[Federal Register Volume 61, Number 124 (Wednesday, June 26, 1996)]
[Rules and Regulations]
[Pages 32926-32936]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-15830]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8675]
RIN 1545-AR04


Modifications of Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
modification of debt instruments. The regulations govern when a 
modification is treated as an exchange of the original debt instrument 
for a modified instrument. The regulations provide needed guidance to 
issuers and holders of debt instruments.

DATES: These regulations are effective September 24, 1996.
    For dates of applicability of these regulations, see Sec. 1.1001-
3(h).

FOR FURTHER INFORMATION CONTACT: Thomas J. Kelly, (202) 622-3930 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On December 2, 1992, proposed amendments to 26 CFR part 1 were 
published in the Federal Register (57 FR 57034) to provide guidance 
under Sec. 1.1001-3. The proposed regulations relate to the 
modification of debt instruments. On February 17, 1993, the IRS held a 
public hearing on the proposed regulations. In addition, the IRS 
received numerous written comments on the proposed regulations. The 
proposed regulations, with certain changes made in response to 
comments, are adopted in this Treasury decision as final regulations. 
The principal changes to the regulations, as well as the major comments 
and suggestions, are discussed below.

Explanation of Provisions

A. General

    The preamble to the proposed regulations states that the proposed

[[Page 32927]]

regulations are intended to address the uncertainty concerning when the 
modification of a debt instrument results in a deemed exchange of the 
old debt instrument for a new instrument. Some of this uncertainty 
resulted from the possible impact of the decision of the Supreme Court 
in Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991). The 
preamble invites comments with respect to whether it is desirable to 
provide rules for the modification of debt instruments as well as 
comments with respect to what those rules should be.
    Although the IRS received many comments on the proposed 
regulations, relatively few commentators addressed the question of 
whether regulations on the modification of debt instruments are 
desirable. A few commentators argued against the promulgation of 
regulations on this subject. A number of other commentators were 
supportive of the attempt to provide certainty through a series of 
specific rules. Some commentators suggested that the regulations adopt 
a facts and circumstances approach with safe harbors under which 
certain modifications would not be treated as exchanges. In contrast, 
other commentators suggested using additional bright-line rules to 
provide more certainty with respect to when a modification is, and is 
not, treated as an exchange of the old debt instrument for a new 
instrument. Most commentators, however, limited their comments to the 
specific rules of the proposed regulations.
    The IRS and Treasury considered adopting a single, general rule 
instead of several detailed rules. That approach, while providing less 
guidance, would have the advantage of reducing complexity and avoiding 
anomalies that can result from bright-line rules (for example, 
different results for economically similar transactions). Nevertheless, 
after considering that approach the IRS and Treasury concluded that 
both taxpayers and the IRS would benefit from regulations specifically 
addressing the treatment of certain modifications. A debt modification 
that results in an exchange may have a variety of consequences, and 
parties contemplating a change to a debt instrument should be able to 
determine whether that change will result in an exchange.
    Accordingly, the final regulations retain the basic structure of 
the proposed regulations. Thus, an alteration of the terms of a debt 
instrument is first tested to determine whether the alteration is a 
``modification.'' If there is a modification, the modification is then 
tested to determine whether it is a ``significant modification.'' A 
significant modification results in an exchange of the original debt 
instrument for a modified instrument that differs materially either in 
kind or in extent within the meaning of Sec. 1.1001-1(a).
    Although the final regulations generally follow the approach of the 
proposed regulations, certain rules have been added or modified to 
address a number of issues noted by commentators. For example, in one 
instance the final regulations provide a general rule with respect to a 
particular type of modification together with a safe harbor for certain 
changes that will not result in exchanges. In other instances, the 
final regulations retain the bright-line approach of the proposed 
regulations. The IRS and Treasury invite comments on the operation of 
the final regulations and will consider providing additional guidance 
as appropriate.

B. Other Instruments

    In the preamble to the proposed regulations, the IRS invites 
comments with respect to whether the regulations should be expanded to 
address modifications of financial instruments other than debt 
instruments. In response, several commentators argued that a dealer's 
assignment of its position in an interest rate swap contract or other 
notional principal contract should not result in an exchange under 
section 1001 for the nonassigning counterparty. In response to these 
comments, the IRS and Treasury are issuing proposed and temporary 
regulations that provide a special rule for dealer assignments of 
notional principal contracts. However, those temporary and proposed 
regulations and these final regulations do not address whether 
particular instruments are debt instruments for Federal income tax 
purposes.
    With the exception of those temporary and proposed regulations, the 
final regulations have not been expanded to cover the modification of 
financial instruments other than debt instruments. The modification of 
other instruments is less common than the modification of debt 
instruments, and the rules for modifications of debt instruments would 
not necessarily work well or be appropriate in determining whether 
modifications of other instruments result in exchanges under section 
1001. For equity instruments in particular, the IRS and Treasury 
believe that the application of certain rules in these regulations 
would be inappropriate. Similarly, for contracts that are not debt 
instruments, the final regulations do not limit or otherwise affect the 
application of the ``fundamental change'' concept articulated in Rev. 
Rul. 90-109 (1990-2 C.B. 191), in which the IRS concluded that the 
exercise by a life insurance policyholder of an option to change the 
insured under the policy changed ``the fundamental substance'' of the 
contract, and thus was a disposition under section 1001.

C. Modifications

    The final regulations retain the general rule of the proposed 
regulations that a modification includes any alteration of a legal 
right or obligation of the issuer or holder. The final regulations, 
however, do not adopt the rule of the proposed regulations that a 
unilateral waiver of a right that does not rise to the level of a 
settlement of terms between the parties is not a modification of the 
original instrument. Commentators noted that it often is impossible to 
distinguish between a unilateral waiver of a right and a workout agreed 
to by the parties in which only the holder of the instrument makes 
meaningful concessions. Moreover, in the case of a prepayable debt 
instrument, the holder's waiver of rights may be an inducement to the 
obligor not to terminate the debt instrument.
    In defining when an alteration is a modification, the final 
regulations also generally retain the rule that a change in a term of a 
debt instrument that occurs by operation of the terms of a debt 
instrument is not a modification. A change may occur by operation of 
the terms of an instrument at a specified time, as a result of a 
contingency specified in the instrument, or upon the exercise of an 
option provided for in the instrument to change a term.
    The final regulations limit the application of the rule for changes 
that occur by operation of the terms of a debt instrument in three 
respects. First, the final regulations retain the rule of the proposed 
regulations that any alteration that results in an instrument or 
property right that is not debt for federal income tax purposes is a 
modification, even if the alteration occurs by operation of the terms 
of the instrument (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). Second, the final regulations also provide that 
any alteration that results in a substitution of a new obligor, the 
addition or deletion of a co-obligor, or a change in the recourse 
nature of an instrument is a modification. The IRS and Treasury believe 
that these changes may be so fundamental that they should be

[[Page 32928]]

considered modifications even if they occur by operation of the terms 
of an instrument. Thus, these modifications always must be tested for 
significance to determine whether they result in exchanges.
    Third, the final regulations provide that alterations resulting 
from the exercise of either of two categories of options are 
modifications. These two categories of options are (i) those that are 
not unilateral (defined essentially in the same manner as in the 
proposed regulations) and (ii) holder options the exercise of which 
results in a deferral or a reduction in any scheduled payment of 
interest or principal. Because alterations resulting from the exercise 
of such options typically involve either negotiations between an issuer 
and holder or a workout, the IRS and Treasury believe it is appropriate 
to treat them as modifications and test for significance. In this 
regard, the rule for holder options resulting in deferrals or 
reductions of payments addresses more specifically the concerns 
underlying the proposed regulations' rule discussed above regarding 
unilateral waivers that rise to the level of a settlement of the terms.
    Many commentators argued that the proposed regulations are overly 
restrictive in recognizing only temporary nonperformance by the issuer 
and temporary waivers of default rights by holders as not being 
modifications. In particular, commentators expressed concern about an 
example in the proposed regulations that illustrates the temporary 
waiver rule with a situation in which the waiver is only for a 3-month 
period. The IRS and Treasury recognize that parties may need a period 
of time to modify the terms of a debt instrument following an issuer's 
default and that a holder's waiver or nonenforcement of default rights 
may not itself evidence an agreement with respect to new terms.
    The final regulations respond to these comments in two respects. 
First, the regulations provide that nonperformance by the issuer is 
not, in and of itself, a modification. Second, the regulations provide 
a limited exception to the rule that a waiver of rights is a 
modification. Under this exception, absent an actual written or oral 
agreement by the issuer and the holder to alter other terms of the 
instrument, an agreement by the holder to stay collection or 
temporarily waive an acceleration clause or similar default right is 
not a modification for a period of two years following the issuer's 
nonperformance, or for a longer period (after the initial two-year 
period) during which the parties conduct good faith negotiations or 
during the pendency of bankruptcy proceedings. Once the parties agree 
to new terms, however, there is a modification of the instrument.
    As under the proposed regulations, a modification is tested when 
the parties agree to a change even if the change is not immediately 
effective, but the final regulations add exceptions for a change in a 
term that is agreed to by the parties but is subject to reasonable 
closing conditions or that occurs as a result of bankruptcy 
proceedings. In these cases, a modification occurs on the date the 
change in the term becomes effective. Thus, if the conditions do not 
occur (and the change in the term does not become effective), a 
modification does not occur.

D. Significant Modifications

    The final regulations retain the structure of the proposed 
regulations for determining whether a modification is significant, but 
change a number of the specific rules for particular types of 
modifications. The final regulations also add a new general rule for 
types of modifications for which specific rules are not provided. Under 
this general rule (the general significance rule), a modification is 
significant if, based on all the facts and circumstances, the legal 
rights or obligations being changed and the degree to which they are 
being changed are economically significant.
    The general significance rule also applies to a type of 
modification for which specific rules are provided if the modification 
is effective upon the occurrence of a substantial contingency. 
Moreover, the general significance rule will apply for certain types of 
modifications that are effective on a substantially deferred basis. 
When testing a modification under the general significance rule, all 
modifications made to the instrument (other than those for which 
specific bright-line rules are provided) are considered collectively. 
Thus, a series of related modifications, each of which independently is 
not significant under the general significance rule, may together 
constitute a significant modification.
    With the addition of the general significance rule, certain 
specific rules of the proposed regulations have not been included in 
the final regulations. For example, under the proposed regulations, 
whether the addition or deletion of a put or call right is a 
significant modification depends on the value of the put or call. The 
significance of an alteration of a put or call right depends on whether 
the alteration significantly affects the value of the right. The 
proposed regulations provide similar rules for the addition, deletion, 
or alteration of a conversion or exchange right. Under the proposed 
regulations, certain changes in the types of payments under a debt 
instrument (for example, a change from a fixed rate debt instrument to 
a variable rate or contingent payment debt instrument) are significant 
modifications. These rules have not been included in the final 
regulations because the general significance rule provides adequate 
guidance.
    For changes in the yield of a debt instrument, the final 
regulations provide that a change in yield is significant if the change 
exceeds the greater of 25 basis points or five percent of the original 
yield on the instrument. This rule was modified in response to comments 
that a change of more than 25 basis points should be permitted in the 
case of debt instruments issued with high interest rates. The final 
regulations also limit this change-of-yield bright-line rule to fixed 
rate and variable rate debt instruments. Because of the difficulties in 
developing appropriate mechanisms for measuring changes in the yield of 
other debt instruments (for example, contingent payment debt 
instruments), the final regulations provide that the significance of 
changes in the yield of those other instruments is determined under the 
general significance rule. The final regulations also incorporate other 
technical changes to clarify the application of the change-in-yield 
rules.
    The final regulations do not adopt the suggestion of some 
commentators that a reduction in the principal amount of a debt 
instrument should not be considered a modification. As under the 
proposed regulations, for purposes of determining if there is a 
significant modification, the yield on the modified instrument is 
computed by reference to the adjusted issue price immediately before 
the modification. A reduction in principal reduces the total payments 
on the modified instrument and often results in a significantly reduced 
yield on the instrument. Thus, these rules give the same weight to 
changes in the principal amount as to changes in the interest payments. 
The IRS and Treasury believe that the tax consequences of a change in 
the yield that results from a change in the amounts payable should not 
differ because of the characterization of the payments that are reduced 
as principal rather than interest.
    For changes in the timing of payments (including any resulting 
change in the amount of payments), the proposed regulations contain a 
rule that an extension of the final maturity of an instrument for the 
lesser of five years or

[[Page 32929]]

50 percent of the original term of the instrument is not a significant 
modification. Any other change in the timing of payments is subject to 
two rules. Under the first rule, any material deferral of payments is a 
significant modification. Under the second rule, any change in terms 
designed to avoid the application of the rules for original issue 
discount is a significant modification. Commentators objected to both 
of these rules because they do not provide bright-line rules for 
determining whether a modification is significant. In addition, the 
commentators argued that an example in the proposed regulations that 
concerns the deferral of interim payments is inconsistent with the rule 
for an extension of final maturity.
    The final regulations combine the rules for extensions of final 
maturity and other changes in the timing and/or amounts of payments. 
While adopting the material deferral rule generally, the final 
regulations also allow the deferral of payments within a safe-harbor 
period (the lesser of five years or 50 percent of the original term of 
the instrument) if the deferred amounts are unconditionally payable at 
the end of that period. The final regulations do not contain the rule 
that the Commissioner may treat any deferral of payments made with a 
principal purpose of avoiding the time value of money rules, including 
the rules for original issue discount, as a significant modification. 
The concerns addressed by this rule in the proposed regulations have 
been resolved in final regulations recently issued under section 1275. 
See Sec. 1.1275-2(j).
    For a change in the obligor on an instrument, the final regulations 
retain the general rule in the proposed regulations that changing the 
obligor on a recourse debt instrument is significant. In addition to 
the exception for section 381(a) transactions in the proposed 
regulations, the final regulations include an exception for 
transactions in which the new obligor acquires substantially all of the 
assets of the original obligor. Each exception must meet two 
requirements. First, other than the substitution of a new obligor, the 
transaction must not result in any alteration that would be a 
significant modification but for the fact that it occurs by operation 
of the terms of the instrument. Second, the transaction must not result 
in a change in payment expectations. The final regulations also provide 
that 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 the 
original obligor and the collateral securing the instrument continues 
to include the original collateral.
    A change in payment expectations occurs if there is a substantial 
enhancement or impairment of the obligor's capacity to meet its payment 
obligations under the instrument and the enhancement or impairment 
results in a change to an adequate capacity from a speculative capacity 
or vice versa. There is no change in payment expectations, however, if 
the obligor has at least an adequate capacity to meet its payment 
obligations both before and after the modification.
    The final regulations also apply the payment expectations test to 
determine whether the addition or deletion of a co-obligor is a 
significant modification. Similarly, the final regulations provide that 
whether certain other modifications are significant is determined by 
reference to whether the modifications result in a change in payment 
expectations. Those modifications include (i) the release, 
substitution, or addition of collateral as security for a recourse 
debt, (ii) the addition, deletion, or alteration of a guarantee or 
other credit enhancement, and (iii) a change in the priority of a debt 
instrument. As under the proposed regulations, a modification that 
releases, substitutes, or adds a substantial amount of collateral as 
security for a nonrecourse debt instrument is a significant 
modification.
    A number of commentators raised questions regarding the 
circumstances under which the modification of a debt instrument will 
require a determination of whether the modified instrument is debt or 
equity. Many expressed concern that a deterioration in the financial 
condition of the issuer between the date of original issuance and the 
date of the modification could lead to a determination that the 
modified instrument is not debt for tax purposes. The final regulations 
address this concern by providing a rule that for purposes of this 
regulation, unless there is a substitution of a new obligor, any 
deterioration in the financial condition of the issuer is not 
considered in determining whether the modified instrument is properly 
characterized as debt.
    The final regulations also modify the rules pertaining to the 
significance of changes in the method under which payments are 
calculated. The proposed regulations provide that a modification is 
significant if it results in a change between the categories of fixed 
rate, variable rate, and contingent payment instruments or if it 
changes the currency in which payment under the debt instrument is 
made. The Treasury and the IRS determined that such an approach was 
both too broad and too narrow (i.e., certain changes involving 
economically insignificant adjustments would be characterized as 
significant, while other more economically dramatic changes would not 
be characterized as significant). Accordingly, the final regulations do 
not provide any bright-line rules so that the significance of any 
change in the method under which payments are calculated is determined 
under the general significance rule.
    The final regulations adopt the rule of the proposed regulations 
that a change in the recourse nature of an instrument is a significant 
modification, but limit this specific rule to changes from 
substantially all recourse to substantially all nonrecourse, or vice 
versa. 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 the general 
significance rule. The final regulations also provide two exceptions. 
First, 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. 
Second, a defeasance of a tax-exempt bond permitted by the terms of the 
instrument generally is not a significant modification.

E. Rules of Application

    The rules of application in the final regulations are similar to 
those in the proposed regulations. In general, the final regulations 
treat a series of changes of an instrument over time as a single 
change. To avoid the need to retain information for all modifications 
that affect yield over the life of the debt instrument, however, the 
final regulations add a rule that, for changes in the yield, 
modifications occurring more than five years earlier are disregarded.
    The final regulations do not adopt the suggestion of commentators 
that the rules in Sec. 1.1001-3 should not apply to tax- exempt bonds. 
These commentators stated that, as a result of an intervening change in 
the Internal Revenue Code (Code) or regulations, a significant 
modification could result in bonds that were tax-exempt when issued 
ceasing to be tax-exempt bonds. Because many changes in the Code and 
regulations have been made applicable to refunding bonds, it is 
appropriate that changes to outstanding tax-exempt bonds that are, in 
substance, the equivalent of

[[Page 32930]]

refundings be treated as such. The IRS and Treasury believe that the 
standards used under Sec. 1.1001-3 generally are appropriate for this 
purpose.
    In response to other comments, a number of changes have been made 
to better coordinate the final regulations with municipal financing 
practices. The regulations clarify that state and local bonds (other 
than those financing conduit loans) are treated as recourse obligations 
for purposes of determining whether a modification is significant. 
State and local bonds financing conduit loans are nonrecourse only if 
there is no recourse to either the actual issuer or the conduit 
borrower. In the case of bonds financing conduit loans, the final 
regulations clarify that the obligor of a tax-exempt bond is the entity 
that issues the bond and not the conduit borrower. The regulations 
note, however, that a transaction between a holder of a tax- exempt 
bond and a conduit borrower may result in an indirect modification of 
the tax-exempt bond.

F. Other Matters

    The preamble to the proposed regulations indicates that Notice 88-
130 (1988-2 C.B. 543), which provides special rules for qualified 
tender bonds, will continue to apply. The final regulations continue 
this approach, and thus do 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. The IRS and Treasury 
are reviewing the rules of Notice 88-130 and intend to issue proposed 
regulations on this subject under section 150. When the final 
regulations are issued under section 150, the exclusion for qualified 
tender bonds in Sec. 1.1001-3 will be revised or eliminated as 
appropriate.
    Also, as noted in the preamble to the proposed regulations, a 
modification of a debt instrument that results in an exchange under 
section 1001 does not determine if there has been an exchange or other 
disposition of an installment obligation under section 453B. Whether or 
not there has been an exchange or other disposition of an installment 
obligation is determined under the cases and rulings applicable to 
section 453B. Similarly, the fact that an alteration does not 
constitute a modification or a significant modification does not 
preclude other tax consequences.
    Simultaneously with the issuance of these final regulations, the 
IRS and Treasury are issuing temporary and proposed regulations under 
section 166. Those regulations allow taxpayers, in certain limited 
situations, to claim a deduction for a partially worthless debt when 
the terms of a debt instrument are modified. Commentators on the 
proposed regulations noted that section 166 permits a deduction for a 
partially worthless debt only in the year that the taxpayer makes a 
partial charge-off for book accounting purposes. A significant 
modification of a debt instrument that has been partially charged off 
may result in the recognition of gain and an increased tax basis in the 
instrument. Because the book charge-off is not reversed, however, the 
taxpayer cannot take another charge-off, and thus the taxpayer cannot 
meet the requirement for a deduction for a partially worthless debt 
under section 166. In this situation, the temporary and proposed 
regulations deem the charge-off to have occurred at the time of the 
significant modification if certain requirements are met.

Effective Dates

    The final regulation 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.

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 the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. 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 these regulations 
is Thomas J. Kelly, Office of Assistant Chief Counsel (Financial 
Institutions & Products), IRS. However, other personnel from the IRS 
and the 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. Section 1.1001-3 is added to read as follows:


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

[[Page 32931]]

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 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 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.

[[Page 32932]]

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.
    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
    (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

[[Page 32933]]

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 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

[[Page 32934]]

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 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 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

[[Page 32935]]

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 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)(E) of this section 
and is a significant modification under paragraph (e)(4)(i)(A) of 
this section.
    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.

[[Page 32936]]

    (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.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: May 31, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-15830 Filed 6-25-96; 8:45 am]
BILLING CODE 4830-01-U