[Federal Register Volume 61, Number 123 (Tuesday, June 25, 1996)]
[Rules and Regulations]
[Pages 32653-32654]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-15829]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8676]
RIN 1545-AT14


Modifications of Bad Debts and Dealer Assignments of Notional 
Principal Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations relating to the 
allowance of a deduction for a partially worthless debt when the terms 
of a debt instrument have been modified. The temporary regulations 
provide guidance to certain taxpayers that modify the terms of a debt 
instrument after deducting an amount for partial worthlessness. This 
document also contains temporary regulations relating to certain 
assignments of notional principal contracts by dealers in those 
contracts. The temporary regulations provide guidance to taxpayers 
relating to consequences of these assignments. The text of these 
temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking on this 
subject in the Proposed Rules section of this issue of the Federal 
Register.

DATES: These regulations are effective September 23, 1996.

FOR FURTHER INFORMATION CONTACT: Concerning the modifications of bad 
debts, Craig R. Wojay, Office of Assistant Chief Counsel (Financial 
Institutions and Products), (202) 622-3920 (not a toll-free number), 
and concerning dealer assignments of notional principal contracts, 
Thomas J. Kelly, Office of the Assistant Chief Counsel (Financial 
Institutions and Products), (202) 622- 3940 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On December 2, 1992, the IRS published in the Federal Register (57 
FR 57034) a notice of proposed rulemaking that set forth proposed 
income tax regulations (26 CFR part 1) under section 1001 of the 
Internal Revenue Code (Code). Under Sec. 1.1001-3(a) of the proposed 
regulations, a significant modification of a debt instrument is deemed 
to result in an exchange of the original debt instrument for a modified 
instrument that differs materially either in kind or in extent. This 
rule is retained in the final regulations under Sec. 1.1001-3, 
published in the Rules and Regulations section of this issue of the 
Federal Register. Thus, when a debt is significantly modified, a 
taxpayer (holder) is required to recognize gain or loss based on the 
difference between the issue price of the significantly modified debt 
and the taxpayer's adjusted issue price in the original instrument.
    Prior to finalizing the Sec. 1.1001-3 regulations, the IRS and 
Treasury received comments that gain recognized as the result of a 
significant modification of a debt instrument often is attributable to 
the fact that the taxpayer previously claimed a deduction for partial 
worthlessness with respect to the debt. According to the commentators, 
the modification does not alter the fact that a portion of the debt 
remains uncollectible. Thus, the commentators suggested that, in this 
situation, a taxpayer should be permitted to offset the gain with a 
corresponding bad debt deduction.
    The IRS and Treasury also received comments that the assignment by 
a dealer in notional principal contracts of its position in a contract 
to another dealer should not result in a deemed exchange under section 
1001. Although the dealer will recognize gain or loss on the 
disposition of its position, treating the transaction as a deemed 
exchange would force the counterparty to realize the gain or loss on 
the contract even though the counterparty is maintaining its position. 
The commentators argued that dealer-to-dealer assignments are a common 
business practice and that these assignments have relatively little 
significance to the dealers' counterparties.

Explanation of Provisions

    Section 166(a)(2) and Sec. 1.166-3(a) provide that a deduction for 
a partially worthless debt is allowed only to the extent the debt is 
charged off in the taxable year. The charge-off requirement is also 
contained in Sec. 1.166-2(d) (1) and (3), which provides for a 
conclusive presumption of worthlessness under certain circumstances.
    In general, the amount of a deduction on account of partial 
worthlessness is the amount by which the adjusted basis of a debt (as 
determined under section 1011) exceeds the amount recoverable on the 
debt. The amount of the deduction, however, may not exceed the amount 
charged off during the taxable year. The charge-off requirement is 
satisfied for a debt when a portion of the debt is removed from a 
taxpayer's books and records. This generally is accomplished by 
reducing the debt's book basis. Thus, when an amount has been deducted 
for partial worthlessness, there is generally a reduction of both the 
book basis and tax basis of a debt.
    When a taxpayer is required to recognize gain under section 1001 
because of a modification of a debt instrument, the taxpayer's tax 
basis in the debt is increased by the amount of gain recognized. 
Commentators on the proposed Sec. 1.1001-3 regulations have indicated, 
however, that regulatory and general accounting principles generally 
would not permit a corresponding increase in the book basis of the 
debt. Because the prior charge-off is not restored (that is, the book 
basis of the debt is not increased), there is no opportunity for the 
taxpayer to take a new charge-off for pre-existing worthlessness. Thus, 
the charge-off requirement of section 166(a)(2) can never be satisfied 
with respect to the amount by which the debt's tax basis exceeds its 
book basis as a result of the modification, and the excess would not be 
allowed as a deduction until the debt becomes totally worthless.
    The temporary regulations contained in this document set forth 
limited circumstances under which a taxpayer will be permitted to 
deduct an amount on account of a partially worthless debt

[[Page 32654]]

even though no amount has been charged off within the taxable year. The 
purpose of these temporary regulations is to preserve the portion of a 
taxpayer's bad debt deduction with respect to a partially worthless 
debt that corresponds to the amount the taxpayer would have been 
entitled to deduct for partial worthlessness with respect to the 
modified debt if the book basis of the modified debt were increased to 
the same extent as the tax basis of that debt. Thus, these temporary 
regulations apply only if all of the following conditions are 
satisfied. First, a significant modification of a debt instrument 
(within the meaning of Sec. 1.1001-3) must result in a taxpayer's 
recognition of gain under Sec. 1.1001-1(a). In addition, the debt must 
have been previously charged off and deducted by the taxpayer, and the 
prior charge-off and deduction must have satisfied the requirements of 
Sec. 1.166-3(a)(1) and (2). If these conditions are satisfied, then a 
modified debt is deemed to have been charged off in the year in which 
gain is recognized. The amount of the charge-off, however, is limited 
to the difference between the tax basis of the debt and the greater of 
the book basis or the fair market value of the debt.
    Both the proposed and the final regulations under Sec. 1.1001-3 
deal only with modifications of debt instruments. In response to 
comments on the proposed regulations, however, the temporary 
regulations contained in this document provide a limited rule dealing 
with a dealer's assignment of its position in an interest rate or 
commodity swap, or other notional principal contract to another dealer. 
If the assignment is permitted by the terms of the contract, the 
assignment will not be treated as a deemed exchange by the nonassigning 
party of the original contract for a new contract that differs 
materially either in kind or in extent. Thus, an assignment to which 
the rule applies does not trigger gain or loss to the dealer's 
counterparty. No inference is intended with respect to whether an 
assignment of rights by one party to other types of bilateral contracts 
results in an exchange or other disposition under section 1001 by the 
nonassigning party.

Effective Dates

    The temporary regulations apply to significant modifications of 
debt instruments and assignments of interest rate swaps, commodity 
swaps, and other notional principal contracts occurring on or after 
September 23, 1996.

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, 
these temporary regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of the regulations concerning the modification 
of bad debts is Craig R. Wojay, Office of the Assistant Chief Counsel 
(Financial Institutions and Products), IRS. The principal author of the 
regulations concerning the dealer assignments of certain notional 
principal contracts is Thomas J. Kelly, Office of the Assistant Chief 
Counsel (Financial Institutions and Products), IRS. However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.166-3T is added to read as follows:


Sec. 1.166-3T  Partial or total worthlessness (temporary).

    (a)(1) and (2) [Reserved]. For guidance, see Sec. 1.166- 3(a)(1) 
and (2).
    (3) Significantly modified debt--(i) Deemed charge-off. If a 
significant modification of a debt instrument (within the meaning of 
Sec. 1.1001-3) during a taxable year results in the recognition of gain 
by a taxpayer under Sec. 1.1001-1(a), and if the requirements of 
paragraph (a)(3)(ii) of this section are met, there is a deemed charge-
off of the debt during that taxable year in the amount specified in 
paragraph (a)(3)(iii) of this section.
    (ii) Requirements for deemed charge-off. A debt is deemed to have 
been charged off only if--
    (A) The taxpayer (or, in the case of a debt that constitutes 
transferred basis property within the meaning of section 7701(a)(43), a 
transferor taxpayer) has claimed a deduction for partial worthlessness 
of the debt in any prior taxable year; and
    (B) Each prior charge-off and deduction for partial worthlessness 
satisfied the requirements of paragraphs (a)(1) and (2) of this 
section.
    (iii) Amount of deemed charge-off. The amount of the deemed charge-
off, if any, is the amount by which the tax basis of the debt exceeds 
the greater of the fair market value of the debt or the amount of the 
debt recorded on the taxpayer's books and records reduced as 
appropriate for a specific allowance for loan losses. The amount of the 
deemed charge-off, however, may not exceed the amount of recognized 
gain described in paragraph (a)(3)(i) of this section.
    (iv) Effective date. This paragraph (a)(3) is effective September 
23, 1996.
    (b) [Reserved]. For further guidance, see Sec. 1.166-3(b).
    Par. 3. Section 1.1001-4T is added to read as follows:


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

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

    Approved: May 31, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-15829 Filed 6-24-96; 8:45 am]
BILLING CODE 4830-01-P