[Federal Register Volume 63, Number 19 (Thursday, January 29, 1998)]
[Rules and Regulations]
[Pages 4394-4396]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-2093]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8763]
RIN 1545-AU06


Modifications of Bad Debts and Dealer Assignments of Notional 
Principal Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains regulations that deem a charge-off and

[[Page 4395]]

allow a deduction for a partially worthless debt when the terms of a 
debt instrument have been modified.
    The regulations provide guidance to certain taxpayers that have 
claimed a deduction for a partially worthless debt and then modified 
the terms of the debt instrument. This document also contains 
regulations relating to certain assignments of notional principal 
contracts by dealers in those contracts. The regulations provide 
guidance to taxpayers relating to the consequences of these 
assignments.

DATES: Effective date: These regulations are effective February 29, 
1998.
    Applicability date: These regulations apply to significant 
modifications of debt instruments and assignments of interest rate 
swaps, commodity swaps, and other notional principal contracts 
occurring on or after September 23, 1996.

FOR FURTHER INFORMATION CONTACT: Concerning the modifications of bad 
debts, Craig Wojay, (202) 622-3920, and concerning dealer assignments 
of notional principal contracts, Thomas M. Preston, (202) 622-3940 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    On June 25, 1996, temporary regulations (TD 8676) relating to 
modifications of bad debts and dealer assignments of notional principal 
contracts under sections 166 and 1001 of the Internal Revenue Code 
(Code) were published in the Federal Register (61 FR 32653). A notice 
of proposed rulemaking (REG-209743-94, formerly FI-59-94) cross-
referencing the temporary regulations was published in the Federal 
Register for the same day (61 FR 32728). No public hearing was 
requested or held.
    Written comments responding to the notice were received. After 
consideration of the comments, the regulations proposed by REG-209743-
94 are adopted by this Treasury decision, and the corresponding 
temporary regulations are removed.

Explanation of Provisions

    The preamble to the temporary regulations sets forth limited 
circumstances under which a taxpayer will be permitted to deduct an 
amount on account of a partially worthless debt even though an amount 
has not been charged off within the taxable year.
    Section 166(a)(2) and Sec. 1.166-3(a) provide that a deduction for 
a partially worthless debt is allowed only to the extent the debt is 
charged off in the taxable year. The charge-off requirement is 
satisfied when a portion of the debt is removed from the taxpayer's 
books and records. This generally is accomplished by reducing the 
debt's book basis. Thus, when an amount has been deducted for partial 
worthlessness, there is generally a reduction of both the book basis 
and the tax basis of a debt.
    When a taxpayer is required to recognize gain under Sec. 1.1001-1 
because of a modification of a debt instrument, the taxpayer's tax 
basis in the debt is increased by the amount of gain recognized. 
However, regulatory and general accounting principles generally would 
not permit a corresponding increase in the book basis of the debt. 
Because the prior charge-off is not restored (that is, the book basis 
of the debt is not increased), there is no opportunity for the taxpayer 
to take a new charge-off for pre-existing worthlessness.
    The purpose of the temporary regulations is to preserve a portion 
of a taxpayer's bad debt deduction with respect to a partially 
worthless debt. The portion preserved corresponds to the amount the 
taxpayer would have been entitled to deduct for partial worthlessness 
with respect to the modified debt if the book basis of the modified 
debt were increased to the same extent as the tax basis of that debt. 
Thus, if all the conditions of the temporary regulations are satisfied, 
then a modified debt is deemed to have been charged off in the year in 
which gain is recognized. The amount of the deemed charge-off, however, 
is limited to the difference between the tax basis of the debt and the 
greater of the book basis or the fair market value of the debt. The 
temporary regulations also address debt that constitutes transferred 
basis property under section 7701(a)(43).
    In addition, the temporary regulations provide a limited rule 
dealing with a dealer's assignment of its position in an interest rate 
swap, commodity swap, or other notional principal contract to another 
dealer. If the assignment is permitted by the terms of the contract, 
the assignment is not treated as a deemed exchange by the nonassigning 
party of the original contract for a new contract that differs 
materially either in kind or in extent. Thus, an assignment to which 
the rule applies does not trigger gain or loss to the dealer's 
counterparty.
    Three comments were received on the Sec. 1.166-3T regulations. The 
first comment requests a deemed charge-off for a taxpayer that 
purchased at a discount debt for which a previous deduction for partial 
worthlessness was claimed, and then significantly modified the debt 
under Sec. 1.1001-3 and recognized gain on the modification. Whenever 
debt is purchased for less than the stated redemption price, recognized 
gain from a significant modification is attributable to market discount 
as defined in section 1278(a)(2)(A) and not to a previously claimed 
deduction for partial worthlessness. In addition, the temporary 
regulations refer to Sec. 1.166-3(a) (1) and (2) for guidance relating 
to prior charge-offs and deductions for partial worthlessness. 
Extending the temporary regulations to cover a discount purchase would 
significantly expand the regulations beyond their intended scope and 
create a situation that would be extremely difficult to administer. The 
regulations do not adopt the request to extend the regulations to cover 
such a purchase.
    The second comment requests a deemed charge-off for a member of a 
consolidated group that purchased debt, for which a previous deduction 
for partial worthlessness was claimed, from another member of the 
group, then significantly modified the debt under Sec. 1.1001-3 and 
recognized gain on the modification. Whenever debt is purchased for 
less than the stated redemption price, subsequently recognized gain 
from a significant modification is attributable to market discount as 
defined in section 1278(a)(2)(A) and not to a previously claimed 
deduction for partial worthlessness. Extending the temporary 
regulations to cover a purchase from another member of the consolidated 
group would significantly expand the regulations beyond their intended 
scope. The regulations do not adopt the request to extend the 
regulations to cover an intercompany transaction.
    The third comment requests expanding the temporary regulations to 
include other situations in which a taxpayer has tax basis in a debt 
but no corresponding book basis. The first situation involves the 
accrual of interest income on loans that have been placed on non-
accrual status for book purposes. The second situation involves the 
requirement to accrue interest on original issue discount obligations 
even if the loan has become uncollectible. This comment deals with 
situations other than the modification of a debt instrument and is 
beyond the scope of this regulation project.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of

[[Page 4396]]

the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations, and because the regulation does not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of 
the Internal Revenue Code, the notice of proposed rulemaking preceding 
these regulations was submitted to the Small Business Administration 
for comment on its impact on small business.
    Drafting Information: The principal author of the regulations 
concerning the modifications of bad debts is Craig Wojay, Office of the 
Assistant Chief Counsel (Financial Institutions and Products), IRS. The 
principal author of the regulations concerning the dealer assignments 
of notional principal contracts is Thomas M. Preston, Office of the 
Assistant Chief Counsel (Financial Institutions and Products), IRS. 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. In Sec. 1.166-3, paragraph (a)(3) is added to read as 
follows:


Sec. 1.166-3  Partial or total worthlessness.

    (a) * * *
    (3) Significantly modified debt--(i) Deemed charge-off. If a 
significant modification of a debt instrument (within the meaning of 
Sec. 1.1001-3) during a taxable year results in the recognition of gain 
by a taxpayer under Sec. 1.1001-1(a), and if the requirements of 
paragraph (a)(3)(ii) of this section are met, there is a deemed charge-
off of the debt during that taxable year in the amount specified in 
paragraph (a)(3)(iii) of this section.
    (ii) Requirements for deemed charge-off. A debt is deemed to have 
been charged off only if--
    (A) The taxpayer (or, in the case of a debt that constitutes 
transferred basis property within the meaning of section 7701(a)(43), a 
transferor taxpayer) has claimed a deduction for partial worthlessness 
of the debt in any prior taxable year; and
    (B) Each prior charge-off and deduction for partial worthlessness 
satisfied the requirements of paragraphs (a) (1) and (2) of this 
section.
    (iii) Amount of deemed charge-off. The amount of the deemed charge-
off, if any, is the amount by which the tax basis of the debt exceeds 
the greater of the fair market value of the debt or the amount of the 
debt recorded on the taxpayer's books and records reduced as 
appropriate for a specific allowance for loan losses. The amount of the 
deemed charge-off, however, may not exceed the amount of recognized 
gain described in paragraph (a)(3)(i) of this section.
    (iv) Effective date. This paragraph (a)(3) applies to significant 
modifications of debt instruments occurring on or after September 23, 
1996.
* * * * *


Sec. 1.166-3T  [Removed]

    Par. 3. Section 1.166-3T is removed.

Par. 4. Section 1.1001-4 is added to read as follows:


Sec. 1.1001-4  Modifications of certain notional principal contracts.

    (a) Dealer assignments. For purposes of Sec. 1.1001-1(a), the 
substitution of a new party on an interest rate or commodity swap, or 
other notional principal contract (as defined in Sec. 1.446-3(c)(1)), 
is not treated as a deemed exchange by the nonassigning party of the 
original contract for a modified contract that differs materially 
either in kind or in extent if--
    (1) The party assigning its rights and obligations under the 
contract and the party to which the rights and obligations are assigned 
are both dealers in notional principal contracts, as defined in 
Sec. 1.446-3(c)(4)(iii); and
    (2) The terms of the contract permit the substitution.
    (b) Effective date. This section applies to assignments of interest 
rate swaps, commodity swaps, and other notional principal contracts 
occurring on or after September 23, 1996.


Sec. 1.1001-4T  [Removed]

    Par. 5. Section 1.1001-4T is removed.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.

    Approved: January 14, 1998.

Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 98-2093 Filed 1-28-98; 8:45 am]
BILLING CODE 4830-01-U