) In general. The yield
computed under this paragraph (e)(2)(iii) is the annual yield of a debt
instrument with--
(1) An issue price equal to the adjusted issue price of the
unmodified instrument on the date of the modification (increased by any
accrued but unpaid interest and decreased by any accrued bond issuance
premium not yet taken into account, and increased or decreased,
respectively, to reflect payments made to the issuer or to the holder as
consideration for the modification); and
(2) Payments equal to the payments on the modified debt instrument
from the date of the modification.
(B) Prepayment penalty. For purposes of this paragraph (e)(2)(iii),
a commercially reasonable prepayment penalty for a pro rata prepayment
(as defined in Sec. 1.1275-2(f)) is not consideration for a modification
of a debt instrument and is not taken into account in determining the
yield of the modified instrument.
(iv) Variable rate debt instruments. For purposes of this paragraph
(e)(2), the annual yield of a variable rate debt instrument is the
annual yield of the equivalent fixed rate debt instrument (as defined in
Sec. 1.1275-5(e)) which is constructed based on the terms of the
instrument (either modified or unmodified, whichever is applicable) as
of the date of the modification.
(3) Changes in timing of payments--(i) In general. A modification
that changes the timing of payments (including any resulting change in
the amount of payments) due under a debt instrument is a significant
modification if it results in the material deferral of scheduled
payments. The deferral may occur either through an extension of the
final maturity date of an instrument or through a deferral of payments
due prior to maturity. 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.
(ii) Safe-harbor period. The 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. The safe-harbor period 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 percent of the original
term of the instrument. For purposes of this paragraph (e)(3)(ii), the
term of an instrument is determined without regard to any option to
extend the original maturity and deferrals of de minimis payments are
ignored. 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.
(4) Change in obligor or security--(i) Substitution of a new obligor
on recourse debt instruments--(A) In general. Except as provided in
paragraph (e)(4)(i) (B), (C), or (D) of this section, the substitution
of a new obligor on a recourse debt instrument is a significant
modification.
(B) Section 381(a) transaction. The substitution of a new obligor is
not a significant modification if the acquiring corporation (within the
meaning of section 381) becomes the new obligor pursuant to a
transaction to which section 381(a) applies, the transaction does not
result in a change in payment expectations, and the transaction (other
than a reorganization within the meaning of section 368(a)(1)(F)) does
not result in a significant alteration.
(C) Certain asset acquisitions. The substitution of a new obligor is
not a significant modification if the new obligor acquires substantially
all of the assets of the original obligor, the transaction does not
result in a change in payment expectations, and the transaction does not
result in a significant alteration.
(D) Tax-exempt bonds. The substitution of a new obligor on a tax-
exempt bond is not a significant modification if the new obligor is a
related entity to
[[Page 22]]
the original obligor as defined in section 168(h)(4)(A) and the
collateral securing the instrument continues to include the original
collateral.
(E) Significant alteration. For purposes of this paragraph (e)(4), a
significant alteration is an alteration that would be a significant
modification but for the fact that the alteration occurs by operation of
the terms of the instrument.
(F) Section 338 election. For purposes of this section, an election
under section 338 following a qualified stock purchase of an issuer's
stock does not result in the substitution of a new obligor.
(G) Bankruptcy proceedings. For purposes of this section, the filing
of a petition in a title 11 or similar case (as defined in section
368(a)(3)(A)) by itself does not result in the substitution of a new
obligor.
(ii) Substitution of a new obligor on nonrecourse debt instruments.
The substitution of a new obligor on a nonrecourse debt instrument is
not a significant modification.
(iii) Addition or deletion of co-obligor. The addition or deletion
of a co-obligor on a debt instrument is a significant modification if
the addition or deletion of the co-obligor results in a change in
payment expectations. If the addition or deletion of a co-obligor is
part of a transaction or series of related transactions that results in
the substitution of a new obligor, however, the transaction is treated
as a substitution of a new obligor (and is tested under paragraph
(e)(4)(i)) of this section rather than as an addition or deletion of a
co-obligor.
(iv) Change in security or credit enhancement--(A) Recourse debt
instruments. A modification that releases, substitutes, adds or
otherwise alters the collateral for, a guarantee on, or other form of
credit enhancement for a recourse debt instrument is a significant
modification if the modification results in a change in payment
expectations.
(B) Nonrecourse debt instruments. A modification that releases,
substitutes, adds or otherwise alters a substantial amount of the
collateral for, a guarantee on, or other form of credit enhancement for
a nonrecourse debt instrument is a significant modification. A
substitution of collateral is not a significant modification, however,
if the collateral is fungible or otherwise of a type where the
particular units pledged are unimportant (for example, government
securities or financial instruments of a particular type and rating). In
addition, the substitution of a similar commercially available credit
enhancement contract is not a significant modification, and an
improvement to the property securing a nonrecourse debt instrument does
not result in a significant modification.
(v) Change in priority of debt. A change in the priority of a debt
instrument relative to other debt of the issuer is a significant
modification if it results in a change in payment expectations.
(vi) Change in payment expectations--(A) In general. For purposes of
this section, a change in payment expectations occurs if, as a result of
a transaction--
(1) There is a substantial enhancement of the obligor's capacity to
meet the payment obligations under a debt instrument and that capacity
was primarily speculative prior to the modification and is adequate
after the modification; or
(2) There is a substantial impairment of the obligor's capacity to
meet the payment obligations under a debt instrument and that capacity
was adequate prior to the modification and is primarily speculative
after the modification.
(B) Obligor's capacity. The obligor's capacity includes any source
for payment, including collateral, guarantees, or other credit
enhancement.
(5) Changes in the nature of a debt instrument--(i) Property that is
not debt. A modification of a debt instrument that results in an
instrument or property right that is not debt for Federal income tax
purposes is a significant modification. For purposes of this paragraph
(e)(5)(i), any deterioration in the financial condition of the obligor
between the issue date of the unmodified instrument and the date of
modification (as it relates to the obligor's ability to repay the debt)
is not taken into account unless, in connection with
[[Page 23]]
the modification, there is a substitution of a new obligor or the
addition or deletion of a co-obligor.
(ii) Change in recourse nature--(A) In general. Except as provided
in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a
debt instrument from recourse (or substantially all recourse) to
nonrecourse (or substantially all nonrecourse) is a significant
modification. Thus, for example, a legal defeasance of a debt instrument
in which the issuer is released from all liability to make payments on
the debt instrument (including an obligation to contribute additional
securities to a trust if necessary to provide sufficient funds to meet
all scheduled payments on the instrument) is a significant modification.
Similarly, a change in the nature of the debt instrument from
nonrecourse (or substantially all nonrecourse) to recourse (or
substantially all recourse) is a significant modification. If an
instrument is not substantially all recourse or not substantially all
nonrecourse either before or after a modification, the significance of
the modification is determined under paragraph (e)(1) of this section.
(B) Exceptions--(1) Defeasance of tax-exempt bonds. A defeasance of
a tax-exempt bond is not a significant modification even if the issuer
is released from any liability to make payments under the instrument if
the defeasance occurs by operation of the terms of the original bond and
the issuer places in trust government securities or tax-exempt
government bonds that are reasonably expected to provide interest and
principal payments sufficient to satisfy the payment obligations under
the bond.
(2) Original collateral. A modification that changes a recourse debt
instrument to a nonrecourse debt instrument is not a significant
modification if the instrument continues to be secured only by the
original collateral and the modification does not result in a change in
payment expectations. For this purpose, if the original collateral is
fungible or otherwise of a type where the particular units pledged are
unimportant (for example, government securities or financial instruments
of a particular type and rating), replacement of some or all units of
the original collateral with other units of the same or similar type and
aggregate value is not considered a change in the original collateral.
(6) Accounting or financial covenants. A modification that adds,
deletes, or alters customary accounting or financial covenants is not a
significant modification.
(f) Rules of application--(1) Testing for significance--(i) In
general. Whether a modification of any term is a significant
modification is determined under each applicable rule in paragraphs (e)
(2) through (6) of this section and, if not specifically addressed in
those rules, under the general rule in paragraph (e)(1) of this section.
For example, a deferral of payments that changes the yield of a fixed
rate debt instrument must be tested under both paragraphs (e) (2) and
(3) of this section.
(ii) Contingent modifications. If a modification described in
paragraphs (e) (2) through (5) of this section is effective only upon
the occurrence of a substantial contingency, whether or not the change
is a significant modification is determined under paragraph (e)(1) of
this section rather than under paragraphs (e) (2) through (5) of this
section.
(iii) Deferred modifications. If a modification described in
paragraphs (e) (4) and (5) of this section is effective on a
substantially deferred basis, whether or not the change is a significant
modification is determined under paragraph (e)(1) of this section rather
than under paragraphs (e) (4) and (5) of this section.
(2) Modifications that are not significant. If a rule in paragraphs
(e) (2) through (4) of this section prescribes a degree of change in a
term of a debt instrument that is a significant modification, a change
of the same type but of a lesser degree is not a significant
modification under that rule. For example, a 20 basis point change in
the yield of a fixed rate debt instrument is not a significant
modification under paragraph (e)(2) of this section. Likewise, if a rule
in paragraph (e)(4) of this section requires a change in payment
expectations for a modification to be significant, a modification of the
same type that does not result in a change in
[[Page 24]]
payment expectations is not a significant modification under that rule.
(3) Cumulative effect of modifications. Two or more modifications of
a debt instrument over any period of time constitute a significant
modification if, had they been done as a single change, the change would
have resulted in a significant modification under paragraph (e) of this
section. Thus, for example, a series of changes in the maturity of a
debt instrument constitutes a significant modification if, combined as a
single change, the change would have resulted in a significant
modification. The significant modification occurs at the time that the
cumulative modification would be significant under paragraph (e) of this
section. In testing for a change of yield under paragraph (e)(2) of this
section, however, any prior modification occurring more than 5 years
before the date of the modification being tested is disregarded.
(4) Modifications of different terms. Modifications of different
terms of a debt instrument, none of which separately would be a
significant modification under paragraphs (e) (2) through (6) of this
section, do not collectively constitute a significant modification. For
example, a change in yield that is not a significant modification under
paragraph (e)(2) of this section and a substitution of collateral that
is not a significant modification under paragraph (e)(4)(iv) of this
section do not together result in a significant modification. Although
the significance of each modification is determined independently, in
testing a particular modification it is assumed that all other
simultaneous modifications have already occurred.
(5) Definitions. For purposes of this section:
(i) Issuer and obligor are used interchangeably and mean the issuer
of a debt instrument or a successor obligor.
(ii) Variable rate debt instrument and contingent payment debt
instrument have the meanings given those terms in section 1275 and the
regulations thereunder.
(iii) Tax-exempt bond means a state or local bond that satisfies the
requirements of section 103(a).
(iv) Conduit loan and conduit borrower have the same meanings as in
Sec. 1.150-1(b).
(6) Certain rules for tax-exempt bonds--(i) Conduit loans. For
purposes of this section, the obligor of a tax-exempt bond is the entity
that actually issues the bond and not a conduit borrower of bond
proceeds. In determining whether there is a significant modification of
a tax-exempt bond, however, transactions between holders of the tax-
exempt bond and a borrower of a conduit loan may be an indirect
modification under paragraph (a)(1) of this section. For example, a
payment by the holder of a tax-exempt bond to a conduit borrower to
waive a call right may result in an indirect modification of the tax-
exempt bond by changing the yield on that bond.
(ii) Recourse nature--(A) In general. For purposes of this section,
a tax-exempt bond that does not finance a conduit loan is a recourse
debt instrument.
(B) Proceeds used for conduit loans. For purposes of this section, a
tax-exempt bond that finances a conduit loan is a recourse debt
instrument unless both the bond and the conduit loan are nonrecourse
instruments.
(C) Government securities as collateral. Notwithstanding paragraphs
(f)(6)(ii) (A) and (B) of this section, for purposes of this section a
tax-exempt bond that is secured only by a trust holding government
securities or tax-exempt government bonds that are reasonably expected
to provide interest and principal payments sufficient to satisfy the
payment obligations under the bond is a nonrecourse instrument.
(g) Examples. The following examples illustrate the provisions of
paragraphs (e) and (f) of this section:
Example 1. Modification of call right. (i) Under the terms of a 30-
year, fixed-rate bond, the issuer can call the bond for 102 percent of
par at the end of ten years or for 101 percent of par at the end of 20
years. At the end of the eighth year, the holder of the bond pays the
issuer to waive the issuer's right to call the bond at the end of the
tenth year. On the date of the modification, the issuer's credit rating
is approximately the same as when the bond was issued, but market rates
of interest have declined from that date.
(ii) The holder's payment to the issuer changes the yield on the
bond. Whether the
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change in yield is a significant modification depends on whether the
yield on the modified bond varies from the yield on the original bond by
more than the change in yield as described in paragraph (e)(2)(ii) of
this section.
(iii) If the change in yield is not a significant modification, the
elimination of the issuer's call right must also be tested for
significance. Because the specific rules of paragraphs (e)(2) through
(e)(6) of this section do not address this modification, the
significance of the modification must be determined under the general
rule of paragraph (e)(1) of this section.
Example 2. Extension of maturity and change in yield. (i) A zero-
coupon bond has an original maturity of ten years. At the end of the
fifth year, the parties agree to extend the maturity for a period of two
years without increasing the stated redemption price at maturity (i.e.,
there are no additional payments due between the original and extended
maturity dates, and the amount due at the extended maturity date is
equal to the amount due at the original maturity date).
(ii) The deferral of the scheduled payment at maturity is tested
under paragraph (e)(3) of this section. The safe-harbor period under
paragraph (e)(3)(ii) of this section starts with the date the payment
that is being deferred is due. For this modification, the safe-harbor
period starts on the original maturity date, and ends five years from
this date. All payments deferred within this period are unconditionally
payable before the end of the safe-harbor period. Thus, the deferral of
the payment at maturity for a period of two years is not a material
deferral under the safe-harbor rule of paragraph (e)(3)(ii) of this
section and thus is not a significant modification.
(iii) Even though the extension of maturity is not a significant
modification under paragraph (e)(3)(ii) of this section, the
modification also decreases the yield of the bond. The change in yield
must be tested under paragraph (e)(2) of this section.
Example 3. Change in yield resulting from reduction of principal.
(i) A debt instrument issued at par has an original maturity of ten
years and provides for the payment of $100,000 at maturity with interest
payments at the rate of 10 percent payable at the end of each year. At
the end of the fifth year, and after the annual payment of interest, the
issuer and holder agree to reduce the amount payable at maturity to
$80,000. The annual interest rate remains at 10 percent but is payable
on the reduced principal.
(ii) In applying the change in yield rule of paragraph (e)(2) of
this section, the yield of the instrument after the modification
(measured from the date that the parties agree to the modification to
its final maturity date) is computed using the adjusted issue price of
$100,000. With four annual payments of $8,000, and a payment of $88,000
at maturity, the yield on the instrument after the modification for
purposes of determining if there has been a significant modification
under paragraph (e)(2)(i) of this section is 4.332 percent. Thus, the
reduction in principal is a significant modification.
Example 4. Deferral of scheduled interest payments. (i) A 20-year
debt instrument issued at par provides for the payment of $100,000 at
maturity with annual interest payments at the rate of 10 percent. At the
beginning of the eleventh year, the issuer and holder agree to defer all
remaining interest payments until maturity with compounding. The yield
of the modified instrument remains at 10 percent.
(ii) The safe-harbor period of paragraph (e)(3)(ii) of this section
begins at the end of the eleventh year, when the interest payment for
that year is deferred, and ends at the end of the sixteenth year.
However, the payments deferred during this period are not
unconditionally payable by the end of that 5-year period. Thus, the
deferral of the interest payments is not within the safe-harbor period.
(iii) This modification materially defers the payments due under the
instrument and is a significant modification under paragraph (e)(3)(i)
of this section.
Example 5. Assumption of mortgage with increase in interest rate.
(i) A recourse debt instrument with a 9 percent annual yield is secured
by an office building. Under the terms of the instrument, a purchaser of
the building may assume the debt and be substituted for the original
obligor if the purchaser has a specified credit rating and if the
interest rate on the instrument is increased by one-half percent (50
basis points). The building is sold, the purchaser assumes the debt, and
the interest rate increases by 50 basis points.
(ii) If the purchaser's acquisition of the building does not satisfy
the requirements of paragraphs (e)(4)(i) (B) or (C) of this section, the
substitution of the purchaser as the obligor is a significant
modification under paragraph (e)(4)(i)(A) of this section.
(iii) If the purchaser acquires substantially all of the assets of
the original obligor, the assumption of the debt instrument will not
result in a significant modification if there is not a change in payment
expectations and the assumption does not result in a significant
alteration.
(iv) The change in the interest rate, if tested under the rules of
paragraph (e)(2) of this section, would result in a significant
modification. The change in interest rate that results from the
transaction is a significant alteration. Thus, the transaction does not
meet the requirements of paragraph (e)(4)(i)(C) of this section and is a
significant modification under paragraph (e)(4)(i)(A) of this section.
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Example 6. Assumption of mortgage. (i) A recourse debt instrument is
secured by a building. In connection with the sale of the building, the
purchaser of the building assumes the debt and is substituted as the new
obligor on the debt instrument. The purchaser does not acquire
substantially all of the assets of the original obligor.
(ii) The transaction does not satisfy any of the exceptions set
forth in paragraph (e)(4)(i) (B) or (C) of this section. Thus, the
substitution of the purchaser as the obligor is a significant
modification under paragraph (e)(4)(i)(A) of this section.
(iii) Section 1274(c)(4), however, provides that if a debt
instrument is assumed in connection with the sale or exchange of
property, the assumption is not taken into account in determining if
section 1274 applies to the debt instrument unless the terms and
conditions of the debt instrument are modified in connection with the
sale or exchange. Because the purchaser assumed the debt instrument in
connection with the sale of property and the debt instrument was not
otherwise modified, the debt instrument is not retested to determine
whether it provides for adequate stated interest.
Example 7. Substitution of a new obligor in section 381(a)
transaction. (i) The interest rate on a 30-year debt instrument issued
by a corporation provides for a variable rate of interest that is reset
annually on June 1st based on an objective index.
(ii) In the tenth year, the issuer merges (in a transaction to which
section 381(a) applies) into another corporation that becomes the new
obligor on the debt instrument. The merger occurs on June 1st, at which
time the interest rate is also reset by operation of the terms of the
instrument. The new interest rate varies from the previous interest rate
by more than the greater of 25 basis points and 5 percent of the annual
yield of the unmodified instrument. The substitution of a new obligor
does not result in a change in payment expectations.
(iii) The substitution of the new obligor occurs in a section 381(a)
transaction and does not result in a change in payment expectations.
Although the interest rate changed by more than the greater of 25 basis
points and 5 percent of the annual yield of the unmodified instrument,
this alteration did not occur as a result of the transaction and is not
a significant alteration under paragraph (e)(4)(i)(E) of this section.
Thus, the substitution meets the requirements of paragraph (e)(4)(i)(B)
of this section and is not a significant modification.
Example 8. Substitution of credit enhancement contract. (i) Under
the terms of a recourse debt instrument, the issuer's obligations are
secured by a letter of credit from a specified bank. The debt instrument
does not contain any provision allowing a substitution of a letter of
credit from a different bank. The specified bank, however, encounters
financial difficulty and rating agencies lower its credit rating. The
issuer and holder agree that the issuer will substitute a letter of
credit from another bank with a higher credit rating.
(ii) Under paragraph (e)(4)(iv)(A) of this section, the substitution
of a different credit enhancement contract is not a significant
modification of a recourse debt instrument unless the substitution
results in a change in payment expectations. While the substitution of a
new letter of credit by a bank with a higher credit rating does not
itself result in a change in payment expectations, such a substitution
may result in a change in payment expectations under certain
circumstances (for example, if the obligor's capacity to meet payment
obligations is dependent on the letter of credit and the substitution
substantially enhances that capacity from primarily speculative to
adequate).
Example 9. Improvement to collateral securing nonrecourse debt. A
parcel of land and its improvements, a shopping center, secure a
nonrecourse debt instrument. The obligor expands the shopping center
with the construction of an additional building on the same parcel of
land. After the construction, the improvements that secure the
nonrecourse debt include the new building. The building is an
improvement to the property securing the nonrecourse debt instrument and
its inclusion in the collateral securing the debt is not a significant
modification under paragraph (e)(4)(iv)(B) of this section.
(h) Effective date. This section applies to alterations of the terms
of a debt instrument on or after September 24, 1996. Taxpayers, however,
may rely on this section for alterations of the terms of a debt
instrument after December 2, 1992, and before September 24, 1996.
[T.D. 8675, 61 FR 32930, June 26, 1996; 61 FR 47822, Sept. 11, 1996]