32926 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

implications to warrant the preparation

of a Federalism Assessment.

List of Subjects

21 CFR Part 1309

Administrative practice and

procedure, Drug traffic control, List I

and List II chemicals, Security

measures.

21 CFR Part 1310

Drug traffic control, List I and List II

chemicals, Reporting and recordkeeping

requirements.

For reasons set out above, 21 CFR

parts 1309, and 1310 are amended as

follows:

PART 1309—[AMENDED]

1. The authority citation for part 1309

continues to read as follows:

Authority: 21 U.S.C. 821, 822, 823, 824,

830, 871(b), 875, 877, 958

2. Section 1309.21 is revised to read

as follows:

§ 1309.21 Persons required to register.

(a) Every person who distributes,

imports, or exports any List I chemical,

other than those List I chemicals

contained in a product exempted under

Section 1310.01(f)(1)(iv) of this chapter,

or who proposes to engage in the

distribution, importation, or exportation

of any List I chemical, shall obtain

annually a registration specific to the

List I chemicals to be handled, unless

exempted by law or pursuant to

§§ 1309.24 through 1309.28 of this part.

Only persons actually engaged in such

activities are required to obtain a

registration; related or affiliated persons

who are not engaged in such activities

are not required to be registered. (For

example, a stockholder or parent

corporation of a corporation distributing

List I chemicals is not required to obtain

a registration.)

(b) Every person who distributes or

exports a List I chemical they have

manufactured, other than a List I

chemical contained in a product

exempted under § 1310.01(f)(1)(iv) of

this chapter, or proposes to distribute or

export a List I chemical they have

manufactured, shall obtain annually a

registration specific to the List I

chemicals to be handled, unless

exempted by law or pursuant to

§§ 1309.24 through 1309.28 of this part.

3. Section 1309.22 is amended by

revising paragraph (b) to read as follows:

§ 1309.22 Separate registration for

independent activities.

* * * * *

(b) Every person who engages in more

than one group of independent activities

shall obtain a separate registration for

each group of activities, unless

otherwise exempted by the Act or

Sections 1309.24 through 1309.28 of

this part, except that a person registered

to import any List I chemical shall be

authorized to distribute that List I

chemical after importation, but no other

chemical that the person is not

registered to import.

4. Section 1309.28 is added to read as

follows:

§ 1309.28 Exemption of distributors of

regulated prescription drug products.

(a) The requirement of registration is

waived for any person who distributes

a prescription drug product containing

a List I chemical that is regulated

pursuant to § 1310.01(f)(1)(iv) of this

chapter.

(b) If any person exempted by this

section also engages in the distribution,

importation or exportation of a List I

chemical, other than as described in

paragraph (a) of this section, the person

shall obtain a registration for such

activities, as required by § 1309.21 of

this part.

(c) The Administrator may, upon

finding that continuation of the waiver

granted in paragraph (a) of this section

would not be in the public interest,

suspend or revoke a person’s waiver

pursuant to the procedures set forth in

§ § 1309.43 through 1309.46 and

1309.51 through 1309.57 of this part.

PART 1310—[AMENDED]

5. The authority citation for part 1310

continues to read as follows:

Authority: 21 U.S.C. 802, 830, 871(b)

6. Section 1310.06 is amended by

revising paragraph (b) to read as follows:

§ 1310.06 Content of records and reports.

* * * * *

(b) For purposes of this section,

normal business records shall be

considered adequate if they contain the

information listed in paragraph (a) of

this section and are readily retrievable

from other business records of the

regulated person. For prescription drug

products, prescription and hospital

records kept in the normal course of

medical treatment shall be considered

adequate for satisfying the requirements

of paragraph (a) of this section with

respect to dispensing to patients, and

records required to be maintained

pursuant to the Federal Food and Drug

Administration regulations relating to

the distribution of prescription drugs, as

set forth in 21 CFR part 205, shall be

considered adequate for satisfying the

requirements of paragraph (a) of this

section with respect to distributions.

* * * * *

Dated: May 28, 1996.

Stephen H. Greene,

Deputy Administrator, Drug Enforcement

Administration.

[FR Doc. 96–16299 Filed 6–25–96; 8:45 am]

BILLING CODE 4410–09–M

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.

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 § 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

§ 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
Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations 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 § 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 brightline 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
32928 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

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
Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations 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

§ 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 taxexempt 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 coobligor 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 brightline 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 § 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
32930 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

refundings be treated as such. The IRS

and Treasury believe that the standards

used under § 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 taxexempt 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 § 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:

§ 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 § 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

§ 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 § 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
Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations 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

§ 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.
32932 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

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

§ 1.1272–1(c), debt instruments that

provide for a fixed yield subject to

§ 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 ×

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
Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations 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 § 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 § 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 taxexempt 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
32934 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

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 taxexempt bonds. A defeasance of a taxexempt 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

§ 1.150–1(b).

(6) Certain rules for tax-exempt

bonds—(i) Conduit loans. For purposes

of this section, the obligor of a taxexempt 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
Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations 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 taxexempt 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 taxexempt 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 taxexempt 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 safeharbor 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.
32936 Federal Register / Vol. 61, No. 124 / Wednesday, June 26, 1996 / Rules and Regulations

(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

Office of Foreign Assets Control

31 CFR Chapter V

Blocked Persons, Specially Designated

Nationals, Specially Designated

Terrorists, Specially Designated

Narcotics Traffickers, and Blocked

Vessels

AGENCY: Office of Foreign Assets

Control, Treasury

ACTION: Final rule; amendments.

SUMMARY: The Office of Foreign Assets

Control is creating consolidated

appendices that contain lists of all

blocked persons, specially designated

nationals, specially designated

terrorists, specially designated narcotics

traffickers and blocked vessels under

the various sanctions programs

administered by the Treasury

Department’s Office of Foreign Assets

Control as of June 26, 1996 in order to

enhance public awareness of these

persons and vessels and to facilitate

compliance with the applicable

prohibitions on dealing in property in

which these persons have an interest.

EFFECTIVE DATE: June 26, 1996.

FOR FURTHER INFORMATION CONTACT:

Chief, International Programs, tel.: 202/

622–2420, or Chief Counsel, tel.: 202/

622–2410, Office of Foreign Assets

Control, Department of the Treasury,

Washington, D.C. 20220.

SUPPLEMENTARY INFORMATION:

Electronic and Facsimile Availability

This document is available as an

electronic file on The Federal Bulletin

Board the day of publication in the

Federal Register. By modem, dial 202/

512–1387 and type ‘‘/GO FAC,’’ or call

202/512–1530 for disk or paper copies.

This file is available for downloading

without charge in WordPerfect 5.1,

ASCII, and Adobe AcrobatTM readable

(*.PDF) formats. For Internet access, the

address for use with the World Wide

Web (Home Page), Telnet, or FTP

protocol is: fedbbs.access.gpo.gov. The

document is also accessible for

downloading in ASCII format without

charge from Treasury’s Electronic

Library (‘‘TEL’’) in the ‘‘Business, Trade

and Labor Mall’’ of the FedWorld

bulletin board. By modem, dial 703/

321–3339, and select the appropriate

self–expanding file in TEL. For Internet

access, use one of the following

protocols: Telnet = fedworld.gov

(192.239.93.3); World Wide Web (Home

Page) = http://www.fedworld.gov; FTP

= ftp.fedworld.gov (192.239.92.205).

Additional information concerning the

programs of the Office of Foreign Assets

Control is available for downloading

from the Office’s Internet Home Page:

http://www.ustreas.gov/treasury/

services/fac/fac.html, or in fax form

through the Office’s 24–hour fax–on–

demand service: call 202/622–0077

using a fax machine, fax modem, or

touch tone telephone.

Background

The Office of Foreign Assets Control

(‘‘OFAC’’) is creating three new

appendices (the ‘‘Appendices’’) to 31

CFR chapter V that contain lists of

individuals and entities that the

Director of OFAC has determined to be

either blocked persons, specially

designated nationals (‘‘SDNs’’),

specially designated terrorists (‘‘SDTs’’),

or specially designated narcotics

traffickers (‘‘SDNTs’’), as well as vessels

that have been determined to be the

property of a blocked person or SDN

(‘‘blocked vessels’’). This final rule

supersedes the comprehensive list

published as a Notice in the Federal

Register on November 17, 1994, (59 FR

59460) (as amended in 59 FR 61656,

December 1, 1994) and removes

appendices now contained in the

Libyan Sanctions Regulations (31 CFR

part 550) and the Iraqi Sanctions

Regulations (31 CFR part 575) and

consolidates them with additional

information concerning other sanctions

programs administered by OFAC in

three new Appendices located at the

end of 31 CFR chapter V. References to

the Appendices are added to existing

regulatory sections in chapter V to

which they apply.

Appendix A to 31 CFR chapter V

contains blocked persons, SDNs, SDTs

and SDNTs, arranged alphabetically.

Appendix B to 31 CFR chapter V

contains blocked persons, SDNs, SDTs

and SDNTs arranged alphabetically by

country of location, where their location

is known, and alphabetically where no

location is known. Appendix C to 31

CFR chapter V contains blocked vessels

arranged alphabetically.

Appendices A and B contain the

names of blocked persons and SDNs

that the Director of OFAC has

determined, as of June 25, 1996, to be

(1) organized or located in a country

subject to economic sanctions, (2)

owned and controlled by entities that

are organized or located in a country

subject to economic sanctions, or (3)

owned or controlled by, or acting or

purporting to act directly or indirectly

on behalf of, the government or the de

facto regime of a country subject to

economic sanctions. The listed specially

designated nationals and blocked

persons relate to sanctions imposed

against Cuba, the Bosnian Serbs, the

Federal Republic of Yugoslavia (Serbia